Financing the energy transition: Fundamentals and basic concepts

This article in a series of articles highlights the interactions between capital costs and specific risks for energy power plants. It emphasizes special features such as the balance sheet effects provided by project financing and the influence of capital costs on electricity production costs. The article illustrates that the level of capital costs in particular is a decisive factor in the economic viability of investments in renewable energies. An example shows that an increase in capital costs from 2% to 10% can raise electricity production costs by up to 80%. This is due to high upfront investments and long project durations. The factors that influence capital costs and how they can be calculated are discussed below.

In order to raise the up to €10 trillion needed annually to defossilize the global economy (see Cash flows for a climate-neutral world), global financial flows must be directed toward the relevant technologies. Money from investors can generally be provided in the form of equity or debt. Both types of capital have their advantages and disadvantages, and as a rule, both are needed for financing a project. The debt-to-equity ratio has a significant impact on the cost of capital of a company or project.

The contribution of equity is an investor’s direct participation in a company or project and is usually determined by the acquisition of shares. The advantage of equity is its positive effect on creditworthiness. A high equity portion allows easier and, above all, cheaper access to debt. On the other hand, the cost for equity is significantly higher than that for debt. This is due to the following factors: Since equity investors bear a significantly higher risk than debt investors, they also demand a higher risk premium for their investment. This increased risk is particularly reflected in the event of insolvency and liquidation, as debt investors credits are paid out preferentially, while equity investors receive subordinated paybacks. This can lead to a total loss of the investment. The increased risk is offset by the possibility of achieving an “uptake.” While debt investors generally receive fixed-interest repayments, returns for equity investors are based on the success of the project or company. This means that there is the possibility of multiplying the original investment without limitations.

Financing through debt, on the other hand, is the provision of money without the acquisition of shares. With a normal loan, this money is usually repaid in fixed annuities, including interest. Due to the lower risk involved, the interest rate is generally lower than that for equity, which explains the outstanding importance of debt for financing. In addition, debt interest is included in a company’s profit and loss statement as an expense that reduces profits (see Figure 1). This leads to tax savings (“tax shield”) on debt interest. This is why a differentiation on pre-tax and post-tax cost of capital can be made. In comparison, the interest on equity, also known as dividends, may only be paid out to equity investors after taxes have been deducted. This means that the dividends paid out must first be taxed in full and cannot be included in a company’s profit and loss statement as a reduction in profit.

The total cost of capital consists of the sum of the costs of equity and debt, weighted according to their respective share of debt and equity contribution. This is also referred to as WACC, or weighted average cost of capital. However, since the capital structure of a company or project is constantly changing, the WACC also changes accordingly over time.

When calculating the cost of capital, it is important to distinguish between the interest rate on equity and the interest rate on debt, which are then added together to give the cost of capital, taking into account the proportions of equity and debt capital as well as the tax shield (see Figure 1).

The equity interest rate demanded by an equity investor serves as the basis for the equity share. The level of this interest rate depends on the risk that the equity investor must bear. The earlier the life cycle of a project or company, the higher this interest rate is likely to be. For example, a venture capitalist who invests in start-ups must factor in that 9 out of 10 of his investments will be lost 100 %. The one successful investment must therefore yield such a high return that it can cover the losses from the written-off investments. In this early phase, multiples are often used for calculation purposes. This means that an investment must yield a multiple of the original investment. The further advanced the project life cycle is, the lower the required returns for equity investors due to decreased risk. In the development phase of an infrastructure project, a return on equity of approximately 15 to 20 % is assumed, in the construction phase 10 to 12 %, and in the operational phase 7 to 8 %. However, it is not possible to generalize assumptions about the level of equity interest rates, as the market is very opaque and equity interest rates can vary greatly in some cases.

The reference interest rate, which is assumed to be risk-free, plays a particularly important role in the development of capital costs. This must be applied as a minimum when borrowing capital from banks. For example, the Euribor can be used for this purpose in Europe. This is the average interest rate at which European banks lend unsecured money to each other on the money market. Figure 2 shows that this rate rose by approximately 5 % within a year due to inflationary pressure before gradually declining again after 2023. The risk-free interest rate serves as an opportunity for determining both the adequate equity and debt interest rates and must be applied at minimum when financing, which has led to projects becoming more expensive due to rising capital costs.

