Financing Renewable Energy Projects
0xB58F
June 7th, 2022

We all know about global warming

  • We all also know about the main advantage of renewable energy projects: reduction of CO2 emissions

  • Required low-carbon investment levels in green infrastructure to keep temperature increase below 1.5ºC threshold are enormous ($460B/yr until 2030, $1560B/yr thereafter)*

  • There are additional considerations:

    • What if your country does import oil and/or gas?
    • Take advantage of your local resources
    • Fuel is free! All countries have wind and/or solar to some extent
    • Benefits to local communities

    * What investments are needed in the global energy system in order to satisfy the NDCs and 2 and 1.5 °C goals? – International Institute for Applied System Analysis

What are renewable energy projects?

  • Electricity is generated from a renewable energy source (e.g. wind, solar, hydro, biomass, tides, geothermal)
  • Instance of infrastructure projects. As such, characterized by:
    • Capital intensive before any revenue is generated
    • High risk / high return
    • Long term investment horizons (10+ years)
    • Complex contractual interplay between many parties (construction contracts, loan agreements, land leases, offtake agreements, interconnection rights, operation and maintenance, and many more)
  • Once these projects are up and running, the cost of running them is almost zero!

Examples of renewable energy projects

Ciudad Victoria & La Mesa wind farms in Tamaulipas, Mexico
Ciudad Victoria & La Mesa wind farms in Tamaulipas, Mexico
Los Remedios solar PV project in Acajutla, El Salvador
Los Remedios solar PV project in Acajutla, El Salvador

Examples of the contractual structure of a renewable energy project

Source: Tice and Walter [2014] based on Smith, Walter and De Long [2012]
Source: Tice and Walter [2014] based on Smith, Walter and De Long [2012]

Let’s build a renewable energy project!

  • Not so quick… what options are available?
    • You can start a development from scratch (greenfield projects) - High risk and high return
      • Long development times
      • High probability of failure, project development is complex and risky
    • You can acquire a partially developed project (brownfield projects) – Medium risk and medium return
      • Usually ready to build
      • Construction risk
    • Or you can acquire a project already in operation – Low risk and low return
      • Think of it as a bond
      • Stable and predictable cash flows
      • All major risks behind

Show me the money!

  • Once project development is ready, the time has come to commit serious money (mostly construction and purchase of equipment)
  • The most common tool used to finance renewable energy projects is Project Finance:
    • Project owned by a SPV (Special Purpose Vehicle), completely separated from the project Sponsor
    • Finance is provided to the SPV, that assumes the risks and the financial consequences
    • If things go south, banks have no recourse to the project Sponsor, “only” the equity is exposed
    • The project Sponsor keeps a “clean” balance sheet

Corporate Finance vs. Project Finance

Source: Financing and Investing in Infrastructure – Università Commerciale Luigi Bocconi
Source: Financing and Investing in Infrastructure – Università Commerciale Luigi Bocconi

Hold on… how much did you say you need!?

  • Renewable energy projects have big capital expenditure requirements (CAPEX) and are highly leveraged (small equity vs. big debt)
  • Banks tend to be wary
    • If things go well, no upside
    • If things go wrong… only recourse to the SPV
  • Process to finance a renewable energy project tends to be long and complex
    • Banks spend a high amount of time studying in detail the project (Due Diligence)
    • Usually they do not want to do it alone – Syndicate of banks

What will the weather be like tomorrow?

  • Renewable energy projects rely on electricity generation to generate cash flows
  • The problem with renewable energy generation: you cannot control when it is going to be sunny or windy
  • Through thorough measurement campaigns, it is possible to estimate the level of renewable energy resource of a project
  • Banks rely on these analysis to estimate the amount of debt the project is able to accommodate:
    • P-levels: Annual generation levels to be exceeded (P50 and P90)
    • Coverage Ratios: CFs available vs. debt service
Source: Excel Probability Functions – Project Finance Institute
Source: Excel Probability Functions – Project Finance Institute

