In this primer, specially written for NDCi.global, renewable energy finance expert Tom Murley tells you all you need to know about project finance.
Climate Change presents both risks and opportunities. Risks of food security, flooding, population displacement, and political uncertainty. Opportunities for new investment, new technologies and a better, cleaner more sustainable future. It also presents many challenges – primary of which is a financial challenge. About $90 trillion in infrastructure investment is required to 2030 to both replace ageing infrastructure and meet growing demand.  Much of this investment will be in energy infrastructure, and all of it will need to be in sustainable infrastructure that helps to deliver the goals of the Paris Climate Agreement. The required investment of $12 Trillion per year is almost double the current level of annual global infrastructure investment.
This paper is one of a series for NDCi Global that explore proven and emerging structures and methods for mobilizing appropriately-priced private sector capital to finance the low carbon transition, with the view to informing policy makers of how policy decisions can affect investment flows. These papers will focus primarily on investments in energy infrastructure, which will be the largest area of investment. They do not address venture capital for new climate technologies or financing the manufacturing of renewable energy equipment.
This paper is a primer on Project Finance.
Project finance is an established financing technique used to finance large, high cost, long-lived infrastructure assets – Projects –such as gas and oil pipelines, electric transmission and distribution grids, port facilities, airports to electric power generation, including renewable energy projects. In many ways, project finance came into its own in the power generation sector in both the US and the UK in the 1980s and 1990s, where it was used to finance a wide range of early renewable and conventional power generation projects outside of traditional state or privately-ownedelectric utilities.
In essence, project finance refers to the financing of a single or small discrete group of infrastructure assets on a stand-alone basis. “Stand alone” means that the debt and equity investors in the projects only earn their returns from the earnings of the projects, not from any growth of the company sponsoring them. For example, an investor in a project financed power generation project will only be earn returns from what that project makes, it does not benefit from all the other activities of the electric utility that might purchase the power generated (e.g. no revenues from transmission or distribution of power, or selling energy services to customers). If the project fails, the investment fails. Therefore, project financing presents different risks than corporate financing.
Project finance is a structured finance technique based on norms developed over decades. The underlying principal of project finance is allocating risks – construction risk, pricing risk, operating risk – among investors, operators, builders, lenders. These risks change and evolve over time, for example, the construction stage presents greater risks than the operating stage. Navigating the project finance conventions evolved to allocate and manage these changing layers of risk to a successful has been compared to threading a needle, or assembling a jigsaw puzzle.
Project finance has advantages and disadvantages. The principal advantage is that it allows projects to secure more debt for longer terms. With debt being the lowest cost capital, this lowers the overall cost of capital, which in turn means the annual costs to consumers of the infrastructure is lower. It also has financing efficiencies for developers, sponsors and owners as they do not have to pledge corporate assets as security or provide long-term guarantees to lenders The disadvantages are time and cost to implement complicated structures. The advantages generally outweigh the disadvantages, which is why project finance is an important and enduring financing method
What is Project Finance?
Project Finance is an established debt and equity financing technique used for large and long-lived infrastructure assets: power plants, pipelines, water treatment facilities, ports, airports, transmission lines, etc. It is called Project Finance, because it is typically done one project at a time, or with a discrete set of projects, unlike financing an entire utility or a company.
Academic definitions of project finance include:
“A form of asset based financing in which a firm finances a discrete set of assets on a stand-alone basis.” – Harvey’s Finance Glossary
“Project finance is the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure, in which project debt and equity used to finance the project are paid back from the cash flow generated by the project. Project financing is a loan structure that relies primarily on the project’s cash flow for repayment, with the project’s assets, rights and interests held as secondary security or collateral. Project finance is especially attractive to the private sector because companies can fund major projects off balance sheet.” – Investopedia
The Author’s definition is:
“A form of off-balance sheet structured financing for large, long-term industrial and infrastructure projects based on non-or limited recourse finance so that the sole source of repayment of debt and equity are cash flows from the project and not a sponsor balance sheet, and where construction cost, operating cost and revenue risk are allocated by contract or law away from the debt investors, and in some cases equity investors, to the parties best able to assess, mitigate and accept such risks.”
Parsing the definition provides a better understanding of the underlying principles of project finance:
A form of off-balance sheet structured financing: off-balance means that the debt it is generally not considered in calculating the debt / creditworthiness of the owners or sponsors of the project, thus preserving their balance sheet for other financing needs. Structured means that it is highly technical and subject to a number of conventions. The non- or limited recourse nature of project finance is critical to securing off balance sheet treatment.
