Obtaining financing is vitally important for renewable energy and other capital-intensive cleantech projects. These projects are typically high-leveraged, with up to 70-80% of the project total being financed through dept. That’s why the availability of financing and loan’s terms and conditions play a crucial role in project’s feasibility and profitability. From the lender’s perspective, when considering a project, a financier will usually prepare a risk-return analysis to assess the revenue projections and major risks that can potentially impact the project. If not effectively identified and mitigated, these risks will dramatically impact the amount, timing, cost and availability of financing. As a result, the type of financing available to renewable energy projects is largely dependent on the risk management approaches adopted by the project developers and the instruments available to mitigate real and perceived risks.
Today renewable energy companies become more and more experienced and many of them use with competence different risk management instruments, including long-term power purchase agreements with utilities, operating and maintenance contracts with experienced contractors , and transferring a part of risks to third parties. The most common mechanism of risk transfer is insurance, which plays an important role in supporting investment in renewable energy projects. It provides financial indemnification for losses arising from a defined set of causes, mainly from acts of nature, from human error and malfeasance and from other accidental causes. Cover for loss of income can be a critical issue from a lender’s perspective, as it affects a project’s ability to pay the loan. The traditional products which insurers respond to include: contractors’ risks; property damage; machinery breakdown; delays in startup/business interruption; errors and omissions; as well as legal liability and some financial risks. Initially developed for traditional industries, these insurance products are becoming more widely available in the renewable energy and cleantech sectors.
At the same time there are clear constraints on the types of risks that can be insured and on the magnitude of these risks that can be transferred to insurance markets. In fact, only some project risks are insurable – generally those that permit insurers to classify and price the risk. Insurers want risks which have: quantifiable losses; reliable estimates of claim frequency and severity; little potential for catastrophic loss; feasible premium levels; and a large pool of potential insured projects to distribute risk. One-off projects, innovative technologies and unfamiliar operating environments are generally not interesting for traditional insurance market. That’s one of the reasons why renewable energy and cleantech projects are still having a high level of perceived risk.
As the result, Alternative Risk Transfer (ART) instruments are evolving and can be adapted to meet the needs of the renewable energy sector. ART products are known informally as the derivatives of the insurance industry, and compared to traditional insurance products, they are still not familiar for many project developers, especially for small and medium-sized companies. In this context, basing on the report ‘’Financial Risk Management Instruments for Renewable Energy Projects’’ published by United Nations Environment Program, I would like to make a brief overview of existing alternative risk transfer instruments that could help renewable energy project developers enhance lenders confidence, and thus increase projects bankability.
Renewable energy projects naturally depend on weather, which is the most significant source of day-to-day uncertainty. Weather derivatives are used to protect renewable energy project’s revenue streams against the financial uncertainty associated with wind, precipitation and temperature variability. Temperature is still the most commonly traded weather product but other risks are gaining prominence. Wind power indices (WPIs) are available to wind farm developers in areas where there is sufficient data to create an index that is highly correlated to the wind flow into the turbine. As an example of wind insurance, a wind farm operator may choose to purchase an annual put option, struck at 95 Wind Power Index units. This would give him in return a compensation if the wind fall below that level, thus reducing his risk considerably. Similarly, precipitation and temperature indices are available.
Integrated multi-trigger products
Steep rises in insurance premiums have increased the attractiveness of products such as multi-trigger business-interruption policies that pay out for a disaster only if all “trigger” events occur. Multi-trigger contracts offer businesses a new way to cover risks that otherwise would be difficult to insure. For example, a dual-trigger policy pays only if both risk thresholds are passed. The probability that uncorrelated triggers are met is considerably lower than the probability that either one independently will occur. Accordingly, it costs less to insure all risks together. Trigger combinations typically link a financial index and a casualty event, such as an increase in the spot market price of electricity and an event that reduces electric power production capacity. For example, German reinsurance company Munich Re described a double-trigger deal recently done with the power company Aquila for business interruption risk for gas-fired turbines in the USA as follows: IF a gas-fired turbine faced an unscheduled inoperative period THEN the reinsurer would finance the purchase of power to feed the grid in Aquila’s name. The two triggers for activation of the product are: 1) An unplanned outage at the facility AND; 2) A spike in spot electricity prices – the contingent event for which the product would provide financial coverage. In the case of the spike in volatile spot electricity prices, it would be very expensive for Aquila to buy power from the market in order to meet its power delivery obligation to the grid.
Contingent Capital Structures (Synthetic Debt & Equity)
Contingent Capital Structures are a type of risk finance that can take the form of an insurance policy, a swap, an option, or hybrid security, such as a specially structured notes or fixed-term preference shares. The (re)insurer functions as a source of stand-by capital (risk finance) that can be called upon to replenish equity capital that gets depleted due to the occurrence of some contingent event. Since the customer may not want or be able to carry the cost of extra debt/equity capital to finance such contingencies, paying for “contingent capital” can be viewed (and valued) as an option. This option gives the holder the right to raise capital from an option provider at pre-defined terms upon the occurrence of a pre-agreed event for a pre-specified amount of time. The cost of purchasing the contingent capital commitment is less than the cost of carrying additional equity capital of the same amount.
