We shouldn’t underestimate Solvency II


September 12, 2014

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I am slow to agree that Solvency II cannot matter much to the outlook for renewables and infrastructure in general. Here is why.

Institutional money — pensions, insurers, sovereign wealth funds — provides deep pools of capital that get deployed across all asset classes. These guys make the world go round. They have been investing in renewables from the outset through intermediate vehicles, such as utilities, private equity funds or infrastructure funds, who invest in renewables energy projects. They also invest in banks that in turn lend to renewables projects.

These institutions are coming to better understand the renewables sector, and removing intermediate layers of investment vehicles to get closer to the generation assets and cash flows generated by them. This is to remove the fees associated with intermediaries and better fine-tune their portfolios by taking direct control of the assets they want to invest in. They are also encroaching on the senior debt role played by project finance banks, thereby replacing some of the lending capacity that disappeared with the financial crisis.

The industry has long talked about using project finance senior debt to get things built with a flip to the capital markets for the long-term operational phase. It is a good solution. But it looks like that could be stopped in its tracks by a wrongly designed Solvency II.

The use of project finance for the long-term operational phase would be less efficient than direct institutional funding, and result in higher delivered electricity costs. Forty-two percent of life and general insurance assets were in fixed income in 2012. Funds allocated to that bucket could be invested in renewables to capture the lowest risk operational cash flows directly rather than being intermediated through banks. It would be bad if this development was throttled in its infancy.

For equity, things may be more bleak. If insurers are not to be allowed to invest directly in the equity of infrastructure projects, without capital reserving requirements that undermine the economics of investing, then does this mean intermediate vehicles need to be put in place — or returned to, having been abandoned? Do we have investing expenses that deliver a higher cost of using infrastructure and poorer standard of living for pensioners who, in due course, have to live off the returns on their invested pensions?

But Solvency II cannot offer much protection from the perceived perils of infrastructure (that necessitates the high capital reserving against such investments) if its strictures do not require a look through any intermediate vehicle to the cash flows of the underlying assets and interpret the capital reserving requirement on that basis. Otherwise we have a regulatory arbitrage that says investing directly in a road is high risk but in a publicly quoted share in a company that owns the road is lower risk. This will encourage the type of egregious behaviour that caused the crash, which Solvency II is meant to protect us from.

It is unwelcome that current trends that suit the pools of capital and the project sponsors, and deliver efficiencies to electricity consumers through lower cost of capital in a capital-intensive industry, would be stymied by an unintended consequence of new rules. These trends in funding are emerging, and their full force is not yet in view, so it may serve to understate the significance of Solvency II stopping them in their tracks.

This is not just about marginal projects losing out. Rather, it is about whether the sources who have been investing in infrastructure and renewables can still come out to play; or, if so, only on terms that re-introduce inefficiencies by way of fees for multiple intermediary layers that put enough space between the assets and the investors to overwhelm or spuriously comply with ‘protections’ of Solvency II.

The irony is there is overlap between customers of these insurers – households, drivers, pensioners – and the end users of infrastructure and electricity users. They are by and large the same. Efficiency of investment makes us all double winners.

But we will be double losers in our joint capacity if Solvency II does not get a reality check. And who is the winner? The usual advice is: ‘Follow the money’.

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