Investment in mini-grids is on the rise, but the burgeoning space risks falling victim to the same issues that plagued early investments in the broader cleantech sector.
BENJAMIN ATTIA AND JUSTIN GUAY | JUNE 06, 2018
Remote mini-grids are finally starting to get the attention they deserve as a fundamental building block in efforts to deliver clean, reliable, and affordable electricity to customers beyond the grid's reach.
As early-stage private investment begins to flow into the space, investors need to sidestep the inevitable hype and disappointment cycle, and realign their expectations to see mini-grids for what they really are: long-term infrastructure projects.
In sub-Saharan Africa, mini-grids have been on the receiving end of over $250 million in committed public debt, set to leverage over $4 billion in total investment. Most of this money has come from the Green Climate Fund and the African Development Bank. In September 2016, Deutsche Bank launched its Universal Green Energy Access Program through the Green Climate Fund, which seeks to mobilize $3.5 billion in debt finance by 2030, including building over 10,000 solar mini-grids across the region.
In subsequent months, the African Development Bank (ADB) led funding rounds and partnerships totaling over $160 million committed to mini-grid focused energy access efforts, through an alphabet soup of programs: the Sustainable Energy Fund for Africa, the Green Mini-Grid Market Development Programme, and the Facility for Energy Inclusion Off-Grid Energy Access Fund. Finally, the ADB’s New Deal on Energy for Africa targets billions more towards 75 million new off-grid connections by 2025.
But it’s not just public money getting into the game. While there has not been significant interest from private investors in the past (with less than $100 million in total corporate-level investment over the last five years), there are now promising new attempts to attract private investment including the Facebook-seeded Microgrid Investment Accelerator. The MIA is the first attempt at an investment vehicle focused on deploying private investment exclusively into the mini-grid project pipeline.
MIA plans to leverage $50 million from early investors with a goal of mobilizing $115 million of long-term debt by 2023. And it's not alone. Husk Power Systems recently raised $20 million from Shell Technology Ventures for mini-grids in sub-Saharan Africa, while OMC has struck a strategic partnership with Mitsui for projects in India. A litany of unconventional investors have been making strategic investments into various segments of the off-grid space, with varying motives.
There’s suddenly a lot of attention and money focused on mini-grid investment.
Looming riskOn its face, this is a great thing. Without mini-grids, universal energy access simply won’t happen. In fact, recent analysis from CrossBoundary suggests that mini-grids are the cheapest solution for 100 million people across sub-Saharan Africa today. Participation from multilateral development banks, technical assistance programs, and embryonic private investment has helped kick-start a market that could make good on this promise.
However, if return expectations are not quickly realigned, these resources will struggle to find a bankable project pipeline. The reality is that without well-targeted interventions, there is an outsized risk that this capital won’t be deployed, or worse — that it will be sunk into poorly developed projects that never see the sun. That would be a tremendous waste of opportunity.
Fortunately, we've seen this movie before and we can learn from it. Back in 2009, an overheated venture capital scene led to an investment boom in upstream clean energy startups that saw $25 billion in capital deployed into the sector between 2006 and 2011, over half of which they never got back. The number of new cleantech startups, the number and volume of tickets, and the sector's share of total VC investment all plummeted.
The resulting destruction of value was so spectacular it had VCs saying they wouldn't touch the sector with a 10-foot pole. Cleantech became a Silicon Valley pariah.
It was a classic case of mismatched expectations. The inherent risk/return profile of the sector simply did not match the expectations and appetite of VCs. Clearly, the mini-grid market is nowhere near as hyped, with much less total money at stake. But, like VC cleantech 1.0, we do see a brewing incongruity between investor expectations and the realities of the mini-grid market today. It just cannot afford a similar backlash to take place that could detract from broader energy access efforts and stall the sector’s growth for years.
Here are four guiding ideas to ensure that the mini-grid space doesn't suffer this fate.
1. Align return expectations appropriately for infrastructure tenors and returns First things first. Investors need to see mini-grids for what they are: infrastructure.
That’s why financing mini-grids in emerging economies is challenging. Currently, most private mini-grid projects require long-term funding (10 to 15 years) with a low cost of capital to be feasible. Local banks in developing countries are often reluctant or unable to offer long-term loans, either because they lack funds or can’t risk losses due to high or uncertain inflation. In many emerging economies, interest rates for commercial loans may exceed 15 percent and have high collateral requirements. And because the market is still budding, returns vary wildly and business models are still being proven out. Eventually, they are probably going to settle near infrastructure-grade returns.
