Green capex lending faces up to the reality of an energy crisis

The structural capital expenditure needs of corporates are undergoing rapid change, as firms rush to exploit investors’ seemingly insatiable appetite for cleaner assets. However, uncertainties around stranded assets and returns on investment are now top of mind for those lenders as the global energy crisis drives up input costs.

The International Energy Agency projects that transition-related investments must reach $4 trillion annually by 2030 to meet net-zero targets under the Network for Greening the Financial System 1.5-degree scenario; while a recent McKinsey report puts average annual spending on physical assets at $9.2 trillion a year by 2050.

Much of this spending will be driven by corporates’ evolving infrastructure and technology needs.

Goldman Sachs expects primary energy capex to grow 60% by 2025 to $1.4 trillion, according to a recent Carbonomics report. The firm suggests that European leaders’ interest in energy security will drive renewable power and network infrastructure capex upwards, but that it will also revive capex growth in traditional energy sectors like natural gas.

“A major acceleration is required, as low carbon energy technologies require two to three times the capex per unit of output energy compared to the hydrocarbons they displace” the report states.

For head of commodity equity research at Goldman Sachs, Michele DellaVigna, decarbonization and energy availability and affordability go hand in hand.

“In Europe, the higher oil and gas prices are actually accelerating the low carbon economy by making alternatives relatively more attractive, especially green hydrogen” he explains.

This goes beyond the energy sector, however. Across global markets, companies with high energy consumption or highly polluting processes will be eager to decarbonize and reduce their energy use.

“We expect quite a sizeable acceleration in terms of the borrowing needs of companies,” says Societe Generale’s head of emerging markets and credit research, Guy Stear.

The bank has been quantifying the amount of capital that companies will have to invest in their green transition based on MSCI’s implied temperature rise metric and sees an opportunity to grow its asset base and invest in dynamic markets.

However, this green capex surge has been impacted as businesses become increasingly cautious given production cost inflation and supply chain uncertainties following the outbreak of war in Ukraine.

“Most companies that are trying to build out green infrastructure now are faced with cost inflation and keep having to update expenditure plans,” points out Paul O’Connor, JPMorgan’s head of environmental, social and governance (ESG) debt capital markets in Europe, Middle East and Africa.

Increased production, labour, shipping and commodity costs are affecting corporates’ profit margins and driving cash flow volatility. If costs of production continue to increase in the short term and total revenues are threatened, smaller corporates will not prioritize long-term restructuring plans.

Therefore, if the negative impact of the energy crisis on corporate revenue growth continues, it will make it more difficult to find green capex opportunities, especially if balance sheets are being targeted at existing operational costs.

Even for companies choosing to invest in green capex, banks face a difficult challenge when it comes to assessing creditworthiness and conducting risk assessments.

Not only are the credit profiles of green projects affected by the rise of input costs but lenders also need to take into account that much of the capex spend will need to be allocated to research and development rather than operations.

Much of the technology needed for transition is still maturing. For EY’s sustainability and ESG solutions leader and partner Will Rhode, this makes it difficult for banks to justify lending, as returns on investment are less certain.

“If an energy company wants to diversify its energy mix by creating an alternative business, a lot of the initial capex will go into figuring out how to make the facility viable. It’s difficult to assess the level of risk of this type of lending,” he says.

An investment rush into green capex would also impact the debt-to-equity ratios of corporates, especially given rising capital costs in power generation and end-use sectors. Increasing the debt burden of highly polluting and energy-intensive sectors will be risky if revenues stall.

“It comes down to whether you make your debt repayments based on the revenues that you are generating from the project. Higher input costs mean available revenues to pay off the debt could be affected,” adds O’Connor.

Uncertainties around capex lending could also leave banks with a higher exposure to defaults given Europe’s geopolitical challenges. In a recent European bank lending economic forecast report, EY expects loan losses to rise to a five-year high of 3.9% in 2023.

“The rise in defaults sits against a backdrop of slowing lending growth, which is set to decelerate to 2.9% in 2023 as demand for lending post-pandemic is suppressed by rising inflation and the financial impact of the war in Ukraine,” the firm notes.

The banking sector needs to step up on green capex lending, but it also needs to be acutely aware of the risks involved.

There is an added cost benefit to green capex if overall energy consumption is reduced in the long term given the rising price of energy. Companies that can quickly demonstrate the motivation and capacity to decarbonize will attract investor interest, reducing the overall cost of capital.

“We’re starting from a comfortable position because we’ve had constant deleveraging for the last seven quarters,” argues Stear, pointing to the good health of lenders’ balance sheets.

Ultimately, it’ll come down to whether the incentive to achieve net-zero targets outweighs the risks and whether banks can find new ways to make green capex more palatable from a lending perspective during an energy crisis.