Raising capital in a market in transition
Capital is usually harder to raise during periods of uncertainty about government policy. Lenders and investors adjust to changes in the market itself. The taps are wide open this time through both mild policy uncertainty and significant market changes. The first panel at the annual Renewable Energy Finance Forum in New York in late June talked about why, and how the various sources of capital are adapting. The following is an edited transcript.
The panelists are Ted Brandt, CEO of Marathon Capital, Catherine Helleux, head of transactions in the Americas for Allianz Global Investors, Andrew Redinger, managing director and group of head of project finance at KeyBanc Capital Markets, and Himanshu Saxena, CEO of the Starwood Energy Group. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
MR. MARTIN: Greg Wetstone, in his presentation immediately before this panel, talked about some of the transitions currently underway in the market. We are moving to a corporate PPA and hedge market. The tax credits for wind and solar are phasing out. Storage is coming; we haven't yet reached a tipping point, but you can see it coming. The customer base is moving in places like California away from the utilities to community choice aggregators. Eventually blockchain may displace them. The shift to electric vehicles has the potential to increase demand for electricity.
Are there any trends to add to this list?
MR. SAXENA: Did you say data centers?
MR. MARTIN: I did not. What about them?
MR. SAXENA: I think they may be a very significant source of demand going forward. Microsoft says it is building a data center a month in some parts of the world. I see that as a pretty significant demand driver, especially for renewables because they want to connect these to renewable energy. All the cat videos that people are putting out use a lot of space. [Laughter]
MR. MARTIN: Any other contributions to the list? What about cryptocurrency? Bitcoin uses an enormous amount of electricity through data mining.
In a market that is in transition, one would think raising capital would be more difficult, and yet it is not. Why not?
Awash in Capital
MR. BRANDT: There just seems to be a tremendous amount of it. The volume is overwhelming.
MR. MARTIN: Is the fact that we are awash in liquidity a sign that we are so affluent that we don't know what to do with our money?
MR. BRANDT: I don't know that liquidity and affluence are the same thing. I think what we are seeing is the logical result of about 11 years of accommodative central bank policy. There has not been a lot of tightening. Institutional investors tell us they are not making much on their fixed-income investments. Many think that public equities are nearing the peak, so they are allocating money away from those two buckets and into infrastructure. Billions and billions of dollars have been raised to look for real rates of return around the world in the developed economies.
MS. HELLEUX: There is indeed a lot of money being raised, but the fact that it is deployed means there is a need. It would be an issue if the money were raised and sat dormant. There are a few markets where the deployment is a little bit slow, but all this capital finds a home.
MR. SAXENA: There is about $130 billion of private capital that is being raised currently. For example, Blackstone is raising a $40 billion infrastructure fund. GIP has just raised a $20 billion fund. Stonepeak has just raised a $7.5 billion dollar fund. These are US-based investors that are investing fairly large amounts of capital. Brookfield led another $20 billion. Capital Dynamics has just raised a fund.
Not all of the $130 billion is dedicated to renewable energy, but a significant portion is. There are not enough assets to go around for this much capital, and that is showing up in a pretty significant compression in discount rates.
MR. MARTIN: But there must be something right about renewables because the money is not going to the areas of greatest need. We are not rebuilding our bridges or our crumbling roads.
MS. HELLEUX: A bridge is a little bit more exposed to the highs and lows of economic cycles. And most such projects have a government entity as opposed to a private offtaker as a counterparty to the revenue contract.
MR. MARTIN: The Financial Times reported yesterday that there are $12 trillion in government bonds that are now paying a negative yield. People are paying governments to take their money. Is that affirmation that there is too much money sloshing around, or what does it say?
MR. BRANDT: The investors putting their money into such bonds are largely in Europe and Japan. There is a clear fear of deflation in those economies. You don't see that in the United States because people believe that inflation still will be a positive number. The 10-year treasury bond pays about 2.1%, in an economy with an expected inflation rate a little over 2%, so the rates of return are still about zero. It is all about the inflation-deflation expectations.
Financing Merchant Revenue
MR. MARTIN: So if you are going to have a transition, when it would normally be tough to raise money, it is good to do it while there is so much money that you don't feel the pain.
