Financing renewable energy projects with the US military
Projects with the US military present special challenges. Financiers focus on the revenue stream. A developer may have a long-term power contract to supply electricity at an agreed price per kilowatt hour. The military also signs energy savings performance contracts (ESPCs) and utility energy services contracts (UESCs) where energy efficiency improvements are installed on a military base and the base is charged a percentage of the energy savings. Several veterans of financing projects with the military and other government agencies talked about the challenges at an Infocast conference on defense renewables in Washington in March. (For prior coverage of this subject, see "The US Army Goes In Search of Electricity" in the February 2013 NewsWire and "Power Contracts with the US Military" in the June 2013 NewsWire.)
The panelists are Peter Flynn, a partner at Bostonia partners, Robert Johnson, senior vice president for public sector origination with Hannon Armstrong Sustainable Infrastructure, Dan Rosen, director of structured finance for Siemens Government Technologies, and Bharath Srinivasan, senior vice president for operations at Distributed Sun. The moderator is Keith Martin with Chadbourne in Washington.
MR. MARTIN: The defense renewables market kicked off with a plan by the US Army in 2012 for $7 billion in power purchase agreements. More than 600 people showed up for an initial meeting in late August 2012 to learn more about the opportunity. Then things seemed to slow down. Contracts are being awarded much more slowly than anyone expected. Bharath Srinivasan, how much opportunity do you see in this market today?
MR. SRINIVASAN: The primary mission of the three divisions — the Army, Navy and Air Force — is to be prepared to fight a war, and energy procurement is secondary to that. We still see a lot of opportunity, but over an extended time period.
MR. MARTIN: Dan Rosen, has this been the opportunity that Siemens expected?
MR. ROSEN: From the Siemens perspective, there is still tremendous opportunity, and there have been tremendous obstacles. It has been a slow and frustrating process. We won some of the early projects. It has been hard since then to win projects that work. It is a very competitive marketplace. We are in this for the long haul.
MR. MARTIN: So you have to be patient. Bob Johnson, big opportunity?
MR. JOHNSON: I agree with the other panelists about the speed with which the opportunity is being realized. It is taking different forms than we expected. We thought it would be more of a finance opportunity. It may not be. We have a huge commercial portfolio under contract currently — almost $3.2 billion, mostly in wind and solar — but we have not seen that kind of volume to date in the federal sector.
MR. MARTIN: If it has not turned out to be a financing opportunity, then what is it?
MR. JOHNSON: It is slow starting.
MR. MARTIN: So no opportunity?
MR. JOHNSON: No. Some opportunity, but the opportunities have been few and far between. The announcements about potential new projects are months apart followed by a long gestation period to get each project off the ground. There is a huge time lag between when a contract is awarded to a developer or contractor to when the project is ready to put shovels in the ground.
MR. MARTIN: How many contracts have been awarded under the program since 2012?
MR. FLYNN: Since I don’t know the exact number, I will say not enough.
MR. MARTIN: Does anyone have a number? Dan Rosen?
MR. ROSEN: I would say too few as well, but to follow up on a point that Bob Johnson made, we are here representing capital. Capital is fungible. We like to invest in renewable energy projects. We have other opportunities besides the federal sector to deploy our capital. Anyone interested in supplying capital to fund federal projects must be really patient and must have a very low cost of funding to be able to survive in this environment.
MR. FLYNN: I will give you a number relative to the total market size. Focusing on the ESPC and UESC market, depending on the year, there may be anywhere from $600 million to $1 billion in projects awarded.
MR. MARTIN: That is a very large number.
MR. FLYNN: There is a significant pipeline of projects, but as has already been noted, there is a time lag of 18 to 24 months after a project is awarded before it is ready for financing. Most renewables developers who follow this market appear to see the federal renewables market as a $3 to $4 billion opportunity overall.
MR. MARTIN: Over what time period?
MR. FLYNN: Over the next few years as the market currently exists. More opportunities may develop later.
MR. MARTIN: Somebody please put this into context. Lots of people attended the Infocast defense renewables conference in 2013. By 2014, interest seemed to be waning. Attendance was not so great. I wasn’t here in 2015. Are the attendance and mood like 2014 with developers feeling disappointed or are things picking up again?
