DOE releases guidelines for loan guarantees

DOE releases guidelines for loan guarantees

September 01, 2006

By Luis Torres

New guidelines released by the US Department of Energy in mid-August explain when the US government is prepared to guarantee repayment of commercial debt in energy projects. Congress authorized the Department of Energy to guarantee such debt in the Energy Policy Act in August 2005 for a variety of energy projects.

The new guidelines only apply to the first round of loan guarantees to be issued under the program. Total guarantee commitments in the first round will not exceed $2 billion. The first round will only cover guarantees under title XVII of the Energy Policy Act, which deals with projects that use innovative technologies.

The deadline to apply for guarantees during the first round is November 6.

The department will review the applications it receives, but it will not be able to issue any actual guarantees without an appropriation from Congress. The appropriation is needed to cover administrative costs of the program. Borrowers will be required to pay fees to cover any subsidies they receive.

Eligible Projects

Ten categories of projects qualify potentially for guarantees in the first round. They are listed in the chart on the next page. Congress also authorized guarantees for nuclear and oil refinery projects, but they will be the subject of a future round of solicitations.

The new guidelines only answer some questions. The default rules and audit requirements will be addressed in separate regulations.

Substantive Insights

The department said it plans only to guarantee debt on projects with technologies that are mature enough to generate sufficient revenues once the project begins commercial operations. The rationale is that the more tested or mature the technology is, the greater the chances of repayment of the guaranteed loan.

This is sure to disappoint developers who were hoping the loan guarantee program would help projects that are having trouble borrowing in the private sector because banks do not want to take risk on newer technologies that have not been proven yet on a commercial scale. It is not clear the US government is prepared to take technology risk, either. The guidelines make clear the government will not guarantee debt on technologies that are still in the research and development or pilot phase.

Congress limited the amount of the guarantees to 80% of “project costs” without defining what costs qualify as project costs. The guidelines define “project costs” as costs that are “necessary, reasonable and directly related to the design, construction, and startup of a project.” Project costs include costs for the purchase of land and equipment as well as engineering, legal and other professional fees. Spending on research and development, post-construction operating costs, and fees paid to the US government to secure a loan guarantee do not qualify as project costs.

Any other debt on the project beyond the amount the US government guarantees must be subordinated to the guaranteed debt.

Each project that applies for a guarantee will be subject to a review under the National Environmental Policy Act. Such reviews can take four to six months (longer if studies are required to evaluate four seasons of data). Reviews can be costly and may make a project vulnerable to citizen challenges by project opponents.

The fact that a project also qualifies for other forms of government assistance will not prevent it from receiving a loan guarantee, but the Department of Energy will want to know the sponsor has enough of his or her own equity invested to be fully committed to the project.

In a further blow to developers who were hoping the US government would take technology risk, the Department of Energy is insisting on first position on any recovery on the project in the event there is a loss. For example, if the Department of Energy guarantees 50% of the debt on a project, it will expect any repayment by the borrower that falls short of the full amount owed to be applied first against the guaranteed portion of the debt before it is applied against the non-guaranteed portion.

From the government’s perspective, this approach makes sense. It lacks the resources to do a full evaluation of project risk. Its approach creates an incentive for lenders to be careful in their choosing of projects and not make the government bear all of the responsibility for projects that are poorly planned or managed. On the other hand, the guarantees are supposed to be a way for the government to help developers get financing for projects that use new technologies. Instead, the government is forcing the lenders to take risk ahead of it. The program may not have its intended effect.

The Department of Energy describes the 80% loan cap as a “preference” and says it is willing to take a larger stake (but not 100%) as long as there is “sufficient evidence” to believe the project can support more debt. The guidelines do not give any insight as to what “sufficient evidence” is.

Commercial lenders usually expect guarantees to be unconditional come “hell or high water.” That is, lenders expect a guarantor to pay if the borrower does not pay on time. Any conditions on the guarantor’s duty to pay make a guarantee less attractive. Under the new guidelines, lenders must take on some tasks such as making annual reports to the Department of Energy, but the guidelines do not say what would happen if a lender fails on any of these tasks. If the DOE conditions payment of its guarantee on these requirements, it would make the guarantee program less attractive to the market..

The guidelines require that both the guaranteed and non-guaranteed tranches of a loan must be traded together in secondary markets. In project finance, lenders that originally acquire a portion of a loan facility often resell it later in the secondary market. The DOE loan facilities will have a DOE- guaranteed portion and a non-guaranteed portion. A lender cannot resell just the guaranteed portion. The guidelines do not explain what happens if this condition is breached, but it could lead to inability to enforce the guarantee.

Unanswered Questions

Many questions remain unanswered about how the new program will work.

Projects must meet two basic requirements to qualify for loan guarantees under title XVII: they must avoid, reduce or sequester pollutants and gases, and they must use new or significantly-improved technologies when compared to technologies in general use in the market. The guidelines provide no details on these requirements.

The guidelines emphasize that the Department of Energy will consider the sponsors’ financial commitment to a project, including the amount of equity the sponsors are contributing and the extent of risk sharing, but they provide no further insight - for example, whether equity of at least 20% of project cost is required to secure a guarantee.

Some questions relating to project completion and viability also remain unanswered. For example, the guidelines request applicants to provide details about construction contracts, liquidated damages and performance bonds, but there is no indication what level of liquidated damages will be required. The guidelines are also silent on whether the government is willing to take merchant risk.

Congress has not appropriated any monies to cover losses if the government ends up having to pay on a guarantee. Therefore, the department is expecting applicants whose projects are guaranteed to pay the full costs of the program. No detailed guidance has been provided on the calculation of such costs.

The actual loan guarantee agreement that the Department of Energy plans to use has not been released yet. It is probably a good bet that the agreement will look similar to other loan guarantee agreements used by the US government, but the market would benefit from an early look at the agreement.

Applications Process

Applying for a guarantee is a five-step process. First, the applicant must submit a “pre-application” with his or her project proposal. The guidelines list the information that the government expects to see at this stage. Pre-applications are due on November 6. Within 90 days after the November 6 deadline, DOE will invite short-listed pre-applicants to submit a more comprehensive application. Others will be notified why their applications were not selected.

The department is not charging fees for the pre-application round, but it expects to charge an administrative expenses fee and a loan guarantee fee at later stages of the process. The amount of such fees has not yet been determined.

A DOE credit committee will review the applications. The committee is expected to include the department’s chief financial officer and the director of the loan guarantee program. If an application is approved, then the DOE will issue a term sheet with the terms of the loan guarantee. Once the parties agree on the term sheet, the terms will be reduced to a formal agreement. The Department of Energy will need approval from the US Treasury before actually executing the guarantee.