Project Finance for Renewables 101
Project finance is the fabric that brings together the stakeholders and components that make capital-intensive renewable energy projects a reality. The world has significant decarbonization targets to reach by 2050, and the energy transition is estimated by Bloomberg and McKinsey to cost about $200 trillion. With so much money required and being earmarked to propel this transition, it is worth understanding how energy projects source funding, what goes into the “valuation” and risk assessments of these projects, as well as the parties and structures involved.
What is project financing?
Project financing for renewable energy involves raising capital to develop, construct, and operate renewable energy projects. Investors provide long-term debt and equity financing, often using the project’s assets and revenue streams as collateral. The financing structure and terms vary depending on the project’s characteristics, such as technology, size, location, and regulatory environment.
Financing of the long-term infrastructure project is usually done through non-recourse financing, which requires the project’s cash flows as debt repayment. Non-recourse means that the project sponsors are not held personally liable for the payments on the loan if the project doesn’t generate enough cash.
Let’s walk through a hypothetical example with Duke Energy, a solar project developer: Duke sells shares to investors to raise equity financing and also raises debt financing from a bank.
The parent company, Duke Energy, sets up an SPV as a project company. The debt financing comes from a bank, and the equity finance is from a sponsor (Duke itself). Debt is repaid in dividends from the cash flow generated by the project. Debt financing is provided on a non-resource basis so the bank can’t go to the project sponsor (in this case, Duke) if something goes wrong with the project.
Compared to mortgage financing, the property can’t serve as collateral because the project itself isn’t worth that much. The lender will only look at the cash flows of the company to cover loan interest and amount.
That’s right, every solar or wind farm is it’s own little company. The Special Purpose Vehicle, such as an LLC, is a risk management mechanism. There’s a concept of “ring-fencing” and control so that there is limited liability for the project sponsor. The sponsor only risks the money invested into the company, and the SPV is shielded from the sponsor’s holding company.
The project company is financed with debt and equity. Once the project is built, the company may sell its energy to a PPA (Power Purchase Agreement) customer. This becomes a secure, long-term revenue stream for the project company. The market risk is taken by the off-taker (customer). Construction risk is taken by the EPC contractor. Operational risk is taken by the O&M (Operations & Management) contractor. This way, the risks are not borne solely by the project company.
Sources of Financing
Usually, project finance includes equity provided by the project sponsor (and sometimes an investor with a tax appetite) and debt provided by lenders.
You’ll often hear the term “bankability” in the context of renewable projects: Is the project financeable? This is the question that project funders ask when an energy seller raises equity/debt financing to develop the project. One of the main ways to de-risk the project is if the off-taker (the buyer of the electricity) is creditworthy, such as an investment-grade utility with sovereign guarantees.
Equity can be provided by the project sponsor as well as a corporation or financial institution interested in the tax benefits generated by the project.
Debt is provided by commercial banks, usually the largest and most experienced ones. Loan types can include construction loans, term loans, revolving credit facilities, and commercial bank loans.
Tax credits became an instrument to incentivize renewable energy in 2005, with the Congress enacting the Energy Policy Act. This led to substantial growth in the clean energy sector, contributing to 100GW of solar and a workforce of 250,000. In 2022, the Inflation Reduction Act was passed to supercharge tax incentives (I covered the role of tax credits in an earlier post). However, tax credit monetization and structuring is still a burdensome financial construct.
Production Tax Credit
PTC is the per-kWh tax credit for electricity generated. It can be claimed for a 10-year period once a qualifying facility is placed in service. It is mainly used for wind projects because the capacity factor of wind projects is higher than that of solar.
Investment Tax Credit
The ITC is mainly used by solar projects. It is an upfront tax credit that can be claimed once the project is in production. It is usually 30% of eligible costs in the year that construction starts.
$1 of ITC can offset $1 of tax payable.
Here’s the interesting thing: Even if a project costs $1M to build and you, as the developer (sponsor) gets $300,000 in tax credits, you might not actually have that much in taxes to pay because you’re barely generating any income yet. So you are technically an ‘inefficient’ taxpayer. The solution? Enter tax equity.
As noted above, an efficient taxpayer achieves a significantly higher investment return from tax credits when compared to inefficient taxpayers.
Therefore, to monetize the tax benefits, tax equity structures emerged in 2005. In a nutshell, two parties can form a partnership: One party assigns tax benefits in exchange for equity investments, and the other provides the investment.
The party that assigns tax benefits to the other is a General Partner. The party that receives the tax benefits is a Limited Partner. The tax equity investor is usually a large corporation with predictable tax liabilities, such as a large bank like US Bank or JP Morgan. It is unlikely that they are actually interested in the project itself.
In a partnership-flip model, the LP is initially entitled to the majority of tax benefits for a certain period of time — for example, until the LP’s tax credit needs are paid off. At that point, there’s a “flip” at which the tax benefits can be claimed by the GP. Note that the IRS has a rule that tax benefits allocated to a party cannot exceed the capital provided.
Note that while the investor benefits from the tax credits, they can still earn some of the cash flows generated by the solar project.
In a typical capital structure of a project:
- Tax equity makes up 40–50%
- Debt makes up 20–40%
- The sponsor provides the remainder of the equity, 20–40%
As noted earlier, in a tax equity financing structure, there is a partnership between the sponsor/developer and the tax equity investor. This partnership is structured as an LLC that is owned in part by the sponsor, and in part by the tax equity investor. The sponsor can still take out a loan (raise debt), and These lenders take interest in the sponsor as opposed to the entire partnership — hence “back leverage”. The back-leverage lenders don’t receive cash flows from the assets of the tax equity partnership.
The cash distribution from the project first goes to satisfy the debt and then pays dividends to the project sponsor.
One caveat is that tax equity investors are reluctant about a project raising back-levered debt. Therefore, tax equity investors often require a higher cost of capital in these cases: A 10–12% IRR vs. 6–8% IRR without the debt at the project level.
Starting in 2023, developers will be allowed to make a one-time sale of tax credits to an unrelated party in exchange for cash. The cash earned from the sale is federally tax-exempt. This opens up the opportunity for more players to enter the tax equity market, such as corporations, family offices, high net worth individuals, and real estate. REITs can install clean energy technology at their properties and then sell the tax credits for cash.
This could mean new financing models, and getting the financing into a standardized and scalable format could be critical to hitting America’s (and the world’s) net-zero targets.
In 2022 alone, there were nearly $20B of tax equity investments, doubling over the last 5 years. The demand for tax equity, however, is closer to $40B and is expected to exceed $90B by 2030. The Inflation Reduction Act directs nearly $400B in federal funding to clean energy in the form of tax incentives, grants, and loan guarantees. The industry must now ask itself a few key questions, including:
- How do we properly leverage this massive bill and apply the funds in the highest-leverage way?
- How do we do this in the presence of headwinds such as supply chain issues and stalled interconnection queues?
As we’ve seen, project financing is a crucial tool for the development, construction, and operation of renewable energy projects. Tax equity is a financial construct used to monetize tax incentives, ensuring that all parties achieve a significantly higher investment return. But as of 2022, the rules of the game are changing — while the clock of sustainability targets keeps ticking.