TODAY’S STUDY: FINANCING NEW ENERGY WHILE THE ECONOMY HEALS

Those who think politics doesn't matter might want to ask themselves if New Energy matters. If benefits like a boom in domestic jobs, increased U.S. revenues, enhanced energy security, relief from foreign oil dependence and the elimination of environmental devastations matter, politics matters.

How? The New Energies had a banner year in 2009, thanks to provisions in the 2008 rescue plan and the 2009 Recovery Act. Things have slowed in 2010, however, and 2011 looks ominous. Why? Because a minority of fossil fools in Congress has so far refused to extend abridgements to traditional incentive mechanisms provided in the 2009 Recovery Act, as detailed in the study below.

Prospects for action by the new Congress are not promising. It is too late to do anything about this at the polls until November 2012 but Congress responds to pressure from constituencies so get ready raise a resounding demand for New Energy by emails, phone calls and letters next year. It matters.

Renewable Energy Project Finance in the U.S.: An Overview and Midterm Outlook
November 2010 (Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.)

Executive Summary

Wind, solar and geothermal energy projects in the United States are typically paid for using an approach known as ‘project finance.’ This is a structure employed to finance capital-intensive projects that are either difficult to support on a corporate balance sheet or that become more attractive when financed on their own. Project financing structures will vary on a project-by-project basis, but renewable energy projects in the U.S. utilizing project financing generally rely upon a mix of direct equity investors, tax equity investors and project-level loans provided by a syndicate of banks.

Turbulence in the financial markets began disrupting the flow of project financing (both equity and debt) into renewable energy projects in the U.S. in the fourth quarter of 2008.

Nearly two years later, the availability of project financing has improved considerably due to the thawing of the lending markets, with a return to longer tenors on term-debt, and legislative support mechanisms introduced as part of the American Recovery and Reinvestment Act (ARRA)—particularly the ITC cash grant.

In this report, we provide an update on the current terms and availability of project financing for large-scale wind, solar and geothermal projects in the U.S. and forecast the amount of project financing we expect to be sought by the sector through 2012.


In analyzing where this financing is likely to come from, we address the potential impacts of the upcoming expiration of the cash grant and changes to the tax equity supply—two main themes in the renewable energy project financing arena at present.

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The key TAKEAWAYS in this report are:

• The cash grant program has provided significant liquidity to the renewable energy sector and allowed hundreds of projects to directly monetize the 30 percent ITC without requiring a tax equity partner to do so. As of October 6, 2010, $5.4B in cash grants had been paid out to renewable energy projects in the U.S., supporting a total investment of over $18.0B.

• The likelihood is diminishing that the grant could be extended past its December 31, 2010 deadline (to 2012, as proposed). Potential obstacles include: 1) the limited number of days remaining before Congress adjourns for the year and 2) concerns regarding cash grant recipients that are incorporating foreign-built plants and equipment into their projects.

• If the cash grant is not extended, the $4.1B and $6.6B in cash grants that we anticipate would have been sought by the sector in 2011 and 2012, respectively, will have to be sought in the tax equity, debt, and direct equity markets.

• The supply of tax equity to renewable energy has improved somewhat and is expected to reach ~$3.0B for 2010 (2009: $1.2B), but the tax equity supply for renewables is not expected to reach pre-financial crisis levels (2007: $6.1B) for several years. Traditional tax equity investors still have limited future tax base visibility and new entrants (likely to come from the oil, technology and utility sectors) have high learning curves, which we expect to limit their contributions over the midterm. Finally, remaining tax equity investors are only providing financing to larger projects and are conducting protracted diligence in order to insulate themselves from any project risk.

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• We forecast large-scale wind, solar and geothermal projects in the U.S. to seek a cumulative $10.1B in project financing over the remainder of 2010, followed by $17.5B in 2011 and $28.3B in 2012—the majority (> 60 percent) being sought by the solar sector.

• For the remainder of 2010, we expect the sector to seek an additional $2.4B in cash grants, $1.4B in tax equity investments and $6.3B in debt and direct equity.

