The Four Forces of the Energy Evolution

Project Finance in Renewables (Microeconomic)

There are many variations of sayings about money in pop culture that are a take on the fact that, although it isn’t everything, everything needs money. The energy evolution certainly needs money to move from the realm of aspiration to reality. To facilitate this necessary flow of money to renewables, however, those who control the capital must be sufficiently incentivized and understand and, if possible, mitigate the risks of their investments. This becomes difficult when, in some cases, the developers of a project in the renewables space may not even have a track record to warrant a loan, let alone a guarantee from anyone creditworthy to repay.
Enter project finance. Project finance isn’t new, and it is certainly not exclusive to renewables projects. The concept of project finance is simple: project cashflows from the investment and allocate away the risk as much as possible. So how do we apply these concepts to renewable projects?
The developer is the one that conceives the project. To do so, they must first identify what they are building, where, how, and when. They become responsible for putting together the specifications of the project, getting the right inputs for an evaluation of future performance, and negotiating the rights to build it when the time comes. In most circumstances, the developer creates a Special Purpose Company (SPC) to which it assigns all this work and associated ownership. Now, they must fund it. The construction costs are high, and they need to be spent before there is any cash flow to the SPC. This requires financing. This is where the lender comes in.
The lender will review the developer’s project and conduct their own due diligence. This will require them to project the cashflows of the asset to size the loan they are willing to give and determine the terms they are comfortable with. The rest of the capital outlay will come from the equity investors. Although some developers own their projects, others need to raise equity commitments or sell their projects outright to investors.
Before the loan and equity terms are finalized and drawn and the construction gets under way, there are terms which must be met. Most of these terms depend on the successful negotiation of contracts by the developer. These contracts are designed to allocate risk away from the SPC and make the investment more palpable for all investors. Even the best and most seasoned developers turn to experts that can better control certain risks along the project lifecycle than they can. The major risks associated with a renewable project can be simplified as construction risk, operational risk, and commodity price risk.
To handle the construction risk, the developer will contract with an engineering, procurement, and construction (EPC) company. EPCs are experts in design and construction of power generation technologies. The EPC contract is usually handled by a general contractor that puts the whole plan together and orchestrates subcontractors where necessary. Given their expertise and experience, they can guarantee parts of the construction process such as time or costs and provide concessions to the developer in case they miss such criteria. Thus, a good EPC contract can allocate away the risks or uncertainties to the lender and equity investors during the construction phase of a project.
Once the EPC commissions the plant and commercial operations start, the risk becomes operational. The day-to-day operations and maintenance are a major cost component and, along with the performance of the plant, is key to the modeled cashflows to the project. This risk is passed on to experts in these operations through an Operations and Maintenance (O&M) contract. The O&M provider will take care of the necessary labor and maintenance of the plant and can guarantee certain availability and performance criteria. Where availability and performance are below the targets or expectations of the SPC, the O&M provider will provide guarantees through pre-determined penalties and adjustments. Here again, the O&M contract allocates away the risk and uncertainty to the lender and equity investors, this time during the operating life of the asset.
The other major risk that remains is the commodity price risk. In other words, the price that the SPC will get for their power generation and/or associated credits. The developer will find a third party, usually a utility, power marketer, or industrial demand source that is willing to be an offtaker of the project’s electricity generation. They will sign a Power Purchase Agreement (PPA) contract, which will specify the duration for which the PPA will be in place, how much power they will receive, and at which price. In effect, the PPA will guarantee a certain price for their generation for a period, alleviating the price uncertainty to the lender and equity investors. The duration of the PPA is key as if the PPA expires before the end of the useful life of the project, or more importantly, the debt tenor, the merchant price risk will be reintroduced to cashflows for better or for worse.
In addition to the above, the PPA structure can provide certainty around other assets like renewable energy credits (RECs) and tax equity structures (covered elsewhere) can monetize some key tax incentives available to renewable energy projects. In the case of wind and solar projects, there is no input risk (it can in fact be considered operational performance risk), but in cases where there is an input (like natural gas) that is necessary for the generation technology, the input price risk is also a factor that can be mitigated through a similar agreement (just in reverse) or passed through to the offtaker.
So, as you can see (for a simplified visual see Figure 1), the developer first goes through the process of bringing a project plan to market. That project company is usually a SPC with no credit history (or, in fact, any history). However, the project’s cash flows can be modeled, albeit with considerable risk to the inputs (hence the due diligence and debt covenants). To make the project palpable to lenders and equity investors, they must allocate the risks associated with the project and do so through contractual means with other third parties. Through EPC, O&M, and PPA contracts, they can mitigate the major risks to the cash flows and secure financing.

Figure 1 | Simplified View of Parties in Renewable Project Finance

It is a fair question to ask, at this point, what risk remains at all? And everyone knows that without some risk, there can’t be returns. Well, first, you can’t ever completely mitigate contract risk. For example: How ironclad are the contracts? How reliable are my counterparties? Did I properly account for all the project risks through these contracts? Additionally, even if the EPC contractor builds the project to specifications and the O&M contractor operates it with good availability, there is no certainty about resource availability. We can’t know for sure that the sunlight will be uninterrupted by cloud cover, or the wind will blow within a certain statistical distribution of its historical observations. Thus, there is always risk to the generation forecasts that are a key input to the cashflow models that are used to calculate potential returns to investors. Admittedly, however, thanks to the allocation of some major risks, the overall project risk is much less pronounced than some other competing investments (think cryptocurrency or Silicon Valley next-big-thing start-up). Therefore, renewable project finance (and in fact most project finance where this allocation of risk is possible) is a relatively low-risk form of equity investment, for which the returns are consequently more modest.

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