Demand is expected to be heavy for the next round of federal loan guarantees for energy projects through the US Department of Energy.

The department is soliciting applications for up to $30.5 billion in guarantees in three targeted areas: up to $18.5 billion to support nuclear power facilities, up to $10 billion for renewable energy projects and up to $2 billion for nuclear fuel projects.

First round nuclear applications were due September 29. The department received 19 applications for 21 reactors seeking a total of $122 billion in financing — more than 10 times the amount of guarantees the department is currently authorized to award.

The deadline for renewables and transmission and distribution project applications was originally December, but has been postponed to February 26.

The renewables program contemplates supporting alternative fuel vehicles, biomass, efficient electricity transmission, distribution and storage, energy-efficient building technologies, geothermal, hydrogen and fuel cell technologies, energy efficiency projects and solar, wind and hydropower projects.

This latest round of solicitations has been launched in an environment of greater regulatory certainty than was the case for an earlier first round. The final rules for the loan guarantee program, issued October 23, 2007, introduced needed clarifications and useful changes that addressed some of the concerns raised in response to an earlier notice of proposed rulemaking. Nevertheless, some significant challenges to making effective use of the program remain.

DOE appears sympathetic to addressing the remaining impediments. Reports have emerged indicating that the department will issue a “notice of proposed rulemaking” as early as mid-November, hoping to have a revised set of rules in place for the program in January.

Key Features of the Current Round

The goal of the current round is to support projects that “avoid, reduce, or sequester air pollutants or anthropogenic emissions of greenhouse gases” and “employ new or significantly improved technologies as compared [with] technologies in service in the United States.”

A “new or significantly improved technology” is one that is

concerned with the production, consumption or transmission of energy that is not a commercial technology, and that either (1) has only recently been developed, discovered or learned; or (2) involves or constitutes one or more meaningful and important improvements in productivity or value, in comparison to commercial technologies in the United States at the time the Term Sheet is issued.

A technology is already “in general use,” and thus ineligible, “if it has been installed in and is being used in three or more commercial projects in the United States” and has been in operation for at least five years.

The Department of Energy is implementing the loan guarantee program through a series of solicitations, each targeting specific areas of technology. The submitted applications compete for the available financing authority. The evaluation process results in the applications being ranked, with the ones seen as better fulfilling the statutory and solicitation criteria receiving higher scores. DOE has declined to establish firm timelines for the processing of applications or the awarding of financing commitments.

The application process for the current round differs for each of the three technology areas covered.

For applicants hoping to share in the $10 billion allocated for “Energy Efficiency, Renewable Energy and Advanced Transmission and Distribution Technologies,” the steps of the process are as follows. Pre-applications are now due February 26, 2009. The Department of Energy is then expected to “pre-select” some of the applicants for further review. If a project passes muster after a more formal review, then the government will issue a term sheet and sign a conditional commitment, pending negotiation and execution of the formal loan guarantee agreement.

In this area, DOE distinguishes among three types of projects and asks applicants to sort theirs according to whether it is a “manufacturing project” (in which the energy-saving technology is reflected in the manufacturing process or in use of the manufactured goods), a “stand-alone project” or a “large-scale integration project” (involving the staged development, financing, construction and operation in one project of more than one renewable energy, energy storage, energy efficiency and advanced transmission and distribution technology), the latter category being subject to some particular rules. A project sponsor may not submit an application for multiple projects using the same technology, other than in the case of large-scale integration projects. However, a sponsor may submit separate applications for each different technology or different project type. Loan guarantees for manufacturing projects or stand-alone projects will be limited to one project per applicant per technology.

Applications for guarantees for renewables and transmission projects will be evaluated based on a weighted average of multiple criteria. Technical and financial factors will each constitute 50% of the score. The technical factors include technical relevance and merit (10%), applicant capabilities, technical approach and work plan (20%), and environmental and energy security benefits (20%). Financial factors to be considered include creditworthiness (30%), construction factors (10%), and legal and regulatory factors (10%).

The process for nuclear power facilities is quite different, introducing an innovative, dynamic ranking mechanism. Applications will be evaluated on a continuous basis as they are received. DOE will review the initial submissions and assign an initial score providing a preliminary ranking of the projects. This ranking is expected to provide applicants information to assist them in making a self-selection decision as to how to improve their applications and their rankings and whether to proceed with the cost of completing a full application. Applicants who complete their applications but are not initially selected to enter into negotiations will be welcome to remain in queue, unless specifically excused.

Nuclear generation applications had to be submitted by September 29, and an initial ranking is expected shortly from DOE. Second round applications are due December 19, 2008.

