Balancing financial risk and innovation in energy transition projects
As the world strives towards a sustainable future, innovation and new technology play a crucial role in the energy transition. However, the financial risk associated with untested technologies often becomes a stumbling block for proposed projects. The need for developing, testing, and scaling new technologies and processes in the energy sector is immense, with trillions of dollars required for green projects. While traditional construction and engineering projects involve familiar elements, there is a growing reliance on new and unproven technologies. This introduces technology risk, necessitating appropriate risk allocation and management among project stakeholders.
The Impact of Funding Sources on Risk Allocation
The source of funding for energy transition projects significantly influences the allocation of risk. Different funding sources, such as banks, government funding, and private equity, have varying risk appetites and compensation preferences. For example, investment funds and pension funds are generally averse to technology risks, while banks are even less inclined to take on such risks. On the other hand, ownership of new technologies can be valuable and a potential source of revenue, making it a key factor in managing risks.
The Role of Engineering, Procurement, and Construction (EPC) Contracts
Banks providing non-recourse project funding often prefer to mitigate technology risks by incorporating them into EPC contracts. These contracts ensure that all project risks, including technology risk, are bundled together. By doing so, banks can secure debt service for the financed project, offering a higher level of certainty to start commercial operations on time and within the agreed budget. However, this approach places a significant burden on contractors, who must assume unknown risks, potentially leading to cost overruns and delays.
The Dangers of the EPC Model
The EPC model, while effective for standard projects with quantifiable risks, may not be suitable for projects involving new technologies. Contractors may demand higher prices to compensate for the additional risk, which could ultimately be passed on to consumers. Smaller contractors lacking the resources to take on such risks may choose not to bid on projects, further increasing prices. In some cases, projects lacking an obvious main contractor may struggle to attract project financing. If technology risks become too great, contractors may face insolvency, resulting in supply chain disruptions.
Aligning Interests through Contractor Equity
When contractors are unwilling or unable to guarantee project delivery on time and within budget, providing them with a stake in the equity can align their interests with project sponsors. This approach ensures that the contractor has a vested interest in the project’s success and manages technology risk through a combination of supply agreements and shareholders’ agreements. Contractors receive consideration under the supply agreement and earn a revenue stream once the project becomes profitable. However, debates arise regarding whether contractors should be allowed to sell down their stake, depending on their role in operations and maintenance.
The EPCm Model for Complex Projects
In cases where there is no clear main contractor, the technology provider may act as an EPCm consultant, coordinating various project contractors without assuming responsibility for on-time and on-budget completion. The fees for the EPCm contractor often include a contingent element to incentivize performance and distribute risks among different contractors, reducing the likelihood of one contractor taking on excessive or unmanageable risks.
Conclusion:
Allocating risk in energy transition projects involving new technology is a complex challenge. The choice of contractual structures, such as EPC contracts or EPCm models, depends on project and financing requirements. Innovators and technology providers can also explore technical certifications or insurance solutions to mitigate risks. Initiatives like the Net Zero Technology Centre and ORE Catapult provide support to innovators, driving early success for innovative projects. However, bridging the gap from early-stage projects to large-scale investment requires further solutions to facilitate innovation and ensure uninterrupted progress in the energy transition.
Leave a Reply