Chapter 6 Overview of the Development and Financing of
B. General Issues For All Projects
Below is a brief description of the general risks that are common to all renewable projects. 58
1. Completion Risk Completion risk is the risk that a project will not be physically constructed on time or on budget and satisfactorily constructed in accordance with applicable specifications and guaranteed performance criteria. The degree of comple- tion risk inherent in a project is a function of three factors:
(a) the level of technical risk involved in the project (projects with simple and well-proven designs, technology, and technical requirements carry lower risks);
(b) the technical capability and financial strength of the contractor(s) and major subcontractors; and
(c) the level of guarantees and sureties provided by the contractor or other third parties and the respective capacity of such parties to perform their obligations under the applicable construction and/or equipment supply agreements.
Most lenders would prefer that completion risk be allocated to a single contractor through a “turnkey” construction contract. In turnkey contracts, the contractor under- takes to build a fully operational facility for a fixed price and will agree to “wrap” any technology risks and the performance by underlying subcontractors. Having a fixed
58 See Chapter 8 for a more detailed discussion of risks that are specifi c or unique risks to a particular type of renewable energy project.
price and fixed scope turnkey construction contract adds certainty to the cost of the project, which, in turn, results in lower financing costs and increases debt capacity.
In many project financings, however, contractors are not willing to build projects on a turnkey basis at an acceptable price because there are too many risks (including reli- ability of local workforce, political instability, import restrictions, and customs con- trols) to enable the contractor to be confident that the project can be built for a specified price. In addition, market conditions can be such that construction firms have leverage to accept lower risks and dictate more favorable terms. Further, differences in market- standard contracting arrangements generally reflect historical patterns and the nature of the relevant technology. Quite often, in building a wind power project, the wind turbine supplier erects the turbines at the project site, and a separate contractor handles the civil works for the balance of the plant: the pads for the towers, access roads, and transmission and interconnection facilities. In other projects, the various components to be constructed are distinct, with significant differences in required skills and tech- nology, so that no single contractor can provide efficiently the full range of technology or skills required to construct a project.
Where turnkey contracts are not generally available in the marketplace or to avoid the incurrence of a “turnkey” premium that might render a project uneconomic, com- pletion risk can be directly assumed by the project sponsors through completion guar- antees issued to the lenders or by affiliates of the project sponsors which act as the turnkey contractor. These completion guarantees can be limited to ensuring physical completion of a project or can extend, for example, to ensuring the maintenance of all financial projections at the time of completion.
2. Offtake (Revenue) Risk Offtake risk is the risk that the demand for the project’s energy or other output will diminish or that other, less costly suppliers will enter the market. The offtake contract or power sales agreement is central to the financeability of a project. Most lenders require a project to have in place a long-term offtake contract of a duration beyond the term of the proposed financing with a sufficiently creditworthy party to ensure that a stable source of revenues will be available for cov- ering the operating and maintenance expenses and the debt service requirements of the project.
Where the offtaker or power purchaser itself lacks an acceptable credit standing, it might be necessary for the offtaker to provide credit support or a guarantee from a creditworthy party to secure the offtaker’s performance under the offtake contract. In baseload thermal projects, the revenue stream from offtake contracts is typically divided into (1) a fixed capital cost component and a variable operating cost compo- nent, or (2) a capacity payment and an energy payment. The capacity payment is gen- erally sized to cover fixed charges (such as debt service, equity return, fixed operating charges, taxes, insurance premiums, and administrative overhead), while the energy payment covers the variable operating costs of a project. In the case of renewable proj- ects, however, where energy can be intermittent, depending on the energy source, the offtake contract is more likely to be structured as an energy-only tariff.
Due to the various RPS requirements adopted in many states, it is often the case that a renewable project developer will be able to obtain a long-term power purchase
DEVELOPMENT OF RENEWABLE ENERGY PROJECTS
agreement (PPA). During 2006 through 2008, however, developers of several renew- able projects were able to secure project financing without entering into long-term off- take contracts through the use of one or more commodity hedge arrangements. 59 These can include futures or forwards contracts (standardized agreements for the sale of some commodity at a specified time and price), or options (including puts and calls affording the holder the right, but not the obligation, to sell or acquire a commodity, like power or gas, at a specified price). However, the market for these types of derivative contracts remains under development and some hedges have proven to be uneconomic.
