An article published recently on an international finance website drove home my suspicions about renewable energy project financing – that the potential providers of debt are not being treated with the appropriate respect.

The article asserted that the flow of institutional investor money into the renewable sector was being “stopped” by credit rating agencies. In essence, some industry players were saying that the rating agencies had a “lack of knowledge” and therefore were assigning ratings below investment grade (this means below the BBB category, where many institutional investors are generally reluctant to invest because of material default risk). They lamented that project sponsors were married to the banks because of this ineptitude.

Such statements smack of arrogance and do more than highlight a problem – they help to undermine the credibility of the industry. It would be concerning if project sponsors thought that debt investors should be queuing up to do a ‘public good’ by lending without proper due diligence to an untested, emerging sector.

The first lesson in market sustainability is that poor risk allocation often destroys a market before it matures. The cost of debt financing is lower than equity because the debt servicing cost is generally covered by strong or contracted cash flows and/or unencumbered assets – so if renewable energy projects have construction and commissioning guarantees coupled with strong energy off-take agreements, they have good prospects for raising a reasonable amount of the project cost from lenders, thereby lessening the equity contribution from project sponsors.

In the absence of these attributes, projects should not expect lenders to take a punt. We are likely to go through a period of significant change where the economics of fossil fuel-based generation dissolves rapidly in response to the threat of harsh emissions pricing. Also, as renewable energy-based technologies scale up they will eventually become competitive, or economic, in their own right. But before we get to that point, projects are going to require some form of support, which will be sheeted home to government in some form, directly or indirectly.

We hear a lot about renewable energy bonds issued in various parts of the world, such as those issued by the World Bank. But don’t be fooled by the headlines, the World Bank is taking on the risk of an underlying project and using the whole of its balance sheet to guarantee returns to bond investors. They are mobilising private sector savings but there is little or no real risk transfer to the private sector. The World Bank is a multi-government sponsored entity which, in this case, is guaranteeing returns to bond investors.

Lenders come in two main forms, banks and bond investors. For reasons of economic stability and shareholder interests, we would expect our banks to make prudent lending decisions. Even if we establish a green investment bank with a mandate to support renewable energy projects, it either has to be funded with private equity capital, through public means or a combination of the two. If government wants to force it into uncommercial lending arrangements, then that is fine – as long as the government understands what it is getting into and puts its own capital at risk in that process.

We would also expect fund managers, appointed by the trustees of our superannuation funds, to make prudent lending decisions when they make their bond investments. Fund trustees would be breaching their fiduciary duty to do otherwise. So there is no free lunch from either the bank or bond investor sector.

Renewable energy project development is one of the key planks in our response to climate change. But let’s be realistic about the role that private investment can and will play in project financing: there is no bottomless pit of money seeking to take equity-like risk and receive bond-like returns.

Project sponsors need to realise that, in the absence of strong, stand-alone project economics, they will either need to contribute relatively high levels of equity or obtain government or regulatory support in some form to facilitate meaningful levels of debt funding.

I’ve never known a credit rating agency to turn down an opportunity to rate a decent project. Despite their erratic behaviour just prior to the global financial crisis, they are generally well disciplined and prudent when it comes to rating companies and projects. Their unwillingness to assign investment grade ratings to certain renewable energy projects is a symptom of a bigger, underlying problem of unrealistic expectations, not the cause.

Phil Preston is the Principal of Seacliff Consulting, a firm offering specialised consulting services in the financial and responsible investment fields. His prior work includes 17 years of financial research and portfolio management in the funds management industry.