More new trends
Four industry veterans talked about new trends in financing renewable energy projects at the 15th annual ACORE/Euromoney REFF-Wall Street conference in New York in late June. The following is an edited transcript. The four are Ted Brandt, CEO of Marathon Capital, David Giordano, managing director of BlackRock Alternative Investors, Susan Nickey, managing director of Hannon Armstrong Sustainable Infrastructure, and Ray Wood, global head of power and renewables for Bank of America Merrill Lynch. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
MR. MARTIN: What new trends do you see in how projects are being financed, and how developers are capitalizing themselves?
MR. GIORDANO: There is a lot of competition for asset-level investments in renewables. Most of the competition is around more mature assets, call them late-stage development through assets that are already in operation.
There is less activity at the higher risk end of the spectrum, meaning earlier stage, and also at the innovation end of the spectrum. This sector needs more creativity and innovation in the siting and permitting stage of projects.
MR. MARTIN: So we need more innovation from financiers and investors at one end of the spectrum. What recent innovations do you see along the rest of the spectrum?
MR. BRANDT: We have seen a lot of innovation around development capital.
MR. MARTIN: What are examples?
MR. BRANDT: Smaller developers have traditionally relied on money from family and friends. But second-round capital is now coming from pretty innovative capital providers that have been looking at early- and mid-stage companies. That is how Cypress Creek Renewables and a whole lot of other folks got traction and grew rapidly.
MR. MARTIN: More details, please.
MR. BRANDT: What we used to see is all development was done with 100% equity and, over the last couple years, equity has become the first leg, but then non-dilutive mezzanine funding — call it 13%, 14%, 15%-type of money — comes in.
MR. MARTIN: And who provides that?
MR. BRANDT: There are a number of mezzanine providers. One the most innovative is Scott Brown at New Energy Capital, but at least six or seven other companies have entered the sector.
MR. MARTIN: Is the mezzanine money preferred equity or debt?
MR. WOOD: Both. We have never had this much liquidity in the market. Looking back at the last three to four years, developer profits have been extremely high. Equipment prices have fallen, interest rates have remained low, and there has been a return to a kind of a basic capital structure for projects, after the yield co experiment where equity was cheaper than debt for a short period of time.
The capital stacks still have at their core traditional leverage against an IRR-based equity investor. There are financial players who are comfortable with the asset class and now want to earn higher returns by investing at the development stage. You have strategics who would like to move into development themselves and who might invest in order to learn the business. There are several other players who are also thinking about it.
You have a convergence of appetite for development companies and, to Ted’s point, that has spurred innovation in capital structures. The money could come in as preferred equity. It could be mezzanine debt.
There is a sense of optimism. Construction debt is plentiful. Tax equity terms are improving, notwithstanding tax reform. You have strategics interested in investing equity. So what could go wrong? The money is there. We are all here. Let’s go party.
MR. BRANDT: The challenge now is equipment prices are going up due to tariffs. At the same time, electricity prices are low and falling, causing load-serving entities to wonder why they should lock into 20-year power purchase agreements. You have shorter-duration PPAs, if you can get them at all. The last three to four years have been phenomenal, but you have a looming end to federal tax credits for renewables and a rush to build and, with increasing equipment costs, where are the returns?
Michael Polsky said in the session immediately before this panel that if you are not making money from a project during the PPA period, you are not ever going to earn money from it.
The risk is that the returns to which people have been accustomed in the past are collapsing just as everyone shows up for the party.
It is a pretty interesting market right now. There is frenetic activity, but storm clouds are looming.
MR. MARTIN: Ray Wood, when do the financiers lose interest as contracted revenue streams shorten in duration? The reason Michael Polsky said that if you are not earning money during the term of the power contract, you will not earn it later is because there is always someone else who will offer power for less after the project comes off contract.
MR. WOOD: That’s a very good question, but one that is hard to answer. It is hard to find a power contract in Texas, and yet projects are being financed based on hedges that run 10 to 12 years. We see some community solar projects with five-year subscription agreements, and those are getting done. Whenever we say doom and gloom and this is not going to work, there is a new wave of capital that makes it happen.
MR. GIORDANO: What people have loaned against or invested equity in has done pretty well. There are only two things that ultimately stop the party. One is if real interest rates continue rise and the other is if the spread between industry returns and real returns narrows to such a degree that investors start losing money.