One of the other transitions we did not talk about is getting used to doing business on a trampoline with a slightly overweight 70-year old bouncing up and down while you are negotiating deals. Let's drill down into some of these issues.
Andy Redinger, you said famously a couple years ago that you have been trying to persuade KeyBank that it should be willing to finance projects that are wholly merchant because, after all, it finances McDonald's hamburger stores and they don't have forward hamburger sales agreements. How is that coming? [Laughter]
MR. REDINGER: It's actually coming along very well. But the point of that statement is that we finance lots of industries that don't presell their output. The energy sector is interesting in that financial institutions like mine usually require project owners to presell their output. I was always frustrated by that.
We are able to finance merchant. Everyone says that's great, but they want the same terms for merchant as for financing contracted projects. KeyBank can finance merchant projects, but we can do it at three or four times leverage on EBITDA. We do not finance merchant projects under the same structure that we are financing contracted projects, so it is coming along very well. It is just the market will not accept when I say, "Listen, we'll do merchant, but it is three times EBITDA." The developers say, "Okay, but that means less debt. How do we fill the hole?" And I look at the equity and say, "Okay, it's you." And they say, "No, I can't do that."
So there's a little back and forth going on.
MR. MARTIN: Is McDonald's an appropriate analogy? The average store sells 167,000 Big Macs a year. It has a diverse customer base. Power projects have a single off-taker.
MR. REDINGER: My definition of merchant is you are selling into a broad and very liquid marketplace. A merchant project is selling into a liquid market every day to many buyers.
MR. MARTIN: If we move to blockchain as a way to sell electricity, would that open up more financing. Maybe not three times EBITDA, but less?
MR. REDINGER: I think so.
Longer Merchant Tails
MR. MARTIN: Himanshu Saxena, you said a couple weeks ago that in the shorter-term PPAs, you end up getting back maybe only 30% of your capital by the end of the power contract. That's a problem. How common is it?
MR. SAXENA: What we are seeing is a transition. Corporate PPAs used to be 15 years. Now they are 12 years. RFPs today propose PPA terms of anywhere from seven to 15 years. For solar PPAs, the suggested contract terms are getting even shorter, on the order of five to seven years.
The electricity price is going down and the tenor is getting shorter. If you were to do a calculation of what is the ratio of your contracted cash flows to merchant cash flows over the life of the asset, let's say 30 to 35 years, those ratios are shrinking very significantly.
The project may look contracted for 12 years, but if you look at the cash flows over the entire 35 years, they are close to 80% to 85% merchant and 15% contracted, and that is effectively putting a lot more risk on equity than it has had in the past. Equity is taking a risk of the forward price curve for power. There are obviously many consultants willing to advise on where the power curve is headed, but there is significant risk. The merchant tails are getting longer.
All the investments that are being made on the equity side are betting on the price of power remaining strong. These assets are not dispatchable so, in many cases, you are not benefiting from the volatility of the markets like you can with a merchant gas-fired power plant in PJM. Most of the time, you are effectively just long power with an uncertain shape.
New 25-year contracts are simply not available. We sold a transmission line with a 20-year contract recently. We had 76 non-disclosure agreements signed on that deal, so the demand is immense for contracted cash flows, but it is hard to get your invested capital back during the contract term for the newer contracts that are on offer in the market, which means that a return on that capital is effectively coming almost entirely from the merchant cash flows. That is the new business we are in. We are all in the merchant business.
MR. MARTIN: Catherine Helleux, you are investing equity or attempting to do so. This suggests you are taking a lot more risks. Are you able to find returns commensurate with the risk?
MS. HELLEUX: Even if you find a 25-year PPA, the return will be low, so it is better to go to the extra risk of merchant, as it comes with an extra return, as it should. That is really becoming the market now.
There is a market for refinancing de-risked assets that are operating under long-term PPAs with a decent price where there is a need for fresh capital. There is a separate market where people are adding greenfield capacity to the grid and, like Himanshu said, it is really tough to isolate those assets from some level of merchant exposure.
MR. MARTIN: Michael Polsky said last year that if you don't get your capital back by the end of your power contract, you will never get it back fully. Does anyone agree with that statement?
MS. HELLEUX: I hope the industry as a whole disagrees. Otherwise, we are not going to see a lot of megawatts built this year.
