The World's #1 Renewable Energy Network for News, Information, and Companies.
Untitled Document

Should Renewable Energy Be Afraid of Basel III Banking Standards?

The Basel III Accords, the latest set of international banking standards from the Basel Committee on Banking and Supervision, are set to take effect in just a few short months. This new banking regime was designed to create a more resilient and robust international banking system with a suite of capital adequacy, leverage, and liquidity requirements. Basel III will have impacts across the broader commercial lending market, though the renewable energy (RE) sector, with its heavy reliance on project finance, will be particularly vulnerable to the new liquidity standards.

The general thrust of these standards is to ensure that banks withhold sufficient levels of high quality, stable, and unencumbered assets throughout all of their activities so that they may better weather both short-term and long-term periods of stress. Regulating liquidity is a new feature of the Basel regime (neither Basel I nor II included any liquidity provisions), and it is expected to complicate the economics of certain types of lending. Project finance loans—which are characterized by long tenors (from 10 years up to 40 years in some cases) and are serviced by income-generating assets that may not have a ready secondary market during an economic shock — comprise one such type.

There are two Basel III provisions that address banks' liquidity stores: the Liquidity Coverage Ratio and the Net Stable Funding Requirement. The combined effect of these rules will likely foreshorten loan tenors and raise interest rates in the project — and by extension RE — finance market. To understand how, let's take a look at each provision individually.

The Liquidity Coverage Ratio (LCR) is designed as a short-term protection and requires banks to maintain a proportion of "high quality liquid assets" (such as cash and central bank reserves) to capital outflows (for example, drawdowns on loans) over a period of 30 days. This provision will affect all commercial loans, though there is an additional requirement that banks hold 100% liquidity cover against loans made to special purpose vehicles, which will hit RE projects particularly hard. (These kinds of vehicles are universally employed in non-recourse project financing, though they are more commonly referred to as "project entities" or "project companies.") Requiring 100% cover for RE loans represents a heightened risk for banks, and lenders will likely raise interest rates in response — though by how much remains anyone's guess.

Additionally, the LCR allows national regulators to specify their own liquidity requirements on letters of credit — guarantee instruments issued by banks on behalf of the project entity and that are heavily utilized in the project finance marketplace. Raising the liquidity levels necessary to cover these guarantees could price them out of reach for some projects. This in turn may limit the project company's access to short-term funding options, putting it at greater risk of default. Higher default risk in the project finance markets could be another impetus for lenders to bump up interest rates.

The second liquidity provision, the Net Stable Funding Requirement (NSFR), compels banks to demonstrate stable funding (such as customer deposits and equity capital) over the long term (one year) in rough proportion to the liquidity profiles of its assets. For example, if a bank had a loan with a one-year maturity, it would need to maintain funding of at least that long to back the loan. Tying up capital to match liabilities for a 10- to 20-year period (which has until recently been the typical tenor range for RE projects) limits a bank's ability to "put its money to work" in the market and can act as a disincentive to longer-term lending. The market is already beginning to reflect this, and mini-perm project structures (5- to 10-year loans with built-in incentives to refinance afterward) have become more prevalent as a sort of stopgap.

Both the LCR and NSFR will likely create a contraction in the RE debt markets as several banks make their exit and as more capital is taken out of play to back existing loans. European banks have already sold over $11 billion of their project loan books off to U.S. and Japanese banks in preparation for the Basel III regime (implementation in Europe begins at the start of 2013 and will carry through until 2019), many taking a haircut in the transaction, according to Bloomberg New Energy Finance. It is worth bearing in mind that European banks have been the biggest players in RE project lending, both in the Euro zone and in the United States. A large pullout of these institutions—certainly because of stresses related to Basel III compliance, but also because of the general turmoil in the Euro zone — could put a significant squeeze on the availability of finance for RE projects in the near term.