• We believe the expiration of the cash grant is likely to have the biggest negative impact on the solar sector. Of the amounts we expect would have been elected as cash grants if the grant were extended, the majority would have been sought by the solar sector (> 65%). Once the cash grant expires, most projects will still require a tax equity partner in order to monetize the ITC or PTC, and we believe wind projects are likely to be preferred over solar in a limited tax equity supply environment, hindering the solar sector’s ability to monetize tax incentives.

• Conversely, we believe the potential extension of the cash grant could be the biggest boon to the solar sector, improving the ease with which solar projects are able to obtain additional financing. CSP projects in particular could benefit from an extension, as 85 percent of the CSP projects we expect to seek project financing through 2012 are ≥100 MW, and capital-intensive projects are considered to be much easier to finance when 30 percent of the capital costs are recoverable as a direct cash grant.

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• We do not expect the wind and geothermal sectors to be as heavily impacted by the expiration of the cash grant. We estimate that 25 percent of wind projects prefer the PTC to the cash grant at present regardless, and the increase in PTC/ITC election from wind that would result from the cash grant expiration could largely be met with forecast tax equity supplies through 2012. The geothermal sector continues to face difficulty in obtaining the financing necessary to even begin construction, such that a cash grant, if eventually received, is a major positive, but is not generally assumed to be an integral piece in the overall project financing.

• If the tax equity supply for renewables were to grow after 2010, we believe that the effect on renewable energy project financing would be positive, but limited. Conversely, a decrease in the tax equity supply, as per “our worst-case scenario,” could have a much more profound, negative impact on the overall sector, limiting the ability to monetize the ITC or PTC across wind, solar and geothermal.

• Without knowing whether project financing supply will meet expected demand over 2012, we believe that most quality projects (i.e., by established developers with PPAs from credit-worthy off-takers) will continue to be able to access project financing at reasonable terms over the midterm. Any potential bottlenecks in project financing (whether for debt, tax equity or direct equity) are likely to come at the expense of projects from smaller projects, less established developers, and/or projects with higher technology or development risks (i.e., geothermal and newer solar technologies).

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Overview

Project finance is a structure employed to finance capital-intensive projects that are either difficult to support on a corporate balance sheet or that have become more attractive when financed on their own. Renewable energy projects in the United States are typically financed using project finance and generally include a mix of project equity investors, tax equity investors and project-level loans provided by a syndicate of banks. Terms set forth by both lenders and equity investors are based on the project’s perceived riskiness and its expected future cash flows.

The project finance structure revolves around the creation of a “project company.” The project company holds all of the project’s assets, including its contractual rights and obligations. The project c ompany is typically a limited-liability company (LLC) or, in some cases, a limited partnership (LLP). Project-level loans are usually non-recourse, meaning that they are secured by the project’s assets and paid off by the project’s cash flow: the investors’ assets are shielded should the project be unable to meet loan repayment terms.

Most renewable energy projects require a signed power purchase agreement (PPA) in order to reach financial close and commence construction. The commercial terms of the PPA and the engineering, procurement and construction (EPC) contract, together with the project’s associated market and technology risks, will largely determine whether lenders consider the project “financeable.” The maturing of the wind power market in recent years has allowed some major wind parks to receive project financing in the absence of a long-term PPA (known as “merchant projects”), but solar and
geothermal projects rarely receive financing in advance of a PPA being signed.

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Direct Equity

Project equity (aka ‘cash equity’ or ‘private equity’) is supplied by private equity firms or the developers themselves.

Direct equity investors invest a specified amount in a project in return for a certain stake in the project’s future cash flows.

Tax Equity

Renewable energy project developers typically do not have tax liabilities large enough to efficiently capture the full amount of tax credits available for large projects. To circumvent this issue, project developers can pair with a tax equity partner that is better able to utilize a project’s tax benefits. Traditionally, tax equity investors have been large investment banks, commercial banks and insurance companies with a high tax burden that seek to offset some portion of their expected tax liability.

The two primary tax equity financing structures of renewable energy projects in the U.S. are the sale-leaseback model and the partnership flip model.