Today, those base conditions are exacerbated by prohibitively high costs of financing that can add on average roughly USD $0.50-$1.00 per kWh. In East Africa, for instance, commercial banks can require up to 40 percent of capex upfront for long-tenor, non-recourse project financing, for which interest rates can be as high as 20 percent. To date, most mini-grids have relied completely on equity or grant financing rather than commercial debt, stunting market growth by tying up developer capital in mini-grid assets with long payback periods.
2. Invest at an earlier stage in pipeline developmentMost of the investment being marshaled today is focused on bankable projects that have already been developed to the point they can take on project-level debt. Getting to that point requires significant amounts of sweat equity and high-risk capital to produce high-quality projects. One of the problems is that nobody "owns" this task today. As a result, there is a lack of a large, high-quality pipeline, which will make it difficult for those seeking risk-adjusted returns from mini-grid projects to deploy their capital.
However, strategic interventions today focused on early-stage project development will not only develop a more robust pipeline, but they will also be highly leveraged given the capital waiting at the end of the project development cycle. Those are excellent internal performance indicators for development banks and foundations looking to build a market — and a mini-grid hero in the making.
Good examples of such efforts include the Africa Clean Energy Finance and India Clean Energy Finance programs, associated with the U.S. Overseas Private Investment Corporation, both of which provide early-stage project preparation support. That support has proved that significant leverage on modest investments is possible — ACEF mobilizes $54 in investment for every $1 in program funds — and helps drive a pipeline of bankable projects.
To address this problem, financial intermediaries also structure blended finance funds, which allows first-loss "junior" capital from non-commercial investors like Facebook to hold a portion of upfront risks, and even use returns to hedge risk on future funds. This allows commercial investors to invest with more market-favorable terms, and creates a multiplier effect that has opened the door to hundreds of millions in investment in the energy access sector as a whole.
3. Be patientThis market development will take time. Not only do investors need to align their return expectations with what the market is currently producing, they also need to recognize that because these are ultimately public infrastructure projects, tenors need to be significantly longer than other off-grid market segments (i.e., two- to three-year solar home system loans).
Beyond extended loan tenors, developers are still gaining experience and descending the learning curve and, in some cases, operating without competition as new entrants are still pouring in. We can glimpse the beginnings of a robust ecosystem, but truly competitive players know the private market is just starting to heat up.
As a result, at this early stage, public first-loss financing will likely continue to be necessary in most geographies in the short term, at least until commercial viability is proven. Patient equity from development finance institutions with below-market-rate returns is also needed, and in contrast to pure grant financing, patient equity can be invested in a way that corresponds with mini-grid timelines and returns, while supporting progress toward commercial viability. Venture debt from development finance institutions can also serve a similar purpose.
4. Standardized, utility-led competitive reverse auctions One of the most powerful lessons in recent cleantech history has been the ability of competitive reverse auctions to drive down prices and scale up new markets. Forthcoming work from GTM Research shows that these programs are more successful when auctions are transparent and regularly cadenced because they allow developers to plan up the supply chain and increase serious competition.
Utilities developing regulatory policies for distributed energy service companies should embrace auctions and their ability to target procurement and drive down costs as part of an integrated electrification plan. Combined with a set of standardized specifications, transparent, national-level competitive reverse auctions could drive a quicker scale-up of the private market and allow large financiers with large ticket thresholds to participate more easily.
They could also pool initial diligence and site screening and define a clear tariff structure, ensuring cost-reflective tariff-setting. In the near term, these programs must reflect current market realities, and could focus on results-based financing of standalone pilot auctions with long contract tenures (10+ years), provide viability gap funding for cost-reflective tariffs, or incentivize developers to offer other value-add services like productive use appliances, cold chain applications, or transactive energy systems.
Ultimately, none of this undermines the case for mini-grids — it just undermines the case for risk-adjusted returns in emerging markets without adequate public de-risking (also known as subsidies). It is largely accepted that the mini-grid sector is still incipient and unproven, but holds tremendous promise as it quickly matures. Investors moving into the space would be wise to realign their expectations, so the mini-grid market can be more than a bad sequel of cleantech 1.0’s VC failures.
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