According to recent surveys, about 50% of energy projects are postponed due to “lack of upfront capital.” Financing projects is a solution to this problem. However, when seeking to finance an energy project, few things are more frustrating than having high hopes and then learning that funds are unobtainable due to an improperly structured transaction that cannot be used in the financing markets.
This article is intended to help facility managers, project developers and ESCOs avoid this problem by identifying and explaining specific risk and structural provisions that are key to creating bankable energy management projects.
Lenders See You As “Risk”
Assessing, allocating and mitigating risk serve as the initial points of focus for achieving bankable transactions.
In order to attract capital market investors, a transaction must present a risk profile commensurate with the nature of the financing (i.e. debt or equity) and anticipated investor returns. This concept is frequently and most commonly described in terms of a basic risk/reward analysis – higher risk requires a greater return to the investor, and at some point unmitigated risks will be too daunting to hurdle. Risk analysis and mitigation in energy management transactions are significantly more complex than simply pricing the transaction to provide attractive investor returns.
To underwrite an energy management transaction, the capital markets analyze several broad categories of risk, including:
1. Obligor credit risk (borrower’s credit)
2. Construction/installation risk
3. Counterparty (ESCO/contractor/other) credit risk
4. Technology risk
5. Performance risk
6. Structural risk
In order to structure a bankable transaction, each of these risks must be considered and mitigated to the extent required by the (debt) capital markets. To do so, one must understand the nature of these risks and the capital markets’ tolerance for each of them.
1. Obligor credit risk
Obligor credit risk is the keystone risk for all financing transactions and can be simply stated as the end-user’s ability to satisfy all of its obligations (payment and otherwise) under the terms of the transaction. Despite the wide variety of financing structures for energy projects, their common foundation is the end-user’s obligation to make payments in exchange for the products or services received upon funding of the transaction.
In whatever form it takes (i.e., lease payment, loan payment, services payment, utility payment, etc.), that payment obligation provides the lender’s primary source of debt service, in addition to returns on the equity investment, if any. As a result, the bulk of the lender’s underwriting activities are focused on a detailed analysis of the end-user’s overall credit profile. Operating performance, profitability, cash flow, debt service capacity, liquidity, balance sheet strength, market/competitive positioning, management capabilities, and prospects for future success are among the many factors examined during the underwriting process.
2. Construction/installation risk
The assessment of construction/installation risk begins with identifying the party responsible for guaranteeing repayment to investors should the project not be completed on time, on budget or at all. In most cases, construction/installation risk is borne by the ESCO or other prime contractor and or its subcontractors in the form of repayment guarantees to the lender in the event that the project is not completed to the end-user’s satisfaction and there is no commencement of debt service payments under the applicable transaction documents.
3. Counterparty risk
Counterparty (e.g. ESCO or contractor) risk is a function of the applicable party’s role in the project, such as construction and ongoing operations and maintenance of the project. Counterparty risk typically takes three main forms: construction/installation risk, performance risk, and general credit risk of insolvency and/or contractual default.
Because these counterparty risks can stem from varying yet interrelated circumstances, the lender must analyze them individually and mitigate each to the maximum extent possible.
4. Technology risk
Often with energy projects, the end-use obligor’s (customer’s) payment obligations may be partially or wholly contingent on performance of the project. For example, if the equipment comprising the project malfunctions or does not operate as expected, the revenue stream to support debt service will be jeopardized and the lender could suffer a loss.
As a result, lenders will perform significant due diligence on the key technology utilized in the project, focusing on issues such as historical performance, uptime reliability, operations and maintenance requirements, market penetration and acceptance, technical standards, mechanical complexity, fuel requirements (including fuel supply and price risk) and other indicators of technical risk.
5. Performance risk
Performance risk is measured in terms of the lender’s risk of repayment in the event of a performance deficiency and/or performance default within the financed project. If the end-user has an absolute and unconditional payment obligation to the lender regardless of project performance problems such as equipment failure or service disruptions, then the lender’s exposure to performance risk is minimized.
On the other hand, if the end-user’s payments are conditional upon satisfactory performance – as in the case of most traditional project finance transactions – then the lender must have recourse to a third party (typically the ESCO or other operations and maintenance contractor) for debt service shortfalls resulting from project performance deficiencies.
6. Structural Risk
Structural risk stems from the contractual nature of the transaction and the specific terms and conditions. These risks must be addressed early in the transaction development process. Failure to clearly identify these risks and allocate them to the appropriate parties is the most common mistake that leads to a non-bankable transaction.
This is a broad category but some of the important risks in it include:
· Performance risk vs. credit risk
· Payment obligation(s)
· Funding during construction/installation
· Payment and cash flow logistics
· Taxes, insurance and maintenance
· Title, security interests and collateral
· Termination provisions
· Assignment rights
· Contracts and documentation
· Lack of clarity
· Co-mingling of lender and ESCO or contractor risks.
In theory, the capital markets have a nearly unlimited capacity to fund creditworthy and properly structured energy efficiency and distributed generation transactions. In practice, awareness of investor requirements and working collaboratively with a knowledgeable financing partner from the earliest stages of a project is critical for end-user obligors and their contractors to avoid costly project delays, maintain competitive advantages, meet or exceed customer expectations, avoid leveraging their balance sheets, and gain broad access to the capital markets to fund their bankable projects.
Most of this article is from a chapter in Eric’s upcoming book, How to Finance Your Energy Management Projects, which will be in print later this year.