The following is the first blog in a multi-part series on solar project finance in the US. It is part of Sol Systems‘ continuing efforts to provide the industry with the information and ideas that it needs to continue to succeed. For additional resources on project development, we recommend you join the SolMarket community, which provides a number of informational resources and the SolSmart suite of legal documents.
Part 1: Project Finance Background
When discussing the growth prospects of solar energy, particularly commercial and utility scale solar, “project finance” is a key term that comes to mind. Simply put, if a project cannot secure financing, it is not likely to be built. However, what exactly do the energy and financial industries mean when they use the term project finance?
Project finance is not simply raising funds to pay for a project. Rather, it is a nonrecourse or limited recourse financing structure in which equity partners and lenders rely on the future revenue stream of the individual facility rather than the general assets of the sponsor. In the energy industry, project finance has become an increasingly common way to structure financing, resulting in a shift away from more traditional corporate financing. Due to the capital intensity of the energy sector, even the most efficient technologies require significant funding upfront before they can become revenue-producing. To walk through an example of project finance, it is helpful to first examine a more traditional project, such as the recovery and production of oil.
If a large multinational oil corporation (MNC) is looking to take advantage of a new offshore oil site, it must initially invest significant amounts of capital into the project, similar to a solar developer looking to construct a new multi-megawatt PV project. The company could simply secure the necessary funds for the oil project through regular financing tools such as equity, bonds, loans, or retained earnings. However, if the project fails, the company’s assets will be at direct risk as the financiers look to recover their investment. To avoid such a gamble, this MNC can engage in project finance, meaning the lending will be based on future cash flows of the oil site.
Lending based on future cash flows is a type of non-recourse loan. In essence, a non-recourse loan means that if something goes wrong with the project (regulatory change, huge storm etc.), the company’s assets are not liable. Returning to the oil example, if the project costs $1 billion dollars, then the MNC will want to avoid $750 million in debt on their corporate balance sheet, thus instead associating that liability with the project company. Under non-recourse loans, a new entity separate from the company’s actual balance sheet is created. This new entity will be the only entity at risk if the project fails, and typically it will be set up to be legally independent and comprised of a single-purpose industrial asset that with a limited life.
In order to utilize this method of finance, there must be a guarantee of future cash flows. Therefore, one of the first and arguably most important steps to project finance is to secure a long-term contract with an independent buyer. In this case, the MNC could write a 20-year contract to a foreign government to purchase the oil that they are producing at a certain price, likely a moving average. The independent buyer signing the long-term contract to purchase the oil (or solar electricity) typically must be a credit-rated entity, as to make the off-take contract financeable. Now, armed with this guarantee of consistent revenue for 20 years (provided the project is successful), the MNC can find a lead bank or financier that will secure non-recourse loans for this project. The lead bank will have collection rights on this stream of output and can find other interested financiers to form a syndicate. In this specific example, the new syndicate might raise $800 million for the project, with the MNC still having a $200 million stake. This $800 million will be given in a combination of debt and equity to the MNC’s project company for their oil project, but the loan will be a non-recourse loan, meaning if something does happen and the MNC cannot extract the oil, the company is not liable beyond the 20% of capital they put in. Instead, the lenders are taking on the primary risk. They are doing this because they see the bankable off-take contract that represents consistent revenue for the next 20 years, and they believe the project will be successful.
Once the project achieves the required level of funding, the MNC can proceed with extracting and producing the oil, and as they begin to sell the oil under their contract, the lenders will be able to enjoy their portion of the revenue. Throughout the negotiation process, the potential lenders and the MNC will be considering one key issue, and that essentially is the “cost of money”. The “cost of money” for this project can be determined by 1) the amount of money loaned, 2) the interest rate of the loan, and 3) the maturity date. It is no surprise that AAA loans will be much different than riskier projects with either an inexperienced developer or a potentially volatile host country. In the latter circumstance, political risk insurance and foreign exchange risk will emerge as primary concerns.
Although there are many different nuances and additional points when it comes to project finance, this walk-through can hopefully serve as a starting point for understanding the advantages and potential issues of project finance as it relates to large scale energy projects. Next time, we will take this understanding of project finance and look specifically at the solar space, where additional incentives such as the Investment Tax Credit and Solar Renewable Energy Credits (SRECs) have spurred solar project development while also making the project finance process more complicated.