DOE Loan Guarantee Update
Negotiations with the US Department of Energy over loan guarantees for innovative and renewable energy projects have been moving much faster since a confidential White House memorandum critiquing the loan guarantee program leaked to the press in late October.
Numerous commitments to a broad variety of projects are expected to be announced in the next few weeks.
Guarantees are made in a two-step process.
First, a term sheet is negotiated leading to a conditional commitment for a guarantee. Then further negotiations of the full documents lead to issuance of an actual guarantee.
The pace of issuing actual guarantees has also picked up. The first “section 1703” loan guarantee for a project using an innovative technology (Solyndra: cylindrical solar photovoltaic panel manufacturing, $535 million) closed in September 2009. The second (Kahuku: wind power generation, $117 million) closed nearly a year later, in July 2010. Another closed in August (Beacon: a flywheel power storage plant, $43 million), with another in September (Nevada Geothermal: geothermal power generation, $98.5 million), which was the first closing under the “section 1705” program for a renewable energy power project using a commercially-proven technology (also known as the “Financial Institution Partnership Program” or “FIPP”).
In December, the pace of closings accelerated dramatically, with four closings in two weeks (Abound Solar: solar panel manufacturing, $400 million; Shepherd’s Flat: wind power generation, $1.3 billion; Abengoa: solar power generation, $1.45 billion; and AES Westover: battery storage, $17 million). These four projects together received $3.17 billion of the total $3.96 billion in DOE-guaranteed financing that has closed to date.
Most doors into the section 1705 program have closed for new applicants. The part I filing deadlines for all open solicitations have passed. The sole loan guarantee deadline still lying ahead is the final part II deadline under the solicitation for new manufacturing facilities that make “commercial technology renewable energy systems and components,” which is January 31, 2011.
Congress recently gave a second wind to a number of section 1705 program applicants whose applications had found preliminary favor with the Department of Energy but who were depending also on section 1603 grants disbursed by the Department of the Treasury. Those grants required construction to begin by December 31, 2010, a deadline that was infeasible for some projects and required some others to commence construction ahead of what DOE’s own process permitted, since projects qualifying for DOE loan guarantees must undergo a potentially time-consuming environmental review under the National Environmental Policy Act before they can start construction. With slippage of the section 1603 deadline to December 31, 2011, the critical path item has become the September 30, 2011 deadline both to start construction and to reach financial closure under the loan guarantee program.
An intensified pace of conditional commitments and, in due course, closings should continue through the September 30, 2011 sunset for the section 1705 program. What happens then is open to speculation.
While, absent Congressional re-invigoration, the section 1705 program will pass into history, there are signs of renewed life for the section 1703 program for innovative energy projects. Unlike the section 1705 program, the section 1703 program has no legislative sunset. However, Congress must authorize additional guarantees or the program may not be in a position to invite new applicants. Whether Congress would offer fresh authorizations, and in what volume, is not clear.
Whether the section 1703 program would attract an adequate number of applicants has also been debatable as a consequence of three interplaying factors, all related to credit subsidy costs. Credit subsidy costs are premiums, like for insurance, that the government is required to pay, either from an appropriation or from amounts collected from companies benefiting from loan guarantees, to cover the cost of the program as a result of credit defaults. First, under section 1703, the applicants (rather than the Department of Energy) are responsible for paying credit subsidy costs. Second, although its credit subsidy calculations are state secrets, the Office of Management and Budget, an arm of the White House that must approve the determination of credit subsidy costs for any guarantees that are issued, is rumored to be biased toward estimating high credit subsidy costs. Third, because OMB makes those determinations only immediately pre-closing, applicants must invest in the whole DOE application and negotiation process without knowing a material cost of closing the financing.
To date, no sponsor has had to pay the credit subsidy cost for a loan guarantee. While six of the eight closed projects qualified for DOE support under the section 1703 program for innovative energy projects, all, including the two FIPP projects, also qualified under section 1705, and credit subsidy charges are paid by DOE from the section 1705 appropriation for projects qualifying for guarantees under that program. Constellation Energy withdrew its application at an advanced stage of its negotiation of loan guarantee terms for the Calvert Cliffs nuclear power generating project, reportedly because of OMB’s preliminary indications of a high credit subsidy cost—which the project sponsors would have to pay. Given OMB’s apparent high-balling of credit subsidy cost estimates, the prospect looms that project developers could find themselves subsidizing the government’s participation in the section 1703 program more than the other way around.
In response, the renewable energy trade associations have lobbied Congress for an appropriation of funds to support credit subsidy costs along the lines of the expiring section 1705 program and as is typical in other federal financing programs.
Those prayers may be answered. The President’s 2011 budget not only provides fresh authority for guarantees for qualifying projects, but it also earmarks $400 million to cover the credit subsidy costs of at least a portion of those guarantees. While that budget has not been enacted, the continuing resolution under which the government is spending money currently provided in an early version an appropriation for credit subsidy costs under the 1703 program, even though the continuing resolution that was ultimately enacted did not include that appropriation. The idea that the section 1703 program needs appropriated funds akin to other federal financing programs if it is to function effectively does, however, seem to have achieved some traction with the Congressional members and staff who have supported the DOE loan guarantee program. If such an appropriation is included in the 2011 federal budget when (and if) enacted, then the section 1703 program will have taken a huge step toward becoming part of the permanent landscape for financing innovative energy projects in the United States.
For those already in the loan guarantee pipeline, here are some lessons learned by your predecessors in that process.