. . . for large, long-term industrial and infrastructure projects: it is for large projects because the transactional costs, including legal and due diligence costs, are high, often, but not always, making it uneconomic for projects of less than $10 million, but which is very efficient for large projects of $100 million or greater. It is used for long-term projects because it allows for capital financed by debt and equity investors to be repaid over 15-25 years, which provides for lower annual costs to consumers (e.g., electric customers) who pay for the infrastructure. If one thinks about it in home mortgage terms, a $100,000 10-year mortgage at 5% interest has monthly payments of $1,061 versus $537 for a 30-year mortgage.
. . . based on non- or limited recourse finance so that the sole source of repayment of debt and equity are cash flows from the project and not a sponsor balance sheet: limited recourse or non-recourse financing means that if things go badly – the project does not work, or there are cost overruns to build, or revenues are less than expected – the lenders and equity investors can look only to the project and the revenues it earns for repayment. They cannot seek out the owner’s balance sheet. For example, today pension funds and insurance companies are increasingly investing in infrastructure. If the project goes south, the entire pension fund is not available to repay debt, just the fixed amount paid in by the investor. Thus, in the case of failure all the lenders can do is seize the physical asset. Again, this is like the US residential mortgage market. If a homeowner defaults, all the lender can do is foreclose and take the house, it cannot attach the borrower’s income for any deficiency if the value of the house is less than the mortgage.
. . . and where construction cost, operating cost and revenue risk are allocated by contract or law away from the debt investors, and in some cases equity investors, to the parties best able to assess, mitigate and accept such risks: risk allocation and mitigation is at the heart of project finance. For example, bank lenders are not builders. If there is a cost overrun, then the project either needs to earn more money to repay the additional costs (which is very hard to do) or the bank has a poorer credit. Therefore, it is common for a large construction company to agree to build a project for a fixed price, to be completed on a fixed date. The risk of cost overruns is borne by the contractor, who is after all best place to identify, assess, price and manage cost overrun risks. As we will see fixing of costs and revenues applies to almost every aspect of project financing.
Sounds a bit complicated, doesn’t it? It is, and often even more so in practice, so why use project finance? Or why not?
Project Finance: Advantages and Disadvantages
The following table outlines the principal advantages and disadvantages of project finance:
|Maximizes debt, reducing WACC||Debt is the cheapest form of capital, and equity the most expensive. Utilities are usually financed 50% debt and 50% equity. In project finance debt levels are often 70-85%, which means the Weighted Average Cost of Capital (WACC) is lower, which means charges to consumers can be lower.
|Higher interest rates and fees||Generally, project finance debt has higher interest rates and fees than bonds and other financings, though equity costs are quite attractive. The higher costs are usually offset by higher leverage, lowering project WACC.|
|Longer terms, reducing consumer cost||As noted above, project finance loans are routinely for 15 years or more. The longer repayment means that the annual charges to users of the infrastructure are lower. For example, utility corporate bonds are normally 5-7 years in duration.
|Debt levels can increase equity risk.||With higher debt levels, there is less margin for error. If something goes wrong equity can find themselves in a loss position faster than in less geared structures.|
|Off-balance Sheet frees up balance sheet for other financing needs||Although the rules for off-balance sheet treatment by debt rating agencies (Moody’s, Standard & Poor’s) has become stricter, it still offers off-balance sheet classification, allowing corporate sponsors (e.g. utilities) to make better use of their balance sheets for other investment or operating needs.||Slow execution and relatively high transaction costs||As we will see below, project financing involves multiple parties and contracts that need to fit together like a jigsaw puzzle. This takes time. It is not unusual for it to take 6-12 months to arrange and negotiate all the contracts and lending agreements for a project finance transaction. Legal fees are high, as are up front bank charges.
|Deep global markets||Project financing has been refined over nearly 40 years. There is a deep pool of global banks, insurance companies, investment funds and pension funds willing to provide debt and equity for well-structured projects.
|Idle cash that earns the lowest interest rate||As explained below, because there is no external source of repayment, the lenders will insist on various cash reserve accounts, which are added insurance and cannot be used for other purposes, and earn interest at the lowest market rate.
