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)
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:
- 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;
- 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;
- 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;
- 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;
- 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:
- 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;
- 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;
- 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;
- 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