Short of those two seismic events, the party will continue. I was at a conference — as a matter of fact, your conference, Keith — where Herb Magid of Ares said: “I’m on this global $120 billion asset management platform. I think my business sucks.” I’m talking to lots of people, and everybody else says, “Our business sucks, too.” Yet the market remains awash in liquidity.
The wall of money is not unique to this business. It is all over the capital markets, both private and public, everywhere.
MR. MARTIN: Susan Nickey, we just heard that the last three to four years have been good for developers. There are possible storm clouds ahead, but there is also optimism. Do you want to add any new trends to what has already been said?
MS. NICKEY: There is innovation in terms of how capital is being put to work in distributed generation. Commercial PACE programs are bringing capital to help real estate owners become more energy efficient or convert to using more clean energy.
Investment funds are looking for ways to decarbonize their portfolios.
Companies that have been major leaders — the Europeans, in particular — are not only continuing to invest in utility-scale renewable energy, but they are also acquiring companies and diversifying to behind the meter on the distributed side.
These are all areas that need more capital and provide room to innovate.
MR. MARTIN: Andy Redinger from Key Bank said at a conference a couple of years ago that he has been trying to persuade Key Bank to lend without a power contract. He said, “We lend to McDonald’s based on future hamburger sales. There is no contracted revenue stream. Why is power different?” Do you see the market moving in that direction given that PPA tenors are shortening?
MS. NICKEY: The challenges in merchant power deals are basis and congestion risk. You may be able to run sensitivities as an investor around views on gas prices and future electric prices, but how do you forecast around basis and curtailment risk?
MR. GIORDANO: One thing we have been watching is the unbelievable competition across the bank market. For years and years, the constraint with banking always worked out to coverage ratio applied to the contract term. Those coverage ratios are becoming tighter.
MR. MARTIN: “Tighter” meaning instead of 1.35 times debt service for solar, the coverage ratio is what?
MR. GIORDANO: Without insurance, 1:25x and, with insurance, 1.1x.
MR. MARTIN: You are using the word “insurance” to mean a solar production put?
MR. GIORDANO: Right. A number of insurance products are coming to market that guarantee electricity production. Lenders have been using such insurance to justify lending more money against a lower debt service coverage ratio. Debt might move from 42% in a typical capital structure to 52% or 53%. It reduces the amount of expensive equity required in a project.
In places like North Carolina, the PPAs now run for 10 years. We are seeing 15-year loans with the last five years of debt service being paid out of merchant electricity sales. That is an innovation that probably can only be explained by the oversupply of bank debt. Banks are not ready to finance purely merchant projects, but things are creeping in that direction.
MR. MARTIN: Let’s drill down into some trends. One new trend is assets moving to pension fund ownership. Are the pension funds only buying operating assets? Do you see them also bidding earlier in the development cycle?
MR. WOOD: We see them buying at notice to proceed with construction. They no longer insist that the project already be in commercial operation. There is little to no difference in the discount rates used to price a project at NTP rather than the end of construction. We have seen some pre-NTP sales as well.
It is not just pension funds that are doing this. It is insurance companies, money managers and strategics, as well. Most people view the construction risk as being relatively easy to accept in cases where the EPC counterparty is creditworthy, unless there is something unusual about the project.
MR. MARTIN: The pension funds seem to be the low cost capital at the moment. Am I correct? If they are the low cost capital, how are others like private equity funds getting traction?
MR. WOOD: Private equity funds are bidding on development platforms and then earning a return through some catalyst like reselling the company after it has had a period of organic growth. I can’t think of any situations where a private equity firm, other than a dedicated infrastructure fund, has just bought a contracted portfolio.
MR. BRANDT: I think that’s right. Pension funds that three or four years ago were interested only in operating assets have migrated over the last couple years to earlier-stage projects in order to get higher returns.
For example, Omers is buying Leeward. It is a purchase of a development platform that owns both a development pipeline and operating assets. We saw AIMCo, together with AES, buy sPower, another development platform. We are hearing more frequently from larger pension funds, particularly Canadians, that they are willing to invest earlier in the development cycle to earn higher returns.
