Current financing challenges
How are tax equity investors and lenders addressing the unusually large number of risks this year?
Tangled supply chains and labor shortages are causing delays. Inflation is making projects more expensive to complete than expected. There is still risk that the US government will collect anti-circumvention duties on the roughly 80% of solar panels that are imported from Southeast Asia despite a proposed 24-month moratorium on such duties. US Customs started enforcing stricter rules on June 21 on importing solar panels and batteries that may have benefited from forced labor. There was uncertainty around whether US tax credits for renewables would be extended and around possible domestic content, wage and apprentice requirements, a possible new book minimum tax and the effects of "Pillar Two" on multinational companies that claim US tax credits.
A group of tax equity investors and lenders talked about these issues at our 31st energy finance conference in South Carolina in mid-June. The following is an edited transcript.
The panelists are Jack Cargas, head of renewable energy tax equity origination for Bank of America, Rubiao Song, head of energy investments for JPMorgan Capital Corporation, Elizabeth Waters, managing director at MUFG, Gisela Kroess, managing director at CoBank, and Mark Williams, managing director at PNC Bank. The moderator is David Burton with Norton Rose Fulbright in New York.
MR. BURTON: Jack Cargas, how much tax equity volume has slipped from 2022 to 2023?
MR. CARGAS: We have seen some significant delays since the cost of capital outlook call that Keith Martin hosted in January. In January, we predicted there would be about the same amount of tax equity this year as we saw for last year, which is about $20 billion. We were predicting this year there would be roughly a 50-50 split between wind on the one hand and solar and storage on the other. (For the earlier transcript, see "Cost of Capital: 2022 Outlook" in the March 2022 NewsWire.)
Somewhere between 30% and 50% of the $10 billion in solar and storage tax equity this year is at risk of slipping into 2023. That is $3 to $5 billion of tax equity.
MR. BURTON: Beth Waters, are you seeing the same thing as a lender?
MS. WATERS: We are not seeing as much of an effect on the bank lending market. We expect to have a record year this year. I keep asking our clients what effect supply-chain disruptions and labor shortages are having on their projects. The answer for now at least is not much yet.
MR. BURTON: So tax equity is seeing a bigger slowdown while, for lending, it is more of a trickle effect.
MS. WATERS: That's my experience.
MS. KROESS: Deals have certainly been backed up. We had a few mandates with sponsors that rely on Chinese solar panels. Those deals were uncertain given the pending issues around the Auxin petition and Biden's proclamation.
We see a lot of deals backed up for the second half of this year, but with some slipping into 2023 because all banks have the same staff shortages that are affecting all sectors. There are only so many deals we can do.
MR. BURTON: Rubiao Song, if a significant number of solar deals slips to next year, will there be enough tax equity next year to handle not only the delayed projects, but also what were already expected to be 2023 projects?
MR. SONG: We think we will see 30% to 40% of projects on which investment tax credits will be claimed delayed into 2023. These are transactions to which we committed last year or earlier this year to fund in 2022. Funding will be delayed until 2023.
Demand for new commitments remains strong. There will be more pressure on tax capacity in 2023. We see some new entrants into the market, but not enough to have a meaningful effect on supply of tax equity. Meanwhile, the macroeconomic outlook will affect both demand and supply. Tax equity investors are likely to be more conservative the rest of this year about their tax capacity forecasts for next year.
MR. BURTON: In what new or different technologies, besides wind and solar, are tax equity investments being made?
MR. CARGAS: The renewable energy finance group, which is where I work at Bank of America, is really still focused on utility-scale wind, utility-scale solar, residential solar and storage. However, we have an adjacent business within our firm called "global sustainable finance," and the people in it are interested in many other assets. We are shifting some of our resources toward things like desalination plants, carbon capture, electric vehicles, offshore wind debt and commercial-and-industrial-scale solar tax equity.
MR. BURTON: Is anybody else expanding beyond the traditional tax equity technologies?
MR. SONG: I agree with Jack in terms of the new areas from a tax equity standpoint. We are looking actively at section 45Q opportunities and offshore wind.
MR. BURTON: Beth Waters?
MS. WATERS: There is a little bit of exploration into hydrogen. We have done one deal, but it is not your typical hydrogen project. It is more like gas stations where hydrogen is used for trucks. We are a Japanese bank, it is a Japanese sponsor, and so it is a toe-dipping exercise.