MR. FLYNN: It is important to view the market holistically. I think that is why Dan Rosen and Siemens are still here when some others are not. Siemens, Honeywell and others have a broad view of the market. They are big companies with staying power. Smaller companies invested some resources initially, but they have moved on because the opportunities and pipeline are not what they expected.
MR. SRINIVASAN: The program should continue to grow. Developers have had to spend a lot of time to date educating base-level contracting officers dealing with smaller projects. Once the larger projects start being awarded and once we get greater standardization of terms because the contracts are being reviewed at higher levels, then the pace should start to pick up.
Termination for Convenience
MR. MARTIN: I want to dive into some details that have made it challenging to finance projects with the US military. Projects on US military bases are getting financed, but the facts that the military retains the right to terminate the power contract for convenience and, depending on the contract officer, it may or may not agree in advance to a schedule of termination payments have been a significant impediment to raising financing. Is this still an issue and, if so, how common?
MR. ROSEN: It is an issue, but a solvable one. People may differ about whether it is a drop-dead issue or something that can be overcome. From a Siemens Capital perspective, there has to be a termination payment schedule and we have to feel comfortable that it is enforceable.
MR. MARTIN: So for you, it is a go, no-go issue. Does anyone have a different perspective?
MR. JOHNSON: The termination payment must cover a number of items. The financier wants to be repaid the principal amount of its investment plus accrued, but unpaid, interest on that investment with no questions asked. There may also be costs, like swap breakage charges, that also need to be covered.
The deal structure may also affect what should happen upon termination. It is easier to deal with termination where the project is on the military base and all the output goes to the base, but what about where there is also a power contract to supply part of the output to someone off the base? How does termination for convenience work in that case?
In many projects, there is also the complication of a tax equity investor. A termination for convenience may cause recapture of tax benefits for which the tax equity investor will require compensation.
Finally, what happens if the military says it has to take over the project due to national security concerns: what happens then? I don’t know that we have crossed that bridge yet.
MR. MARTIN: That is a good list. Is it true that it is up to each individual contract officer to decide whether there will be a termination payment schedule?
MR. JOHNSON: The government is a decentralized organization, from a contracting standpoint as well as from a legal standpoint. You see it at this conference with many different people from the Pentagon and the service branches expressing different opinions. Each contracting officer can make his or her own decisions about the best way to address local issues on the base. Each can take a different approach.
MR. MARTIN: Are some of the service branches better at this than others? Peter Flynn? [Laughter]
MR. FLYNN: All right. I’ll go. In cases where the developer has an enhanced use lease or other form of lease allowing use of real estate for offsite power sales, what has seemed to work is to secure an exception from the secretary of the Army, Navy or Air Force to allow termination only where there has been a default by the developer. That seems to work for lenders.
MR. MARTIN: Is that true? What if there is a national security issue?
MR. FLYNN: That is a more difficult issue. What we have seen when the assets are on the military base and the power goes offsite, the only termination would be through default of the contractor. Otherwise, the lease would stay in place. If you introduce termination or suspension for national security reasons, then you end up with a smaller number of potential investors who can get comfortable with the risk. It is really difficult to quantify the national security risk. What kind of discretion exists around that? Can it be whittled down to specific events?
In cases where the government is buying the electricity under a long-term power contract from an asset behind the fence, you really look for a pre-agreed schedule of termination payments.
The termination-for-convenience issue started with the Navy requiring that termination payments are fully negotiable, which is a non-starter for tax equity investors and lenders. Now we are in a position where a par-value termination payment is permitted, but all other costs are negotiable, which is very difficult for many investors and requires at least a significant pricing premium.
MR. MARTIN: So did you answer my question: is one service branch better than the others? [Laughter]
MR. FLYNN: I think each service has its strengths. For example, the Navy at least has said, “We want to engage and solve this.”
MR. MARTIN: The next risk is non-appropriation or the possibility that Congress might not provide funds to make payments. Is this still a fear for anyone? Bob Johnson, you are nodding your head no.
MR. JOHNSON: I don’t think it is.
MR. MARTIN: Why not?
MR. JOHNSON: That is a risk that we underwrite as financiers of federal, state and municipal projects every day. We are looking at an offtaker that is a AA+ or AAA credit.
