Lessons from community solar financings
Community solar projects are starting to be financed by traditional lenders and tax equity investors, but many sponsors still struggle to figure out how to attract financing.
Financiers are still learning how to underwrite this asset class. Financing of community solar projects will, at least for the time being, probably take longer and be more difficult than other, more traditional solar projects while the market still feels its way.
However, community solar developers can take a number of simple, concrete steps to facilitate financing. These steps include focusing on the credit quality of offtakers, assembling large enough portfolios that have limited geographic diversity and combining community solar with better-understood solar assets. In the short run, some developers may also want to look for other sources of capital.
Community solar is a relatively new solar asset class that lets customers who do not want to (or cannot) have a solar system on their property to do the next best thing. A community solar project is a solar array, typically around one megawatt in size, in which customers subscribe to shares of the electricity output or buy one or more solar panels.
Community solar projects are utility-scale solar facilities. The customers who subscribe to them are in the same utility service territory as the solar facility. The electricity goes to the local utility. The customers receive credits for their share of the electricity that can be used against their electricity bills from the local utility. They continue to buy their electricity from the local utility. The customers can be individuals, commercial or industrial businesses or municipalities.
There are many types of community solar regimes: some where the utility runs the show and others where the customers own the panels. This article focuses on the dominant model in use in Colorado, Minnesota and Massachusetts.
There are currently at least 14 states plus the District of Columbia with community solar enabling legislation. In other states, some utilities permit community solar projects, despite the lack of appropriate enabling legislation. Through 2015, only 88.5 megawatts had been installed. This is expected to reach 1.5 gigawatts by 2020, with California, Massachusetts and Minnesota leading the way.
Lenders and tax equity investors are comfortable financing utility-scale solar projects, portfolios of residential rooftop installations and commercial and industrial (C&I) projects. Community solar is fundamentally not much different than these other types of solar assets and, in fact, combines some of the strongest features of these other solar asset classes. However, the perceived novelty of community solar means many financiers still need to be better educated by developers about state program nuances and other distinct attributes of community solar.
One of the most important aspects of any project finance transaction is the credit quality of the offtaker. With community solar projects, the offtakers can be residential consumers, businesses or municipalities. Finding the right mix of offtaker and maximizing the offtakers’ credit are vitally important to attract financing.
With respect to residential offtakers, financiers usually require that individuals have a certain minimum FICO score. This can be complicated when the enabling legislation requires a certain percentage of subscribers be low income, as is the case in Colorado. A customer with little income could still have a good credit record. Some developers have suggested that acquiring customers (regardless of FICO score) is most important. For now, financiers beg to differ. To attract financing, developers focused on residential customers should acquire as many such customers with high FICO scores as possible.
There are a couple important advantages with residential offtakers.
First, each individual customer represents a very small percentage of the overall portfolio. Consequently, the loss of any one residential customer will have minimal effect on cash flow.
Second, residential customers can be easily replaced if they default or move out of the service territory. The developer should try to build a waiting list of customers who want to subscribe to a community solar project so that customers that default can be easily replaced.
The financiers will need to be comfortable that the developer is a capable operator and can find customers and manage substitutions quickly. In addition, some term financiers will finance projects that are not fully subscribed, but they are unlikely to make the full commitment available to the developer at inception. The financing will probably involve a mechanism that makes available an increasing percentage of funds as the project becomes fully subscribed.
Non-residential customers, like businesses and municipalities, are larger and a single customer could represent a material portion of the portfolio. Given the importance of such customers to cash flow and economic viability of a portfolio, financiers may require the offtaker to be rated as investment grade. If the entity is not publicly rated, some financiers will allow the sponsor to use a shadow rating. Without a rating, financiers will limit the amount of non-residential customers that they are willing to finance.
One way financiers gain some comfort with larger, non-residential offtakers is through the use of a termination payment. The customer agreement with the non-residential customer should require the payment of a certain amount of money if the customer defaults or terminates the agreement. The payment is used to “right size” a financing by paying down debt or making a special distribution of cash to a tax equity investor. The credit quality of the customer will be very important because the financier will want assurances that the payment will be made.
The percentage of residential customers versus non-residential customers in portfolios is important. There may be state rules about offtaker mix. Financiers already know how to underwrite C&I customers. They also know how to underwrite residential portfolios. The perceived novelty of community solar makes it advantageous to mix the two types of offtakers in order to reduce risk and accelerate financing. The developer should find out the preferred mix of the financiers with whom it hopes to deal.
Most community solar projects are relatively small: in the one to two megawatt range. A single project is too small to finance individually other than on balance sheet because the transaction costs are too high. Finding the right size portfolio is important. The portfolio must be large enough to justify not only the developer’s, but also the financiers’ transaction costs.
While assembling a portfolio that is large enough to be financed efficiently, the developer should keep an eye on the locations of projects and the number of states where the projects are located. It is easier to finance a portfolio of projects in a single state. The portfolio should not include projects from more than three or four states at the outside.
There are two reasons to limit the number of states.
First, each state has a different and complicated regulatory regime. Financiers need to understand each regime, how it works and how it could change in the future before they will close on a financing. Some regimes are so new that developers are still engaged in the rulemaking process. Financiers will look favorably on portfolios in states in which the developer has a deep understanding of the regulatory and business environment. However, the financiers will also want as good an understanding.
Second, each state usually has its own forms of contracts that are used in community solar projects, especially to set up the unique utility relationship. The more states and the more forms a financier must review, the longer financing takes and the higher the transaction costs.
Another way to help some financiers gain comfort is to include other, better understood assets, such as some C&I projects, in the portfolio. Financiers are generally already more comfortable with C&I projects, so including them reduces perceived risks of the portfolio. Rather than underwriting a portfolio entirely made up of community solar projects, which may be too risky for some financiers, a portfolio that is 50% to 70% community solar may more easily attract financing.
Many large lenders and tax equity investors are hesitant to lend to or invest in projects developed and owned by inexperienced developers. Until the developers prove themselves, they may need to seek other non-balance sheet methods to finance their initial portfolios.
Some developers have successfully raised financing from regional banks and high-net-worth individuals. These sources of capital are likely to have less rigorous processes and be able to move more quickly through diligence with lower transaction costs. However, they may require higher margins. It is also unlikely that developers can use this type of capital for large portfolios.
The difficulty smaller developers have raising financing may lead eventually to consolidation.