MR. BURTON: In the US?
MS. WATERS: Yes. Otherwise, we continue to do the traditional types of projects and also gas, diesel and transmission.
MR. BURTON: Jack and Rubiao, you both mentioned section 45Q tax credits for carbon capture. Has either of your institutions actually made a carbon capture investment? Are you aware of any closed deals?
MS. KROESS: Not on the debt side. Banks typically are conservative in nature. They shy away from technology risk.
MR. CARGAS: We haven't closed such an investment yet at Bank of America. We expect one or two transactions to get done in the market this year, but there are some pretty significant challenges with them, despite the seeming attractiveness of the tax credit.
MR. BURTON: Do you want to elaborate on the challenges? What has credit committees concerned?
MR. CARGAS: Credit committees are concerned about a couple of things that we don't see in the renewables sector, such as when you build a carbon sequestration or capture facility tied to a single plant, you worry, from a credit perspective, about there being no secondary source of repayment. What happens if you shut off the feedstock? It may be a little challenging for some firms when they think of their feedstock as being carbon, which is something that some ESG-oriented firms may not really want to be associated with.
There is also a question about the legal separation. If there were a downside scenario at the end of an early termination of a section 45Q transaction, how do you separate, legally, the sequestration asset from the host facility? Those two things are definitely taking up credit committee time.
MR. BURTON: Rubiao, do you have thoughts about that?
MR. SONG: We have evaluated a few section 45Q opportunities. There are different sizes and flavors. We have not closed any. We have been awarded one, and we are working on a few others.
They present some new challenges. You have sponsors who may not have the traditional investment-grade credit that investors will be looking for, particularly going into a new field. The deals have supply-or-pay or take-or-pay contracts, but the credit behind those contracts could be challenging.
We believe most, if not all, of the section 45Q deals will be done using a safe-harbor partnership structure. That means 20% of the tax equity investment will have to be made up front with another 30% of the investment paid over time as fixed payments and the balance paid as variable payments plus O&M expenses. That structure provides a lot of structuring flexibility for the investors. Investors will have to get comfortable with the technology and the commodity supply risks.
MR. BURTON: Jack Cargas, what are you seeing in terms of structuring for merchant projects in ERCOT, given the shift away from the fixed-capacity hedges after Winter Storm Uri. Are people no longer financing such projects? Are there new financial products to address the merchant variability?
MR. CARGAS: The entire market is very cautious about any sort of contract that requires a fixed delivery of power. The entire market suffered as a result of Uri in addition to the terrible human loss of life.
We are not seeing new financial products. We are seeing more use of already existing products such as a put structure, where a floor is established for the benefit of the tax equity investor and the upside is retained by the sponsor. We are also seeing more use of a pref structure, where the tax equity investor has a preferred return during the early period of the offtake, which of course is junior to payment of operating expenses, but senior to the cash distributions to the sponsor. Those two products are allowing us to continue to do business.
MR. SONG: Uri put a spotlight on particularly onerous features of some offtake contracts. Some projects have contracts for differences with corporate offtakers. The projects are in very congested parts of the grid, and the electricity basis risk is exploding.
We are seeing some offtakers agree to risk sharing. The electricity price is subject to a floor. The upside is shared between the project and the offtaker. The Wood Mackenzie presentation immediately before this panel looked at the pattern of declining wholesale merchant prices over time. The study should probably have distinguished between wind and solar projects that receive the hub price from the grid, don't have to contend with grid congestion and have no electricity basis risk. Those can earn a very good return.
Investors should look closely at the offtake contracts and avoid projects that have all downside risk and no upside potential.
MR. BURTON: Lenders, any thoughts on ERCOT and merchant projects?
MS. WATERS: At MUFG, we are cautious of ERCOT because of what happened last year. There were losses on the tax equity side in the institution, but not on the debt side. We will not finance a purely merchant project in ERCOT. There has to be a power contract or a hedge.
MS. KROESS: Many of our sponsors have a mixed strategy for ERCOT. They are doing partially contracted merchant projects. We see simple power price hedges for 45% or 50% of generation to establish a price floor. Those are not like the fixed-volume hedges that we saw in the past. We are cautious after what happened last year and would not finance a 100% merchant project in ERCOT today.
MR. BURTON: Mark Williams, we see headlines about inflation. The Fed raised interest rates 75 basis points. Do you think it is a viable strategy for sponsors to try to renegotiate power purchase agreements so that the electricity prices cover their higher construction costs?