|Risk Sharing||Project finance allocates risks away from the main sponsor, and shares the risk among all project parties – suppliers, constructors, lenders, operators – in a manner that minimizes risk to any single party.||Unsuitable for emerging technologies||As debt and equity investment is repaid only from project cash flows, investors require a high level of certainty that those cash flows will be there. New and unproven technologies may not work as expected, thus project finance is rarely used for new technologies, which are financed with either equity or recourse debt.
|Low default rates||Data compiled by the main rating agencies and lending banks shows that project finance loans have far lower than average loan default rates, and where there are defaults much higher than average loan recovery rates. This makes it an attractive investment for long-term investors.||Equity at greater risk in defaults||Although the overall default risk is lower, when defaults do occur, due to higher gearing levels, the equity investors can easily lose all or substantially all of their investment.|
Project Finance Structure and Participants
The basic project finance structure is illustrated below – in this case the primary example is a wind farm or solar farm. The analysis starts at the center – then moves on the various principal participants in an energy project financing. There is one thing to keep in mind: When a new or greenfield project is financed, the project consists of nothing but a bundle of legal rights – permits to build and operate, rights to use the land, contracts to purchase equipment and build the project, a power sales agreement or a legal right to a tariff and legal commitments from debt and equity investors to invest capital. All these pieces come together like a jigsaw puzzle. The chart also shows the basic economic risks and rewards taken by the parties.
The Project. The Project takes center stage. Or rather the Project Company. In project financing, each project is owned by a separate legal entity with limited liability created for especially for the project. It is called a “special purpose vehicle” or “SPV” and is normally a corporation, but may be a limited partnership or limited liability company depending on the jurisdiction and tax structures. The SPV or Project Company is the beneficiary of all the rights to build and operate the project. It holds the construction and operation permits (e.g. zoning or planning, environmental discharge). It enters into contracts with suppliers to build, operate and maintain the project. It holds rights to a renewable energy tariff or has a power purchase agreement with a utility or other buyer of power. If it is biomass plant, it has contracts to supply fuel. It has agreements with lenders to advance loans for construction, and commitments from investors for equity.
One thing it does not have is employees. During construction, workers are employees of the contractor or subcontractor. During operations, they are employed by a third-party operator. This is to insulate the project from legal claims for injury, death, discrimination, sexual harassment and the like. Such claims are not forecast in the revenue or operating costs, and could bankrupt the SPV, so they are allocated to third parties. This practice and other practices make the SPV “bankruptcy remote” – in other words it becomes very hard for anyone other than the equity investors or the lenders to place the project in bankruptcy or receivership.
The Developer. Developers (or sponsors) range from large utilities with thousands of employees to 1-3 person entrepreneurs with small amounts of capital, and almost all shapes and sizes in between. Developers take entrepreneurial risk to make the project happen. Developers (i) find the appropriate site and buy or lease the land, (ii) conduct the necessary environmental, noise, traffic and other studies necessary to get permits, (iii) apply for permits and prosecute permit applications, (iv) qualify for renewable tariffs (including bidding in auctions) or negotiate long-term power purchase agreements, (v) select equipment and design the site and select operators and (vi) in some, but not all cases, negotiate and arrange debt and equity financing.
Development costs money. Far less than the cost to build, a project, but it can easily run into millions of dollars for medium to large scale projects, and this capital is at real risk of loss. Permits may not be obtained, the site may be too costly, PPA tenders may not be won, or renewable support regimes may be modified before the project gets under construction, rendering it uneconomic.
Some developers like the large utilities will develop, build, finance and own projects for the long-term. Others will do so through construction, then sell to investors once construction is complete. Still others will sell at the start of construction and some small developers will sell permits and tariff or PPA rights and let others arrange finance, construction and operations.
The reward for developers is either selling the project to investors for a profit over what it costs to develop, or staying in the project and recouping that “development premium” through long-term ownership
The Owners/Equity Investors. The owners / equity investors provide the equity capital to build the project. Increasingly, even large utilities are bringing in outside financial investors – pension funds, insurance companies, family offices, Yieldcos and infrastructure and private equity funds as investors, ranging from minority investors to 100% ownership. The investors are responsible for overseeing the contracted construction and operations, managing banking relationships, and in some cases arranging construction, finance and operations. In return for their investment, investors receive annual dividends from the project after operating costs and debt service are paid, and any capital appreciation in the asset over time.