MR. MARTIN: That seems to be another trend — disinvestment in Canada to reinvest in the United States because of the disparity in tax rates. The US rates are now significantly lower.
Coming back to the pension funds, they have a hard time owning solar assets during the first five years when the investment tax credit is vesting or owning wind assets during the first 10 years when production tax credits are being claimed on the electricity output. If you see them invest early, are they investing through blocker corporations?
MR. BRANDT: Every such transaction we have seen has involved a blocker corporation.
MR. MARTIN: Are you seeing any novel structures being used to make such investments?
MR. WOOD: They have been pretty plain vanilla.
MR. BRANDT: I think people generally play it conservatively when it comes to that front. They use a blocker corporation so as not to do anything that could harm the tax benefits at the project level. We are not seeing anything exotic.
MR. MARTIN: Another trend is the percentage of the capital stack that is tax equity is shrinking as a result of the lower corporate tax rate. What percentage of the capital stack is tax equity today in a solar project versus a wind project?
MR. GIORDANO: It is 30% to 38% for solar, depending on the structure. For wind, it depends on the capacity factor, but we are seeing 47% to about 62%.
MR. MARTIN: Have there been any other effects from the tax reform bill the US enacted in late December besides shrinking the percentage of tax equity in the typical capital stack?
MS. NICKEY: Greg Wetstone [CEO of the American Council on Renewable Energy] reported this morning on a new survey that shows 40% of respondents say it is business as usual and 30% believe the effects of the tax bill are still to be determined, but people are still investing. There are more tax equity investors today than before tax reform.
It took time at the start of the year for everyone to digest what had been done and to redo deal models. A lot of time was lost, and projects were delayed. The outside deadline of December 2020 to finish wind farms is starting to be a concern.
MR. MARTIN: Speaking of that, MAKE, a consultancy, estimates that people stockpiled enough turbines in late 2016 to build 45,000 megawatts of new wind farms and qualify for production tax credits at the full rate. Many people sitting on such equipment are asking how much more time they have in practice to find a home for the equipment.
MR. WOOD: I think the moderator should answer that question. That’s a little snarky, but you get those calls, my friend.
MR. MARTIN: You guys are in the market. Paul Gaynor from Longroad Energy said last week at a conference that people are looking at this point where they can deploy most rapidly, and that is probably in ERCOT.
MS. NICKEY: Just what we need.
MR. GIORDANO: I think there are some white knuckles, but I don’t think the clock has run out yet.
MR. MARTIN: Then let’s move to import tariffs. President Trump announced in the last few days that he plans to impose a 25% import tariff on $50 billion a year in Chinese goods. The targeted goods are divided into two lists. There is a $34 billion list on which the tariffs will take effect on July 6. There is a $16 billion list on which the tariffs will take effect later this year. The $16 billion list includes solar panels and cells from China that are already subject to a 30% tariff plus anti-dumping and countervailing duties.
Do you see much effect? Are you seeing many solar panels imported directly from China for use here?
MR. GIORDANO: My sense is that the developers are adapting. We are not seeing much direct sourcing from China.
MR. MARTIN: This is just the latest round of tariffs on top of other tariffs Trump has imposed this year on steel, aluminum, solar panels and solar cells from virtually all countries. We are seeing retaliatory tariffs imposed on US goods by Canada, Mexico, the European Union and China. This makes for uncertainty about what things will cost. What effect is the uncertainty having?
MR. BRANDT: It can’t be good, but it is too new really to assess. By the time we see a deal teed up for financing, the solar panels and other equipment have already been secured.
MS. NICKEY: There has been a rush on First Solar panels because they are not affected by the tariffs. There have been some slowdowns because of difficulty getting panels.
MR. GIORDANO: We have not seen the effects work through the system fully yet. The next six to 12 months will tell how they will affect pricing. Over the 15-year history of this conference, we have seen changes affecting all parts of the market, from the offtake side and the capital side, both debt and equity, developer profits, etcetera. The market has rolled with the changes.
MR. MARTIN: The tariffs tend to push up costs. In 2013, there was a drive to reduce the cost of capital. A lot of new concepts were explored, such as yield cos, solar REITs, MLPs, Canadian income trusts, securitizations. Do you see a similar drive starting, perhaps pushed by the import tariffs?
