Part I: A Quick Note on Project Finance

Project finance is a benchmark financing technique for long-term investment that is emerging as the financing method of choice for renewable energy projects.

The basic premise behind project finance is that lenders loan out money for the financing of one single project, based only on that project’s risks and future cash flows.

Project finance is:

  • mostly used by private companies
  • used for complex infrastructure projects like energy projects
  • tackles one specific project at a time (NOT a portfolio of projects)

However, an easier way to wrap your head around PF, is to think of it as a web of contracts between the project company (we’ll get there) and its stakeholders.

But before we get there, let’s have a quick look at what the macro picture looks like for PF.

In terms of sectors, Scope Ratings analysts estimate that power, particularly renewables, and transportation will continue to dominate new project financing issuance in the short term, with oil and gas representing the primary uses of funds.

Figure 1: EMEA Project Financing H1 2016 (tot: €76bn)

Renewable Energy Project Finance
From Scope Ratings, 2017

The “Power” pie wedge represents 30% largely because of renewables. Indeed, 2016 was marked by strong PF activity, especially in the UK (EUR 11.7bn), with two mega offshore wind projects, Dudgeon (EUR 1.6bn) and Beatrice (EUR 2.8bn), in particular.

How does project finance take place? 

STEP 1: A company wants to build a wind farm. The wind farm is complex, expensive and will require a long-term plan. Since it is unlikely that a single company will be able to swing such a project on its own, the company then seeks out other investors who are interested is such a project, to share the risk (and return) of the project with. This group of initial investors becomes known as the project sponsors.

STEP 2: The project sponsors then create a Special Purpose Vehicle (SPV), which is a company in its own right, with its own balance sheets and cash flows separated from its sponsors. The SPV is created with the sole purpose of managing and handling that one specific project. The SPV is also called the project company.

STEP 3: The SPV and it’s sponsors then must raise money to fund its project, so it approaches banks and bond holders for financing.

Why do companies choose project finance for their investments?

To understand why many (renewable) energy projects are financed via project finance, you have to look at what project finance offers to both the project sponsors (money borrowers) as well as the lender‘s side.

On the Project Sponsor’s side: Project Sponsor’s love to project finance because the liabilities and obligations associated with the project are removed from the Sponsors. This has many benefits, including:

  1. Limited Recourse: Usually, when a company defaults on a loan, the bank has “recourse” to the assets of the company. In project finance, the bank’s only recourse is to the assets of the project company. Given that the magnitude of the average project is in the order of 100m and above, this is an important consideration. This enables the Sponsors to effectively protect their assets, investments in other projects, intellectual property, and key personnel;
  2. Avoiding Risk Contamination: closely tied to the above point, project finance makes sure that risk incurred by the Project Company does not spread to the project sponsors because the Project Company is it’s own entity with its own balance sheet, so risk does not spread to the balance sheet of its sponsor. Sponsors avoid mixing cash flows with other projects they are financing;
  3. High Leverage: Project finance is typically involved highly leveraged transactions, usually not financed with less than 60/40 debt/equity. The key advantages that such a capital structure for has for the project sponsors are:
    • more debt means that lower initial equity injections are needed, making the project less risky (leading to a lower cost of borrowing);
    • enhanced shareholder equity returns;
    • debt finance interest may be tax deductible from profit before tax, further lowering the cost of borrowing;
  4. Balance Sheet: Normally, in “non project” finance situations, when a company needs to raise debt financing, they approach a bank, which will judge the company’s creditworthiness based on its balance sheet. Project finance allows debt to be booked off the balance sheet, depending on projects;
  5. Hedging Risks: Project finance is also a way for companies to hedge risks of their core business.

The advantages above all come down to this→ the reduction of risk corresponds to a lower cost of borrowing for the Project Sponsor’s balance sheet. Having a high Weighted Cost of Capital has negative effects on balance sheets, so avoiding this is an imperative. Shareholders will look very favorably at this.

Moving on to the lender’s side: The lenders, which are banks or bond holds tend to view project finance favorably as well.

The main disadvantage of project finance for banks (and a corresponding advantage for the Project Sponsors) is that the structure is nonrecourse that we discussed above. The revenue generated by the SPV is the primary, if not sole, the source of payback of the project debt. Thus, banks in project finance transactions, view the increased risk of not being repaid if the project is unsuccessful very negatively. So, if the risk cannot be allocated or credit-enhanced, by default the risk falls to the banks.

In spite of this, lenders are keen on project finance because:

  1. Higher Fees for Banks: The higher degree of risk for lenders also translates into higher fees and costs than for other types of financings. The risk inherent in project finance and the complexity of the projects result in an extensive and expensive due diligence process (the cost of which is borne by the project sponsors) conducted by the lenders’ lawyers, technical adviser, insurance consultant and other consultants, and big fees can be earned here;
  2. More Fees for Banks: owing to the higher risk involved, lenders scrutinize project sponsors more. Banks require more supervision over the construction, management, and operation of the project relative to other forms of financing.  The increased supervision during construction, startup or commissioning, and operations often adds up to higher transaction costs;
  3. Avoid Sharing Cash Flows: Once a bank identifies a project as being worthy of investment, they will not want to mix the eventual cash flows that the SPV will generate with other, pre-existing creditors;
  4. Focus on One Project: Lenders like PF also because they can focus on one specific project. This means that the lender evaluation will be on analyzing if that project will be able to generate sufficient cash to pay back principal and interest.