A very small number of wind energy projects have been financed without a long- term offtake contract or hedging arrangement. These merchant power financings were effectuated for projects that sold power into well-established, functioning, and liquid spot markets, where market forecasts reflected limited price volatility and a market clearing price that supported the economic viability of the project. The merchant plants were also required to have adequate transmission arrangements that do not pose a sig- nificant risk of curtailment and/or subject the project to high imbalance penalties. The small group of lenders willing to finance a merchant power project have required sig- nificant levels of equity or contingent equity support and/or funded reserves, as well as cash sweep requirements. The merchant power project lenders must have a high level of comfort with low operational costs relative to historical market energy prices and forecasted prices, as well as a high level of comfort with the wind resource. Since the tightening of the credit markets in September 2008 and the lack of correlation or power and gas hedges in certain markets, it is unlikely that lenders will be willing to provide financing for renewable projects without a long-term PPA with a creditworthy offtaker.
3. Operating Risk Operating risk is the risk that (1) the cost of operating and main- taining a project will exceed its budgeted forecasts; (2) the project will be unable to perform consistently at a level sufficient to meet performance criteria; or (3) the proj- ect’s operation will be interrupted by the acts or omissions of the operator.
The operator must have the financial and technical expertise to operate the project in accordance with the cost and production specifications that form the basis of the feasibility study. Necessary skills extend not only to routine operations, but also to undertaking major overhauls of complex equipment (which can be separately subcon- tracted to the relevant equipment supplier). The operator might be an independent company or an affiliate of the project sponsors. Although operators generally resist underwriting the full operating risk of a project, a well-crafted agreement pro- vides sufficient incentives to ensure compliance with industry standards of perfor- mance. To the extent that the operator does assume the risk of operating cost overruns, debt and equity investors can place greater reliance on the certainty of the financial projections.
In addition to skilled operators, a good management team is crucial to the success of a project. Management personnel make basic policy decisions, arrange financing,
59 See chapters 15 and 17 for a discussion of the hedging arrangements that have been used in certain renewable energy project fi nancings.
provide information to lenders, and investors, and take responsibility for monitoring and administrating the project company and its contractual obligations. Management also controls the ability of the project to maintain production levels. Thus, the manage- ment team must be experienced, reliable, and serve as a bridge between sponsors, operators, customers and vendors, and lenders.
4. Resource Supply, Fuel/Feedstock, and Transportation Risk Each project must have sufficient renewable energy resource to meet the project’s financial forecasts.
This means that biomass and biofuels projects must have a guaranteed and steady supply of fuel and raw materials (at a cost that does not significantly exceed the provi- sion for those costs in the project’s financial forecasts). While wind, solar, and hydro- electric projects benefit in that nature provides their “fuel” without cost, it is particularly important in a renewable energy project that the characteristics of the renewable energy resource be thoroughly studied, modeled, and analyzed. To the extent that the project relies on a single source of supply, as may be the case, for example, with projects fueled by the wind or the sun, investors focus particular attention on the availability of the project’s renewable energy resource (that is, the wind or the sun).
In a wind project, a neighboring wind project can interfere with the availability of the wind resource at the project site. Potential detrimental impacts to the wind energy resource can be mitigated by acquiring wind rights to adjacent lands or entering into build-out agreements with neighboring or planned projects. These agreements typi- cally call for compensation to an existing project upon the completion of a new project, based on an analysis of the wind interference effect of the new project.
To enable a project to be constructed, serviced, and operated — and to deliver elec- tric power — it is often necessary to build new road and transmission infrastructure.
These ancillary improvements are often completed by parties other than the project company. Adequate transmission availability is particularly challenging for remotely located renewable energy resources. New transmission lines are expensive and can take years to site, get approved, and construct. The risk that the necessary infrastruc- ture will not be completed in a timely manner must also be addressed. With existing transmission lines, it is important to investigate whether the transmission lines can support additional electric current. A technical analysis from a transmission consultant of an existing transmission line’s capacity is crucial. Such analysis should address a variety of dispatch scenarios, as well as projected generation growth in the area.
In addition, a project must have access to replacement parts and materials. The choice of a turbine supplier, for example, gives rise to various concerns in respect of the turbine’s warranty and the availability of replacement parts.
5. Environmental and Social Risk The construction and operation of renewable power facilities may emit some waste and pollutants into the air, water, and soil, and in such cases will require permits and other authorizations to construct and operate. Environmental concerns have become more prominent as a result of increased public awareness, more stringent environmental, health and safety laws, permitting requirements, and height- ened liability for the identification and cleanup of hazardous materials and wastes.
Regulations to moderate harmful emissions usually exist on a national level and
DEVELOPMENT OF RENEWABLE ENERGY PROJECTS
sometimes also exist on the local levels. These regulations often require studies of the impact of project construction and operation on the natural and social environment and authorization of the project to regulate harmful emissions and impacts.