The United States will also implement its own version of Basel III. The Federal Reserve board just recently voted 7-0 to do so, and the U.S. Federal Deposit Insurance Corporation followed up five days later with a 5-0 vote. The big ticket item of these agencies' proposals is the requirement that U.S. banks of all sizes must hold a minimum of 7% high-tier capital against total assets, to be phased in over seven years. The U.S. banking sector also has to adapt to the various provisions of the Dodd-Frank legislation which are slowly being phased-in. Many of these address some of Basel III's capital and liquidity requirements, while placing additional restraints on such practices as proprietary trading and swap dealing.

The looming storm clouds over the project finance markets is not without its silver lining however. Some analysts are expecting that, with a large bank pullout from the RE sector, developers will seek funding in the capital markets through instruments such as bond issuances. RE bonds could be regarded as short-term liquidity if they are of high enough quality, and thus would help banks to meet their required ratios under Basel III. Bloomberg New Energy Finance estimates that clean energy project bond issuance could grow from $2 billion annually today to $18 billion–$40 billion by 2020.

And, to be sure, Basel III represents a positive development in a financial system that is highly leveraged and had previously been trading in complex instruments of dubious value. There is still a great deal of uncertainty about how the effects of Basel III will play out after implementation, but the long-term necessity to stabilize our banks is hardly debatable. Even if the shock of implementation is considerable, innovation in the face of regulatory impositions has long been the modus operandi of the financial markets; surely we will see new structures and clever means of leveraging the rulebook in the coming years to get steel in the ground.

This article was originally published on NREL Renewable Energy Finance and was republished with permission.

Lead image: Caution sign via Shutterstock

Untitled Document

RELATED ARTICLES

Energy Storage and Geothermal Markets Look To Team Up in the Hunt for Lithium

Meg Cichon In today's fast-paced tech environment, no one can make a splash quite like Elon Musk. So when he decided to enter the energy storage game in 2014, he did it with gusto. Musk is now in the process of building what he coined...

Regional News from the July/August 2015 Digital Edition of Renewable Energy World

Renewable Energy World Editors EcoFasten Solar announced that it launched a new mounting "Rock-It System" that it would be displaying during Intersolar. Product compliance was determined through testing per UL Subject 2703, which reviews integr...

UK Government Proposes Solar and Biomass Subsidy Cuts

Alex Morales, Bloomberg The U.K. proposed to reduce support for the solar and biomass-power industries to help consumers who fund the subsidies through their energy bills. Ministers plan to end a government aid program for small solar projects a y...

Some Hope for US Renewable Energy Tax Credits As Extension Bill Passes Committee

Vince Font In a lopsided 23-3 vote, the U.S. Senate Finance Committee voted yesterday to extend a number of renewable energy production tax credits through the end of 2016. The vote allows developers of wind, geothermal, biomass, land...
Travis Lowder is an Energy Analyst with the National Renewable Energy Laboratory's Project Finance Team. His research encompasses the U.S. renewable energy project finance market and financial policy, PV project risk management, PV asset and cash ...

CURRENT MAGAZINE ISSUE

Volume 18, Issue 4
1507REW_C11

STAY CONNECTED

To register for our free
e-Newsletters, subscribe today:

SOCIAL ACTIVITY

Tweet the Editors! @megcichon @jennrunyon

FEATURED PARTNERS



EVENTS

Doing Business in South Africa – in partnership with GWEC, the Glob...

Wind Energy in South Africa has been expanding dramatically, growing fro...

Presenting at Infocast's Utility Scale Solar Summit 2015

Oct. 21, 2015 4:30-5:15pm Albie Fong, National Director, Solar Frontier ...

Utility Scale Solar Summit 2015

Oct. 21, 2015 4:30-5:15pm Albie Fong, National Director, Solar Frontier ...

COMPANY BLOGS

Behind Every Good Decision

When something about your business isn’t working, you set out to c...

Clean Energy Patents Maintain High Levels in First Quarter, Solar L...

U.S. patents for Clean Energy technologies from the first quarter of 201...

An Overwhelming Paradox

I’m sure we’re all very familiar with the feeling of being o...

NEWSLETTERS

Renewable Energy: Subscribe Now

Solar Energy: Subscribe Now

Wind Energy: Subscribe Now

Geothermal Energy: Subscribe Now

Bioenergy: Subscribe Now  

 

FEATURED PARTNERS