The Contractor/Turbine Supplier. Large energy and infrastructure construction is complex. For example, in a wind plant there are civil works such as access roads, turbine foundations and conduit for underground cables. There are the turbines and towers, cabling, electrical grid connection, control systems. In a biomass plant there are civil works, plus boilers, steam generators, fuel storage and delivery, cabling, control systems, grid connection, air pollution control systems, cooling water systems and more. Typically, building a project involves tens if not hundreds of specialist contractors. The risk that one does not perform, or performs late delaying others, present risks of cost overruns.
In classic project finance the EPC contract was created to mitigate these risks. EPC stands for Engineer, Procure, and Construct. In an EPC, the EPC Contractor agrees to deliver a project for a fixed price, on a fixed date, meeting agreed performance standards (e.g. MW of capacity) and a warranty for several years. It is also called a Turnkey Contract, as when it the project is complete, the owner can be handed the keys and can turn on a working project.
The EPC contractor takes the risk of cost overruns (except Acts of God or War), the risk that subcontractors are late or do not perform, weather delays, that the project will be built and be able to operate consistent with permits and other regulations, and that the equipment will perform, as measured by independently-verified tests. They coordinate all the necessary contractors, choreographing a dance as it were to have each one do its job at the right time and manage the interface risks among them. The EPC contractor pays agreed damages for each day of delay, for underperformance and other matters. For taking on the risk, the EPC contractor receives 7-10% of the total project construction cost as a profit margin, and sometimes higher.
Over the last decade or so, in wind and solar a somewhat different model has developed – the multi-contract approach. Wind turbines and solar panels are built in factories and are shipped ready to install (as opposed to biomass boilers which are assembled on site), and there is no mechanical fuel handling installation. Solar and onshore wind are as close as the industry comes to plug and play. Recognizing that the civil, electrical and equipment risk of wind and solar are much lower, and the interface between the turbine or panel installation and the civil and electrical works are well known and easily managed, wind and solar projects have evolved to multi contracts – usually three contracts (1) a turbine or solar panel supply and installation contract with the turbine maker or solar panel maker, (2) a civil contract for foundations, roads, cable trenches and the like and (3) an electrical contract for the grid connection and hooking the wind or solar array together. Each one of these will be a fixed price contract, will have tests like and EPC and will have fixed delivery dates. In the case of biomass projects, the traditional EPC route prevails. Offshore wind has been done on a mix of EPC and multi-contract, but mostly multi contract with substantial contingency reserves. EPC Contracts are typically hundreds of pages long.
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The Power Purchaser. As discussed in more detail below, at the core of energy project finance is a long-term fixed price or limited price variability contract for the sale of electricity, known as a Power Purchase Agreement or PPA. The PPA provider, historically an electric utility, agrees to purchase the electricity produced (or biogas or other product) for a fixed price for a fixed period of time. For renewables in many countries, especially Europe, this has been achieved through feed in tariffs (FITS) under which utilities are obliged to purchase renewable output for typically 15-20 years. In the United States, and in many emerging markets such as South Africa, utilities run auctions or tenders for PPAS, with the developers bidding the lowest price winning. In recent years, large corporations with large power needs have entered PPAs, both to control their energy costs and to further their sustainability goals. Google, Amazon, Ikea and Facebook are all substantial PPA parties. The PPAs are usually for a fixed price for all of the output, though there can be contracts for variable prices and output. The credit of the PPA provider (or the electric system in the case of FITs) is the backbone on which project financing rests. Does the purchaser have the economic wherewithal to pay as agreed for 15-20-year typical period?
Banks/Lenders. Project finance was developed to maximize long-term bank or other loans, which are cheaper sources of capital than equity. More debt brings down the weighted average cost of capital (WACC) for the project, ultimately lowering annual costs to consumers. In the early days of project finance, few banks would lend very long term, but they would lend during project construction, with the long-term debt often provided by insurance companies who saw the long-term debt as a good match for their long-term liabilities. Today banks, insurance companies and pension funds are active in this market, but banks still take the leading role in organizing and structuring the loans.
The Lenders lend the project money to build the project, disbursing funds quarterly or monthly as construction progresses. The loan is repaid over 12-15 years from operating cash flows. To secure repayment, the lenders take first ranking mortgages or charges over all the physical assets, intangible assets (e.g., PPA, permits, EPC contracts) and have the rights to step in and enforce the PPA, EPC and other contracts should the owner fail. The sole source of repayment are revenues generated by the Project.