MR. WOOD: The market is awash in liquidity, so access to capital and the cost of capital are not current constraints. The tariffs are probably driving EPC margins and procurement, and there are probably things that can be done at the project level to improve output. That is where the efficiencies are coming.
You had about a 12% or 13% year-over-year decline for the last several years in the cost of solar, and maybe 7% to 8% for wind. So now you have this uptick in equipment prices, and the real debate is where the innovation will come from to offset those costs.
The people winning the PPAs have assumed a certain forward curve and they have been able to procure below that point over the last three or four years; hence the profits. We will see whether there is a stuck generation that gets caught. The jury is still out.
MR. MARTIN: At the Infocast solar finance summit in March, several CEOs said they expect to see some stress later this year for the reason you just said. Solar companies signed contracts to deliver electricity at prices that assumed a continuing downward trend in equipment costs. That downward trend has been arrested by the tariffs. Do you see any evidence of such stress?
MR. WOOD: No.
MR. GIORDANO: I think what we continue to see is different dials being turned to make the projects work, to fit the PPAs that are getting signed, and this will continue. The equipment manufacturers have margin built in. If you compare equipment costs to where they were 15 years ago on a real basis to where they are today, you might argue that there is still room in the current pricing to absorb some of the shock.
You could argue that equity is still being priced 300 to 400 basis points too high compared to the cost of equity in traditional real estate investments. So we are still at an early stage in the transformation of capital for this sector. Returning to a word that has been used several time this morning, innovation, it does not just mean more leverage. Innovation in the industry as a whole looking means through a different lens, reclassifying away from an emerging stage and into mainstream infrastructure.
MR. WOOD: There has been a maturation of the sector. Developers who may be facing cost pressure to deliver electricity at prices promised under new PPAs can now sell a project to a utility that wants to put the project into its rate base. The utility may even buy the project at an early stage when the land has been procured and there is an interconnection agreement.
These sales are early in the permitting process and may not earn the developer as much as if he advanced the project farther, but there is a still a very good profit margin. The developer can then recycle the development capital. If we do have this conundrum where people bid too low to win PPAs, I think you will see utilities filling the void.
Utility stocks are off a little with tax reform and with the yield curve, but certainly not catastrophically so, and they continue to be rewarded for adding to rate base.
MS. NICKEY: We see more and more developers looking at adding energy storage to be able to grab other revenue streams that will help make these projects more economic.
MR. BRANDT: Another trend is we have been pitched now 10 times by people that want to tokenize the cash flows in solar projects. I keep scratching my head and asking, “Do you really think the problem in the business is that it is not efficiently financed?”
There are a lot of people with business plans who think that bringing the cost of equity in C&I and residential solar and utility-scale solar down to 6% or so is a worthy use of energy. I keep asking, “What about the cost of acquiring these projects and the low margins?” Nobody wants to deal with that.
MR. MARTIN: Tokenize meaning an initial coin offering?
MR. BRANDT: Yes. They would do an initial coin offering and then effectively have it trade off the value of the cash flows.
MR. MARTIN: Meaning sell access to a platform where people can buy electricity? You buy a token. You can get on the platform.
MR. BRANDT: No. The purchasers of tokens are buying and selling cash flow and not the right to take electricity.
MR. MARTIN: People are raising hundreds of millions of dollars through such offerings.
MR. WOOD: Ted, the Securities and Exchange Commission wants to speak with you after this panel.
MR. BRANDT: We have not accepted any of these assignments, I just want you to know.
MR. MARTIN: Not yet. The SEC chairman last week suggested the SEC does not think ethereum and bitcoin are securities.
MR. GIORDANO: Susan Nicky mentioned something before this panel that I think is also a big piece of maturation of the capital stack for renewables generators. We are moving to a much smarter grid with smarter meters.
MS. NICKEY: Renewable generators who have added energy storage or put in smart controls feel like they can bid forward in the day-ahead market and gain extra revenue by using storage to offer power during peak hours instead of overnight. These changes can have a meaningful effect on revenue.
MR. MARTIN: Storage allows tapping into as many as 13 additional revenue streams. Storage is more of a software than a hardware play. You need a brain to decide which revenue streams to tap at any given time. What percentage of projects do you see having storage today as a component? 25%? 10%? Less?
