Tariffs, inflation and other challenges
A panel of veteran financiers at the annual ACORE finance forum in New York in early June was optimistic, but cautious about whether the Biden proclamation shielding solar panels imported from four Southeast Asian countries over the next 24 months from anti-circumvention duties will allow stalled solar financings to move forward. The panel also talked about how inflation and the current economic outlook are affecting the market. The conference is hosted by the American Council on Renewable Energy.
The panelists are Mit Buchanan, managing director on the tax equity desk at JPMorgan Capital Corporation, Gaurav Raniwala, global head of renewable energy for GE Energy Financial Services, Ted Brandt, CEO of Marathon Capital, Claus Hertel, a managing director at Rabobank, and Alain Halimi, an executive director at Nomura. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
MR. MARTIN: The Biden administration moved yesterday to ease solar industry fears that solar panels imported from Vietnam, Malaysia, Thailand and Cambodia will be subject to large anti-circumvention duties. It said there will be a 24-month moratorium on any such duties that the Commerce Department decides later this summer to impose.
Auxin, the US solar panel manufacturer that launched the Commerce investigation, is not happy. It could sue to block implementation.
Will solar projects that are currently in limbo because they cannot tolerate the extra duties now move forward with financing?
MS. BUCHANAN: The Biden proclamation was welcome news. Whether it will ultimately succeed in its objective has to be worked through, but we are hopeful that some near-term projects that are in the pipeline will be able to close their financings as a result.
MR. MARTIN: Biden used authority under section 318 of the Tariff Act of 1930 to waive duties. That authority allows the president to waive tariffs on “food, clothing, and medical, surgical and other supplies for use in emergency relief work.” The issue will be whether it allows tariffs to be waived on solar panels. Greg Wetstone mentioned immediately before this panel that Covington produced an analysis last night that suggested Biden was on firm ground to use this authority. I suspect financiers are going to want to see the analysis.
Ted Brandt, will this allow financings that have stalled over tariff fears to move forward?
MR. BRANDT: It was clearly a good day yesterday. The developers we talked to in the last 24 hours are optimistic that it will allow projects to advance. Everybody was waiting until late August for the preliminary Commerce decision and April 2023 for the final decision. This helps.
Unfortunately it may not have come in time to salvage 2022. We are hearing about a lot of 2022 solar projects that have shifted to 2023. Panel orders had slowed to a trickle. It is not as if there are a lot of shovel-ready projects. We are at a point where supply chain and labor issues and escalating costs are starting to affect even 2023 projects and cause them to slip into 2024.
MR. MARTIN: Bankers, any views?
MR. HERTEL: We have had to put five or six transactions with reputable developers on hold. It was pencils down earlier this year. With the news yesterday, I think folks are somewhat exuberant. Maybe not irrationally so, but they are excited that they can get to work again. I think we will see some extra closings this year. Some will slip into next year. Lawyers are back in action. Construction contractors may be able to get panels now.
MR. MARTIN: It seems like deals in the M&A market were closing anyway, but with sellers accepting a lower initial price with a possible earnout later depending on how the Commerce investigation comes out.
Alain Halimi, do you have a view?
MR. HALIMI: I agree with Claus. We have been busy since the Commerce investigation started helping developers structure around the tariff risk by providing bridge facilities that allow construction to get underway and that provide flexibility to shift the source of panels. We are working now on such a transaction that is supposed to close next week.
Obviously what happened yesterday is helpful. In terms of the pipeline of deals, with more people getting back on their horses, this could create more challenges with supply chains. It is a game of supply and demand.
MR. MARTIN: You were prepared to close bridge financings before the Biden proclamation. How have you structured around the tariff risk?
MR. HALIMI: We can do it non-recourse or partial recourse. Having a recourse loan is the lazy way to do it. The risk is present. It is a matter of shifting the risk to someone who can bear it. Everyone works together. By everyone, I mean the EPC contractor, the electricity offtaker, the developer and the lenders. For example, the offtaker says, “I need the power. I am happy to amend the PPA to have a price step up in the event there is a negative action on tariffs.” That gives comfort to the lenders.
MR. MARTIN: So the offtaker is willing to take the risk. If it is a utility, it passes through the tariff increase to its millions of customers.