A quick note of explanation is necessary: You’re probably wondering why on earth would a bank forgo recourse to a project’s sponsor, therefore putting itself in a risky position?

Renewable energy has a projected and predictable revenue stream that can be secured to ensure repayment of bank loans. When it comes to wind and solar power projects, this revenue is typically generated from a power purchase agreement (“PPA“) with a utility, under which the can piggyback on the creditworthiness of the utility to reduce its borrowing costs. While the wind power market has matured, resulting in the successful project financing of “merchant” projects in the absence of long-term PPAs, solar projects are generally not there yet.

As legal advisors, Wilson, Sonsini, Goodrich and Rosato explain in this detailed note,
in merchant power projects, lenders get a guarantee of the project’s ability to repay its debt by focusing on commodity hedging, collateral, and the income that will be generated based on historical and forward-looking power price curves.

While project finance lenders prefer a long-term power contracts that ensure a consistent and guaranteed revenue stream (including assured margins over the cost of inputs), in the context of some industries, banks know that sufficient revenues to support the project’s debt are of a high enough probability that they will provide debt financing without a long-term off-take agreement.

However, solar projects are different. Due to their peak period production, high marginal costs, and lack of demonstrated merchant capabilities are not yet viewed as “project financeable” without PPAs that most of their output. Moreover, solar’s lack of merchant viability is worsened by the fact that the southwest United States (the region most appropriate for utility-scale solar power development in the USA) does not have a mature merchant power market that functions in the absence of long-term bilateral sales agreements. This is not likely to change in the short or medium term.

Stay Tuned for Part II: Renewable Energy Project Finance: The Checklist

Trend #2: Equity Capital for Wind Energy

There are some interesting developments in terms of who’s got skin in the equity game in renewable energy. What’s really interesting to me is that the equity investment landscape has transformed quite a bit in the last few years and in this post we’ll see how and why.

Renewable Energy Asset Financing, 2004-2015

capture
In USD billion, statlink: http://dx.doi.org/10.1787/888933362596

But first, remember that, according to the OECD, there are three (main) ways to finance renewable energy projects:

  1. Project Finance: This involves a mixture of debt (usually from banks) and equity capital (we will go into more detail below). According to Bloomberg, 2015 was the first year in which project finance constitutes more than half of total asset finance in RE electricity. Remember that project finance involves creating a Special Purpose Vehicle (SPV) with its cash flows separated from those of its sponsor companies;
  2. On-the-balance sheet financing: Done by utilities (EDF, ENEL, Suez), independent power producers and other project developers. On the balance sheet financing, makes up over 47% of total asset finance in RE, about 94 billion;
  3. Project Bonds: Project Bonds, these do not include corporate bonds or government bonds. They account for a small fraction of financing.

Nevertheless, there are other emerging financial structures, which I can go into in another post, but venture capital is one of them. Utilities are substantial providers of equity capital in the renewable sector. However, due to the large scale investment and stable income returns, there is greater interest from the financial services industry.

This brings us to wind equity financing

Back in the day, the first offshore wind-power farms were usually financed on the balance sheets of the utilities that planned, built, and operated them. Today, there are many more players involved, such as banks, private equity funds, pension funds, state-backed “green” banks (such as the Green Investment Bank, the Nordic Investment bank and the European Investment Bank) and insurance companies. The graph below shows how the equity mix has morphed in the last couple of years.

Change in Equity Mix for Wind Energy

wind-equity

The share of equity provided by utilities is steadily shrinking as other players get involved, decreasing from 62% in 2010 to 39% in 2015, and that of non-utility corporates from 31% to 15%. In other words, the combined share of the two traditional equity investors in the wind energy sector decreased substantially, from 93% in 2010 to 54% in 2015. Accordingly, other investors have stepped up their game. One of the possible explanations for this decrease may potentially be due to deleveraging as a consequence of the financial crisis.

The Rise of Institutional Investors

For brownfield wind projects, meaning wind projects where there is already existing infrastructure and possibly licenses as well, institutional investors such as pension funds, insurance companies, private equity and infrastructure funds have become major equity investors. According to the OECD, their cut in total equity provisions increased from 6% in 2010 to a staggering 37% in 2015, making them the second most important equity providers in the 2015 sample, just 1% behind utilities. This sharp increase of equity provision by institutional investors can be traced mainly to the acquisition of brownfield assets or portfolios for onshore wind deals. Pension funds and insurers were not involved in any greenfield onshore wind-power transactions included in the OECD 2015 sample.

