This article was originally published in Chadbourne & Parke’s October 2016 “Project Finance Newsire”
By Richard Matsui, Jason Kaminsky and Jared Blanton, with kWh Analytics in San Francisco
Summary
The solar market needs a revenue put like what is now used to finance merchant gas-fired power plants, except it would cover output rather than price risk.
Such a put would lead to higher advance rates for solar project debt and possibly also tax equity.
The insurance market is the natural venue in which to place this product.
Challenge
While the multi-year extension of the federal investment tax credit has reduced market risk, solar companies nevertheless continue facing challenges in financing projects and securing cost-effective project debt.
The deterioration of the yield co model and the liquidation of industry giant SunEdison point to a need for a “back-to-basics” approach to securing capital. With these recent crises fresh in investors’ memories, corporate debt is increasingly difficult to raise. Firms are now focused on raising capital against the cash flows of their existing assets, highlighted recently by the $305 million sale of future cash flows SolarCity completed for a 230-megawatt portfolio of residential, commercial and industrial PV projects.
New financial instruments, such as energy hedges, that facilitate increased capital flows would be highly welcomed in this industry context. But new financial instruments require a new depth of understanding about solar risks.
At its most basic level, cash flows in the electricity generation business are a function of two factors: the price of electricity multiplied by the quantity of electricity. This basic equation applies across all electricity sectors. With gas-fired generators, the quantity of electricity produced is controlled by the plant operator. The unknown part of the equation — the risky part — is volatile prices for electricity sold on the wholesale markets.
For solar, the problem is reversed. With zero marginal cost to produce a unit of energy, there is no price risk with a photovoltaic system. Well-structured PPAs ensure that the electricity delivered will be sold at an agreed-upon price to an offtaker with a strong balance sheet such as utilities, big-box retailers, or residential customers with high credit scores. The unknown variable in the equation is the amount of energy produced. In other words, uncertainty in solar production is the real risk.
Uncertainty chiefly comes from two sources: weather and system quality. Cloud cover and other weather patterns are major contributors to inter-annual weather variability, in addition to inclement weather events such as snow and hurricanes. In addition to weather risk, the quality of the photovoltaic system itself is variable due to the choices between hundreds of module manufacturers, dozens of inverter brands, thousands of different contractors, and varying O&M programs. All of these variables create millions of permutations that add uncertainty to the expected energy output of a project.
This volatility, without widely available data to quantify it, is the reason lenders assign conservative coverage ratios for solar projects. Independent engineers provide lenders with projected energy output, but these are only opinions — estimates that are not guaranteed.
Volatility in cash flows is not a new problem. Other asset classes have faced similar financing challenges and have overcome them through independent, industry-wide databases of historical performance. There is an opportunity to combine data with strong balance sheets to create new financial products that transfer risk away from the solar projects and into the hands of well-capitalized specialists like insurance companies; it is not dissimilar to what happened with revenue puts for combined-cycle gas-fired power projects.
Natural Gas Hedges
An instructive example can be found in the experience of gas-fired generators. These generators smoothed out the volatility in the delta between electricity revenue and the cost of inputs through hedges called revenue puts.
An essential primer on the revenue put was covered in the article on page 38 of the November 2015 Project Finance NewsWire by Chadbourne attorneys Robert Eberhardt and Monika Szymanski. As described by the authors, a revenue put operates as insurance against volatile wholesale power prices for power project owners. A revenue put establishes a floor — a minimum revenue amount — for a merchant gas-fired generator. If the revenue from electricity delivered does not meet that floor in a given period of time (typically a year), then the hedge provider pays the difference.
The revenue put became prevalent in the immediate aftermath of electricity market deregulation in the late 1990s when merchant-based projects were being proposed and the price of natural gas subsequently increased. Revenue puts have become an essential component of most project finance deals involving combined-cycle gas-fired power assets.
Applying a similar hedge to solar, wrapping not the price of electricity but rather the expected power production of a project, would substantially lower the cost of capital by allowing lenders to increase project leverage.
