The continuous reduction of solar energy tariffs is a process that has until now focused on capital expenditure and O&M costs. Cost reduction on those items will reach its limits and the strive for even lower solar energy tariffs needs to be satisfied through other means. A main contributor to pricing of energy tariffs is the cost of capital required to finance the projects.
To date financing institutions have largely protected their margins given certain funding limitations in the markets and regulatory boundaries imposed on them. Can bond financing be an instrument for reducing cost of capital for solar projects?
Generally, banks will at a certain stage of a project roll the debt and sell whole or parts of it to the capital markets. Financial investors take comfort in the structuring capabilities of the bank’s in-house credit teams that allow the banks to take financing risk. Banks take a margin from the project for arranging the debt and an additional margin for having de-risked the project when selling the debt on to the capital markets at a discounted rate.
Since financial investors are the ultimate source of funding, what prerequisites need to be fulfilled to enable a project to get financing straight from the capital markets and avoid the banking charges? And are those costs significantly lower than a traditional bank financing approach?
The general nature of the infrastructure project lends itself to bond financing. In most cases a renewable energy project has a power purchase agreement (PPA) that will secure the cash inflow over a period of time exceeding the payback period of the bond. These PPAs, if not with governmental agencies, are signed with reputable utilities or IPP companies operating in the local market.
After the construction period no significant or unforeseeable (operating) costs have to be borne by the project, which reduces risk and allows a steady cash flow during the payback period of the bond.
This said risk evaluation and de-risking of the project are key for a successful placement of a paper.
For the evaluation of infrastructure credit risks sponsors can turn to the classical credit rating agencies that will provide a neutral risk assessment for the financial investor. These assessments are quite similar to the ones prepared by the bank’s internal credit teams. In addition rating agencies provide a high level of transparency to the financial investor and allow the investor to qualify the risk assessment based on data made available through the reports.
The pockets of money available in the capital markets and the pricing depend on the rating. Project bonds generally need to achieve a rating between A and BBB. Selecting the right partners and providing certain protections from those credible partners to the investors such as extended guarantees or security mechanisms are paramount to reduce exposure and enhance the rating.
The knowledge of how to structure the project to effectively de-risk it and receive the targeted rating resides with the sponsor choosing the partners and negotiating the EPC and O&M documents. Sufficient in-house experience is necessary to understand the leverage of the guarantee structures and credit worthiness of the supplying partners.
A bond financing is a ridged structure as financial investors are generally unanimous. In those cases where a modification of the bond documents is required (e.g. delay of project beyond the contingency period) the typical mechanism of passing through a trustee to get approval for the change of documentation is more complicated and potentially more time consuming than talking to a bank with project finance experience to reach a solution.
When raising a bond that covers the construction phase there is a significant cost of carry as the coupon needs to be paid also on the unutilised capital. This may take away a significant part of the upside of the lower cost of funding through the bond.
The bond financing is a novel instrument and full market acceptance will only be reached over time. Consequently, pricing may be higher than for an investment into a corporate bond with a similar rating.
Soitec decided to engage in a bond financing process on the back of the outlook to reduce the cost of funding in its 36MW project in Touwsrivier in South Africa. Given the high cost of financing in the South African markets the margin differentials have been quite attractive.
The rating process was extremely efficient also given that all documentation was in place prior to engaging with the rating agency. Soitec has had an excellent reception of the instrument in the capital markets. Some investors have been waiting for an opportunity to directly invest into such a project rather than going through a bank. Nonetheless financial investors took more time to understand the documents than for a usual bond as the structure was more complex than what they are used to see.
Bond financing is generally a feasible alternative for financing solar energy projects. The longevity and the low cash inflow risk supports this approach as long as the project is structured in such a way as to sufficiently protect the bond holders; but not necessarily more than what a bank would require.
There are currently only a few renewable solar bonds placed. With more of those instruments in the market financial investors will become more comfortable which will have a positive effect on pricing of such instruments.
An optimised structure would consist of a traditional construction financing and once the project is in commercial operation a bond refinancing to avoid the cost of coupon payments for non-utilised capital during the construction period.
Holger Janke is VP of project finance, focusing on the structuring and financing of Soitec’s solar projects globally and lead the bond listing of the Touwsrivier project in South Africa