MR. HALIMI: A portion.
MR. MARTIN: What percentage?
MR. HALIMI: Up to 60% of any tariff increase.
There is also flexibility shown by the parties around the construction schedule in the event the developer needs to procure the panels from another source.
Tax Equity Volume
MR. MARTIN: Back to Mit Buchanan. Last year was about a $19 to $20 billion tax equity year. People were predicting at the start of this year that tax equity volume for 2022 will be about $20 billion, plus or minus 5%. We are now six months into the year. Where does it feel like the final figure will land?
MS. BUCHANAN: I think we are still on track for $20 billion for commitments in the form of an executed equity capital contribution agreement or letter of intent, but actual closings on some of that $20 billion will be delayed into 2023. We will be figuring out over the next month what really can close in 2022 versus 2023.
Going back to the Biden announcement yesterday, it is good news and it will allow some developers to move forward with their transactions in 2022, but this is June. Anyone hoping to close this year has to have the transaction well underway by now. It is not a matter solely of getting the documents done. You also have to have the construction contractor and the other technical resources lined up. Everyone is working flat out trying to get a few deals done.
MR. MARTIN: There are labor shortages across the spectrum.
MR. BUCHANAN: There are labor shortages.
MR. MARTIN: Tax equity desks, bankers, lawyers, appraisers, technical consultants, everybody.
MR. RANIWALA: We are seeing delays across the board. New solar capacity additions could be reduced by more than half this year. New wind construction could be down by a half this year compared to the past peak of 18,000 megawatts.
Without policy support for both solar and wind, while the short-term commitments might be keeping up, in reality the market is shrinking dramatically. Without a policy change, we are looking at a much smaller industry going forward.
MR. MARTIN: Ted Brandt and I were on a panel in January in New Orleans. The Lightsource BP US CEO said something surprising. I thought supply chain difficulties and labor shortages were accounting for the delays. He said it is inability to interconnect.
MR. BRANDT: I think you have both causes. Interconnections have slowed dramatically in PJM. That was a place where people were counting on significant new capacity additions in the next couple years. We are hearing in the onshore wind and solar markets of nightmares in terms of procuring panels, finding labor and all the other things required to build a project. General inflation is also taking a toll.
MR. RANIWALA: Five years ago, it used to take 1.5 years to interconnect a project. Now it takes an average of three years, according to a US Department of Energy study.
MR. MARTIN: Interconnection measured from what start date?
MR. RANIWALA: Measured from when the developer first applies to interconnect. There are something like 250,000 megawatts of wind projects and 400,000 to 500,000 megawatts of solar projects in line to interconnect. We have a massive backlog issue that is not getting resolved.
MR. MARTIN: PJM has now imposed a two-year moratorium on new interconnections. Bankers, coming back to you. What percentage of projects are you seeing pushed into 2023 or suffering some sort of delay?
MR. HERTEL: Around 50% of projects are moving into 2023.
MR. MARTIN: What is the average delay in months?
MR. HERTEL: We have three transactions in house that received credit approval last year that have still not closed because of all kinds of issues, from escalating financing costs to supply chain difficulties, inability to get panels, labor shortages and transportation snafus. It has been a perfect storm.
We have not seen anything like this in a long time where costs are increasing rather than going down.
We are doing more loans at the holding company level to help developers bridge a gap until they are in a position to build in 2023 and 2024.
MR. MARTIN: They are drawing money, but what are they spending it on if everything is delayed?
MR. HERTEL: It costs a lot of money to develop. If we are extending development capital at SOFR plus 350 basis points, that is cheaper than the equity that they have to get from a private equity fund at a cost of 15% or 20%.
MR. MARTIN: This helps explain a phenomenon we are starting to see where projects are worth less at the end of construction than they cost to construct. Alain Halimi, what delays are you seeing?
MR. HALIMI: Our experience is the same as what Claus described. We have been seeing opportunities to lend to acquire equipment, particularly in Europe where solar panel tariffs are not a threat. Another growth area is developers who want to recycle capital by borrowing against the equity value in projects.
MR. HERTEL: One more thing on the developer side. Projects that are ripe for construction were developed over the last few years. The developers have not been paid a developer margin or developer fee yet. Those margins are being squeezed with costs going up. The private equity owners are not happy. They need to renegotiate the EPC contracts or PPAs to get the margins back to something tolerable.
