Power project financing demands are constantly changing. The current model for structuring project finance transactions began with the emergence of independent power producers (IPPs). Many IPPs only wanted to finance a single, large project. The capital cost was typically in the hundreds of millions of dollars, and the developer commonly wanted to finance a substantial part of the project’s cost with nonrecourse debt.
Nonrecourse debt does not allow the lender to pursue anything other than the collateral. If a borrower defaults on the loan, the lender can foreclose on the property, but generally can’t take further legal action to collect the money owed if the collateral doesn’t cover the full value of the debt.
Project Financing Models Evolve
The original structure was born out of credit criteria published by the national rating agencies for project financings in all industries. The essence of higher credit quality in that rubric was the de-risking of cash flows for the purpose of satisfying the nonrecourse lender. It was meant to provide an interest rate that offered a risk-adjusted return on the loan capital and nothing more. Nonrecourse lenders have no upside in a project, the way equity investors do, and for that reason, credibility of cash flows is king.
It is interesting to examine how the project finance model continues to evolve in light of growth in renewables and the trend toward more distributed generation. For the last decade, Stern Brothers has been providing nonrecourse project financing from the bond market as an alternative to syndicated bank debt or tax equity, specifically when developers were not eligible for the latter two forms of financing. In general, commercial bank financing has not been available for renewable power projects except where there is no technology, offtake, or feedstock risk; and therefore, the project, while not investment-grade rated, is close to investment grade in its credit quality. Examples of this are utility scale wind and solar, where both tax equity and back leverage have been used.
The biomass and waste-to-power sectors have presented lenders with technology risks and feedstock risks, which neither investors nor the rating agencies have had the tools to analyze properly. That has created the need for credit enhancement in those sectors and the allocation of unmitigated risks to at least one party in the transaction. Typically, this has not been the developer, who often does not have the balance sheet to guarantee the technology’s performance. Where the power generation technologies are considered commercialized, feedstock risk has taken the deals out of the money for commercial banks.
Another area of equal interest is projects driven by the objectives of the Clean Power Plan (CPP). Even though the CPP has been rolled back by the Trump administration, some investment bankers continue to assume that many coal-fired power plants, and even natural gas–fueled plants, will eventually be retrofitted with new technologies to reduce pollution and lower or sequester carbon emissions. These projects will present additional technology risk to nonrecourse lenders.
The traditional approach to mitigating technology risk was securing an engineering, procurement, and construction (EPC) contract that included a wrap of the technology. In this way, the contractor presented a single point of responsibility to the nonrecourse lenders in the event of default on the debt.
Our investment bank has looked at a number of options for de-risking technologies in this context. Rather than asking the sponsor to put up its balance sheet or a letter of credit, we have been pursuing de-risking mechanisms that can be sourced from other parties in the transaction.
The loan guarantee programs offered by federal agencies, such as the U.S. Department of Agriculture and U.S. Department of Energy along with multilateral loan guarantees for projects in Organization for Economic Co-operation and Development and other countries, have been a common source of recourse and de-risking. The challenge with loan guarantee programs has always been the time and expense associated with government bureaucracy. Developers have chafed at the idea that these programs decelerate the pace of project development, and thus slow the time to creation of enterprise value and to the ultimate liquidity event.
Now, the private sector has introduced a new de-risking mechanism—the use of technology risk or efficacy insurance. The use of an insurance policy as a backstop for the project developer or technology licensor warranties has the effect of changing technology risk to credit risk for the nonrecourse lender. Early results suggest that premiums for these insurance products are much less expensive than EPC wraps, and incorporating insurance into project financing deals takes much less time than pursuing loan program guarantees. For these reasons, insurance has the possibility to be a game changer in the structuring and execution of first-commercial-scale-project financings in the power sector in general, and in renewable energy projects in particular. ■
—John M. May is a managing director for Stern Brothers and is co-head of the firm’s Cleantech Energy & Infrastructure group.