MR. MARTIN: You have more confidence in Congress to appropriate money than the American people do.
MR. JOHNSON: Non-appropriation for us is more of a concern in some of the deals we do with municipalities.
MR. ROSEN: It is a different analysis on the federal side. Most financiers working in the federal sector understand that there may sometimes be payment delays — for example, as we have seen during the recent budget sequestrations — but it is not a matter of never receiving payment.
MR. FLYNN: Non-appropriation risk is different for many federal transactions in part because the military has been given multi-year contract authority for certain types of contracts like ESPC and UESC agreements. Congress has said, “We’re giving you authority to enter into these long-term agreements,” and Congress does not have to come back each year and appropriate funds for the contract payments.
MR. ROSEN: Failure to appropriate on the municipal side would be a real problem.
MR. SRINIVASAN: Look at the electricity prices in these contracts. The military is being offered electricity at below the rate it pays the local utility. The base needs the electricity. It is not likely to stop payments for power from the independent generator in order to pay more to the local utility. This helps to minimize the risk.
MR. MARTIN: These projects require outside financing. There may be a lender. There may be a tax equity investor. What happens if there is a default? The project is on a military base. Can the financiers come in and take over or remove the asset. If not, is this an issue?
MR. FLYNN: Lenders want step-in rights. They want the ability to control the asset and fix the problem. They also want to receive copies of any default notices sent by the military to the developer and vice versa. In reality, it is unlikely that a lender will pull equipment at an installation like Fort Bragg. That is difficult to do. But lenders need that right in the contract in the event of a default. It will be an important part of the financing package.
MR. MARTIN: Bob Johnson, as a lender, you probably do not want to take back the asset in any event. You want to be able to leave it in place and sell it to someone else.
MR. JOHNSON: All we want is to get paid at the end of the day. If it is the government that is in default by not making contract payments, then that is the non-appropriation risk that we evaluated and agreed to take. If the developer is in default, either for failure under the EPC contract or an O&M contract, then we want step-in rights and the ability to fix the problem without losing the power contract with the military. At that point, we are acting on behalf of the government to make sure that the solar array does what it is supposed to do with another contractor that we have agreed with the government to bring in to replace the original developer. We are working collaboratively with the government at that point. Our interests are aligned with the government and not in conflict.
MR. MARTIN: You just want the government to recognize that you have an interest in the asset and want the ability to step in after a default to fix things before the project is lost.
MR. ROSEN: Speaking as a representative of Siemens, that is why it is important to deal with contractors who can finish the job.
MR. MARTIN: The next topic is power prices. The military wants to buy electricity from renewables at lower cost than it pays the local utility, and yet these are technologies that are more expensive to produce electricity than from gas or coal that the local utility may be using. In addition, the Army, at least early on, wanted to keep the renewable energy credits that are supposed to close the gap for the developer. How is this requirement that renewable energy be supplied at lower than the local retail rate working out in practice?
MR. SRINIVASAN: The reality is that it is difficult to bifurcate the RECs in most markets. The offtaker often takes the RECs as part of the price it pays for the electricity.
MR. ROSEN: Do you have any customers who are willing to pay more than the local utility rate? [Laughter] We would love to sell to them. We work with states, municipalities, universities, schools, hospitals, the federal government; we are all over that space. We have not found a customer yet who said, “We are going to put a value on the fact that this is clean energy, and we will pay you a premium for the electricity.” Every customer says, “We love to have solar, but we really want to save money at the same time.”
MR. MARTIN: That is an excellent point. Peter Flynn?
MR. FLYNN: I agree with that. The difference is that the military is interested in keeping the RECs as a way of meeting renewable energy goals while, in the private sector, the RECs are sometimes left with the developer or folded into what is sold to the offtaker under the power contract.
MR. MARTIN: What about the risk of future political pressure to amend the contract terms? These are long-term contracts, 25 years in some cases and perhaps as long as 30 years in other cases. The electricity price is agreed in year 1. There may be a fixed inflation adjustment written into the contract. Are you worried that, over time, the electricity price being paid under the contract will end up higher than the local retail rate and that there will be pressure to change the contract?