There are three primary environmental risks to a project: (1) liability for the dis- charge of contaminants into the environment; (2) availability and uncertainty in envi- ronmental permitting; and (3) changes in laws and enforcement priorities that tend to make environmental requirements more stringent over time. The United States — like many countries — regulates contamination under a “polluter pays” regime.
Contamination at a project site could give rise to liability and requirements that the polluter investigate and remediate the contamination. Permitting risk arises from con- cerns about whether a project will be able to obtain permits to construct and operate on terms that are favorable and not unduly burdensome or unfair. Change-in-law risk acknowledges that environmental laws tend to become more stringent over time, often requiring capital upgrades for additional pollution controls or the acquisition of pollu- tion credits.
Lenders and equity investors generally seek assurance that their involvement in projects will not expose them to liability for hazardous discharges or any type of envi- ronmental problems. In some jurisdictions, for example, the owner or operator of a project (which could be the lenders following foreclosure) might face liability for cleaning up soil contaminated by waste discharge committed by prior owners or oper- ators. If the project site is acquired or leased, the project company might seek the benefit of an appropriate indemnity from the seller or lessor for any past or existing environmental problems. In any event, lenders usually obtain advice from experienced counsel in relation to environmental laws and liability.
6. Force Majeure Risk Force majeure is a legal concept that encompasses events that are reasonably beyond the control of parties to a contract that may frustrate or impair the performance by any of them of their contractual obligations. The principal legal issue in relation to force majeure is the extent to which contractual commitments can be relieved if a party’s performance is rendered more difficult or even impossible.
Force majeure is often analyzed under two categories: insurable and uninsurable risks.
Events such as fires, earthquakes, and similar acts of God may be insurable. Other events, such as labor strikes and changes in laws are not typically commercially insur- able, and exposure to these risks must be assessed.
To the extent a project’s ability to perform its contractual obligations can be affected by force majeure, it is important to consider first whether the project will be relieved of liability for breach of contract if force majeure occurs and, second, whether the project can withstand the disruption caused by force majeure. Likewise, the project documents must be reviewed to assess the extent to which the project’s suppliers and offtakers are relieved of liability to the extent their performance is affected by force majeure. It is important to ensure that the respective force majeure provisions in the various project contracts are consistently defined so there are no mismatches under the various project contracts. 60
60 See Chapter 12 for a specifi c discussion of force majeure clauses under New York law.
A. COMMERCIALLY INSURABLE RISKS
The development of a comprehensive insurance program is perhaps the most signifi- cant means to manage force majeure risk. 61 The construction and operation of a tech- nologically complex facility raises a host of risks that have to be assessed and in many instances insured. Lenders and most sponsors will not generally allow themselves to assume the risk of acts of God or similar events (such as storms, floods, earthquakes, and the like). A typical insurance package will include “all-risk” coverage during con- struction, with a delay in start-up coverage extension. The basic coverage will address the cost of replacing any lost or damaged equipment and the extension will cover increases in financing and other costs arising from delays in completion. Once the facility has been completed, the builders “all-risk” policy will be replaced by property and operating insurances with business interruption extensions that are similar in scope (covering lost revenues) to the delay in start-up coverage. Appropriate coverage for third-party liability is also generally required.
The insurance package is generally reviewed by an adviser to the lenders to assess its adequacy. The principal commercial issue will be to weigh the scope and amount of coverage against its cost. The project lenders will generally desire that losses to the project be insured on a replacement cost basis and will resist significant deductibles.
The project lenders will also seek an assignment of all insurance proceeds (other than those related to third-party liability) and will require that they be named “loss payee”
in respect of property and similar insurance. The project lenders may be concerned to the extent that applicable law will allow the vitiation of insurance arising by reason of misrepresentations or breaches by the insured. There have been cases in which insurers had alleged that the insured did not adequately disclose the full scope of risk and have thus argued that the insurance was void. The project lenders may require separate cover or indemnities to address the risk of vitiation. In some jurisdictions, insurance can only be placed with a national insurer, with the risk being reinsured with interna- tional insurers. In these cases, the lenders may seek “cut through” or similar clauses, allowing them to achieve direct recourse against the reinsurers in the event of failure of payment by the primary insurer.
B. UNINSURABLE RISKS
The assessment of uninsurable risks is perhaps more art than science. These uninsur- able risks include changes in the regulatory regime, changes in tax laws and other laws, as well as factors such as availability of local labor and political conditions (such as, community support or opposition) which must be considered. Predicting the stabil- ity of these conditions through the life of a project is difficult at best and appropriate contingencies should be factored where possible.
61 See Chapter 22 addressing insurance considerations.
DEVELOPMENT OF RENEWABLE ENERGY PROJECTS