Pledge of Shares
Pledging of shares is a mechanism where project developers pledge its holding shares to a lender for the purpose of securing debt. The project developer keeps his own stake as collateral for the borrowed funds. The lender of the debt maintains possession of the pledged shares, but does not have ownership unless default occurs. Pledged shares are returned to the borrower when all conditions of the debt have been satisfied. Private investors often need a pledge over other shares in a company so they can take control if the company defaults on its obligations. Pledge of shares may be a useful collateral instrument especially in cases, where the company structure and company laws are quite clear, but land property rights and mortgage laws are complex and risky.
Exchange risk instruments (swaps)
A swap is an agreement between two counterparties to exchange something (one “leg” of the swap) for something else (the other “leg”). These things can be anything that has a financial value. Cross currency swap is the most useful solution for renewable energy projects. Foreign exchange is a special concern for many renewable energy projects developed overseas. In this case projects typically generate revenues in local currency, while their financing costs and investment cost are denominated in U.S. dollars or other hard currencies. This creates the risk of a mismatch in the development of the exchange rate between the two currencies.
In order to understand how a swap works, let’s consider an example a US company with operations in Brazil, which can obtain comparatively better terms by borrowing dollars, but prefers a loan in Brazilian reals. At the same time, a Brazilian company with operations in the US can obtain better terms by borrowing reals, but prefers a loan in dollars. The two companies can go to a swap bank that will arrange for a loan swap. Assuming that the exchange rate between Brazil (BRL) and the U.S (USD) is 1.60BRL/1.00 USD and that both companies require the same equivalent amount of funding, the Brazilian company receives $100 million from its American counterpart in exchange for 160 million reals; these notional amounts are swapped. The American company now holds the funds it required in reals, while Brazilian company is in possession of USD. However, both companies have to pay interest on the loans to their respective domestic banks in the original borrowed currency. As a result, both companies will incur interest payments equivalent to the other party’s cost of borrowing. Consequently, swaps can solve the problem of foreign exchange risk at reasonable price, corresponding to premium charged by the swap bank.
Securitization of credits
The term credit securitization refers to the transformation of non-marketed assets into marketable assets, i.e. securities. It is the process of combining financial assets into a pool and then selling portions of that combined pool on the secondary market to institutional investors, such as pension funds. The resulting asset generally requires a credit rating from a rating agency assessing the risk associated with it. By allowing the original investor in a project to sell the resulting asset on the secondary market, securitization increases initial lenders’ willingness to provide low-cost capital. The process of securitization generally includes the following stages:
- In the first step of the credit securitization process the originator pools a number of roughly homogeneous assets.
- In the next step, the originator sells the assets to a special purpose vehicle (SPV), which is a trust or a corporation with the sole function of holding these assets.
- Finally, the SPV issues securities, which are sold with the help of a banking consortium in private placements or public offerings.
The payment of interest and principal on the securities is directly dependent on the cash-flows deriving from the underlying pool of assets (e.g. solar installations or wind farms). For example, in November 2013 SolarCity placed $54 million of securities backed by a pool of solar-power systems, leases and electricity contracts.
At the same time, in order to attract institutional investors, the resulting securities have to receive a high credit rating. Typically, institutional investors try to avoid complex projects with new unproven technologies. Furthermore, the capital markets currently consider renewable energy projects only if they exceed a certain size, which discourage the majority of renewable energy project developers from using securitization instruments. A viable solution that could solve this situation would be the aggregation of small loans and projects into investment products that meet the size and liquidity requirements of institutional investors.
Public sector instruments
Credit enhancement by the Multilateral Financial Institutions (MFIs) has proved to be an effective tool to mitigate perceived and actual risk. These instruments are mostly important for covering political and regulatory risks, as there is no insurance product at the moment to protect against a particular government changing or reneging on its renewable energy policy. In this context some major international financial institutions have introduced a variety of guarantee products that are well received by commercial banks and insurers.
For example, Partial Risk Guarantee and Partial Credit Guarantee provided by World Bank may cover up to 100 percent of a loan for specific political risks. These products cover creditors for specified sovereign risks arising from a government’s default on contractual obligations, or the occurrence of certain force majeure events of a political nature. As the result, these guarantees can enhance the credit rating, reduce the cost of financing and attract more capital for renewable energy projects. Today public guarantee products are receiving considerable attention, as they facilitate financing renewable energy projects in the fast-growing developing countries where the level of political risk is very high.
Obtaining financing for renewable energy and other capital-intensive cleantech projects is increasingly complex and difficult to negotiate, mostly because of the high level of risk perceived by lenders and investors. That’s why to attract financing, there is a fundamental requirement to manage risks that could have a negative impact on the project. Successful project finance structure can be achieved by transferring a part of risks considered unacceptable away from lenders and investors to third parties. Today there is a diverse range of risk management techniques, including common insurance mechanisms, as well as alternative risk transfer structures and credit enhancement products. At the same time, not all risks are insurable by traditional insurance markets and alternative structures – with the exception of weather derivatives – remain niche markets, often suitable only for very large projects.
One of the main obstacles to wider availability of risk transfer solutions and development of new and better risk management product is lack of industry information. Financial sector requires a better understanding of renewable energy resources, technology and operation risk. In order to bear risk in return for premium a (re)insurer must have sufficient information to be able accurately measure and quantify the likelihood and severity of losses from the insured events. The key to resolving this situation would be a closer cooperation between renewable energy and financial sectors. Since the renewable energy sector is rapidly evolving, industry expertise is not yet widespread, especially in financial circles. In this context, project developers have to initiate the transfer of thier knowledge about technology and industry to insurers and financiers in order to help them better understand all risks related to renewable energy.