MR. ROSEN: We are not too concerned in the federal space. We do this ESPC work all the time. There are fixed escalations. Government agencies live with these contracts. Really, their goal is to get a project that gets them either the energy savings or the renewable resource that they wanted and, while it may be uncomfortable for some contract officers to have to acknowledge to a base commander that an occasional contract has become way out of the money, there are plenty of contracts that are in the money.
MR. FLYNN: No developer asks for revisions in pricing when the shoe is on the other foot and retail prices have risen.
MR. MARTIN: Are there other risks with military contracts that are not present in a utility or commercial deal? What about the risk that the military base will be closed during the contract term?
MR. JOHNSON: Base closure is a risk that we take into account, and it can be a big one, depending on the location of the base. If solar panels are being put on privatized housing on a base, then the risk is a little different because the project is tethered to the military through a commercial contract. You have to assess whether that housing has intrinsic value in the market apart from its use to house military families.
There is also general political risk. The political risk is not around a price for electricity in the PPA. It is the risk that the US government may have less interest, after the upcoming change in administrations, in promoting use of renewable energy on military bases. We won’t know whether the basic program will undergo major changes until next year. That is a risk that will affect the velocity and number of future projects.
MR. SRINIVASAN: Another risk is that anything with the government takes a long time. Renewable energy procurement is just a small part of what the US military does. We see a lot of risk in the time that it takes to go from point A, which is notice of award, to point B, which is when the project is ready to begin construction. That is the largest risk in these projects. Once the project is in operation, we don’t see much risk, including the inflation risk that was discussed earlier.
MR. ROSEN: I agree with that. There is also an opportunity cost to chasing military projects. It is spending so much time and not knowing whether you will be able to get the contract. That is the biggest risk for us.
MR. JOHNSON: In the fall 2008 to early 2009, interest rates went crazy and credit dried up. Another risk, because of the long time it takes to move these projects through the queue, is that there will be a similar financial event that will put a project out of the money. The risk is of a global financial event that pushes up interest rates and pushes the price at which you can supply electricity above what you had to promise to win the contract.
There is a need to shorten the timelines. We have seen credit risk increase since 2014. Corporate bond spreads are widening. The longer it takes to move a military project from contract bid to financing, the greater the risk of a major credit event happening to put the project out of the money from the developer side.
MR. MARTIN: Let me ask a question that calls for a one-word answer. Are these projects riskier, less risky, or just different from utility and commercial projects?
MR. SRINIVASAN: They are different.
MR. ROSEN: I would say the same: different risks. Maybe they are a little less risky once you get immersed in them, but different.
MR. JOHNSON: Different set of risks.
MR. FLYNN: Different.
Cost of Capital
MR. MARTIN: Let’s move to the cost of capital. You have a federal government credit behind the revenue stream. Does that mean that the cost of tax equity and debt is lower than for a utility- or commercial-scale project?
MR. ROSEN: Debt, yes, tax equity, no.
MR. MARTIN: Why the difference?
MR. ROSEN: The federal government is the gold standard from a lender’s perspective. Tax equity costs what tax equity costs.
MR. MARTIN: Debt is priced based on the creditworthiness of the revenue stream. Tax equity does not move with interest rates because tax equity investors are selling tax capacity. It is a scarce resource. What is the premium to treasuries for debt in this type of transaction?
MR. FLYNN: My price is several points below Bob Johnson’s. [Laughter]
MR. MARTIN: Looks like we are about to have an auction. Do we have an opening bid? [Laughter]
MR. FLYNN: At the end of last year, we were executing well-structured projects at under 100 basis points.
MR. MARTIN: Under 100 basis points above average-life treasuries? You are talking about executing in the securitization market, right?
MR. FLYNN: In a form of it. In the private placement market. Credit spreads have widened since then. I think you are looking at 120 to 140’ish in this environment, depending on where the project is.
MR. MARTIN: What’s the average life treasury right now? What’s the base?
MR. ROSEN: It depends on the term. If you have a 20-year term, the debt life is around 12 or 13 years, depending on interest rates. It is a calculation.
MR. FLYNN: Today the 10-year treasury rate is 1.97%.
MR. MARTIN: So if you add 125 basis points, you are up to 3.22% as an interest rate.
MR. FLYNN: If you are going into a PPA with more risk, then there might be a four as the first number.