The lenders have a very controlling role. They disburse construction loans only after their engineers have verified work is complete. They allow payment of operating costs only if within an approved annual budget. The permit payment of dividends to owners only after their debt has been paid and necessary financial covenants have been met and verified. In the case of loss or damage, they control the application of insurance proceeds to either rebuilding the project or repaying the loans. Typical loan agreements and related mortgage documents run to the thousands of pages.
Operators. The operators do just that, they operate and maintain the project for 5-20 years, providing all necessary personnel and ensuring compliance with laws, permits, equipment warranties, etc. Fee arrangements vary depending on the scope of contract. Fixed costs for personnel and administration are normal. Costs of spare parts and repairs may be fixed, or may be done on a cost-plus basis. The contracts generally provide that the operator will guaranty that the plant will be available to run for most of the time (typically 90-97%) and at certain efficiencies, all backed by liquidated damages.
There are many types of operators. In the wind industry, the wind turbine manufacturers typically provide long-term fixed-price maintenance, spare parts and operations agreements; up to 20 years. In the solar PV industry operations are mostly done by regional firms, who may have been the builders. Large utilities, such as E.On, NRG Energy and Veolia will operate plants for third parties, especially biomass projects. Construction companies for biomass and other thermal plants may also be operators. And there are other companies that are pure independent operators.
Fuel Suppliers. In biomass and waste to energy facilities (and indeed in conventional, coal, oil and gas power plants) there is also the fuel supplier. The fuel supplier guarantees a certain supply of fuel, at an agreed price, delivered to the plant for 5-15 years. Fundamentally, what investors desire are fuel suppliers that guaranty both the volume and price of the fuel over 10-15 years, but this is rare. Fuel suppliers in biomass may be forest product companies, pellet suppliers or transport and logistic firms that have the fleet of vehicles and expertise to collect fuel. In waste to energy facilities they are likely to be government or private garbage haulers or collectors. In most fuel contracts the supplier guarantees quantity and quality. Quality usually refers to things like not having chemically treated waste wood which can affect pollution control systems or may violate permits. Pricing differs from material to material and market to market. Sometimes prices are fixed or linked to inflation, with the supplier taking the long-term price risk. In other contracts the price is tied to market prices, so the project bears price risk, and some contracts have a combination, such as a fixed price for 5 years, followed by a reset every five years to market prices. The duration and price risk of a fuel contract can have a major impact on the project financing terms.
The Fundamental Principles of Project Finance
Returning the definition of Project Finance, for the author the core is the final clause about mitigating and allocating risk:
“…where construction cost, operating cost and revenue risk are allocated by contract or law away from the debt investors, and in some cases equity investors, to the parties best able to assess, mitigate and accept such risks.”
Minimizing or mitigating revenue or cost risks is the very core of project finance. The three main risks, in descending order of financial impact, are:
- Revenue Risks
- Construction Cost Overrun Risks
- Interest Rate and Operating Cost Overrun Rate Risk.
This paper looks at each of these in turn, but before doing so one might ask what about technical risk? That is really part of the revenue or operating cost risk. If the technology does not produce as much electricity, revenues will be lower. If it breaks down more often, it will cost more to operate.
And there is one other aspect – the financial model. All of these risks can be captured in a financial model of the project, which is the key tool for evaluating the investment and impact of risk. Financial models used in Project Financing are huge Excel spreadsheets running to hundreds of pages and usually broken down to month by month forecasts for 1-2 years of project construction and 20-25 years of operation. Every cost, technical parameter, accounting matter, tax matter and revenue source is accounted for, with the ability to change any input to “stress” the project. We will return to the
Revenue risk is the biggest source of risk to project investors. The quality and predictability of revenue streams are key to determining not only the attractiveness and economic viability of the investment, but the capital structure. The less certain the revenues, the lower the amount of debt, affecting the overall WACC of the project. If revenues are less than anticipated, it affects the ability to repay debt, the return to the equity investors and, in the most drastic cases, the ability of the project to simply pay operating costs.
There are two types of revenue risk:
- Commodity (e.g. electricity) price risk
- Commodity volume risk
Commodity Price Risk. Commodity price risk is an anathema to project finance, especially for renewables which have large upfront costs. This is why the Power Purchase Agreement or the Feed-in tariff is so important. The longer the agreement, and the more solid the pricing and the credit of the purchaser, the bigger the loan, and the better the loan terms. Projects that do not have such contracts, that are exposed to the power markets, are called “merchant” projects. Projects with good PPAs or FITs can secure loans of 15-20 years for 75-85% of project costs. Merchant projects, if they can secure debt, might only achieve 5-7 year loans for less than 50% of project costs.