MR. MARTIN: Fair enough. So the power contract terms are shortening. How are the capital markets responding?
MR. BRANDT: Tax equity is still insisting on a contract for the pertinent horizon that it is in the deal, so you are seeing a minimum 10-year corporate PPA for a wind deal on which production tax credits will be claimed.
It is interesting to watch the Texas solar market. There, people are testing how long a hedge is required. They are looking at hedges of something like 6.5 years. I think the economics are reasonably compelling to go pure merchant if you look at the forward price curves, but you would have to go with tax equity or do an internal hedge.
MR. MARTIN: Andy Redinger, how are the banks responding to shorter contract terms?
MR. REDINGER: The spreads or margins have tightened pretty dramatically in the last 12 months. The banks are providing more leverage and getting less margin, which doesn't make sense, but that is what the bank market is doing because there is intense competition for projects, and the market right now is valuing banks on loan growth. So to get a higher stock price, banks need to make more loans.
The other response is we are getting pushed to make up the hole in the capital stack as the market moves to shorter contract terms and to do other things around the loan structure to get more leverage in the deal.
MR. MARTIN: Are you seeing sub-100-basis-point construction debt?
MR. REDINGER: Yes. That's pretty common.
MR. MARTIN: How low?
MR. REDINGER: I think 75 is probably center fairway.
MR. MARTIN: Center of the fairway. 75? So that suggests there are loans below that.
MR. REDINGER: There could be. Yes.
MR. MARTIN: And permanent debt, 137.5 basis points over LIBOR? 175 over?
MR. REDINGER: I hate quoting all this stuff. We are doing twice as much business as we did two years ago from a loan volume perspective.
MR. MARTIN: But earning less.
MR. REDINGER: We are earning less. Those numbers you quoted are pretty accurate. Maybe an eighth lower.
MR. MARTIN: Fred Allen was a radio comedian in the 1940s. He had a down-east Maine character to whom he used to talk. The character told him he bought a pig for $100 at the start of the year and sold it for $80 at the end of the year. Fred Allen said, "Well, that's terrible." The Maine farmer said, "Weren't bad. I had the use of the pig all year." This sounds a little like what the lenders are doing.
MR. MARTIN: Himanshu, how relevant are the lenders to the structure of the deal? Who is driving the bus on structure at this point?
MR. SAXENA: It feels great to talk about 75 basis points, 72.5 or 93.24, but it doesn't make a difference. The construction tenor is so short: less than 12 months. If you look at the financial model and say, "I borrowed 70% at 11 basis points cheaper for a year" the savings would pay for lunch. It has almost become a game where the lenders say, "We can give you 75 basis points above LIBOR." We say, "Fine." It doesn't make a difference. If it was a longer-tenor debt, then the pricing matters.
Really the driver on deal structure in the current market is tax equity. In my mind, tax equity pricing is still very high, and we love our tax equity friends in the room, but why are you so expensive? [Laughter] We are seeing pricing in the 7% and 8% range for the part of the capital stack that takes the least risk.
Meanwhile, we have seen return compression for everybody else. Debt is free. Equity is practically free. Tax equity is super expensive. I wish I had tax appetite. I would start doing tax equity investments because, on a risk-adjusted basis, that is the best part of the capital structure.
The other thing that is driving the market is the phase out of tax credits for renewable energy. There is no reason why folks should be building some of these wind farms and solar projects that are taking this much merchant risk. A lot of people are doing it because it's like the ads on late-night TV shows: If you order within the next hour, we will cancel one of your four payments. And right now, the federal government is cancelling one of the four payments. People are making investments because of the tax credits. Capitalization of these deals used to be 60% tax equity and the balance cash equity and back-levered debt. It is starting to look like 80% tax equity.
MR. MARTIN: Is that solar?
MR. SAXENA: We have seen this for solar and wind. Wind PPA prices are down to $15 and $16 a megawatt hour. In one case, I saw a $9 price for a hedge that would not cover the variable cost to operate the project.
I am begging all of the developers to stop signing these PPAs that you cannot deliver. Stop signing these hedges you can't deliver. Xcel has come to the market twice to replace PPAs on which the developers could not deliver.