MR. WILLIAMS: Yes. It is part of the all-of-the-above strategy that sponsors need to engage in to ensure their projects remain economically viable.
I work in both tax equity and debt. About 40% of the deals on which I am working have had a change in the power purchase agreement to increase the electricity price and extend deadlines to avoid delay damages. We have seen a number of utilities fairly receptive to making those changes, which is unusual. A few years ago, if you tried to suggest that kind of change, it would not have been well received. The amendments, in many cases, require public utility commission approval, which has added to delays.
MR. BURTON: Why do you think utilities are more receptive today to such changes?
MR. WILLIAMS: Various reasons. Some utilities are under pressure to meet renewable portfolio standards. They need the renewable electricity. They are well down the road with a sponsor on a deal, so it does not make sense to scrap an otherwise viable transaction and hope for something better.
MS. WATERS: Historically, it was taboo to touch the PPA. For instance, if banks asked for a change in the PPA because there was a glitch, we were told it was impossible fix because of the risk the utility would ask for something else in exchange.
I have been surveying clients and asking them whether they are having any success renegotiating out-of-market PPAs. The answer in many cases is yes.
MR. BURTON: How are conversations going with borrowers about rising interest rates?
MS. KROESS: Rising rates affect project valuations. Sponsors are trying to diversify their revenue streams. The era of long-term utility PPAs is long gone. Our margins are still pretty low on the renewables side because of the amount of competition among banks to lend. That is a positive for sponsors.
We have one big deal that has been delayed for a while, but that is unusual because of the risks tied to escalating project costs. The sponsors entered into a pre-deal hedge to lock in interest rates. It is a multi-billion-dollar deal. Not all banks can do that type of hedge. Such hedges are expensive.
MS. WATERS: We see a lot of deal-contingent hedges. (For more information on such hedges, see "Deal-Contingent Hedges" in the October 2017 NewsWire.) The longer the duration of the hedge, the more costly it is.
Banks do not make much money on them. They were quite profitable in the early days, but the market has become much more competitive.
MR. BURTON: We will have a discussion later in the conference about crypto mining. Has anybody financed a project that has crypto mining as an offtake?
MS. KROESS: No. Too eclectic for us.
MS. WATERS: I read about one bank doing a crypto offtake project financing.
MR. BURTON: But not MUFG?
MS. WATERS: No.
MR. SONG: We have a project that has a crypto mining data center as part of the offtake. It is not a new financing. We are seeing some opportunities on the horizon with big sponsors who are entering joint ventures with data center companies.
MR. BURTON: The crypto mining offtake helps mitigate against curtailment risk?
MR. SONG: Yes. These types of offtake contracts would help wind projects.
MR. CARGAS: There is still some reticence on the part of financial institutions with respect to crypto. But I heard an interesting perspective last night that those of us who have financed projects in Texas are already financing electrons that are ultimately used by crypto miners. There may be an intermediary party, but at the end of the day, once the project sells power, that power could end up in the hands of those mining companies.
So some institutions may decide it is not such a big stretch to conclude that we are already doing it. I am not saying that is what we have done, but it was an interesting perspective I heard last night at dinner.
MR. BURTON: We see rising interest rates, but tax equity yields are moving down due apparently to some new entrants in the tax equity market and a shortage of projects. Mark Williams, do you agree?
MR. WILLIAMS: Yes, there has been some downward pressure on flip yields.
There is a dearth of product for 2022 because of the delays. If you had a budget to get $X million in tax credits this year, it is a challenge to find projects that are going to get in service by the end of the year. That leads to pressure on pricing. The overall returns have not taken too great a hit. Investors look at the all-in return, assuming the buyout is exercised. Then you look at the return if the buyout is not exercised and you stay in the deal through the entire PPA term. Those returns are still pretty close to where they had been, but there has been some downward pressure on the flip yield.
MR. CARGAS: I promised Mark before the panel that I was going to disagree with him on something, so here it is. We have not observed that phenomenon.
MR. BURTON: When we talk about delays, the things that first come to mind are supply chain issues and tariffs, but what about interconnection queues? Some say that is an even bigger problem than supply chains or tariffs.
MS. KROESS: I disagree with that. We have seen delays on both fronts, but sponsors are generally able to work around interconnection delays and keep to the overall schedule. On tariffs and supply chain issues, some of the impacts have been much more severe and require renegotiating sunset dates. We have had to extend the construction loan maturity by as much as a year.