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The sale-leaseback model allows a project developer to recoup its entire investment in a project, eliminating the need to invest directly. In this model, the developer finances and installs a project and then immediately sells it to a tax equity investor at full value. The tax equity investor then leases the project back to the developer at a fixed rate for a period exceeding the PPA schedule. The developer uses PPA revenue to fund rent payments to the tax equity investor, who also claims all tax benefits associated with the project. At the end of the lease term, the tax equity investor either remains the owner of the project or the developer can buy the project back at its residual value.

The benefit of the sale-leaseback model is that the tax equity investor is able to pass tax savings on to the project developer in the form of lower rent payments. In turn, lower rent payments result in a lower PPA price and lower rates charged to end customers.

A partnership-flip model is structurally more complex than a sale-leaseback model, but gives more freedom to the project developer within the partnership. The project developer and tax equity investor form a partnership company (typically a limited-liability company), through which they co-own a project. The partnership becomes the formal owner of the project, receiving all associated revenue and tax credit. Once formed, the partnership will negotiate over the distribution of revenues and tax credits, which is done on a project-by-project basis. In all cases, the tax equity investor requires a certain rate of return within a certain time frame (typically six to ten years). For example, during this timeframe the tax equity investor may claim 99 percent of revenue and tax incentives within the partnership and the developer just one percent. Once the tax equity investor achieves its required return, the partnership structure flips and the developer may receive 95 percent of revenue and the tax equity investor receives five percent.

A benefit of the partnership-flip model is that the project developer receives assistance in financing the construction of the project from the tax-equity investor; financing is often difficult to source for large-scale projects.

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Debt

Project debt is supplied by a bank or a syndicate of banks, which lend against the expected future cash flow of a project.

Debt packages inevitably vary by project size and technology, but most solar, wind and geothermal projects incorporate one or more of the following:

a. Term Loans: Term loans are a basic vanilla commercial loan. Term loans typically have fixed interest rates with monthly or quarterly repayments.

Term loans for renewable energy projects are typically ‘long term,’ with maturity dates generally between 10 and 20 years (though tenors dropped significantly directly following the financial crisis). The collateral for term-loans is typically the project itself.

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b. Construction Loans: The potential risks and returns to an investor during the construction period differ from those expected once a project has reached commercial operation. As such, most large renewable energy projects have a construction loan component in the overall project-financing package. Construction loans are generally
distributed in several installments.

After the first installment, and through the term of the construction loan, the borrower makes interest only payments on the installments received to date. When construction is complete, payment is due for the entire amount. In some cases, construction loans will automatically convert to term loans once commercial operation is reached. The interest rate on construction loans is generally higher than on term loans.

c. Equity Bridge Loan: Equity bridge loans have grown in popularity since the introduction of the ITC cash grant in 2009. Because cash grants (which cover 30 percent of a project’s installed cost) are made 60 days after the project commences operation, developers still need bridge financing to get through the project’s construction phase. Equity bridge financing is often furnished by equity investors until the grant comes through, at which time the investor is typically repaid. Cash grant bridge loan spreads are similar to term debt spreads, if not somewhat lower.

Other

Although we focus on the main project financing instruments used for U.S. renewable energy projects in this report, there are several additional financing instruments available:
144A bonds, Clean Energy Renewable Bonds (CREBs), which are available to co-ops and municipalities, Class B memberships, and prepaid service contracts, to name a few.

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Conclusion

Nearly two years since the onset of the financial crisis, the availability of project financing to renewable energy projects in the U.S. has improved somewhat due to the thawing of the lending markets, with a return to longer tenors on term debt, and legislative support mechanisms introduced as part of the American Recovery and Reinvestment Act (ARRA)—particularly the ITC cash grant.

However, considerable uncertainty remains as the industry awaits final word on the potential extension of the cash grant program and as tax equity markets continue to rise out of the recessionary depths. Overall, it is unclear whether the amount of project financing to be supplied to the renewable energy sector through 2012 will meet forecast demand.

On the whole, we believe that most quality projects (i.e., from established developers with PPAs from creditworthy off-takers) will continue to be able to access project financing at reasonable terms over the midterm. Any potential bottlenecks in project financing (whether for debt, tax equity or direct equity) are likely to come at the expense of smaller projects, less-established developers, and/or projects with higher technology or development risks.