Financing Decarbonization: Closing the Execution Gap | ENGIE Impact

Financing Decarbonization: Closing the Execution Gap

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Kirti Rudra Director Sustainability Solutions - EMEA
Jeff Waller Senior Director, Head of Sustainable Finance, ENGIE Impact
Rèmi Péne Analyst, Sustainability Solutions - EMEA
Simona Dragoi Senior Manager, Sustainability Solutions - EMEA
Decarbonization
Financing Models
Net Zero

As shown in ENGIE Impact’s fourth annual Net Zero Report, which assesses decarbonization across hundreds of global organizations, budget constraints and a lack of investment are the primary barriers to implementing decarbonization initiatives.

The high cost of robust carbon mitigation investments, combined with the lack of a whole-business perspective toward decarbonization, often leads isolated teams to secure funds for low-cost, quick-payback carbon reduction projects at a specific site or facility. While these projects may provide incremental progress and serve as window-dressing for stakeholders, high-impact sustainability projects requiring significant upfront capital tend to get placed on the back burner. The lack of alignment between decarbonization planning and decarbonization funding widens the gap between ambition and execution.

For corporate decarbonization efforts to succeed, companies must therefore do two things. First, they need to rethink traditional financing criteria to enable long-term decarbonization investments. Second, they must break down departmental silos and take a holistic, organizational approach. This means that finance functions must collaborate with sustainability experts and business unit heads to identify and fund carbon projects. To be worthy partners in this effort, non-financial profiles within the company should be aware of the potential financing options and must be able to understand, articulate, and measure the business case for decarbonization investment. This article is written with these profiles in mind.

Selecting the Right Decarbonization Financing Option

As companies awaken to the fact that sustained investment is needed to turn decarbonization strategy into reality, those initiating new projects, and not just the CFO, should be aware of the available financing options for projects that fall outside the typical return-on-investment framework for core business expenditures.

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Companies have several options when financing their decarbonization projects, but they all fall under three broad categories, namely: internal funds, debt, and service agreements. Investors must weigh multiple factors when deciding which financing avenue is appropriate for their situation. One company might be more inclined to consider the total cost of ownership (TCO) because they have substantial internal funds and prefer to invest for the long term, while others might prefer to look at the impacts on EBIT (earnings before interest and taxes) in the short term because they are in a competitive market with low margins or have low investment capacity.

There is not a single solution to suit all needs. To help evaluate each option, we break down the categories along with their respective pros, cons, and relevant business cases to facilitate the decision-making process in the function of the financial KPIs mentioned above.

Internal Funds

Internal funds typically are existing CAPEX budgets or dedicated funds for decarbonization projects, such as green revolving funds or internal carbon pricing proceeds. This is the most straightforward and flexible solution. Internal funds may be invested in any technology, but self-implementation adds complexity, as designing and implementing a carbon reduction program requires considerable time commitment and robust technical capabilities. Outsourcing is an option, though it involves ceding decisions to the supplier.

Whether one undertakes the solutions oneself or not, the more salient issue is whether the opportunity cost of diverting funds from one’s core business to decarbonization solutions is the best option for obtaining a competitive advantage. It may prove more advantageous to invest capital in one’s own products and services where one has the expertise, and finance in another way the decarbonization solutions where the providers are the experts.

Should one go the self-funding route, it will have a significant impact on the company’s equity and EBIT. Depreciation of the value of the assets also increases the cost of capital over time. Committing millions to projects with a 5–10-year payback period may be impractical or undesirable. Despite the lower TCO due to the absence of financing costs, limitations in technical know-how and funds may hinder the execution of a more expansive scope of identified solutions. This leads us to the second option.

Debt

If internal funds are not feasible for your investment, external financing options may be explored. Debt financing for decarbonization projects includes general corporate loans or bonds, asset-specific loan products (e.g., leases), and sustainable debt products (e.g., green loans, bonds, sustainability-linked loans).

While external funds will not solve operational complexity issues, they do enable companies to implement larger-scale solutions by lowering their impact on internal funds. Designing the decarbonization program such that the energy cost savings offset the loan payments effectively neutralizes the net financial impact of taking out the loan. For some companies, however, this may still not be a palatable option as it comes at the cost of increasing their debt load and potentially negatively impacting the company’s attractiveness to investors.