Also with tariffs and supply chain issues, you have multi-level issues. You have force majeure notices because ports are backed up. There are transportation delays. You have panels stuck in Customs because of forced labor concerns. You have tariff risks.
At least with anti-circumvention duties, there is a reprieve of two years, but we really need a longer-term solution. The question is whether tariffs on Chinese goods are here to stay. There is some discussion that they might be reduced.
MS. WATERS: I agree with Gisela. Developers come to us when a project is ready for financing. They usually have worked out any interconnection issues by then.
MR. CARGAS: Following up on one thing Gisela said, we are not absolutely convinced that the moratorium on anti-circumvention duties is a reprieve for two years. There was a research note that came out this morning from one of the equity analysts indicating that a number of manufacturers are still wary of importing solar panels into the United States because of the risk of litigation over the ultimate legality of the Biden proclamation.
MS. KROESS: That's a valid point. There is a litigation risk, but it feels to many banks like there is a bit of breathing room.
MR. CARGAS: I hate to agree. [Laughter]
MS. WATERS: It is breathing room, but it is a band-aid.
MS. KROESS: You have some sponsors looking at tier-two technology. For example, banks are feeling pressure to accept Indian solar panels, but there is still a fair amount of resistance.
MR. WILLIAMS: The moratorium is a positive development and everybody's hopeful, but to say there is no risk is a little premature.
MR. BURTON: What we are hearing from the trade lawyers is that while it is not intuitive that solar panels are emergency food, clothing or medical supplies, which is what the statute contemplates, the statute also gives the president a fair amount of discretion.
MR. CARGAS: So David, you can give us a "will" opinion on that? [Laughter] Sorry.
MS. WATERS: No comment, I guess.
MR. BURTON: Are labor shortages still an issue?
MS. WATERS: Yes. It is not just a labor shortage, but also increased costs for labor. EPC contractors on large projects are reluctant to cap the costs.
MR. WILLIAMS: There is also a timing issue. Projects that experience delays will lose workers to other projects. You cannot have a crew hanging around waiting for modules to show up.
This then creates issues with financing terms that were set some time ago based on certain assumptions. You have construction lenders that lent against tax equity commitments that have turned into pumpkins. Sponsors then have to scramble and ask the lenders for concessions. If there are several banks involved, it can be a lengthy process.
It has been a very challenging year. I think sponsors have done a very good job scrambling to keep all the plates spinning in the air.
MS. WATERS: Lenders have to make sure there is a cushion. The project should be expected to be completed well before the sunset date of the PPA. It is an unknown how long some of these delays could last.
MR. BURTON: How long a cushion do lenders want in the current market?
MS. WATERS: There is no general rule of thumb. It depends on the project. Three months might be acceptable to one lender while another wants six months to a year.
MR. BURTON: Any audience questions?
MR. SAXENA: Himanshu Saxena, CEO of Starwood Energy Group. Given the growing concerns about energy security, has there been a shift in mindset around financing conventional assets? I am not talking about financing coal, but about financing gas and carbon capture facilities tied to gas or coal.
It is not the same investment climate as it was a year ago. There is a shortage of natural gas. Australia is talking about burning coal again. India said it will keep burning coal until 2070.
We see the same thing from our equity investors. Increasingly they say, "Gas is good. We don't mind gas," which is different from what we were hearing a year ago.
MR. CARGAS: It is a great question. Energy security is on the tip of many governmental officials' tongues, but it has not translated into interest in financing fossil fuel plants.
MS. WATERS: At our bank, no coal. We are happy to finance gas. However, a lot of banks will not finance gas-fired projects. We have a renewables focus, but we also recognize that you cannot depend solely on wind and solar, even with batteries. You need gas peakers. I think gas is here to stay.
MR. SONG: Banks have to do more analysis to get comfortable when asked to finance a carbon capture project at a fossil fuel plant. They want a life-cycle carbon reduction analysis.
MR. WILLIAMS: My bank provides a lot of liquidity to investor-owned utilities, but does not directly finance gas plants. I don't see that changing.
MS. KROESS: We finance gas peakers, especially portfolio peakers. I not aware of any new baseload combined-cycle gas plants that we have financed. There are some refinancings. We have seen some European banks withdraw from the gas market altogether.