[authors: Kyle W. Drefke, Christopher Gladbach, and Ben H. Davidson]
This article originally appeared in the September 3, 2012 edition of Power Finance & Risk.
Participation in renewable energy projects by institutional investors has been increasing over the last few years, particularly in Europe. In a low interest rate environment like the U.S., the return profiles of these projects are becoming increasingly attractive to these types of investors reaching for additional yield. Institutional investors should be interested in a few trends that are emerging in the renewable energy finance sector.
Renewables & the Bond Market
Despite general economic uncertainty, the renewable energy sector has continued to make strides in recent years. Last year renewable energy facilities (excluding large hydro-power) made up 44% of all new generation added worldwide, up from 34% in 2010 and only 10.3% in 2004. But in the U.S. and elsewhere, the industry is confronting a few substantial headwinds and uncertainties, including policy uncertainty in the U.S.
One of the key financing components for U.S. wind projects, the U.S. production tax credit, currently is scheduled to expire for projects not placed in service by the end of 2012. Sponsors are hurrying to install wind projects before the year-end, and industry forecasts are calling for a dramatic drop-off in wind installations in 2013 if the production tax credit is not extended. The U.S. Department of Treasury cash grant in lieu of investment tax credits only remains available for projects that met fairly liberal “start of construction” criteria by the end of last year. Although the investment tax credit is available for solar projects placed in service by 2016, the recent expiration of the Treasury cash grant is leading some in the field to forecast a “tax-equity gap” between tax-equity financing demand and actual investor tax appetite for financing.
Continuing global macro-economic difficulties and the near-term prospect of heightened capital requirements under Basel III are also beginning to constrain the lending capacities of large financial institutions, the traditional sources of financing for U.S. renewable energy projects. As a result, several European banks have recently exited the project finance debt market, and other bank participants in that market are increasingly inclined to lend on mini perm tenors with shorter average lives. The notable exception to this general trend are the Japanese banks, which have recently increased their lending activity in the renewable sector, and have shown some preference to lend for longer terms.
Given these constraints in the tax equity and lending markets for renewable energy projects, sponsors may be seeking alternative sources of both debt and equity capital at more attractive yields. At the same time, the hard costs of developing and constructing renewable energy projects continue to decline—Bloomberg New Energy Finance reports that in 2011 solar photovoltaic module pricing declined over 50% and onshore wind technology declined between 5-10%. And sponsors are focusing on the cost of debt and equity capital for these projects as another lever in reducing the overall installed costs of renewable energy facilities. This confluence of factors is leading sponsors and developers to begin to explore non-bank institutional investments from pension funds and insurance companies through project bond offerings and direct equity participation.
A couple of large project bond issuances in 2011 and 2012 have shown that for certain types of renewable projects, capital markets bond offerings under Rule 144A or the debt private placement market may present attractive alternatives to bank financing. These bonds usually have longer tenors that more closely match the terms of a project’s power purchase agreements, the interest rates are usually fixed, and the covenants regarding the day-to-day operation of the project are often less restrictive than covenants in bank financings.
On the downside, project bonds typically include a prepayment penalty or make-whole premium. Because all the funds are drawn at closing rather than as needed (with some availability for delayed draws in the private placement market), for projects that have long construction timelines, they also may impose significant negative arbitrage costs. And the transaction costs for project bond deals are also generally higher than bank financings, particularly for Rule 144A transactions which require ratings and the additional disclosure that customarily accompanies those offerings.
The U.S. Department of Energy (DOE) loan guarantee program catalyzed the resurgence of the 144A and private placement market in the last few years, although much of the program's capacity to guarantee new loans expired in September of 2011. These transactions often employed hybrid financing structures that relied on capital markets components, bank financing and sponsor equity. The financing of the 845 megawatt Shepherds Flat wind facility is a good example of a hybrid structure that combined a shorter tenor $675 million floating rate bank financing facility, $231 million in letter of credit facilities, and a $525 million private placement of debt that were each partially guaranteed by the DOE. Another is the 550 MW Desert Sunlight solar facility that included approximately $600 million in private placement bonds partially guaranteed by DOE with over 20 institutional investors participating.
Proponents of capital markets and private placement financing are now able to cite a more recent deal that did not rely on DOE guarantees as additional evidence of increasing possibilities: the $850 million Rule 144A offering to finance the 550 MW Topaz solar facility located 190 miles northwest of Los Angeles. This transaction was heavily oversubscribed and was upsized from an initial offering of $700 million—the spreads were very tight for renewable project finance debt at a 380 basis point spread over the corresponding U.S. Treasury security.