MR. BRANDT: For two decades, the way this industry worked is you sign a PPA at an aggressive price and then delay construction until the prices come down to a point where the project economics work. That was the game. The game no longer works.
MR. MARTIN: Power prices are up 20% to 30%. Developers have been caught flatfooted.
MR. RANIWALA: The same phenomenon applied to solar panels, wind turbines and other equipment. Costs fell over time, but they are no longer falling.
MR. BRANDT: The capital cost is now 20% higher. We are telling our clients not to lock in a power contract. We will help you raise money even if you do not plan to lock in the electricity price until close to the start of construction. We had one project in Oklahoma where the electricity price was $18 a MWh early in the development process. It is now $37 a MWh.
MR. MARTIN: Do you follow the same approach in your personal investing of betting when the stock market will turn?
MR. BRANDT: I was going to say, based on last month’s statement, I am not sure that I am one to emulate. [Laughter]
MR. RANIWALA: It is a tale of two cities. Solar delays are driven by the anti-circumvention duty investigation, but wind projects, which don’t have the same tariff issue, are also experiencing delays due to lack of long-term policy. There is uncertainty whether production tax credits for wind projects will be restored by Congress. Policy uncertainty is a big part of why we are seeing market stagnation.
MR. MARTIN: Mit Buchanan, that tees up the following question. Tax equity investors have been asking sponsors to covenant that they will complete their projects by a deadline. Listening to all this, it is hard to see how sponsors can do that. What do tax equity investors expect to happen if those covenants are breached?
MS. BUCHANAN: We need to plan on our side for all the fundings to which we commit. A lot of work goes into that in terms of having a line of sight into construction schedules. Sometimes coming up with an outside date requires consulting a crystal ball. We try to build in some cushion. We also need an independent engineer to vouch for what is realistic.
If a sponsor breaches the covenant, either we agree to extend the deadline or else we are entitled to get back the initial tax equity funding, if there was one.
Cost of Capital
MR. MARTIN: Let me ask you another question. Tax equity yields appear to have been dropping in the last few months, at least judging what we are seeing in recent term sheets. At the start of the year, they seemed to be headed up. What happened?
MS. BUCHANAN: A number of factors are affecting the bidding dynamics. For example, you probably had five sizable tax equity investors that did the majority of the business and then smaller ones, but this year there is an additional $4.5 to $5 billion of tax equity on top of that that is available from people who are re-entering the market and from several corporates that are big players.
MR. MARTIN: So it is competition?
MS. BUCHANAN: There is a bit more competition, but there is not excess tax capacity. Yields overall are staying in a tight range.
MR. RANIWALA: Rising interest rates will eventually put pressure on yields. As a manufacturer, we like the cost of capital to be as low as possible so that developers can afford to buy more equipment. As a financier, we see our cost of funding going up.
MS. BUCHANAN: You also have internal metrics that you would like to meet, and you can’t do that while continuing to ratchet down yields. Everyone has to share the pain.
MR. MARTIN: So you have to balance competition against the cost of funding.
Bankers, at the start of the year, there seemed to be more than 100 banks and grey market lenders chasing deals. There are not that many deals in the market this year, so that has kept downward pressure on interest rates. The spread above LIBOR for term debt had dropped to as low as 112.5 basis points over, but with most debt in the range of 125 to 137.5 basis points over. Are these margins still holding six months into the year?
MR. HERTEL: The banks are all still there. You are also right about the shortage of deals. We closed 25 and 30 deals a year on the project finance renewable energy side before this year. We have closed maybe six or seven so far this year, and it is the beginning of June.
MR. MARTIN: How many would you have normally done by this point in the year?
MR. HERTEL: Probably 10 to 12, but the deals we have done this year have been higher value-added deals, like holding company loan facilities.
MR. HALIMI: There has clearly been margin compression. It has been going on for several years now. Another factor is the number of banks looking to build their books of green exposure on top of lack of deal flow. It is creating some challenges.
The risk appetite among lenders has shifted as well. Lenders are now willing to take more risks by moving to deals that are more complex where there is more merchant exposure or more electricity basis exposure.
