Risk is inherent to all financial transactions, and its assessment occupies whole departments at large financial institutions. Energy efficiency finance is no exception, but along with an overall lack of standardised terms and contractual agreements, there is also no generally accepted way of discussing, analysing, and potentially mitigating specific risk types in this sector.
The lack of an agreed methodological structure of risk assessment causes many projects to fail, as it leads to agonizing discussions and increases due diligence costs and processing times unnecessarily. Getting a common understanding right from the start on all the key risk areas would help to avoid lost time, should the risk profile not match the investors’ expectations.
The LAUNCH partners are developing standardised tools and benchmarks to support risk assessment, helping contractors “getting it right the first time” as well as allowing investors to use a common methodology, the same benchmarks and set of risk types.
In our latest webinar, organized in collaboration with the Marketplace of the European Innovation Partnership on Smart Cities and Communities (EIP-SCC), we explained how the LAUNCH Risk Assessment Protocol can facilitate project finance and the important role it plays for a bank when evaluating the bankability of a project.
The LAUNCH Risk Assessment methodology aims to overcome the asymmetric information barrier[1] that often prevents successful third-party financing. It does this by simplifying and unifying the understanding of the risks investors consider in their evaluation process towards project finance. In order to do this, the protocol introduces and discusses each of these risks with their relevance, responsibilities, and potential mitigation measures.
In this article, we will highlight three key risk types that project developers should focus on to gain investors’ trust.
Performance risk
This risk includes poor or faulty design, flaws in the implementation of energy efficiency measures, mistakes in the operation of the measures and fluctuation of usage patterns, including change of user behaviour.
Design risks concern the failure of the energy modelling and engineering design to accurately predict the energy savings, in addition to the poor selection of energy efficiency measures. This type of failure may come about for several reasons and might be difficult to establish unless it involves a clear mathematical error or obvious misspecification. When the actual energy performance does not match the designed performance in buildings, there is a performance gap.
To mitigate this risk, the LAUNCH Standardised Service Agreement includes a dedicated section that helps both project developers and investors identify the assigned responsibility for each party. This helps to set transparent and clear roles from the beginning of the relationship and avoids misleading behaviour during project roll-out.
Credit risk
Credit risk is the cornerstone in the assessment of the likelihood of timely and sufficient cash flows as well as potential default rates. It generally refers to the possibility of loss for a creditor due to failure by a debtor or borrower to pay back interest and/or principal amounts of debt.
The particular role of this risk is largely influenced by all the other risks usually considered in the process, like the performance risk mentioned above. For example, when the project developer guarantees certain performance levels, underperformance will directly impact the developer’s financials.
With the purpose of supporting project developers to prepare for the credit risk assessment that will be performed by investors, the LAUNCH Risk Assessment Protocol includes a simplified rating methodology. By analysing specific indicators – such as liquidity, profitability, solvency – ESCOs can identify their own and – more importantly – their clients’ “scores” on this risk.
It is important to keep in mind that this analysis is only part of the assessment conducted by the investors that, usually, run preliminary checks on the credit quality and good standing of the company. Preliminary checks also include considerations on the earnings consistency and quality, leverage position, management experience and qualitative aspects of the business model.
ESG risk
The ESG risk for investors is strongly connected to responsibilities arising from investing in companies and projects that could lead to adverse environmental, social and governance issues.
Environment, social and governance factors should be subjected to specific investment evaluation so that risks related to human rights, climate change and transparency towards investors become an integral part of the due diligence process.
The recent interest of financial markets towards ESG criteria and its application proves that the connection between ESG indicators and the risks related to investment is becoming more and more relevant. In turn, companies need to adapt and expand their corporate disclosures to meet the demand among investors increasingly looking for stable and secure returns in a constantly evolving risk environment.
In order to reduce ESG risks for investors, companies need to disclose how ESG issues impact their corporate performance and how their core business, in turn, could impact ESG factors. When assessing the suitability of an investment, the application of ESG criteria allows investors to take a 360-degree view, leading to mitigation of risks connected to the investment, and allowing companies to increase the level of access to capital at a lower cost.
As the Risk Assessment Protocol is designed to support investors in their financial analysis, the LAUNCH consortium decided to integrate ESG-related information in it as a separate risk category, allowing companies to meet the specific requirements connected to ESG principles.
If you are interested in a more in-depth analysis of this topic, you can download the first draft of the LAUNCH Risk Assessment Protocol here. This version has already been revised by a group of investors and project developers and will be further improved in the coming months.
[1] “Asymmetric information, also known as "information failure," occurs when one party to an economic transaction possesses greater material knowledge than the other party.” (Investopedia)