In addition, a risk premium is applied, which is based on factors such as the financial stability of the company, industry developments, macroeconomic conditions, and the market maturity of the technology, among other things, to determine the level of interest on borrowed capital. A high risk premium indicates that the investment is considered risky, while a low risk premium reflects a secure return expectation with mild risks.

Based on the mathematical principles used to calculate the cost of capital, financing with the highest possible proportion of debt would generally be desirable. However, the cost of debt is not linear. Lenders assess the company’s business situation, and the interest rate on debt capital is based, among other things, on the composition of capital. Consequently, a high planned proportion of debt generally leads to higher risk and also to disproportionately high cost of debt. Debt providers require a substantial proportion of equity to reduce their own risk. This proportion depends on project-specific or company-specific risk factors. General risk factors for renewable technologies arise in the areas of politics and regulation, market, infrastructure, macroeconomics, approval, and technology. An incomplete selection of examples of risks in the context of the energy transition, which are also discussed in the other articles in this series, are listed in Figure 3.

As a central component, capital costs play a key role in the energy transition. Low capital costs will be decisive in determining whether and to what extent defossilization can succeed. Excessively high capital costs in particular have a significant impact on the overall costs of defossilization projects due to the high upfront investments and long project lifetimes. For example, an increase in capital costs from 2 % to 10 % can lead to an increase in total costs of up to 80 % for solar projects (see Figure 4) [2].

Daher ist es essenziell, die Kapitalkosten möglichst gering zu halten, um einen kostengünstigen Zugang zu Defossilisierungstechnologien zu ermöglichen. Ein Aspekt, der insbesondere immer wieder im Zusammenhang mit dem Netzausbau thematisiert wird.

Project finance

Many defossilization projects are characterized by high upfront investments and long project durations. This makes a solid financing structure between companies or project developers and investors crucial for mutual risk minimization. Basically, there are two types of financing concepts to choose from. On the one hand, there is traditional corporate finance, where the entire financing takes place on the balance sheet of the investing company. Since the proportion of debt in these projects is usually well over 50 % and often exceeds 80 %, this type of financing leads to a deterioration in the company’s equity ratio, which can result in the company being unable to obtain fresh capital, or only capital at increased capital costs, due to its high level of debt. This means that a company’s ability to raise debt depends on the amount of equity it has, and financing large projects would therefore only be possible with a lot of equity or the provision of guarantees or collateral.

To avoid this, project finance has proven successful for projects in the energy sector. Here, a new company is established as a special purpose vehicle (SPV) for each project. The company involved (sponsor) holds the equity shares of the SPV on its own balance sheet. This structure is advantageous because the debt does not have to be recorded on the sponsor’s balance sheet. The claim of the lenders is mainly limited to future cash flows, i.e., the cash flow within a period t, of the special purpose vehicle [3].  As a rule, therefore, lenders have no or only very limited claims on the sponsor’s assets if the SPV’s cash flows are insufficient to repay the debt (“ring-fenced or non-recourse”).

The left-hand side of Figure 5 shows that, in the case of corporate finance, new projects can burden the company’s balance sheet with a high debt ratio in terms of type and scope. Only over the years incoming cash flow will repay the borrowed capital to the investors, while the surplus cash flow, if calculated adequately, will contribute to an increase in equity, thereby gradually reducing the company’s debt over the term of the projects. Only through gradual debt reduction will there be room for new investments again. However, the long project durations and high upfront investments are problematic here, as this gradual debt reduction would take too much time to quickly scale projects in the renewable energy sector.

This must be assessed differently in the case of project finance. Here, the sponsor only holds the equity capital of the projects in the form of participations in the SPV. This means that the sponsor’s balance sheet is not unnecessarily inflated. However, this can only work if the risks associated with the occurrence and amount of cash flows can be determined with a high degree of precision. In renewable energy finance, this is determined by the priority feed-in and the amount of the fixed feed-in tariff, or by long-term purchase agreements, which is why economic success can be determined quite precisely. Another advantage of project finance is the separate economic evaluation through separate accounting. If the project is resold during its project life cycle, the relevant documents and economic evaluations can be made available to potential buyers relatively easily as part of due diligence without having to disclose the sponsor’s data and documents.

