Available Mechanisms to Finance the Early Retirement of Coal-Fired Power Plants

Phasing out coal power is a fundamentally important and urgent step in combating climate change. Even though coal plants were built with the expectation that they would operate for a certain time to earn enough profit to repay investors, climate and economic considerations justify their closure ahead of schedule. Equity considerations in ensuring just energy transitions—including the need to avoid overcompensation—should temper any expectations from investors to be compensated for lost profits. Where a government determines that retiring coal plants ahead of their retirement date should entail compensation for investors, cost estimates to finance coal-phaseout in line with a net-zero by 2050 pathway tend to be high: USD 27.5 billion in Indonesia alone, according to one estimate.

Given the urgency and cost, researchers and practitioners have designed numerous mechanisms for financing early retirement. These mechanisms generally locate a cost advantage or alternate method of revenue that can be generated in order to compensate investors. This note discusses mechanisms for financing the early retirement of coal plants using the three categories established by RMI —cost-of-debt, cost-of-equity, and alternate cash flow mechanisms— as well as Germany’s reverse auction system.

Cost-of-Debt Mechanisms

The most basic cost-of-debt mechanism is called “transaction-level financial optimization.” Here, the coal plant is refinanced with a new loan at a lower interest rate. This lower cost of debt comes from concessional lenders—such as governments and multilateral development banks (MDBs)—who are willing to provide a portion of the financing at below-market interest rates. At lower interest rates, the coal plant needs to earn less money to repay its investors, facilitating its early retirement. The Asian Development Bank (ADB), for instance, illustrates a case where a 10-year, USD 300 million loan for refinancing only needs to have 25% of its funding be concessional in order to retire a coal plant 7 years ahead of schedule. That said, the dependence of this mechanism on concessional capital limits its scalability even if it effectively blends it with market rate debt. Even so, the ADB has signed a memorandum of understanding with the Indonesian Cirebon-1 coal plant as a pilot transaction for this model.

A cost-of-debt mechanism that circumvents this limitation is called ratepayer backed securitization (RBS). RBS developed in the United States, where in the majority of utility markets, a fair return on investment for utility providers is built into customers’ electricity bills through a Purchasing Power Agreement (PPA). RBS recognizes that these PPAs function as a kind of debt obligation that customers owe to coal plant owners and investors. Utilities can thus refinance that debt by issuing a bond whose proceeds are used to repay the predetermined return for coal plant investors, enabling the utility to retire the plant early. Utilities can include a surcharge on customers’ energy bills to repay the bond, which allows them to achieve a low interest rate through high certainty of repayment. Remaining bond proceeds can go towards supporting workers and communities impacted by early plant retirement and to financing renewable energy to replace the coal power. Since renewable generation is cheaper than coal power, consumer energy bills should still go down even when the surcharge is included. Accordingly, RBS can provide a triple win for utilities, customers, and coal communities. RBS, however, requires a very particular utility regulatory set-up, and can only be used in jurisdictions with laws enabling the use of securitization to retire coal. Methods to replicate the principles behind RBS in other jurisdictions are currently being explored, such as in Hong Kong’s power sector.

Cost-of-Equity Mechanisms

In both cost-of-debt mechanisms described above, the owner and operator of the coal plant remain the same as the debt obligation is refinanced. A second category of mechanisms, by contrast, posits the purchasing of the coal plant by a new entity at a lower cost of equity, using a “Managed Transition Vehicle” (MTV). That lower cost of equity can stem from the new owner’s access to concessional capital, which lowers the required amount of return they must earn to pay back investors, or a technical or competitive advantage that would allow them to earn the required returns to pay back their investors faster. In either case, this lower cost of equity enables the new owner to close the coal plant earlier than anticipated. 

The MTV concept, broadly speaking, is new and still rather underdeveloped in literature and in practice. An agreement to retire the SLTEC coal plant in the Philippines has been described as using an MTV. The details surrounding the initial transaction remain scarce, however, and the plant was subsequently refinanced using a future cash-flow mechanism described below, leaving the applicability of the MTV label in this context unclear. Indeed, the ADB, who refers to this mechanism as the “acquisition model,” notes that it is only to be used in “exceptional scenarios,” meaning it may be a while before its potential is truly tested.