The sad irony is that there are still investors that are buying such projects. At some point, the music will stop, and I am hoping the tax credits go away and then rationality will return to the market and the PPA prices go up to a point where projects are financeable without the tax credits. If you keep doing deals where nobody makes money, at some point the market will break.
MR. BRANDT: You can tell Himanshu was on a red-eye last night. [Laughter]
MR. REDINGER: Can I make the point, there is still a lot of profit in development, so it is not all dire.
MR. SAXENA: I said this in another conference. We should all wear t-shirts that say, "Who needs returns when you have solar?" [Laughter]
MR. MARTIN: Your fellow panelists are voting you off the island. [Laughter]
Andy Redinger, let me come back to you. So we are shortening the PPA terms. We have crappy prices according to Himanshu. So far it seems that lenders are willing to lend on shorter terms, but they will credit only two or three years of merchant tail revenue, is that correct?
MR. REDINGER: It varies by developer, but yes, that's typically correct. As I said, I have seen as many as five years. We will do merchant all day long, but we cannot provide the same quantum of debt as if the revenue stream were contracted.
MR. MARTIN: What happens when the power contracts go to five-year terms?
MR. REDINGER: The tenor of the contracts determines the amount of debt, so there will be less debt, and the equity or some other person in the capital stack has to fill the gap.
MR. MARTIN: You will discount the post-five year revenue stream, but just use a higher discount rate, correct?
MR. REDINGER: Yes, we would do that.
MR. MARTIN: How do the debt service coverage ratios change as the power contract term shortens?
MR. REDINGER: To be honest with you, I don't think they would change at all. There will just be less debt. We look at it differently. There will be less debt, with the amount determined as a multiple of EBITDA, versus the amount determined by discounting the contracted revenue over 20 years at some DSCR coverage ratio.
MR. MARTIN: Some lenders are saying now that the spreads and fees are so low on single-asset renewable energy deals that they just can't compete, so they are more interested in merchant gas projects and portfolio financings of renewable energy projects where the risk is more in line with the yield.
Catherine Helleux, where is the best risk-adjusted return currently for an equity investor?
MS. HELLEUX: In the greenfield market. We also see pockets of opportunity to grab a little bit more yield without adding appreciably to risk by financing emerging technologies like storage.
MR. MARTIN: So low yields are driving capital to places where it is really needed to help develop new technologies. Ted Brandt, you said before this that the M&A market felt a little different this year. People are coming to the market with a particular shopping list. They are not going to put their money into a blind pool.
MR. BRANDT: What we are watching is people coming in after studying the market and saying, "We want to buy a solar C&I company," or, "We want to buy a utility-scale wind developer," and they have very specific shopping lists as opposed to satchels full of Euros or Yens as in previous years effectively wanting in on the market and not being specific in terms of targets.
MR. MARTIN: What discount rates are successful bidders using to buy contracted solar or wind projects?
MR. BRANDT: That is a hard question to answer because these are 35-year assets that may have contracted revenue of only 10 to 15 years. We are seeing use increasingly of dual discount rates. A low discount rate of maybe 6% or 6.5% might be used to discount the contracted-period revenues from a solar project, and a 10%, 11% or 12% discount rate used to discount the merchant cash flows.
Overall, this works out to something like a leveraged 8% rate for solar and a leveraged 9% or 9.25% for wind for the whole period.
MR. MARTIN: So it seems like still a good time to sell. There is not a wide buy-sell spread that would keep deals from closing. The offer prices are satisfactory to the sellers.
MR. BRANDT: There is still a lot of liquidity. Sellers are getting their prices. Bidders are bidding aggressively. I think it is still a very good time to sell. In particular, it is great to be selling not just operating assets, but also pipelines of development assets.
MR. MARTIN: In the interest of full disclosure, you are usually on the sell side, correct?
MR. BRANDT: Usually, yes.
MR. MARTIN: There may be others in the audience on the buy side who would say the discount rates should be higher, so they would pay less. Perhaps?
MR. BRANDT: Well, Himanshu would always say that. [Laughter]
MR. MARTIN: Let me shift gears. Another transition is the phase-out of tax credits. Greg Wetstone put up statistics that showed 2018 was a pretty strong year in terms of renewables deployment. How does 2019 feel to those of you who are deploying capital?