Since 2015 several in the industry have talked about “subsidy free” renewables. Subsidy free does not mean merchant, rather it means the renewable should be isolated from price risk under a long-term contract whose price is set by auction or by reference to some other energy cost, such as gas-fired generation.
Those countries that have offered the longest contracts with the least price risk (e.g. Germany, Denmark, the United State) have achieved the greatest renewable penetration. Those with more market risk (e.g. Sweden and Norway) are seeing declines in investment as investors harbor the wounds of falling energy prices. Similarly, contracts with price reopeners every few years, or tariffs that can be reviewed, are less favored.
Simply put, longer contracts with fixed prices (and linked to inflation) whether granted by tender or FIT are more likely to achieve the best project financing terms.
In evaluating a PPA or FIT, the lenders and investors will pay close attention to:
- Termination provisions – can the purchaser terminate the contract? Under what conditions and under what notice. It is not unusual for a PPA to require a plant to be operating by a certain date or it can be terminated or the price adjusted. Thus, whether the contractor contractually agrees to deliver on time, and what damages it will pay for failure, are critical to evaluating the risk to the PPA. What are the force majeure provisions?
- What is the legislation underlying a FIT? Can it be changed after the project is built?
- What are the price indexation provisions? Is it linked to the same inflation index as operating costs?
Commodity Volume Risk. Revenues can also be less because the project produces less electricity. This could be for several reasons:
- Incorrect assessment of wind or solar resource
- The equipment does not perform as expected
- The project is “constrained off” the grid and is unable to export electricity
Commodity volume risks are mitigated by contract, sensitivity modelling and insurance.
Contracts are used to mitigate against equipment performance. The wind turbine maker, solar panel maker or other supplier will warrant the amount of electricity generated with respect to the estimated resource. This is a simplified example. A turbine maker guaranty that 20KM / Hour wind will generate 1MWH of electricity. Assume the price under the PPA is $60MWH,. If at 20KMPH the turbine only generates 1.5MWH, then the turbine maker makes a payment to the project of $15MW. Similarly, if the wind is blowing the machine is not available to operate, the turbine maker will pay for lost production. In reality, in such cases the owner is not fully reimbursed for the lost production, but it provides a floor on losses, and a high degree of protection.
Insurance is also used for equipment failure. If there is material damage or loss to equipment, the standard insurance policies include coverage for loss of revenues, which are applied to pay debt and make equity distributions.
Incorrect estimates of wind or solar resource are mitigated financial sensitivity analysis. An expert wind forecast analysis (which are rigorous and have improved drastically over the last 15 years) will have an average or base case forecast and a low or downside case forecast, both statistically determined. Banks will typically lend money based on the low case forecast, which is usually 15-20% below the average forecast. Lenders will size the debt so that if the production is low case, that the project will still generate enough revenue so that after operating costs there is enough cash remaining to pay principal and interest pus 15-20%, giving plenty of cushion. This 15-20% of cash in excess of principal and interest is called the Debt Service Cover Ratio (DSCR) and is expressed generally as a ratio, e.g., 1.20:1.00.
Above we indicated about financial modelling. The Debt Service Coverage Ratio is at the core of the modelling. The lenders will decide the level and duration of debt by running various scenarios or “sensitivities” – low wind, low inflation, higher operating costs, etc. – all with the goal of establishing whether that within understood risk parameters the project is able to repay the debt with acceptable levels of cash flow to spare.
Resource assessment risks are also increasingly being mitigated by insurance. Several large insurance companies are now offering financial insurance against lower wind. It is expensive, and whether it is a good investment depends on each project, but it is available.
The final revenue risk is the risk of constraint. Electricity networks are complicated, but fundamentally they must be in balance all the time (e.g. as much electricity must be generated as is being consumed at any one moment) and they must operate within certain voltage and other limits (lest there is a surge that fries your computer). Further, most electric grids were designed to move power from large power stations in or near cities, out to more rural locations. But most renewable generation occurs in the rural locations, so in a sense the network is being used to send power in the reverse direction for which it was designed. Further, wind and solar production varies from day to day and hour to hour.
The variability or renewable production creates voltage issues on the grid. Further, variations in demand locally and grid bottlenecks may mean in rural areas the grid cannot take all of the power produced when renewables are at full capacity. Thus, in order to keep the grid in balance and ensure continued power for all, renewables may be “curtailed” or “constrained off” the grid. If a project is constrained off, it loses revenues.
