Part II: The Project Finance Checklist ✔️

I already wrote about why renewable energy companies are using project finance for their energy infrastructure projects here, be sure to check it out before reading this.

Given the fact that project finance is often an expensive and complicated undertaking, it becomes fundamental to figure whether project finance is a realistic opportunity for a renewable energy project. Keep in mind the following considerations:

  1. Size:  Is the project large enough to make PF worthwhile? Banks won’t go through the hassle of PF for small projects, bear in mind that although project finance size varies from country to country, we’re looking at $50m to $100m as being in the ballpark. If the project is too small, both lenders and sponsors will be put off project finance;
  2. Establish Realistic Revenue Streams: Since there are two primary sources of revenue for investors, public funds and the other is revenue streams in the form of charges, paid by end users, sponsors and lenders must figure out what that revenue stream will look like. Will the revenue stream be big enough to support the high debt financing taken by the sponsors?
  3. Length of Project: PF is a long term investment spanning 10-15-20 years so there will be a long payback period;
  4. Physical Assets: Will there be physical assets (solar panels, wind turbine) sufficient to ensure lender repayment in case of default? Banks are going to want more “guarantees”, what is the above-mentioned revenue streams doesn’t come through will they will be able to foreclose on the project’s assets sufficient in value to “make themselves whole,” either by selling the project outright or operating it until the debt is repaid;
  5. Tech Risk: Renewable energy is a very innovative and competitive sector, so tech is evolving quickly. While in many project financings, the tech may be relatively new, generally speaking, project finance lenders do not want to be the first to finance an unproven technology. This is not venture capital. A history of successful use in some context will often be necessary to secure project financing;
  6. Quality of the Contract Network: At the end of the day, project finance is a web of contracts between different parties. It is important to know if the project company has contractual relationships with reputable companies for services key to the success of the project or the technology it employs? Banks will be less keen on lending to a project the success of which depends solely on a few star individuals who may depart, leaving the project unable to meet its potential, so credible contracts are very important;
  7. Receipt of Revenue: In that regard, will the receipt of revenue be enforceable under contractual rights from a creditworthy party? If there is no contract or if the creditworthiness of the purchaser is not credible, this will trigger concern for banks  and set off thorough(er) due diligence procedures regarding revenue projections;
  8. Exit Options: What are the ultimate objectives of the sponsors? Are they looking for a quick exit option, do they want to jump ship? Know that once the project is “project financed” and the contracts are in place, divestiture opportunities are complicated by the requirement of the bank consent, and potential purchasers will be thoroughly examined by banks for development and operational expertise as well as creditworthiness;
  9. Risking the Project: In other words, once project financing is completed, the Sponsor will lose the ability to determine how the vast majority of the project’s revenue is spent. In the event a project becomes uneconomic and unable to service its debt, the only option besides refinancing the debt may be to turn over the project to the lenders (voluntarily or involuntarily), with the loss of the Sponsor’s investment in the project.

You may be interested in Part I: Project Finance 

For more check out: https://www.wsgr.com/PDFSearch/ctp_guide.pdf

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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