MR. REDINGER: Better than last year. And I think 2020 will be better than 2019, so as we look forward, there is a lot of activity. It's just that we are making a lot less money.
MR. MARTIN: How does it compare to 2009 when it seemed like the market had gotten on a treadmill turned up to warp speed?
MR. REDINGER: It does not feel like we are overheated.
MR. SAXENA: I think that 2009 is so far away. From what we see right now, 2019 and 2020 are probably 20,000-megawatt markets for wind. That is what the wind turbine suppliers are telling us. They expect to install 20,000 megawatts this year, 20,000 megawatts next year, and then it will go down. And if you do the math, building 20,000 megawatts at somewhere near a cost of $1.2 million an installed megawatt requires a $24 billion investment. We are talking something close to $40 to $50 billion in investment in wind over the next two years. Add solar and the figures are much higher.
After Tax Credits
MR. MARTIN: A lot of people think that when the tax credits go away, the bidding down of electricity prices will stop. Is that a realistic assumption given how much competition there is for power contracts?
MR. SAXENA: I think we already see that PPA pricing for 2021 projects is turning up somewhat from 2020 deliveries. The PTC is currently $25 a megawatt hour. As you roll projects forward past 2020, there is loss of 20% of the PTC value each year, so say $4 to $5 a megawatt hour. Roll it forward another year to 2022 and that's another $4 to $5. Who covers the loss is the question.
Equity returns are already super low, so there is not a lot of room there. You can't squeeze much out of lenders, so your capital structures have to change. Maybe there is more debt and less tax equity. Every party, whether it is the construction contractor or turbine supplier or PPA counterparty, will to have to reach into its pockets to make the numbers work. We see an upward pressure in PPA pricing already for 2021 projects.
MR. MARTIN: Catherine Helleux and Ted Brandt, if tax equity remains for solar, because there is a permanent 10% investment tax credit, but the tax credits have disappeared for wind, how will that affect the relative attractiveness of those two investments?
MS. HELLEUX: We see such a rush currently for wind that, in a few years, there will be so much wind added to the grid that solar will be lagging behind, and with the benefit of a flat, clean 10% ITC, we should expect more capital going into solar.
The current rush to wind is occurring in the most unhealthy way. Wind turbine prices have been bid up in the rush to stockpile equipment to start construction of projects. EPC contracts are overpriced because of artificial demand to finish projects to comply with tax deadlines.
MR. MARTIN: Ted Brandt, how does the disappearance of tax credits affect the value of project portfolios, if at all?
MR. BRANDT: I think Catherine is exactly right. We are seeing more and more developer energy and capital moving toward solar and away from onshore wind.
MR. MARTIN: Is that because solar is more competitive, or do the tax subsidies play a role?
MR. BRANDT: It is a little of both. When you look at the subsidized levelized cost of energy of solar, it is getting cheaper and is correlated with load. A lot of markets — Texas, for example — are pretty flush with wind, but there are still some interesting opportunities, and solar is still pretty nascent. We are clearly seeing much more emphasis on solar.
From an M&A standpoint, wind developers are still valuable because they have all effectively been consolidated with one or two exceptions, so they are fewer in number. Solar is a bit more of a commodity. If I am selling a contracted project, I would probably rather be looking forward at solar.
MR. MARTIN: Gabriel Alonso, former CEO of EDP Renewables, said several years ago that there are two things his grandmother can do: one is develop a wind farm in Texas, and the other is develop a solar project anywhere in the country. That speaks to the low barriers to entry in the solar market. What happens as tax equity becomes a smaller part of the solar capital stack and the wind tax credits disappear? What happens to the cost of capital for the solar market?
MR. BRANDT: That's an interesting analytical question. I think you will see more developers keep the 10% tax credit to carry forward and self-shelter. I also think that you will see leveraged tax equity that we have not seen for about 15 years.
MR. REDINGER: I have a hard time seeing the cost of capital change. I'm with Himanshu. I think what happens is power prices increase. I think capital stays the same. It has to. I think that the pressure is on power prices, because capital has been pretty much beaten down to the minimum we can accept. The only possible movement here is in tax equity yields. Tax equity has never been beaten up. They are getting 400 basis points more in return than I am, and I am taking a lot more risk. I like to say tax equity is super senior debt, and they are getting 400 basis points more, but I am going to get off my soapbox. I did not take a red-eye last night.