Each of these transactions benefitted from being well structured projects by well known, experienced sponsors. Many other sponsors are increasingly looking at this deal as a potential model for accessing the more liquid and deeper Rule 144A and private placement markets typically inhabited by pension funds and insurance companies. As wind and solar become more mature technologies and investors and rating agencies become more comfortable with renewable energy projects, we expect to see more activity in the Rule 144A and private placement markets for well structured, utility scale deals with strong offtakers and experienced, well-known sponsors.
Direct Equity Investments
In addition to the recent successful capital and debt markets renewable energy issuances, institutional investors, particularly pension funds and insurance companies, may also have a greater role to play in direct equity investments in renewable energy projects in the future.
Although a few major insurance companies in the U.S. have been notable participants in the U.S. renewable market for several years and have made sizable direct equity investments in renewable generation, much of the recent growth of institutional investing in renewable energy has been in Europe by European pension funds and insurance companies. The vanguard of this trend is PensionDemark, one of Denmark’s largest pension funds, which has said that it aims to hold more than 10% of its assets in renewable energy investments. European insurance companies have shown interest as well; Munich Re and Allianz both recently announced plans to invest over €2.5 billion and €1 billion in renewables, respectively. And Canadian pension funds have also been looking to make direct investment in U.S. renewable energy projects. Whether this recent growth in European and Canadian insurance company and pension fund renewable participation will gain traction in the United States is an open question.
At present global pension funds hold less than one percent of their assets in infrastructure investments, and renewable projects are only a percentage of those holdings. With U.S., German, Japanese and UK 10-year yields at around or below 2%, institutional investors are seeking higher yielding products out on the risk curve with low correlation to the returns of other assets. With the recent global focus on sustainability, an added benefit of these investments is that they allow institutional investors to burnish their green credentials.
Because renewable energy investments have low operating costs and often zero fuel costs, the return profiles of direct investments can be more or less predictable and can resemble the return profiles of other infrastructure investments such as toll roads. The risk profile of renewables can also be attractive: institutional investors like pension funds or insurance companies may choose not to participate in the development or construction financing but could look to invest in completed projects that may have some operating history.
Significant barriers to entry exist for institutional investors that have not been major participants to date. Some types of highly structured renewable investments—especially tax equity investments—can be complex, and the ability to execute successful investments in this area requires a strong understanding of the energy industry and specialized legal and accounting structuring or working with experienced advisors familiar with these types of transactions.
For pension funds, which are not taxable and thus would be looking to take cash equity positions, co-investment in projects employing tax equity also poses some problems. For example, these investments are usually structured to provide tax equity investors a preferred return until a predetermined internal rate of return is achieved. This structure defers cash distributions to cash equity investors for some period, which can extend to 7-10 years depending on the success of the project. Transfer limitations imposed by tax laws and typical project partnership agreements also make these investments less liquid than institutional investors may prefer. These problems may be mitigated through transaction structuring or delaying investments in projects until the tax credits are exhausted.
Some organizations such as private equity funds and fund arms of some development banks are tailoring unique investment products designed for pension funds to overcome these hurdles. This development may go a long way to resolving the “learning curve” problem associated with renewables. For pension funds, the essence of the “learning curve” problem is that examining project specific risks is really very different than analyzing a publically traded stock, or for that matter, the management team and track record of a private equity or hedge fund. Analysis of renewable project investments requires a dedicated team that is specifically trained to spot values in the industry. Pension funds may be reluctant to invest in-house teams, but may be comfortable in relying on outside expertise (including the kind of expertise of a private equity fund specializing in renewables) with a proven management team or track record.
These trends highlight a growing need to address the liquidity constraints that are prevalent in the bank debt and tax equity markets, which have historically been the principal source of funding for renewable energy projects. Sponsors and their advisors are beginning to look to new, cheaper sources of financing and transaction structures for their renewable energy projects. These include sources like the project bond markets and non-bank institutional investors. Other sources of funding also receiving consideration include master-limited partnerships, real estate investment trusts and securitization of cash flows through asset backed financing. As the industry matures, we expect that non-bank institutional investors will play a substantial role in financing new renewable generation through participation in the project bond market and direct equity investments.