Since the long-term success of a company depends on its ability to generate sustainable earnings, the analysis of future cash flows plays a key role. Investors and lenders therefore analyze the projected cash flows, particularly in the context of project financing, in order to assess the likelihood that a company will be able to meet its financial obligations. There is a higher risk if future cash flows are uncertain or volatile. In this case, project financing is only carried out with the necessary collateral from the sponsor.

The net present value (NPV) is often used to evaluate these future cash flows. The NPV calculates the present value of all future expected cash flows of a company or project, discounted at a risk-adjusted interest rate. A positive NPV indicates that an investment generates financial added value when all relevant capital flows are taken into account, while a negative NPV indicates that the expected returns do not cover the costs. The NPV thus serves as a key indicator for investment decisions and risk assessment in companies. At the same time, scenario analysis is used to analyze delays in the construction phase or variations in the expected cash flows in order to better estimate how this may affect the profitability of the project.

A key factor in calculating the NPV is the interest rate, as it is used to discount future cash flows and thus has a direct impact on their current valuation. On the one hand, the interest rate reflects the time value of money due to cost of capital, and on the other hand, the risk of a project must also be adequately priced in. As a rule, the WACC is used for discounting.

For future cash flows, a higher interest rate means that their present value (discounted value) decreases, as they are discounted more heavily. This can result in the NPV of an investment being negative. Conversely, a lower interest rate means that future earnings have a higher present value, making investments appear more attractive. Thus, the interest rate has a significant impact on the valuation and profitability of companies and projects.

Change in capital structure over the life cycle

The capital structure also changes over the life cycle of a project as the risks change. As can be seen in Figure 7, the comparatively low capital requirements in the early stages of the life cycle are covered by risk-tolerant equity investors. At the start of the project, the risk of the project and the investment volumes required do not yet match the risk appetite of debt investors, as there may be a high degree of uncertainty regarding regulatory, market, or technological conditions that must first be addressed over time before a final investment decision can be made. Until then, the probability is highest that the project will fail, for example due to a lack of permits and lengthy planning. For example, this period for wind turbines in Germany was up to 5 years before they were declared to be of overriding public interest and thus benefited from simplified and accelerated approval procedures [4].  Only over the course of the project do risks become apparent and can be addressed. If the project exceeds critical milestones, additional capital is required. This is usually done through capital increases, the resale of equity shares, and the raising of debt capital.

Once the permits for a wind turbine, for example, have been obtained the project becomes attractive to institutional investors. This capital is also urgently needed for the construction phase, as approximately 95 % of the total project costs are incurred during this period. Investments in the defossilization of the economy are also becoming increasingly important due to non-economic factors and requirements for investors. For example, the EU taxonomy and the Corporate Sustainability Reporting Directive provide guidelines for investors to invest existing capital in sustainable investment opportunities [6, 7]. Therefore, professional investors in particular are a key factor in the realization of the energy transition due to the redirection of capital flows.

References

[1] Deutsche Bundesbank. Geldmarktzinssätze. 2025. https://www.bundesbank.de/de/statistiken/geld-und-kapitalmaerkte/zinssaetze-und-renditen/geldmarktsaetze/geldmarktsaetze-772406. Accessed 19 Aug 2025.

[2] The International Renewable Energy Agency (IRENA). The cost of financing for renewable power; 2023.

[3] Wall Street Prep. Project Finance vs. Corporate Finance; 11.01.2022.

[4] Bundesverband WindEnergie e.V. Planung von Windenergieanlagen. 2025. https://www.wind-energie.de/themen/mensch-und-umwelt/planung/. Accessed 12 Aug 2025.

[5] The Worls Bank. Scaling Hydrogen: Financing for Development; Februar 2024.

[6] EU Parlament. VERORDNUNG (EU) 2020/852 DES EUROPÄISCHEN PARLAMENTS UND DES RATES vom 18. Juni 2020 über die Einrichtung eines Rahmens zur Erleichterung nachhaltiger Investitionen und zur Änderung der Verordnung (EU) 2019/2088: 2020/852; 2020.

[7] EU Parlament. RICHTLINIE (EU) 2022/2464 DES EUROPÄISCHEN PARLAMENTS UND DES RATES vom 14. Dezember 2022 zur Änderung der Verordnung (EU) Nr. 537/2014 und der Richtlinien 2004/109/EG, 2006/43/EG und 2013/34/EU hinsichtlich der Nachhaltigkeitsberichterstattung von Unternehmen: (EU) 2022/2464; 2022.