MR. BRANDT: For new projects, it is closer to 25%. Virtually every RFP we see today has a storage component. The only issue is whether storage is mandatory or optional. I think storage is already upon us.
MS. NICKEY: I think the market is still evolving. We do not see it so much in what we are financing today, but we expect almost all solar will have storage in the future. A few wind-plus-storage projects have been awarded power contracts recently.
MR. MARTIN: Let’s move to a rapid question round. Ray Wood, you mentioned that there is no major drive currently to reduce the cost of capital because the market remains awash in capital. There are 70 to 90 project finance banks chasing deals. How much longer can that continue before there is a shake out?
MR. WOOD: Banks really do not play the primary role in the energy sector. Non-banks do. The only thing that will chase the banks from the market is if there are no longer contracted revenue streams to support the financing.
Contracted assets are earning an acceptable return on risk capital. The regulators are fine with them. If anything, regulatory pressures are easing in the bank sector, at least in the United States.
MR. MARTIN: Some banks are now offering to lend construction debt at less than 100 basis points above LIBOR. We even heard one bank say last week that it is offering 75 basis points. Have you seen construction debt actually close at these levels?
MR. GIORDANO: We have not seen any construction debt below 100 basis points. I would ask what other balance-sheet support there is to support that type of spread.
MR. BRANDT: I think you are hearing these numbers in build-own-transfer arrangements, and it is important to understand that those are different animals. You have an investment-grade utility that agrees to buy the project at the end of construction. You have a developer that needs financing in order to deliver the project with no conditions precedent to the project sale that cannot be insured against. The risk of a take out for the construction lender is really, really small. It is equivalent to financing a trade receivable from a customer with strong credit.
MR. MARTIN: What do you think is the current margin above LIBOR for construction debt?
MR. WOOD: We normally expect to see 150 to 225 basis points.
MR. MARTIN: Are the margins continuing to tighten? They have come in by at least 25 basis points since the start of the year. They had reached that level by mid-spring. Have you seen any further margin compression since then?
MR. BRANDT: Not from our perspective, no. But we are seeing projects that are at a slightly later stage than construction.
MR. MARTIN: Many sponsors are trying to sell development platforms this year. There are also a lot of projects for sale. Is this due partly to a sense that prices may be at a peak or close to it or is there something else driving this trend?
MR. WOOD: The amount of working capital needed to develop projects has increased.
Developer returns have been very good for the last three or four years, so you are seeing a wave of development platforms for sale, and there is a large demand for them. The deals are generally structured with some cash up front and an earn out, so there tends to be a pretty rigorous alignment of interests.
MS. NICKEY: There is a huge pipeline of projects that will require a lot of capital to develop. Another driver is there are global players in the US market who use IFRS accounting and may be looking for partners to allow deconsolidation. HLBV accounting in tax equity partnerships adds complexity for these types of sponsors.
MR. BRANDT: I think Ray touched on some of the drivers for the developers or sellers. Turning to the buyers, many of them are Asian, and they are copying the European business model of using their balance sheets to de-risk projects and then selling down their positions to pension funds. They are actively looking at the few available remaining wind companies for sale and the more significant number of solar development platforms for sale in what is a more fragmented market segment.
MR. MARTIN: Ted Brandt, at what discount rates are wind and solar development platforms trading?
MR. BRANDT: The answer differs depending on whether you are buying a whole portfolio or a specific project. Even though risk-free rates, meaning Treasury bond yields, have moved up from 210 to almost 300, we are seeing bidders discount projected cash flows from utility-scale solar projects at 6.5% to 7%, maybe 7.5%, on an unleveraged, after-tax basis assuming 35 years of revenue. There is a huge issue how to look at the merchant curves. We are seeing rates of 8.25% to 9.5% for wind, depending on the length of the power contracts and how one looks at merchant curves.
MR. MARTIN: Are you representing primarily sellers or buyers, or both, at this point?
MR. BRANDT: A lot more sellers than buyers, but we do both.
MR. MARTIN: Ray Wood, you see a lot of the market. Do these discount rates seem right?
MR. WOOD: I think Ted was referring to asset-level discount rates. If you are talking about a platform, you have have to probability-weight the development pipeline, and bidders tend to want higher returns than when bidding on what is essentially contacted cash flow from individual assets or a portfolio of operating projects.