Because this concept is not new, a project developer today can go to any number of financial institutions and negotiate a production hedge. But because that hedge provider does not possess a strong understanding of solar production risk, it will require prohibitively expensive premiums, if it agrees to take on the risk at all. What is needed in combination with a balance-sheet provider is quality industry-wide performance data that allows for actuarial analysis and deep understanding of the risk.
Increasing Leverage
The liquidity challenges facing the solar industry create fresh urgency for equity investors to raise greater amounts of cheaper debt. The uncertain outlook for corporate credit has forced developers to be more creative in securing project finance.
The challenge is to change the status quo of conservative underwriting to allow for more debt to be safely placed within a project finance transaction. For developers, leveraging project deals frees up equity that can be more optimally deployed toward other business objectives. The more leverage they can stack on project deals, the better.
Coverage ratios in today’s market are typically in the 1.3x to 1.4x range, providing debt for roughly 75% of the projected cash flow of a project. These coverage ratios fall in this range because that is what lenders are comfortable providing given their understanding of the risk presented by solar projects or portfolios of projects. At their core, coverage ratios address perceived volatility in cash flows.
Solar assets today have lower advance rates than aircraft leases, student and auto loans, mortgages, and even credit cards.
Part of the perceived risk is the long-term nature of solar assets. The most comparable of these asset classes might be mortgages: it is a long-term cash flow secured by an asset. Mortgage-backed securities, incidentally, have advance rates of 99%, largely because there is an independent third party with a vast depository of historical performance data on US mortgages that allows for data-driven predictive risk modeling.
The prevailing approach to underwriting loans in solar forces developers to commit pricey sponsor equity to fill the remaining project capital requirements. A floor on energy production, backed by a strong balance sheet provided by the global insurance market, would transfer production risk away from the project finance transaction and result in lower coverage ratios and increased project leverage.
The global insurance market has been used before to secure capital in the solar market. Lenders have reduced exposure to investment tax credit recapture with an insurance product specifically tailored to this market. Recapture insurance unlocked new value in solar project finance by enabling securitizations. Similarly, a production floor would increase leverage and lower equity contributions, reducing the overall cost of capital for solar projects.
The solar industry has seen that strong balance sheets can lead to better terms on debt. Transactions have been completed where diverse corporate balance sheets can wrap solar production risk to achieve a lower cost of capital. The challenge today is how to price the risk effectively for a disinterested third party in a way that creates value for both project sponsor and lender. Traditionally in the insurance market, historical data and actuarial analysis provide the means to correctly price risk.
Insurance Market
A credible production guarantee that captures the drivers of volatility — including weather, equipment performance, O&M practices, etc. — is an effective means of risk transfer that makes the cash-flow profile of solar projects much more predictable.
As has been demonstrated by recapture insurance, having specialty insurers in solar project finance can add value to these structured transactions. For solar, attracting this kind of balance sheet, likely in the form of the global reinsurance market, requires a missing ingredient: data. In order for a provider to feel confident that it understands the risk being transferred to its balance sheet, it needs an actuarial analysis informed by historical, industry-wide production data.
The benefits of such a financial transaction are clear for both asset owners and project lenders.
For lenders, the reduction in volatility takes away the need for conservatism in loan structuring. Having a credible third-party backstop would enable lenders to reduce their risk and extend more capital in each deal.
For asset owners, the benefit of increased leverage means a lower proportion of project capital from sponsor equity and subsequently a lower cost of capital. For the solar industry more broadly, simplified underwriting analysis would attract more investors into the space, potentially reducing the cost of capital even further as more lenders enter the market.
We have observed that as other asset-based markets have matured, they have been able to secure more debt because the variability of those assets was accurately quantified by robust data analysis. Solar is still seen as highly uncertain, thus the high cost of capital today. Simplifying the investment thesis by allocating risk to entities that understand it best is a necessary step in solar’s progression toward a more established asset class.