The volume risks of curtailment are largely handled in the same manner as incorrect resource assessment. If a project is at risk of constraint, debt and equity investors, with the help of experts, will assume loss of production, and revenues in sizing the debt and making the investment. This will be based on how curtailment is handled in the local area. For example, in some countries renewables are the last to be constrained off, in other systems they may be first. Some jurisdictions offer payment for certain curtailment, others do not.
Construction Cost Overrun Risk. The risk of construction cost overruns is largely managed and mitigated through the EPC contract. As outlined above the core principal of EPC is a contract to build at a fixed cost, completed on a fixed date and meeting certain specified and measurable performance criteria. Some of the key customs applied in EPC contracts to effect this result include;
- Independent Engineer Review. The lenders and investors appoint an independent engineer who monitors the construction, commissioning and testing. Before the contractor or suppliers are paid, the engineer certifies to the lenders and investors that the scheduled works are complete and done properly, that necessary permits and standards have been obtained or followed. When the project is complete they monitor the performance criteria and certify compliance.
- Performance Security. The contractor usually posts bonds or other security to secure the performance of its obligations.
- Staged payments. The contractor is paid in instalments against work done, and in fixed amounts at fixed times. The fixed amounts and fixed times are critical, as interest on funds borrowed during construction is paid from additional loans. If the amounts come sooner or larger, then interest would exceed the calculated budget.
- Lender Step-in Rights and Contractor Subordination. Should the project company default, the lenders have the right to step in and cure the default and make the contractor perform. The contractor agrees not to cease work for an extended period until the lenders decide. The contractor also agrees to subordinate its claims for payment to the prior claims of the lenders.
- Force Majeure Clause. The EPC contract is for a fixed price and a date certain subject to limited exceptions, the most important of which is “force majeure”, which is similar to an Act of God. If there is a force majeure event, the contractors time to complete is extended, and it is entitled to compensation for increased costs. Force majeure typically includes extreme weather, terrorism, war, national strikes, earthquakes, etc. Force majeure clauses vary from project to project and are often the subject of intense negotiation, especially in emerging markets.
The final mitigant against cost overrun is contingency. The cost budget of a project will have a contingency for unknown or unforeseeable costs. The lenders and investors will assume in their investment decisions that it is fully spent. Contingency varies from project to project and technology to technology. For biomass projects, it is 7-10%, and for offshore wind it can be as high as 15%.
Interest Rate and Operating Cost Overrun Risk. If expenses are greater than expected, the project will have less cash to repay debt and make dividends to owners. In project financing the two largest expenses are interest on the loans and plant operating costs. For biomass and waste projects, fuel costs are also material.
Banks lend money based on short-term interest rates, e.g. LIBOR +3%. LIBOR fluctuates, so if nothing is done, if interest rates rise, expenses rise. Since World War II, there have been many examples of periods of high interest rates in many countries. Banks do not want the risk of rising rates, so they require projects to enter into interest rate swaps and other hedging arrangements whereby the interest rate is fixed for most of the loan for most of its life. In a typical 15-year loan, the lenders will require the project to fix at least 75% of the principal borrowed for at least 10-12 years.
Pension funds and insurance companies also lend to projects. Unlike banks, they generally prefer to make fixed rate loans, so the interest rates are fixed. One of the downside of the fixed rate loans and interest rate hedges, is that if interest rates decline, the project does not get the benefit, and it can be very costly to break these hedging arrangements when projects are refinanced.
Moving to operating expenses, for wind and solar, the main operating cost overrun risk is the routine maintenance and operation of the turbines or panels. This is typically managed through a combination of performance warranties and long-term operating contracts. In the performance warranties, equipment that is not performing as specified is repaired or replaced at no cost the project. Long-term operating costs – routine repairs, service, spare parts, etc. account for usually 75-80% of wind farm or solar park operating costs. The long-term operating agreements, especially for offshore wind, often run to 15-20 years, and the equipment suppliers agree to provide all normal spares, routine maintenance, emergency service, etc. for a fixed price for the entire period, thus placing the cost risk on the suppliers.
Similar provisions are made for biomass projects, but generally speaking the supplier/operator takes less risk than in wind and solar, which means that the project and investors bear more risk of increased costs. In such projects (and indeed in some onshore wind projects and many offshore wind projects) the lenders will create reserve accounts to fund any increased operating costs. These are usually funded through borrowings from the lenders or capital from equity investors. If they are drawn upon, they must be topped up before and dividends can be paid to the equity investors. This ensures the lenders a further cushion on costs that are not contracted away. The reserves will be higher for biomass and offshore wind, and lower for solar and onshore wind.