With a developed flip or developed sell and recycle, we see people looking for more traditional equity-growth returns. The strategics who are bidding want wind development, solar development, battery development, as well as retail access. They are trying to put all these things together for some sort of storefront that will be the 21st century utility. Whether they might be prepared to bid at lower discount rates because they believe they are getting synergy with other assets is hard to say.
MR. MARTIN: You just pointed us to an interesting topic for another day. Michael Polsky, who spoke just before this panel, left us one as well on the renewables paradox. The more renewables there are, the lower the prices go and the harder it is for anybody to make money.
About a dozen years ago, Polsky began advocating for renewable energy companies to be able to organize themselves as master limited partnerships. Now that the natural gas pipelines seem to be abandoning this structure, should the industry still be pushing on Capitol Hill for the ability to use MLPs? How important are they?
MS. NICKEY: The survey on which Greg Wetstone reported earlier has MLPs at the bottom of the wish list. I understand there was a provision in the tax reform bill at the end of last year that had a materially negative impact on MLPs. When the pass-through nature of MLPs no longer offers the same economics as before, it dries up the advantage.
MR. WOOD: I agree with that. Let’s see when yield cos can recover. Yield cos are trading today at a level that is closer to the intrinsic value and once yield co shares get growth wedged back into them, they will once again become a currency that can be used to make acquisitions or roll-ups.
An MLP is in the same grouping, but it has unique tax disadvantages. I do not see it being a relevant player in this space, absent tax law changes.
MR. MARTIN: Let’s move to audience questions.
MR. DAVIES: Ken Davies, Microsoft. The more we look at these assets, the more they look to us like commercial real estate, whose modus operandi is not project finance, but CLOs. If these projects are, in the end, commercial real estate, what is the floor for the cost of capital?
MR. GIORDANO: The major difference between real estate and renewable assets is residual value. Typically when you buy real estate, it increases in value over time. Industrial assets might go sideways. Whereas a 20-year-old wind farm will be worth some percentage of its original cost.
The hmarket has moved to using a dual rate, a discounted-cash-flow analysis where the contracted revenue stream is discounted at one rate and then a more conservative assumption is made for the merchant revenues.
This is probably different than the way most commercial real estate projects would be evaluated.
MR. HAUG: David Haug, Arctas Capital. Is one of the reasons why so many development platforms are for sale is that developers see fewer and fewer PPAs for shorter and shorter tenors, and corporate PPAs, which are a growing share of the market, are pricing electricity at the hub rather than the node, creating basis risk. What effect do you see this having on the ability to raise debt and tax equity? Do you see the market moving to where shorter PPAs plus merchant tails become the norm?
MR. GIORDANO: I think we are largely there.
As offtakers begin to realize the impact that some of their risk aversion is having on their ultimate cost of energy, it might create opportunities for developers and offtakers to work together to find better ways to handle the risks that will produce a more optimal capital structure.
Right now, you are seeing a lot of risk being pushed down to the project level. The financiers are still figuring out how to price that risk, including what assumptions to make for purposes of pricing.
The tax equity market has become more sophisticated. Using things like pay-go structures to address basis risk might make sense. Or else tax equity investors may come to realize that they are protected from basis risk through delay in the flip date. Maybe with that realization we will see more tax equity willing to take full-on merchant risk.
MR. WOOD: We seeing tax equity portfolios with seasoned projects being resold in the secondary market. It is not a super-liquid secondary market, but the fact that there is such a market is a big step from where we were.
Projects that do not flip on time, but have cash and no more tax attributes, give the tax equity investors returns that are on a par with equity returns. At that point, the tax equity investor is really the major equity in the project.
MR. BRANDT: As I think about the financing constraints and whether a project with no contract or a very short contract can get financed, I do not think the debt or cash equity will be the constraint. The constraint will be the tax equity. If tax equity can be raised, then everything else will get done because of the amount of liquidity in the debt and equity markets.
MS. NICKEY: Good news then, because we said there is more tax equity after tax reform than before.
Many corporations are now moving to buy renewable power. As people learn more about basis risk, there will be innovation. We are seeing innovation on the utility and offtake side — green tariffs in Michigan, things that are happening in Virginia — that are allowing the market to expand for renewables and transfer the risk where it can be better-managed.