Following a difficult period for the renewable energy industry, firms must begin prioritising foreign exchange (FX) risk management against the rising threat of currency movements.
It has been a tough year for the renewable energy industry. The post-COVID inflationary pressures that have gripped the global economy over the last two years are weighing heavily on the economics of building new power generation, specifically the development of variable renewable energy (VRE). The inflationary impact manifests in both higher construction and borrowing costs, with the average capital expenditure (capex) for a wind turbine up as much as 38% from mid-2021 and solar panel and natural gas plant capex up about 8% and 11%, respectively.
Due to the large amount of VRE cost structure that is tied to upfront capex, VRE is very susceptible to increases in borrowing costs and the price of raw materials. For example, according to a Lazard Asset Management study, a 4% increase in borrowing costs leads to a cost increase of roughly 21% for solar plants and 14% for onshore wind plants. The same study concluded that just a 10% rise in capex cost through the rising costs of raw materials leads to cost increases of 8.6% and 8% for solar and onshore wind, respectively.
Amidst the inflationary challenges these firms encounter, they also face the threat of currency movements, as the global nature of the energy market makes these firms highly susceptible to fluctuations in exchange rates. Despite this, many traditionally see FX as second order. They transact in FX through necessity due to their international nature, rather than out of choice.
Despite the relative calming of currency volatility in recent months, the current uncertain economic outlook means that this is subject to change. As manufacturing and maintenance costs rise for renewable energy companies, it is time they perform some maintenance on their FX systems to better assess the FX challenges they face and how to implement effective measures to mitigate these threats and reduce costs.
What FX Challenges Do Renewable Energy Companies Face?
Renewable energy companies face several challenges on the FX front. They include:
- Conversion of Investment Currency into Spending. The energy industry is a naturally global industry, with investment coming from all corners of the globe. Say a European renewable energy company, which operates in euros, receives investment from British, American, and Chinese investors. The energy company will have to exchange the various currencies into euros in order to begin spending. This increases exposure to exchange rates and high transaction fees.
- Capital Expenditure. Most raw materials used in the parts needed for energy plants are transacted in the U.S. dollar, which has surged in recent months. From mid-July to October, the dollar gained more than 6% relative to other major currency pairs, reversing the decline at the start of the year. This surge means that raw materials become more expensive for non-U.S. companies.
- Acquiring Companies That Transact in a Different Currency. Acquisitions are common in the energy industry, due to the high operational costs and presence of large firms. When a company purchases a foreign firm, its assets have to be transferred into the purchaser’s currency. Due to the spread of assets across different investments and accounts, this transfer has to be made in parts over time, leading to greater exposure to currency changes, as well as high fees.
- Selling Energy on a Global Marketplace. The global nature of the energy market means that energy suppliers often sell energy to foreign utility companies. For example, in the second quarter (Q2) 2022, 8% of the power generated in the UK, some 5.5 TWh, was exported abroad—netting the UK £1.5 billion. This international buying and selling leaves energy producers exposed to price swings due to currency volatility.
What Measures Can Renewable Energy Companies Adopt to Mitigate Their FX Risk?
Whilst FX management cannot change the external environment, there are a number of steps that renewable energy firms can take to reduce the threat of currency movements. These include:
- Compare the Market. Many renewable energy companies may be hampered by their inability to access Tier 1 FX liquidity, meaning their access to best execution is often restricted by the fact they often rely on a single bank or broker to meet their hedging requirements. The ability to put trades up for competition is key to ensuring access to the best price, which is crucial to effective risk management.
- Diversification of Liquidity Providers. If the recent banking crisis has taught companies anything, it is the importance of having access to multiple counterparties. Many CFOs have taken this lesson onboard and are now making changes for the better, with 88% of North American corporates exploring diversifying their FX across more counterparties. This means if one counterparty becomes unavailable, the energy firm can continue to manage and execute FX trades.
- Transaction Cost Analysis (TCA). TCA was specifically created to highlight hidden costs and enables firms to understand how much they are being charged for the execution of their FX transactions. Ongoing, quarterly TCA from an independent provider can be embedded as a new operational practice to ensure consistent FX execution performance.
- Outsourcing. When using the right partner, outsourcing can improve transparency and execution quality. This can enable renewable energy companies to dedicate more time to core business matters, which is all the more important given the current high operating costs.
- Strong Governance. Supply chains for renewable energy firms can be long and logistically complex, from raw materials to manufacturing and maintenance costs, with each potentially requiring payment in different currencies. Harnessing solutions that can strengthen governance may help renewable energy firms improve the cost, quality, and transparency of their FX execution.
- Automation. Many firms may continue to rely on manual processes like phone and email to execute FX trades. Harnessing automated solutions can offer end-to-end workflow, greater transparency, and faster onboarding, helping finance departments streamline their FX functions.
Renewable energy firms have faced a tough few years, and with uncertainty expected to persist into 2024, FX risk must no longer be considered a non-priority. Implementing the right processes and harnessing technology-driven tools will help enable many renewable energy companies to effectively deal with increasing FX challenges and protect their bottom lines.
—Jason Gaywood is head of Corporate Solutions at FX-as-a-Service provider MillTechFX.