Fuel costs protection for biomass and waste to energy projects were discussed above in the description of the fuel supplier.
Debt Sizing, Debt Service Coverage Ratio, Reserve Accounts. The concept of the Debt Service Coverage Ratio was discussed above in regard to debt sizing. The banks will allow the project to borrow that amount of debt that leaves the lenders with sufficient cushion to pay principal and interest in the case of conservative situations that could occur, such is incorrect wind or solar assessment. The DSCR also plays an important role as an early warning system.
Because in project finance the only source for debt and equity repayment and profit is the project itself, and because debt makes up the greatest part of the capital, lenders insist that project financings have an early warning system of trouble on the horizon. This is because once cash is paid to the equity investors as a dividend, there is no obligation of the equity investors to repay should things deteriorate in the future. There are several non-financial early triggers, such as adverse regulatory changes or developments, insolvency of the operator, termination of a power sales agreement, etc. In each of these cases the lenders can stop the equity from taking dividends, and in the worst case, they can foreclose on the project. But there are also financial triggers.
Lenders and investors will invest based on forecast adequate DSCRs that appropriately reflect risk. If, however, in actual operation the actual DSCR is substantially lower than expected, or it is trending downward, the lenders can use the DSCR to cut off dividends to the equity investors, or in drastic cases foreclose. In wind and solar project financings, it is common to see equity dividend rights suspended if the DSCR falls below 1.15:1.00, and for the banks to be able to declare a default and foreclose if it falls below 1.05:1.00. Sometimes this test is just based on actual historic financial performance, sometimes it is based on both historic and forecast performance. Forecast performance triggers toughly negotiated by all sides.
Finally, the substantial majority of project financings require the project to maintain a cash funded debt service reserve account, on deposit with the bank, equal to 6 months’ principal and interest payment. Thus, the project always has enough cash on hand to pay debt for another size months before default, allowing time to resolve issues. If it is ever drawn, it must be replenished before dividends to investors can resume.
The reader will gather that project finance is a complex subject and financing structure, but it is a valuable and helpful structure that has proven durable over decades. It will continue to play a role in infrastructure in general and low carbon infrastructure in particular. Its benefits outweigh its complexity and disadvantages.
For policymakers, governments and regulators just embarking on programs to attract investment to meet their NDCI obligations under the Paris treaty, creating an environment that will attract project financeable infrastructure is key. Returning to the theme of reducing and mitigating risk and uncertainty, those new regulators, policymakers and governments are encouraged to consider the following:
- Consult with experienced project finance law firms in designing policies and tariffs, from revenues by contract or tariff, to how renewable installations will be taxed, to how contracts for construction are enforced and how security is enforced.
- Focus on minimizing risks per the ranking above, which means:
- Develop policies and support that provide stable, long-dated revenues that are largely insulated from change, removing the commodity price risk
- Develop policies that expressly reject retroactive changes for projects which are under construction and operation. As the market develops, the rules can change for new projects, but old projects must be “grandfathered”
- Create and maintain legal systems that allow for mortgages and security interests on the tangible and intangible property of projects, and an effective system to allow enforcement of that security
- Create and maintain legal systems that respect the underlying contracts that make project financing work, and the enforcement of those contracts.
About the Author
With over 25 years of principal investment experience in global renewable energy and infrastructure, Tom Murley is one of the early advocates of institutional investor investment in renewable energy and power infrastructure and has been involved in the financing and acquisition of over $10 billion of energy projects. In 2004, he founded HgCapital’s renewable energy funds business, which he led for 12 years; raising and investing over $1 billion in more than 70 EU renewable energy projects. He was appointed to the inaugural board of the UK Green Investment Bank and served on its investment committee and he currently serves on the board of NYSE listed energy services and renewable energy company Ameresco. He also is a Director of the Institutional Investors Group on Climate Change.. A qualified lawyer, Tom began his alternative energy career as an in-house project finance lawyer. He holds degrees from Northwestern University and the Fordham University School of Law, where he was a member of the Law Review. In 2016 he founded Two Lights Energy Advisors, which provides strategic investment advice to institutional investors in global power infrastructure.
 The New Climate Economy, The Sustainable Infrastructure Imperative.