Future and Alternative Cash-Flow Mechanisms

In the absence of a cost-of-debt or cost-of-equity advantage, future and alternative cash-flow mechanisms provide ways to finance early closure. The method with the most traction recently is carbon credits. A report by McKinsey and the Monetary Authority of Singapore notes that there is insufficient concessional capital available to phase out coal, and as such, other ways of raising phaseout finance are needed. The report posits the creation of “transition credits,” generated from the early retirement of a coal plant and its replacement with a renewable energy source. Investors would buy these credits to finance early retirement. The report argues that the direct link between these credits and emissions reductions makes them higher quality than most currently traded carbon credits. 

Perhaps the most significant challenge to this model is the timing mismatch. Since transition credits are generated from shutting down coal and directly replacing it with renewable power, in the case of shutting down young coal plants, investors may have to wait a decade between providing upfront financing for the early retirement and acquiring and selling the credits. The uncertainty of the carbon credit market down the line makes investment in early retirement a less appealing proposition. While the report discusses creative mechanisms to balance these concerns, they all include some trade off between cash flow certainty for the retiring coal plant and flexibility for investors of the retirement.

In December 2023, Singapore’s central bank announced two pilot transactions in the Philippines to test transition credits. One transaction will involve the SLTEC plant discussed above, whose decommissioning date will be brought forward, potentially to 2030. The second transaction involves a 200-MW Mindanao coal plant located in the south of the country. For this transaction, Singapore will partner with the ADB, but few details are public about how the carbon credits will be used.

Germany’s Reverse Auctions

Each of these mechanisms relies on private capital to finance the phaseout, which creates significant limitations. As such, states with enough fiscal capacity to shut down coal plants and directly compensate the owners can phase out coal faster. Policymakers, however, are unlikely to know the true cost of closing a coal plant, incentivizing coal plant owners to overestimate their costs to secure greater compensation. 

To address this issue, Germany implemented a reverse auction system, in which coal plant owners bid for the prices at which to close their plant, with the competition incentivizing them to disclose their true costs. The auction is split up into several rounds, each with a target capacity of coal to be retired. Each round also has a limit on the maximum bid that can be submitted, which decreases in each subsequent round to reflect higher foregone revenues from earlier closures and to incentivize coal plants to enter the earlier rounds. The bid caps for every round of the auction were determined before the first round. Starting in the fifth round, if bids to the auctions leave them below their target capacity of coal reduction for that round, the government can order a forced closure of plants without compensation to reach the target capacity.

The first five rounds of Germany’s reverse auctions were successful, financing the retirement of 44% of the eligible capacity in the country at an estimated carbon price of 2.4 EUR/tCO2, which was below the ceiling price. Auction round six, however, came in the wake of surging power prices that rendered the bid cap, set years prior, far too low, leading to significant undersubscription. Due to energy supply concerns, moreover, the government temporarily allowed some previously decommissioned plants to reopen, which totaled 40% of the coal capacity earmarked for soon-to-be closure by prior auction rounds. Critics argue that these setbacks stem from an overly rigid policy design regarding the fixing of bid caps in advance. They suggest that adding more flexibility, such as linking bid caps to power prices or allowing menu bids, where operators can bid to decommission their plants at different dates in the future, would generate sufficient competition to ensure a cost-effective deal for the government.

Conclusion

Given the extreme importance of phasing out coal power, it is encouraging that significant attention is being devoted to designing financing mechanisms, as appropriate, to facilitate it. That said, all of the mechanisms discussed above have reason for skepticism. Many have never been fully implemented, let alone applied at scale. As such, tracking the implementation of these pilot transactions, and analyzing the aspects of them that are successful and those that are not, will be crucial in ensuring a coal phaseout happens at the speed and scale required to reach climate goals.

Tucker Wilke is a Program Associate at the Columbia Center on Sustainable Investment (CCSI). He would like to thank Perrine Toledano, Martin Dietrich Brauch, and Ana Maria Camelo Vega of CCSI, as well as Robert van Zwieten of Route 17, for their invaluable input.

This blog is the first of a two part series on phasing out coal power. The second entry, which will examine the status of phasing out coal in Southeast Asia, will be published shortly on CCSI’s website.