MR. MARTIN: Which is not bad. Look at the rooftop solar securitizations that SolarCity and Sunrun have done. Until the first quarter this year, they had been in the 4% to 5% range. The securitizations in the first quarter this year have been in the high 5% to 6% range as an all-in interest rate.
MR. FLYNN: That is a commercial deal. Those are private companies and not the federal government. It is a different equation than for a UESC at a military base, which has the lowest possible spread because it is viewed as very close to a federal government credit.
MR. MARTIN: This proves Dan Rosen’s point that the fact that you have a federal government credit behind the payment stream leads to a lower interest rate than in the commercial market. On the difference between bank spreads and securitization, there may be a 125-basis point spread above treasuries for a securitization. Banks offer a floating interest rate that is at a spread above LIBOR. Do you know what the spread is currently when borrowing from a bank against a federal government payment stream?
MR. FLYNN: It depends on the kind of project. With a UESC, there is political risk but no variability in the payment stream. With privatized military housing, there is more risk tied to the payment stream.
MR. MARTIN: Correct me if I am wrong. We are talking about three types of projects. A UESC is a contract with the local utility to install energy efficiency improvements. An ESPC is a contract for energy efficiency improvements where the price paid is a percentage of the energy savings each period. A PPA is a contract by a generator to sell electricity.
MR. ROSEN: A UESC is the least risky because there is no variability in the payment stream. ESPCs and PPAs go up the risk scale. Even higher on the risk spectrum is solar panels mounted on privatized military housing.
MR. MARTIN: Let’s talk then about that spectrum. What would the required debt-service-coverage ratios be across that spectrum?
MR. ROSEN: I am sure that Peter’s will be 1.5x. [Laugher]
MR. MARTIN: Peter Flynn, do you want to defend yourself?
MR. FLYNN: It is 1.35x for a solar PPA. It is not much different than the commercial credit space.
MR. MARTIN: I see everybody else nodding in agreement.
MR. ROSEN: It is 1.35x for a P50 revenue projection. In a P99 case, the ratio is 1.0.
MR. MARTIN: Most finance in this market is either debt or tax equity or some combination of the two. What both have in common is that financers want to see a true equity layer of at least 10% or 15%. Are the returns for developers in these projects high enough to attract that much true equity?
MR. SRINIVASAN: Yes in most cases where a project ends up being built. We have done a number of contracts with the Army.
MR. MARTIN: Peter Flynn, how much true equity do you want to see?
MR. FLYNN: It depends on the contract structure, but, in general, it is the same as for a commercial project. We like to see at least 10%.
MR. JOHNSON: We want as much true equity as possible. We want to see the sponsor have a strong incentive to make the project work.
MR. MARTIN: Is it a common mistake for smaller developers not to realize that they will have to have significant equity to raise other financing?
MR. JOHNSON: It can be sometimes. We have had people come through with little understanding of what the process is from a financing standpoint. They think they just put up panels and make it work, and it is a rude awakening sometimes when the reality sets in.
MR. SRINIVASAN: It is how much equity versus how long the sponsor will have the equity in the deal. Many deals have tax equity. We have invested in projects where the equity may be a smaller portion of the capital structure, but the sponsor waits until the tax equity has reached its return before it starts to get back its invested capital.
MR. MARTIN: Bharath Srinivasan, you said developer returns are high enough to attract the equity required. The obvious follow-up question is what are the developer’s returns?
MR. SRINIVASAN: The sponsor return is somewhere in the low double digits. That is for commercial projects. Returns on projects with the federal government may be a little lower, but I don’t think we are seeing a significant gap between the two.
MR. MARTIN: Dan Rosen, is that what Siemens earns?
MR. ROSEN: We have hurdle rates. I don’t know what sponsors are earning on the equity investments in these projects, but my guess is it is not a lot.
MR. MARTIN: Peter Flynn, what has been the default rate on securitizations involving government paper?
MR. FLYNN: To use that term securitization somewhat broadly, it has been zero in the ESPC and UESC markets. There have been no defaults in fact.
MR. MARTIN: Over what time period?
MR. FLYNN: Since initiation of the program. Actually, I think Enron had to walk away from one of its projects, but there was no default because the contract allowed the lender to find a replacement contractor without default.