Moderate your expectations.
Do not expect DOE to offer terms that reach to the edge of the statutory limits—i.e., leverage equal to 80% of project costs and tenor equal to the lesser of 30 years and 90% of the useful life of the financed assets. DOE’s offer, if the application makes it that far, will reflect leverage based on a reasonably conservative view of the projected debt service coverage ratios and as short a tenor as negotiations (and adequate coverage ratios) will permit.
Expect cash sweeps.
Whatever DOE’s offer by way of tenor, the reality will be somewhat worse. DOE has become enamored of cash sweeps, requiring a portion of cash flow available for debt service to be applied as a mandatory prepayment of the DOE-guaranteed loan. The consequence is that the applicant’s base case will project less debt in place and for a shorter term than the negotiated leverage and maturity would suggest, with a possibly material adverse impact on the expected return on equity. To date DOE has resisted replacing prepaid debt with alternative project financing, absent prepayment in full of the DOE-guaranteed loan.
Section 1603 grants: what’s mine is mine and what’s yours is the project’s.
DOE’s preferred approach to section 1603 cash grants has become clear. Qualifying projects should be obligated to obtain those grants, use a substantial portion of the proceeds (at least a percentage equal to the percentage of project costs financed with DOE-guaranteed debt) immediately to prepay the DOE loan and retain the balance within the project accounts for a potentially indeterminate. That, particularly the third point, is not what project sponsors are likely to have in mind. What happens to those proceeds and when, is being hotly negotiated deal by deal. The outcome is likely to be quite different from what project sponsors imagined when they first heard about the section 1603 grant program.
Change of control matters—a lot.
The DOE wants to know with whom it is doing business. Even if successor equity holders satisfy extensive criteria addressing business qualifications and avoiding bad actors, DOE will want some level of discretion to disapprove, both before and after project completion, successors to the current project sponsors and other equity holders. While some carve outs from DOE consent have been accepted in special circumstances (for example, public companies, investment funds and portfolios of projects), this remains a work in progress in which conventional commercial terms may not fly.
You must negotiate with people not in the room.
The project team is often in the unenviable position of relaying bad news from sources beyond its control—such as the credit committee, OMB, the Treasury Department or the program’s senior management. The sponsors may have no opportunity to voice their objections to, or to make their case directly with, the source of positions that are problematic for the project. There, the experience of the DOE team can be hugely helpful as the DOE team becomes the project’s advocates in navigating the inter-agency, and intra-agency, cross currents that affect the financing terms.
It’s not the private sector.
That cuts both ways. That, of course, is the program’s fundamental attraction, but it can also be the source of frustration. Public sector financing programs necessarily have certain non-commercial qualities. Some—like the program’s motivations—will attract prospective users. The DOE’s willingness to support innovative technologies and the availability of low interest rates are two non-commercial attractions of the DOE loan guarantee program.
Other non-commercial aspects are less attractive. Some of those are reflected in the “final rule,” the formally-adopted federal regulations that govern the program. Although some of the more unworkable aspects of the rule (such as barriers to collateral sharing and to collective decision-making with co-lenders) were eliminated in amendments adopted a year ago, a number of other quirks (such as certain exclusions from the list of project costs eligible for DOE-guaranteed financing and in-kind contributions not counting as “equity” for purposes for the final rule) remain. The quirks have not proven to be fatal to the successful structuring of financings, however, and DOE has been both creative and sensible in finding ways forward notwithstanding impediments that might otherwise have been found in the regulations, which were adopted when the Bush administration opposed the legislation that originally established the program.
The program has learned some lessons—some too well.
The program is maturing. Each issue encountered in negotiating term sheets or final documentation is no longer novel. That’s good news.
Not as good has been the tendency for the DOE to declare as broad programmatic policies positions that were developed for the first project to pose the question. That can work well enough where what matters is that the program has a clear and consistent standard. Then one can plan appropriately. The fact that DOE now knows how it wants to approach a quite wide range of potential issues helps explain the quicker pace at which term sheets are currently being negotiated. The down side is that the program’s emergent policies are at risk of being inappropriate for projects that pose similar questions in dissimilar contexts. It can be an uphill climb, and time-consuming, to persuade DOE that a predetermined policy is inappropriate in fresh circumstances.
Such growing pains are inevitable in a new financing program, but, for applicants trying to find workable terms, it can be challenging to be on the receiving end of new and unexpected policy pronouncements. An important judgment call in negotiating term sheets and final documentation is when to accept DOE policy requirements as just that—requirements that must be accommodated—and when to push back on putative policies as inappropriate for a given project. The good news there is that the loan programs office is well staffed with project finance professionals. They may not be able to address all your concerns, but they will at least understand them, which is half the battle.
A Final Note
Applicants under the commercial manufacturing solicitation will benefit from that solicitation’s correction of some issues that plagued prior solicitations. Most importantly, unlike the FIPP, this solicitation permits direct borrowing from the Federal Financing Bank, an arm of the US Treasury, opening the way to attractive rates and minimizing the transaction costs of structuring a co-financing between the DOE and one or more commercial lenders. On the other hand, perhaps appropriately given the challenges of financing manufacturing projects, DOE has stepped away from presuming a limited recourse project financing model and notes a preference for projects that contemplate “full recourse to the balance sheet of the Applicant and/or a full guarantee from the Project Sponsor, a credit-worthy parent or a third party acceptable to DOE.”