A completed project in Panama. Source: Solarcentury.
Solar PV development is soaring globally prompting developers to expand into new regions. Whilst the technology may be the same, regional market fundamentals and transaction structures vary and can complicate entry into a new market.
Rob Eberhardt, Jeremy Hushon and Amala Nath of global law firm Norton Rose Fulbright compare and contrast the different innovations and challenges faced in financing solar PV projects in the United States and in Latin America.
What are some of the innovations in project finance that are helping contribute towards low cost in solar?
Robert Eberhardt (RE): There are a few notable innovations in the US market which are contributing to lower costs and greater liquidity in the finance market.
For several years now, commercial banks and insurance companies have joined to offer permanent hybrid bank/bond debt financing with a tenor that aligns with a solar project's expected useful life and the length of its offtake contract. The commercial bank tranche typically amortizes in full in the first eight or so years after the start of commercial operations. At maturity of the bank debt, principal repayment starts on the long-dated fixed rate note tranche. This structure allows a sponsor to borrow against its entire contracted revenue stream and avoid the risks of refinancing, while also allowing commercial banks to avoid the regulatory charges or other constraints associated with long tenor debt.
Community solar refers to an arrangement that seeks to facilitate utility-scale solar development by harnessing the interest of residential, municipal and commercial and industrial customers in buying clean energy directly from projects in their retail service territories. Under a community solar programme, a group of retail customers typically subscribe directly to purchase energy from a specific utility-scale solar project. The project is entitled to the payments made by the customers, and the customers receive a credit against their retail electric bill. The local utility receives the project's output, but often does not sign an offtake contract.
The lack of a traditional utility offtake contract presents challenges for traditional project financing, but some capital providers have extended credit to community solar projects after evaluating the details of the programme, taking views on customer credit quality and the ability to replace customers through new subscriptions, and perhaps financing community solar projects as part of a larger portfolio that includes more traditional projects. Many view community solar as a growth area in the US market.
Jeremy Hushon (JH): In Latin America, development banks are now offering extremely long tenors for solar projects and in some cases; tenors are now approaching the length of long-term power purchase agreements. Whilst the availability of long-tenor debt helps keep solar costs low, this development is having a chilling effect on commercial financing, both by local and international lenders, who are not able to offer such extended tenors.
Amala Nath (AN): At the smaller scale, an emerging trend in project finance Latin America is the packaging of small-scale solar schemes to create economies of scale, at least for financing purposes. There are cost savings associated with developing and financing these projects as a series of small-scale portfolios (1-3MW each) with shared common infrastructure and shared, competitively priced EPC and O&M arrangements. The profile of the sponsors developing these types of projects varies somewhat from the traditional large-scale project development companies. For instance, on our projects in El Salvador, the sponsor is a New York-based private equity fund, which through two of its funds organised in Delaware, owns all of the borrowers and the project contractors (some of which are located in other neighbouring Central American countries).
Another aspect contributing to lower costs on solar (and other renewable) financings in the region is the use by sponsors of affiliated companies to undertake all of the development, management, construction and maintenance work, which allows them to keep cash-flows in-house rather than dealing with third-party contractors. However, a potential concern for development finance institutions and other lenders with these sorts of arrangements has been ensuring that the fees (and particularly any success or management fees) being paid to such affiliated entities are reasonable and on arms-length terms.
What financing structures do you tend to encounter?
RE: A typical financing structure used for greenfield utility-scale solar projects in the US includes the three sources of funds. First, a construction loan provided by commercial banks. Second, an equity investment from a financial institution, insurance company or other US taxpayer made primarily in exchange for a fixed return based on a combination of cash distributions and federal tax incentives (including the federal investment tax credit). Third, funds from the sponsor or third-party equity investors, which can be funded in part through debt borrowed at a holding company level, including from some or all of the commercial banks that provide the construction loan.
The construction loan often can be used to fund the bulk of construction costs. It is repaid in full at the start of commercial operations with the other sources of funds. Once this happens, there is little opportunity to raise debt at the project level until the equity investors receive their fixed rate of return.
JH: We see a variety of structures in Latin America but generally speaking, projects are less highly leveraged than in the US Many transactions use traditional project finance structures where debt is lent into a special purpose vehicle which owns the project assets and sponsors contribute equity to that ring-fenced vehicle via share capital and shareholder loans. However, there is also an emerging market for green project bonds which we are seeing in countries such as Brazil and Mexico.
Are there any important sources of funds investing in solar?
RE: Pension funds continue to be an important source of long-term equity capital for US utility-scale solar projects. The long-term contracted revenue streams from US electric utilities associated with many US solar projects, with limited commodity exposure, have proven a good match for the time horizons and risk tolerances of many of these funds. Investments can be made through private equity funds, or increasingly, on a direct basis. Some pension funds have sought higher returns or strategic relationships with key sponsors by making development or construction-stage investments.
JH: Development banks are still an important source of debt finance for renewables in Latin America. We expect to see an increase in commercial bank involvement in construction financing as the appetite of institutional investors and the bond markets continue to grow.
What are some of the ongoing factors that keep the cost of capital persistently higher in some regions than others?
RE: In the US, federal tax incentives – in particular the investment tax credit (ITC) – have helped to spur remarkable growth in the deployment of utility-scale solar projects. A large and growing US solar market in turn has helped to further drive down capital costs. However, the reliance on the ITC also has compelled developers lacking US taxable income to use complicated financing structures to monetise the ITC. The complexity and idiosyncrasies of this "tax equity" financing market results in a higher overall cost of capital than one might otherwise expect for US projects.
JH: A major issue in Latin America is the lack of adequate investment transmission systems. In many countries, particularly in Central America, technical experts are concerned that antiquated and insufficient transmission coverage will be severely tested by the variable output of solar (and wind). This risk is certainly having a damping effect on new renewable projects in the region. On the flip side, advancements in solar and storage present a possible solution to the problem. Storage technology may reduce the variability of loads on the transmission systems and also assist in localizing projects to energy needs.