Five to seven years ago, for instance in Canada, you could borrow at a 200-basis-point spread against a government offtake contract. Now for 200 basis points, you can borrow to finance a project in Texas that has merchant risk.
MR. MARTIN: That is a clear indication of increased competition. Is it still the case that construction loans are available at 70 basis points over LIBOR?
MR. HERTEL: Maybe from some lenders, but not from us.
MR. MARTIN: What would you say is typical?
MR. HERTEL: Anywhere from 87.5 basis points to around 100 basis points for both the tax equity bridge loan and the construction loan.
MR. MARTIN: So bankers want complexity and more risk to justify the higher interest rates.
The market is switching from LIBOR to SOFR. SOFR is a risk-free rate. What should one assume will be the credit adjustment to get to SOFR? People were saying late last year it will settle at between 12.5 to 25 basis points.
MR. HERTEL: We’ve seen everywhere from 10 basis points to around 25 basis points for longer-term transactions in the five- to nine-year range. On the short-term side, construction or warehousing up to two years, perhaps 10 to 12.5, or even zero, basis points.
MR. MARTIN: Let’s switch to M&A. Ted Brandt, I read in the Financial Times yesterday that there has been a 90% drop in the amount of capital raised in initial public offerings in Europe and North America this year compared to last year. We saw hugely inflated asset values coming into this year. There was $10.6 trillion in global fiscal stimulus the last two years. The money had to go somewhere. Have asset valuations started to cool?
MR. BRANDT: The public equity market is ugly. Traditional IPOs are largely on hold. The SPAC market has been virtually wiped out.
We are still seeing private equity funds and strategics putting more capital into the private markets, and so we have not seen any fall off in private market valuations. While valuations in the private market remain somewhat frothy, they were two and three times that in the public market before the collapse. I expect the public markets to recover at some point. What is driving M&A this year is the private market.
MR. MARTIN: It seemed coming into this year like almost every developer with a pipeline of projects under development had at least tested the market for them. Is that still happening?
MR. BRANDT: There is still a lot of inventory in the market. For the first time in six or seven years, we are seeing some sales that are not clearing.
MR. MARTIN: Two things seem important for anyone hoping to place the winning bid in an auction. One is the rate used to discount future cash flows. Even more important is the forecast used for out-year electricity prices — “out-year” meaning after the contracted revenue stream ends. I think you told me in January that it is not even worth bidding if you are more than 5% below the Ventyx electricity price curve. Ventyx tends to be the most optimistic forecast. Did I hear that correctly?
MR. BRANDT: Yes. The market has not turned yet. We are still seeing robust bids, but people are starting to look harder at pricing. The gas curves are showing gas at $8 an mcf for the next couple years and then coming down to $5. Some people are starting to take the view that we will see the same pattern for electricity. The power curve analysis is almost more important than the discount rate in terms of who is going to win any given deal.
MR. MARTIN: That’s because the PPA contract term is just a fraction of the useful life of any project. There is a long merchant tail.
MR. RANIWALA: That’s right.
MR. BRANDT: If you don’t have a robust view of future power prices, you could probably use a discount rate that is as much as 250 basis points lower than the next bidder and come up short.
MR. MARTIN: At the start of the year, it seemed like winning bidders were discounting future cash flows at 7.5% to 8% for contracted onshore wind and 50 to 75 basis points lower for contracted utility-scale solar. Is that still true?
MR. BRANDT: My sense is the rates have creeped up a bit, but they are not crazy different for a contracted vanilla deal.
MR. MARTIN: Mit Buchanan, tax equity accounts for 35% of the capital stack for the average solar project and 65% for the average wind project. Why the difference?
MS. BUCHANAN: Production tax credits claimed over 10 years on wind projects are worth a lot more than an investment tax credit claimed in year one on a solar project. This is especially true after factoring in capacity factors on wind versus solar. Wind projects generate electricity at 40% to 45% of capacity while solar is around 30%.
MR. RANIWALA: Historically, solar cost more than wind per megawatt to build and solar capacity factors were lower, so when you combine those two things, the ITC made more sense for solar while PTCs were better for wind. The ITC is a function of cost. PTCs are a function of output.