The application process for nuclear fuel projects is broadly similar to that for nuclear generation projects, though without the dynamic ranking mechanism. Also, the deadline for the submission of part two of the application is earlier (December 2, 2008).

Financial Structure

Loan guarantees cannot exceed 80% of a project’s costs. The project cost for this purpose includes spending on the design, engineering, financing, construction, startup, commissioning and shake down of a project. Initial research and development costs and operating costs are not included. Also, certain guarantee program-related costs, specifically the credit subsidy cost and administrative fees, that are assigned to applicants to defray the costs of administering the loan guarantee program are ineligible for DOE-guaranteed (or any federally-guaranteed) financing.

The terms of the DOE support vary according to the percentage of loan that is guaranteed. Up to 100% of any project debt may be guaranteed as long as the guarantee does not cover more than 80% of the total project cost. In cases where a 100% guarantee of the debt is chosen, the only permitted lender is the Federal Financing Bank, which is part of the US Treasury Department.

Where the guarantee sought is for less than 100% of the loan amount, DOE may guarantee loans from private lenders. However, if more than 90% of loan is guaranteed, then the non-guaranteed portion of the loan cannot be “stripped” (i.e., traded separately) from the guaranteed portion. The guaranteed portion of the loan may be stripped if DOE guarantees 90% or less of the loan.

DOE will in all cases have a first priority lien on project assets pledged as collateral. If DOE guarantees less than 100% of the loan, DOE and the holders of the non-guaranteed portion of the guaranteed obligations may share the proceeds received from the sale of project assets pledged as collateral. Accordingly, while DOE retains the statutory requirement of having a first lien on all project assets, DOE will negotiate with parties about how the proceeds from the sale of collateral will be shared. However, the non-guaranteed holder cannot receive greater than a pro rata share of enforcement proceeds.

The required terms of these DOE loan guarantees present three major drawbacks.

First, where guarantees cover less than 100% of the loan, DOE currently requires project (and thus technology) risk-sharing from the private lenders as well as the equity. This radically reduces the range of potential sources of project debt and will likely increase the interest costs for those willing to accept the unguaranteed risks, undermining the economics of the projects that DOE was mandated to encourage.

Second, non-strippable instruments (loans that are more than 90% guaranteed) are excluded from the huge market for US government-guaranteed securities. Ironically, since the market would necessarily be investors who have achieved a degree of comfort, through expertise or pricing, with the project risk, the beneficiaries of the proposed guarantee will be the lenders who might, in fact, be least motivated by it. Clearly this scheme, while adding nothing to risk mitigation by DOE, will deprive the projects of much of the interest cost saving that might otherwise be available by virtue of support by US government guarantees. It would be surprising to find many projects adopting this financial structure.

In effect, the price of taking advantage of the large market for government-guarantee securities rather than the Federal Financing Bank is placement of a substantial piece of unguaranteed debt. Given the requirement that the loan, any portion of which is guaranteed, cannot exceed 80% of project costs, a typical structure might have the following elements: 72% of project costs financed with tradable, government-guaranteed paper, 8% covered by an unguaranteed portion of the loan that could share in project collateral pro rata with DOE, and the remaining 20% consisting of a combination of substantial equity and debt with no, or subordinated, recourse to project assets.

The third major drawback is the unfriendliness of the loan guarantee program for complementary project financing outside of the DOE-guaranteed loan. As the program is currently contemplated, any such financing not only would not be invited to share in liens on project assets, but it would also be subordinated with respect to the allocation of collateral enforcement proceeds in a default scenario. These terms are unlikely to be acceptable to the project lending programs of export credit agencies and will discourage or materially raise the interest costs of complementary commercial financing. Particularly for nuclear projects, with their immense financing requirements, a program design that discourages complementary export credit agency or tax exempt bond financing is particularly unfortunate.

Loan guarantees will be offered only to projects where the project sponsors make a “significant [cash] equity contribution” toward the project cost. Although DOE has not established a numerical minimum for the required cash equity contribution, a 10% target is under consideration. When evaluating projects, DOE will consider both the type and the degree of equity contribution proposed for each project. Applications for projects financed entirely through a combination of government-backed loans would be rejected.

DOE originally suggested that it would consider negatively that a project relies on other governmental assistance (e.g., grants, tax credits or other loan guarantees) to support financing, construction or operation of a project. However, after receiving public comments, DOE recognized that, in certain circumstances, multiple forms of federal assistance could be beneficial. The dialog has ended up with no funds obtained from the federal government, or from a loan or other instrument guaranteed by the federal government, being permitted to pay for credit subsidy costs, administrative fees, or other fees charged by DOE for participating in the loan guarantee program.