As with internal funding, debt funding gives the company 100% ownership of its equipment, as well as the savings it generates. It offers control and full decision-making power over the assets, but that also means it assumes responsibility for efficient operation and maintenance to ensure proper performance to generate the expected outcomes. There is no subcontractor performance guarantee to fall back on.

On the financial side, debt funding adds costs, increasing the TCO compared to internal funding. Corporate loan terms of 5-7 years make designing and implementing a financially viable, large-scale decarbonization program challenging. As with the first solution, ownership of the equipment comes with depreciation expenses, further increasing the cost of financing. External funding can expand the scope of a project, but financial viability concerns may limit one’s efforts to ‘quick wins’, as it doesn’t alleviate the complexity of implementing a project internally.

Cumulative Impact of Energy Efficiency Program on EBIT

As-a-Service Agreements

Service agreements are a growing trend in the decarbonization space, as they remove many of the hurdles to the carbon transition process, most notably the disbursement of CAPEX. Indeed, both asset ownership and responsibility for its performance remain with the service provider. The main types of service agreements are energy savings as-a-service (ESaaS) contracts; power purchase agreements (PPAs) linked to either on-site or off-site assets that generate renewable energy; and utilities as a service (UaaS), an integrated, comprehensive set of energy management services.

Common to all these models is the outsourcing to a sustainable services provider of the upfront capital outlay for the assets (energy conservation measures, PV panels, heat pumps, biomass boiler, etc.), as well as responsibility for asset performance, maintenance, and ownership. These outcome-based models have contracts structured to reduce the TCO below that of business-as-usual – a baseline scenario in which no additional actions are taken to mitigate climate change. They can also be less complex operationally, as one only pays for the outcome (e.g., demand reduction) and not the machinery, but they come at the cost of some operational flexibility due to the long-term nature of the contracts.

Service contracts are usually longer than loans, resulting in lower annual expenditures. This enables the implementation of a broader range of projects while maintaining financial viability as they are deconsolidated, providing off-balance sheet solutions. At the end of the contract, the equipment can either be transferred or sold to the client, or, at the client’s request, the service provider may remove the assets from the client’s site.

Lastly, this model has the lowest opportunity cost, freeing up the company to invest in projects that will bring value directly to its clients, such as research and development. Indeed, internal improvement projects can be self-financed by the savings generated by the as-a-service agreement, leaving the company’s internal funds untouched and available for core business priorities.

Interest in Service Agreements Fueled by Five Converging Trends

1. Increasing focus on outcomes, both for resource reductions (energy, water, and emissions) and renewable energy adoption. Goals are often publicly stated, so companies are looking to off-load performance risk to ensure goals are achieved.

2. Lack of in-house expertise to achieve these outcomes, both in terms of planning and implementation. There are new technologies to master, and complicated sets of options to consider.

3. Limitations on self-funding projects to achieve these goals. Entities are CAPEX-constrained and often have difficulty securing internal funding for projects that are expensive and not core to their business.

4. Risk mitigation is an additional advantage of service agreements as the burdens of proper design, implementation and outcomes are transferred to a third party.

5. Changes in accounting treatment, whereas operating leases must now be disclosed on-balance sheet, service agreements generally do not.

Financing will remain a central issue as organizations accelerate their energy transition. Innovative solutions are needed to connect funding with projects, but the first order of business is to recognize that shifting organizational thinking from a short-term to a long-term view of decarbonization investment is one of the biggest hurdles to clear – particularly when the solutions are CAPEX-heavy and require a significant upfront investment.

There are a range of third-party financing options created specifically for sustainability projects, such as green bonds or loans, but the benefits of the as-a-service model are quickly winning corporations over. A balance must be struck between investing in ‘quick wins’ and longer-term, transformative initiatives with benefits that go beyond the business-as-usual framework.