MR. MARTIN: Himanshu Saxena, this is your favorite soapbox.
MR. SAXENA: We love tax equity. They're the best. [Laughter]
Look, I think if you want to see what happens when tax credits go away, just go south of the border and look at what is happening in Mexico. That is a live case study. CFE 20-year contracts were being priced at $20 a megawatt hour. I am talking about prices in the third auction. Those deals were highly financeable with 80% debt-to-equity ratios. Pricing on debt was in the 200s above LIBOR, because there is a bit of a country premium. A lot of European investors did these deals. I don't know how anybody makes money on a $20 PPA, but those deals were getting done.
Now you are seeing deals that are being done on a merchant basis in Mexico. Every other deal we see today in Mexico is merchant solar or merchant wind and, in many cases, projects are going completely merchant and the lenders are financing them. They are talking about 50% debt to equity. The pricing is higher, but the market is taking a view that it is a growing economy with 46,000 megawatts of expected power demand in the next 10 years. There is more risk, but is it any more risk than taking views on the value of energy in year 16 through year 35 in Texas? Or in California, where nobody knows how the markets will look in year 16?
MR. MARTIN: So Mexico is the future for us in terms of how a market works without tax subsidies.
Let's switch gears. I have two remaining questions. One of the transitions we are undergoing is to storage. Storage seems to add about a penny a kilowatt hour to the cost of a project. Does it feel like we are at a tipping point already? If not, does such a tipping point seem close, where all projects will be bid with storage?
MR. BRANDT: I would say 80% of the deals that we are seeing today are solar-plus-storage. Pretty much every solicitation for electricity has a solar option, so I think we are close to a tipping point.
MR. MARTIN: What complications does adding storage make for financing a project, if any?
MS. HELLEUX: Finding lenders that are ready to finance it can be challenging. Banks exist that have the mandate and knowledge of the technology. If your deal is small enough so you don't need all the banks, you need one or two, there is not really an issue. Anything larger may still be a challenge.
From a purely investor perspective, you have to make sure it fits in your mandate. Sometimes we go back to the old question: what is "infrastructure"? Is battery storage infrastructure? Does it make a difference whether it is behind or in front of the meter?
MR. MARTIN: Fair enough. Audience, any questions?
MS. NICKEY: Susan Nickey with Hannon Armstrong Sustainable Infrastructure. We have been talking about how tight a lot of these PPA bids are. Are you seeing import tariffs lead to project cancellations or to projects not being financeable?
MR. BRANDT: I can only say anecdotally that we hear from developers that they are surprised how expensive panel pricing is. We are hearing about acute supply shortages of bifacial panels. We are hearing about some deals that just aren't going to get done. I would say the impacts of tariffs are real.
MR. MARTIN: Last question, as we are at the end of our time. The theme this year is transition and raising capital during a period of change. What do you think we will be talking about next year?
MR. BRANDT: Elections.
MR. MARTIN: Probably. Anything else?
MS. HELLEUX: Even more focused investments.
MR. SAXENA: There may be more distributed generation. It is one of those things whose time is always still to come, but we continue to inch in that direction.
MR. MARTIN: C&I distributed? We already have a lot of residential rooftop solar.
MR. SAXENA: Small-scale distributed generation and more energy efficiency. We would like to make investments in that part of the business, and we don't know how because the opportunities are not there yet, but I think they are coming.
MR. MARTIN: Andy Redinger, you have been remarkably consistent from year to year. One of your themes has been yield cos. Will the return of yield cos in the United States be a theme next year?
MR. REDINGER: I was going to offer two themes. One is residential solar. Our business has changed so much to a point where it is distributed, distributed, distributed. A question was asked earlier, where's the bang for the buck? It is absolutely in residential solar.
MR. MARTIN: That is where Key is putting its resources at this moment?
MR. REDINGER: As much as we can. There are still very good risk-adjusted returns in that market segment. And yes, yield co 3.0. US-based companies are going public on the London exchange in US dollars, and it is starting to look like the yield co phenomenon of a few years ago. They are tapping into the investor base in Europe.