Energy Department Wrestles with Loan Guarantee Details

Energy Department Wrestles with Loan Guarantee Details

June 01, 2006

The US Department of Energy is moving to implement a loan guarantee program for energy projects that employ new technologies. The loan guarantees were authorized in the Energy Policy Act last August. The agency is just getting around to establishing an office to implement the program.

The guarantees are supposed to help such projects as coal-to-liquids plants, IGCC (integrated-gasification combined-cycle) power plants and other large coal and biomass gasification facilities.

Guidelines explaining the ground rules for the program and inviting applications are still months away, although the agency says the guidelines should be ready by October.

In the meantime, energy officials are wrestling with at least 10 significant issues relating to the loan guarantees.

Congress has failed so far to appropriate any money for the loan guarantee program. Congress spends money in a two-step process by first “authorizing” the spending, which it did last August, and then following up with a formal “appropriation,” which it has so far failed to do. The first guarantees are expected to be of the “self pay” variety where project developers whose loans are guaranteed will have to reimburse the US government for the cost of the guarantee program.

Background

Title 17 of the Energy Policy Act authorized the US Department of Energy to guarantee repayment of loans to projects that use innovative technologies to avoid, reduce or sequester pollutants. Energy projects in the following categories are eligible potentially for guarantees: renewables, fossil fuels, nuclear energy, hydrogen fuel cell technologies, carbon capture and sequestration, efficient electrical and end-use technologies, facilities for fuel efficient vehicles, pollution control and oil refinery projects.

The guarantees can cover up to 80% of project cost. There is no limit on the dollar amount of guarantee for a single project, but the loan being guaranteed cannot extend longer than 30 years or 90% of the projected useful life of the facility being financed. The loan guarantee program has no time limit. Therefore, once the program gets going, it will continue indefinitely until Congress or the Department of Energy decides the program has outlived its usefulness.

Implementation Issues

US energy officials are still debating whether to get the program started by issuing guidelines or by writing more formal regulations. The Energy Policy Act requires regulations be issued on at least two subjects: how the agency will deal with defaults and what recordkeeping will be required by borrowers. Regulations take longer to write because the proposed text must be put out first for public comment. If the department waits to implement the guarantee program through formal regulations, then a delay of at least another year is expected before the first guarantees will be available. Energy officials say the program could be up and running by the fall if the department relies on a simpler set of guidelines.

The new guarantees will have the same basic structure as private-sector guarantees where the guarantor promises to repay an underlying loan if the borrower defaults. However, Congress left all the details to the Department of Energy to determine. The department is wrestling with the following issues.

Technological Risk. The guarantees will be available only for projects that “employ new or significantly improved technologies compared to commercial technologies in service in the US.”This means by definition that the projects will have significant technological risk. Commercial lenders do not usually lend to projects that use unproven technologies. One reason for the guarantees is to encourage such lending. However, the government will have to decide where to draw the line. Energy officials are wrestling with the extent to which the government will guarantee demonstration and pilot projects where the technology has not been tested on a commercial scale.

Technical Requirements. Projects that receive guarantees are required to “reduce, avoid or sequester air pollutants or man-made greenhouse gas emissions,” and must also meet any applicable federal or state emission requirements. There are also additional technical hurdles for IGCC plants and certain other gasification projects. The Department of Energy must decide how to evaluate applications for loan guarantees for compliance with these requirements as well as to ensure ongoing compliance and what to do after a guarantee has already been issued if the borrower fails to follow through on its promises.

Completion Risk. Another issue for the department is whether to take completion risk. A project will not generate any revenues until is completed. In conventional project financing, completion risk is managed by having the project company enter into a “turnkey” construction contract with an experienced contractor who would provide liquidated damages if the contractor fails to complete the project by a certain date, but sometimes “turnkey” terms are not available, especially for projects using unproven technologies. Even when “turnkey” terms are available, there is the issue whether the damages to be paid by the contractor are enough to cover the project’s operating costs and debt service until any problems with the project can be cured.

In addition to having the contractor share the burden of completion risk, project financiers usually have the project sponsors provide completion support to the project, whether in the form of completion guarantees or funding commitments. Solid sponsors, such as large mining companies or global power companies with strong balance sheets and substantial non-project assets, may not object to providing some level of completion support, but it will be difficult to obtain sponsor support from smaller sponsors.