Over time, as solar capital costs fall and capacity factors increase, solar will be better off with PTCs. We will start to see such a shift if Congress allows solar developers the same choice of tax credits that wind developers have.
MR. MARTIN: We already see solar companies writing the option to move to PTCs into tax equity papers.
Another question people often ask is about cash flow. Tax equity investors said for the last few years that falling electricity prices were creating challenges. Tax equity investors have to expect a pre-tax yield. They cannot be in the deal solely for tax benefits.
Electricity prices are now increasing. There is more cash. How does that change the dynamics in deals? For example, does it mean that investors can agree to higher deficit restoration obligations? Does the cash sharing ratio tip more in favor of sponsors?
MR. RANIWALA: We were always able to structure around low cash flow by having the tax equity investor make more of its investment over time in the form of pay-go payments that are a function of the production tax credits allocated to the investor. If electricity prices increase, that probably means that construction costs are also increasing, so more capital is required. That may or may not affect DROs.
MR. BUCHANAN: I agree with that.
New Deal Types
MR. MARTIN: Bankers, there are a lot of new types of deals coming to market: carbon capture, standalone merchant storage, renewable natural gas, green hydrogen. How much deal flow are you seeing in these areas?
MR. HALIMI: We have seen increasing interest in all of them. We are working now on a green hydrogen transaction that will probably close in the next three to four weeks. The challenge for these types of deals, especially hydrogen, is they are either too small or too large and involve technologies that are not yet fully proven in the US market.
MR. MARTIN: The hydrogen is being put to what use?
MR. HALIMI: For making electricity.
Hydrogen technologies are key to support the energy transition. You basically convert some fuels to clean energy. From an energy standpoint, it is fantastic and we expect to see more of this type of transaction.
I would say that of the deals now crossing our desks, roughly 70% involve a link to batteries. There are also more merchant projects because you need more risk to make a return. Without that, returns are getting crushed.
MR. MARTIN: One banker told us that current debt service coverage ratios, which determine how much projects can borrow, are about 1.35 times debt service for onshore wind, 1.25 times for utility-scale solar and only 1.2 times for standalone storage. Do you agree?
MR. HALIMI: Those are for contracted revenue streams.
MR. HERTEL: We’ve actually seen as low as 1.15 times debt service for storage in projects with 20-year tolling agreements.
MR. MARTIN: How does a storage tolling agreement work compared to a standard PPA?
MR. HERTEL: Under a tolling agreement, the battery owner receives a fixed capacity payment each period as long as the battery is available and able to store electricity.
MR. MARTIN: The utility pays the battery owner essentially a reservation charge for the right to use the battery to store electricity. Is there an additional charge tied to the amount of electricity actually stored?
MR. HERTEL: No. There is some merchant exposure for the project on the back end after the tolling agreement ends. We take that into account in the debt sizing. For example, we credit the contracted revenue stream at 1.15 times debt service and size the debt against the merchant revenue on the back end at 1.75 to 2.0 times debt service.
The key in those long-term arrangements is really augmentation of the batteries because they get cycled pretty much on a daily basis and, within five to seven years, you need to replace a lot of the cells. It is paramount for us to have a creditworthy entity dedicated to augmenting the battery cells on a continuous basis.
MR. MARTIN: Do you also require a reserve account for cover the cost of replacing cells?
MR. HERTEL: In some cases, but mostly not if there is a creditworthy entity standing behind the obligation.
MR. MARTIN: Mit Buchanan, what new types of deals is the tax equity market seeing?
MS. BUCHANAN: The next big thing for us is offshore wind. We expect to close a significant transaction this year and a couple more will probably follow next year.
MR. MARTIN: Next year or 2024?
MS. BUCHANAN: 2024, thank you. The next big thing after that is carbon capture. We expect to close a transaction later this year or early next year, with some sizable ones to follow.
Next in terms of volume is hydrogen. And then if Congress passes the budget reconciliation bill with an investment credit for high-voltage transmission, we expect to see deal flow around that. We have been talking about transmission issues for 25 years. There could be a large investment opportunity for everyone.
MR. MARTIN: Are you seeing any renewable gas deals?
MS. BUCHANAN: That has not been an area of activity
MR. RANIWALA: Natural gas is a force multiplier. We also see a lot of carbon capture deals heading to market.