This trend suggests that institutional investors look to the onshore wind sector mainly for the acquisition of existing projects.Such a strategy presents several advantages:

  • Lower Costs: Existing projects are already (usually) built, and there they do not need to start from scratch;
  • “Up to Code”: Lengthy permits, licensing and commissioning agreements may already be in place and therefore do not need to be requested;
  • Fast Deployment: Ultimately the project can be up and running (and earning) in less time.

Moreover, equity financing in wind energy assets by state agencies and public finance institutions grew from a negligible cut in 2010 to 9% of total equity invested in 2015. This sharp increase can be linked directly to the investments done by the UK Green Investment Bank. The UK’s GIB, an institution created by the UK government in 2012 with the aim of attracting private sector financing for green infrastructure projects. The creation or expansion of similar institutions is a trend observable at the global level and is important for risk sharing with newer technologies. Take offshore wind, for example, as projects scale up and move into deeper water, newer technologies also add to construction risk. This may be a barrier to entry and discourage some investors from participating.

In Europe, commercial banks have started partnering up with government supported banks (United Kingdom’s Green Investment Bank, Germany’s KfW Development Bank), export credit agencies (Denmark’s EKF and Belgium’s Delcredere – Ducroire and Italy’s SACE), and multilateral banks (the European Investment Bank) as a way to provide equity financing to wind projects .

The diversification of participants is good for everyone, because:

  • Risk: The risk that corresponds to the project is diversified across an array of investors, meaning that investors are more likely to invest if they do it along other reputable investors, rather than going in it solo;
  • Mainstreaming: the diversification of participants shows that equity financing for RE is no longer as niche as it was, with pension funds and insurance companies putting skin in the game.

Example: The Galloper Offshore Wind Farm

The largest wind equity deal in Europe in 2015 the the Galloper Offshore Wind Farm. It’s a project that will be completed in 2018, located off the coast if Suffolk, east England.

 The equity investors are:

  • Innogy Renewables UK, a subsidiary of the German utility company RWE
  • The UK’s Green Investment Bank, a public finance institution
  • Macquarie Capital, an institutional investor
  • Siemens Financial Services, a subsidiary of Siemens, a corporation
  • Sumitomo Corporation, a corporation

This array of private and public investors is an example of what the equity landscape is shifting towards.

So why did the equity investing landscape change?

The explosion of new capacity additions fostered equity market growth for wind projects. New projects not only became more frequent but they also grew in average size, requiring more capital. It would only be normal to have several new, independent developers enter the sector under such favorable market conditions. Moreover, many utilities have been financially constrained due to the difficulties in the merchant power sector, further limiting their contribution to the sector.

The take-home message we can draw from this is that as the demand for wind energy increased so did the associated capital requirements. Utilities and developers did not have the necessary capital to cover demand, so third party investors were roped in. Likewise, corporations like Siemens and Sumitomo are using their financial strength to offer financing directly to smaller developers.

 

What I’m up to…

Firstly,

Happy New Year to everyone, thank you for your e-mails!

I wanted to run you through what articles I am working on at the moment, feel free to chime in at any time if there is something you would prefer to read about ⚡️

  1. How to Handle a Climate Change Skeptic – You guys are requesting this, so I will definitely write about it, although I admit I really resent having to add my two cents on how to handle people who categorically reject fact based evidence;
  2. Solar Securitization – Due to the rise of third-party leasing and Power Purchase Agreement (PPA) models, whereby energy clients can enter long-term developers that install, own and operate solar equipment on their roofs. In return, the host customer pays the developer for the solar system’s electric output, similar to how they would pay a utility for their services. These models lend themselves to the securitization of solar assets, a financing technique that puts together pools of underlying assets and transforms the future cash flows into a security. Once the risks are elaborated and understood, there would be many benefits for all parties;
  3. The Tyranny of Short Termism – There are so many things to say on this topic, on the one hand, a greater long-term focus, a growing body of empirical evidence pointing to, companies’ financial performance becoming more predictable, read: more profitable3.  If your focus on profit is sufficiently long, it starts to become more and more genuine representative of the long-term benefits and costs. But there is a growing appreciation of the massive economic threats posed by climate change, the ultimate long-term risk;

  4. Insurance and Climate Change – The $600 billion reinsurance (insurance for insurance companies-yes, it’s a thing) industry helps insurance companies pay damage claims from hurricanes and floods and can help people and companies get back on their feet after disasters,  which are getting more frequent, and deadly on account of climate change. Swiss Re data shows natural disasters caused an average $180 billion in economic damage per year over the last10 years, of which 70%  was uninsured. I wanted to look at these numbers and explore why insuring climate change was is challenging;
  5. Macquarie’s purchase of the Green Investment Bank – Aussie investment bank Macquarie closed a 2b deal to privatize the UK government backed Green Investment Bank. This will lead to interesting developments fo UK green infrastructure;
  6. An overview of the feasibility of the biofuel industry

Also, I realize that I am not as active as I ought to be, and I promise you, I will publish more regularly!

Stay awesome⚡️

cover photo from the Jimothy Wiggins Archive