Cost overruns are also a factor that bears on completion risk. Any guidelines implementing the loan guarantee program will have to address how the government will insist cost overruns be handled as a condition to receiving a guarantee. For example, will cost overruns be funded through the guaranteed debt, subordinated or shareholder debt, equity contributions or a combination of the foregoing? Will the Department of Energy accept other alternatives to mitigate the risk of cost overruns such as cash reserves during the construction period? These questions remain unanswered.

Sponsor Equity Contribution. The Energy Policy Act limits guarantees to 80% of project cost. It does not address whether the remaining 20% of the project cost must be covered by sponsor equity or whether part of it can also be covered by other (perhaps subordinated) debt. The Department of Energy is expected to require at least a minimum amount of sponsor equity. It will also have to decide on the required schedule of equity contributions as well as what assurances it will require from sponsors to ensure that such contributions are made.

Project Viability. The Energy Policy Act directs the Department of Energy only to guarantee projects for which “there is a reasonable prospect of repayment of the principal and interest,” but does not address what will have to be shown to prove financial viability. Among the topics the guidelines are expected to address are whether a project must have in place an offtake agreement with a creditworthy offtaker (such as a take-or-pay contract that guarantees a minimum level of cash flow for the project) or whether it is enough to show that a project can survive on a merchant basis because there is a reliable market for the project’s output large enough to ensure sufficient and continuous cash flow.

Lender Risk. Another issue with which energy officials are wrestling is whether to make the lender share part of the repayment risk as a way of ensuring that lenders have some skin in the game. Although the department is authorized to guarantee as much as 100% of principal and interest on a loan, it may decide to adopt a partial credit guarantee structure that caps government participation to a percentage of the loan being guaranteed or an aggregate dollar amount or both.

Financing of Fees. From a more detailed financing perspective, another set of questions that remains to be answered is whether payment of fees will be included in the guaranteed package. Banks traditionally charge a front-end or facility fee as well as a commitment fee in their lending transactions. The government itself is also likely to charge its own front-end fee as part of the “self pay” requirements for the program. Will payment of these fees be part of the financing package? Calculation of the “self pay” fee is also an issue and whether the fee should be structured as an origination, front-end fee or an annual fee, or both, with a portion of the fee paid on or around the date the guarantee commitment is issued and with another portion paid throughout the term of the guarantee agreement.

Permitting Risks. Project developers and financiers usually divide permits into two broad categories: construction permits and operating permits. As a general rule, all permits required for the construction of a project are a condition precedent to the closing of a project financing, but many permits are subject to appeal periods that may run 30 to 60 days or longer. Other permits are granted subject to the project meeting certain milestones or may affect the economics of a project (for example, a permit that effectively restricts the output of a project). The government as a guarantor of a project will have to assess on a case-by-case basis the risk that some of the permits needed for construction or operation may be denied.

A related question tied to permits is whether to require all projects that qualify for Energy Policy Act guarantees to comply with the review requirements of the National Environmental Policy Act. Such a review takes time. Certain projects where federal funding is involved are subject to NEPA review. Some states also have similar requirements. A NEPA review or similar state review is also a precondition to obtain certain permits.

Policy and Other Considerations. The Energy Policy Act does not address what types of projects should be given priority over others. For example, will there be a ranking of projects based on how environmentally clean they are? Will renewable energy projects be preferred over production facilities for fuel-efficient vehicles because of the economic and social implications of developing the country’s ethanol industry (for example, replacing foreign sources of oil with domestic energy sources and creating jobs in rural America)? Will coal projects be given priority? These policy questions remain unanswered.

The Energy Policy Act authorized hundreds of millions of dollars in tax subsidies for many of the same projects that qualify potentially for loan guarantees. The dollar amount of such subsidies is limited. The Internal Revenue Service announced plans for how to allocate the scarce tax subsidies and how it intends to rank projects that apply for them. It is not clear whether the Department of Energy will do the same thing. There is no limit on the potential dollar amount of selfpay loan guarantees. However, there could be a limit to the extent the agency funds the program out of appropriations.