MR. MARTIN: Are you aware of any carbon capture tax equity deals that have closed? We know of one with a large tax equity investor, but nothing beyond that.
MR. RANIWALA: There are a lot in the works, but I am not aware of any that has crossed the finish line. Many of them, especially in the power sector, need a higher tax credit to make the economics work.
MR. MARTIN: We have been involved with one where the tax credits over the 12-year period are $1.8 billion. These can be very large transactions.
Ted Brandt, what deal flow are you seeing in new areas?
MR. BRANDT: In terms of carbon capture, we are about to announce what we think will be the first closed deal. It is at an ethanol plant in Texas that will use the captured CO2 emissions for enhanced oil recovery.
MR. MARTIN: Didn’t you just announce it? [Laughter]
MR. BRANDT: Not yet. We have not announced a closing. It has been two weeks away for about two years. I should also mention that we have done a number of renewable natural gas deals, and we actually raised debt for a renewable natural gas project where we got Moody’s to rate the bonds investment grade. The revenue stream was about 50% contracted. That is a maturing market segment. It was a landfill gas portfolio. We are very excited about growth in renewable natural gas.
MR. MARTIN: Are the renewable natural gas deals being driven by LCFS credits in California?
MR. BRANDT: Yes. Most such deals rely on LCFS credits in California plus RINs. It is possible to sign long-term contracts to lock in a revenue stream at a stated price, but we are finding developers using more equity and locking in only a portion of the revenue in order to keep the upside.
MR. MARTIN: Is there any concern about how long California will continue to make LCFS credits available to renewable natural gas projects outside California? I heard a story on NPR about a dairy farmer in the Midwest who was planning to add cows to produce more methane because more than half his income as a farmer is now coming from LCFS credits.
MR. BRANDT: It is amazing how microeconomic incentives work. I would just say if you have to ask that question, you are probably not going to do a deal where LCFS credits are a key to the project economics. You almost just have to grab your ankles and jump.
MR. MARTIN: Here is my last question, starting with Alain Halimi. Are there any other issues in Washington that you are following besides the “Build Back Better” bill and the anti-circumvention duty investigation?
MR. HALIMI: I’ll be very honest. I stopped following actually because . . .
MR. MARTIN: Nothing happens.
MR. HALIMI: Well, I think whatever happens, we find a way to structure around it.
MR. HERTEL: A storage ITC is one thing that we are following closely.
MR. MARTIN: That would be a big deal if it is enacted. Mit Buchanan mentioned a transmission ITC. Mit, you are on the board of at least one of the renewable energy trade associations. Is there any other issue you are following that rises to the level of the BBB bill and the anti-circumvention duty investigation?
MS. BUCHANAN: I would say not. We have been tracking the BBB bill discussion very closely. The deadline is approaching when that bill will have to come together if anything is going to happen this year. We remain optimistic.
MR. MARTIN: That has been your theme today.
MR. RANIWALA: Another thing we are following is an effort to get the Treasury to allow another year to finish construction of projects and claim tax credits in view of the continuing supply-chain difficulties, interconnection challenges and COVID-related shutdowns in China.
A related issue is the 5% test for starting construction. With inflation, the initial safe harbor purchases may not be sufficient so we need to modify the standard. The trade associations are starting to work on that issue as well.
MR. MARTIN: That is a very interesting point. Developers who thought their projects were under construction in time to qualify for tax credits because they incurred at least 5% of the total project cost are now coming up short. Inflation is driving up construction costs.
The Treasury extended the time period to finish projects after construction started to six years last summer, and it let developers buy even more time by proving they worked continuously on their projects. Does the tax equity market accept proof of continuous efforts?
MR. RANIWALA: I am aware of one deal that has been financed on that basis. We are looking at another transaction now with the same issue. However, even if the tax equity market accepts continuous efforts, it will not do so in the volume of projects needed to meet the administration’s clean energy goals.
MR. BRANDT: When the richest man in the world and the top banker are both worried about the economic outlook, I am obviously glued to the inflation numbers and interest rates. This is an industry that benefited from falling interest rates. Increasing rates will have an effect. We have not yet seen an effect on the M&A market or project financings, but clearly that is one of the challenges with which we will have to deal in the months ahead.