A Compelling Investment Case is the Key to Informed Decision-Making

Providing a convincing investment argument is a crucial step in financial and commercial endeavors. Given the increasing importance of ESG (environmental, social, governance) in the finance community, ensuring that an investment proposal is not only persuasive but also comprehensive, necessitates the inclusion of elements beyond the traditional financial metrics, which is why the criteria for investment, as well as the profiles involved in the process, need to be reexamined and broadened. Applying a conventional corporate investment approach that expects a return on investment within three years would disqualify most decarbonization projects. In what follows, we examine the optimal methodologies for constructing a comprehensive decarbonization investment case, emphasizing the significance of incorporating the total cost of ownership, avoided carbon, social benefits, and training.

Total Cost of Ownership (TCO)

Business leaders and financial professionals often prioritize short-term costs, such as initial capital expenditures, when making investment decisions. To ensure a well-informed decision, it is crucial to provide a holistic view of the costs associated with the proposed project. TCO is a financial metric that not only considers the initial capital expenditure and the ongoing operational and maintenance expenses but also accounts for the fact that new technology typically reduces running costs, improving the business case.

This holistic approach aids decision-makers in understanding the complete economic impact of the investment. To integrate TCO in your investment case, categorize costs into areas like capital, operations, and maintenance, and compare them to potential revenue and cost savings.

Why TCO matters in investment cases: Incorporating TCO into your analysis facilitates informed choices, mitigates financial risks, and aligns investments with long-term sustainability goals. TCO provides a comprehensive understanding of the financial implications of an investment, ensuring realistic projections for securing funding and managing stakeholder expectations. It supports informed decision-making about resource allocation to maximize return on investment and helps align long-term organizational goals with environmental and social impacts.

Avoided Carbon Emissions – The Green Advantage

In an era of heightened environmental awareness, investors are concerned about the carbon footprint of their investments. Incorporating information on avoided carbon emissions into your investment case is transparent and enhances the attractiveness of your proposal. Quantify the expected reduction in carbon emissions and translate this into potential cost savings and environmental benefits. Adopt an internal carbon pricing system to embed carbon awareness in decision-making and provide an economic incentive for emissions reduction activities.

Why avoided carbon emissions matter in investment cases: Highlighting the avoided carbon emissions resulting from investments demonstrates a commitment to climate responsibility and aligns your organization with increasingly stringent environmental guidelines and carbon targets, reducing the risk of non-compliance. It enhances the reputation of your company, making it more attractive to consumers and investors, as well as to financial institutions with their own green targets. Investments in decarbonization projects potentially lead to cost reductions over time, providing a financial benefit that enhances the investment case.

Social benefits – investing with impact

Investors should consider the social impact of investments, including job creation, improved healthcare access, education, poverty reduction, and community development. Presenting the social benefits of your investment case builds trust, reduces reputational risk, aligns with ESG criteria valued by investors and funds, helps attract and retain talent, and garners support from local communities and authorities.

Why social benefits matter in investment cases: Including social benefits aligns your organization with stakeholder values. Delivering tangible social benefits can facilitate smoother regulatory approvals, reduce operational disruptions, and create a more favorable environment for project success.

Training and skill development – investing in human capital

Investing in training and skill development improves workforce performance, satisfaction and retention. A commitment to training programs in your project demonstrates alignment with broader CSR goals and will lead to employee growth, as well as increased productivity and innovation. Training and skill development are critical in an ever-evolving business landscape.

Why training and skill development matter in investment cases: A well-trained workforce is more productive and efficient. Fostering their career growth results in a more engaged and adaptable workforce and often leads to improved operational performance and cost savings, ensuring long-term competitiveness. Emphasizing the benefits of continuous employee training shows alignment with broader CSR objectives and highlights efforts to mitigate the potentially costly risks of inadequate training, such as compliance breaches, quality issues, and safety concerns.

An investment case is about more than just crunching the numbers. One must present a compelling narrative that addresses project impacts and ESG concerns. Incorporating into one’s case the TCO, carbon emissions avoided, social benefits, and employee training demonstrates a commitment to transparency, sustainability, and social responsibility. In a world where investors face greater scrutiny than ever, these best practices differentiate your investment case and can lead to more informed and ethical investment decisions.

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