Credit Subsidy Cost

If total project costs for an eligible project are projected to exceed $25 million, applicants must submit a credit assessment for the project. According to DOE, this will inform its evaluation of the project and estimation of the “credit subsidy cost.”

The “credit subsidy cost” is, in effect, a required federal loan loss reserve. It refers to the cost of a loan guarantee, which is defined by the Federal Credit Reform Act of 1990 as the net present value of the estimated payments by the government to cover defaults and delinquencies and interest subsidies, less the amount the government expects to receive back in return as origination fees, penalties and recoveries.

The regulation of the credit subsidy cost is a critical aspect that poses several questions and challenges to the success of the entire program. By law under the loan guarantee program statute, “[n]o guarantee shall be made unless: (1) an appropriation for the cost has been made; or (2) the [Treasury] Secretary has received from the borrower a payment in full for the cost of the obligation and deposited the payment into the Treasury.”

Typically, credit subsidy costs for federal loan and guarantee programs have been largely covered by funds appropriated by Congress for that purpose. No such appropriation has been made for the DOE loan guarantees, and the DOE has indicated that it does not intend to seek one.

DOE has decided to implement the loan guarantee program with “self-pay authority,” which is to say the credit cost subsidy will be funded by up-front fee payments from users of the program. Applicants are not allowed to finance the credit subsidy cost with funds from a loan made or guaranteed by the federal government or with any other funds provided by the federal government.

DOE is working on a methodology that can be used to calculate the credit subsidy cost for prospective loan guarantees, but no guidelines for estimating the credit subsidy cost have been announced yet.

The credit subsidy cost may be the Achilles’ heel of the program. Different criteria can result in widely divergent cost estimates that could well affect a project’s financial viability. Notwithstanding extensive inter-agency and intra-agency discussions, no agreement has been reached yet as to the appropriate levels of subsidy to require or even as to a precise procedure for determining it. Prospective borrowers may have an opportunity to provide their own estimate of an appropriate credit subsidy cost. However, inviting borrowers to propose the size of loan loss reserves, when they are betting their equity on the expectation that there will be no loss, would seem unlikely to lead to numbers that will satisfy government budgetary watchdogs. The subsidy numbers for other government guarantee programs are based on their respective track records. The closest proxy available to DOE might be its own financially-troubled foray into financing innovative energy technologies in the 1970s, which was not reassuring. That track record is unlikely to yield subsidy estimates that would be acceptable to prospective users of the DOE program.

DOE and the Office of Management and Budget will provide to project sponsors, at the same time a term sheet is provided, a preliminary credit subsidy cost estimate for the desired loan guarantee, immediately prior to payment of the facility fee and following payment in full of the application fees (about which more is below). However, the final credit subsidy cost determination will only be made at financial closing, when the credit subsidy cost is required to be paid.

Because of these uncertainties, applicants are free to withdraw their applications at any time if they find that the credit subsidy cost is more than they are willing to pay. However, this decision does not relieve the applicant of any obligations to DOE (for example, non-refundable application fees and the facility fee) that have already come due by the time of withdrawal.

Administrative Fees

The administrative fees, which are non-refundable, include any application fee, a facility fee and maintenance fees.

The application fee recovers costs associated with DOE’s administrative costs incurred in connection with the pre-selection evaluation of an application. The application fee is paid in two installments: 25% with the initial application and the remaining 75% is due only from applicants who are pre-selected for formal review in renewables projects. In nuclear generation and fuels projects, the remaining fee must be submitted with the part II submission in December.

The facility fee recovers costs associated with documenting the deal, from issuance of a term sheet and conditional commitment letter to closing the final loan guarantee agreement. It is due prior to commencing negotiations on a draft term sheet.

DOE charges separate maintenance fees after the loan guarantee agreement is signed to cover its administrative expenses of servicing and monitoring the loan guarantee.

When estimating costs, applicants should also plan to cover costs in addition to the fees specified in the regulations. DOE has announced that it expects to use independent consultants and outside legal counsel in all aspects of the loan guarantee process. The applicant will be responsible for paying their fees.

In sum, DOE has made great strides toward functionality in implementing the loan guarantee program. A few inefficient quirks — such as the no-stripping requirement for guarantees between 90% and 100% of a loan and the mandatory use of the Federal Financing Bank to disburse a fully-guaranteed loan — survive in the program. The real potential show-stoppers, however, remain the credit subsidy cost payment and, for nuclear projects, the inhospitality of the program to unguaranteed co-financing. The requirement to pay stiff application fees and the fees of DOE’s counsel and consultants, while remaining in the dark as to whether the subsidy cost could undermine the economics of going forward with the project, may well discourage participation in the program.