The future ain't what it used to be*

* Quote attributed to baseball-playing philosopher Yogi Berra

  • Historically renewable energy projects have been developed leveraging government support
  • Goal: Achievement of technological maturity through subsidized tariffs
  • Every unit of renewable energy generated was paid at a fixed price not determined by the market (Feed-In-Tariffs)
  • This model has worked very well in the past: Renewable energy technology has achieved grid parity
  • Now what? An additional layer of complexity enters the game
Source: enie.nl
Source: enie.nl

It's tough to make predictions, especially about the future*

* Again Yogi Berra

  • Governments around the globe have slashed subsidized tariffs
  • Renewable energy projects sell electricity directly to the market
  • Electricity market price tends to be volatile and unpredictable, hence direct exposure to market risk
  • Debt tenors tend to be long (10+ years)
  • The project needs stable cash flows to pay back the loan
  • Banks get scared off, cancelling lending or reducing debt size and at hardened terms
Source: Operador del Mercado Ibérico de Energía – Polo Español (OMIE)
Source: Operador del Mercado Ibérico de Energía – Polo Español (OMIE)

PP… what?

  • There are several tools available to transform volatile market prices into stable and predictable cash flows:
  • Power futures
    • Traded in exchanges (e.g. European Energy Exchange EEX)
    • Shorter-termed than required (max. 10 years) and low liquidity
  • Insurance products
    • Derived from weather insurance
    • Revenue swaps exchanging variable revenues for a fixed payment
  • Long-term electricity contracts (aka PPAs)
    • PPA stand for Power Purchase Agreement
    • An agreement between a buyer and a seller to sell a certain amount of electricity for an agreed term at an agreed price
    • OTC market, bespoke agreements

Some additional notes on PPAs

  • Preferred tool
  • PPAs can be physical or virtual
    • Physical: there is a physical link between the renewable energy project and the off-taker
    • Virtual: Financial contract (CfD); the renewable energy project and the off-taker can be not connected by a grid or even in different countries
  • As OTC products, PPAs can have several structures
    • Fixed price
    • Discount to market with floor (basically a put option)
    • Cap and floor (collar)
  • PPAs are not risk-free
    • Market risk, shaping risk, volume risk, balancing risk…

Physical PPA

Financial/Virtual PPA

Source: B. Douglas, G. Brindley, M. Labordena, and S. Dunlop, “Introduction to Corporate Sourcing of Renewable Electricity in Europe,” RE-Source, RESource, European platform for corporate renewable energy sourcing, Jan. 2020
Source: B. Douglas, G. Brindley, M. Labordena, and S. Dunlop, “Introduction to Corporate Sourcing of Renewable Electricity in Europe,” RE-Source, RESource, European platform for corporate renewable energy sourcing, Jan. 2020

PPA Pricing Mechanism - Fixed price

Source: Alastair Carrington (GE Renewable Energy), Power Purchase Agreement – A European Perspective
Source: Alastair Carrington (GE Renewable Energy), Power Purchase Agreement – A European Perspective

PPA Pricing Mechanism - Floor Price with Discount to Market

Source: Alastair Carrington (GE Renewable Energy), Power Purchase Agreement – A European Perspective
Source: Alastair Carrington (GE Renewable Energy), Power Purchase Agreement – A European Perspective

PPA Pricing Mechanism - Zero Cost Collar

Source: Alastair Carrington (GE Renewable Energy), Power Purchase Agreement – A European Perspective
Source: Alastair Carrington (GE Renewable Energy), Power Purchase Agreement – A European Perspective

Investment metrics

  • Leveraging renewable energy projects with debt usually adds value to investors
  • Most common metrics to evaluate renewable energy projects (i.a.):
    • For investors:
      • NPV, IRR, MOI…
    • For banks:
      • Debt-to-Equity ratio, Debt Service Coverage Ratio (DSCR), Loan Life Coverage Ratio (LLC)

Key takeaways

  • Building renewable energy projects require big capital investments upfront and feature long investment horizons
  • Project Finance is the preferred tool to finance renewable energy projects
  • Financing renewable energy projects is challenging due to volatility of cash flows (intermittent generation and market risk) – Tools available to mitigate these risks
  • There are several metrics available to evaluate the quality of renewable energy projects from a financing perspective, depending on your side in the transaction (investor vs bank)

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