How can a renewable energy developer break the chains and provide more value, getting a bigger piece of the project pie? From PLA to financial closure to EPC and O&M. How can it be done?

Renewable Energy developer’s major problem is getting from PLA to financial closing on its own, that is the point at which the developer will receive money for all its efforts and the project begins construction. When you reach this stage developers are faced with a painful decision; sell the PLA for a song and a dance or go for a larger gain by completing the development work.

Shovel ready does not mean having a PLA and PPA. This requires having negotiated, not indicative, contracts with everyone involved including main suppliers, EPC, O&M, feedstock suppliers and more. Then you require an optimized debt/equity structure with at least an indicative term sheet from a financial institution that will provide good conditions on the leveraging which is absolutely crucial to getting the required returns needed. This is when you bring in a serious equity investor. And, by the way everyone and everything has to be bankable (usually investment grade). This requires a good amount of money, a lot of expertise and resources and your average financial advisor or generic investment banker can normally not do it, you need an expert renewable energy advisor. All of this is expensive, can you really do it on your own resources? How can you overcome these hurdles?

 

Source: Bauhaus Capital Partners - Green Giraffe

The answer of course is to raise funding but there are as many models that developers use to fund their own activity as there are renewable energy technologies. Many developers are opportunistic in the sense that they have prime locations, access to some PLAs by chance or some actually turnover projects and do churn through a continuous deal flow, but very few break out of the developer trap and make it into other parts of the value chain like being able to take things from PLA to the full development necessary to reach financial closure and not even mentioning going for the EPC and O&M work which has even more value added. If you want to break out of these chains there are some things that you need to know that can give you the power to choose.

What are the roadblocks to moving up the value chain?

Moving up the value chain by the way is the same thing as saying that you will become a larger player as such you will control and invoice a bigger portion of the project and be in a better position to be a consolidating agent than a consolidation victim. It means more cash and more control of your destiny. It means a better negotiating position with investors and suppliers, but to be able to this requires cash which is in short supply if you are funding a deal flow you don’t want to go to an external equity source and face dilution so early on. Getting a loan is hard enough and would probably not be sufficient and would merely end up as working capital anyway for more deals and you be back at square one compounded by even more development deals.

Even if some how you miraculously manage to get sufficient cash to acquire the resources to finish the development work and maybe even provide the EPC and O&M work you are still not bankable, so you are stuck again. Your track record does not provide the credibility required by investors and banks and your financials probably don’t either. Even if you do convince these two parties, your cost of capital will be way too high to provide an attractive return and you will have an un-fundable project. You need a good level of WACC.

The WACC hurdle

Tne important tool to utilize in the initial stages of a project opportunity pre-feasibility analysis is to calculate the Weighted Average Cost of Capital. Using the WACC formula, the cost of capital to the project is estimated, which is then compared to the financial internal rate of return on the project. In determining the merit of the project, a FIRR in excess of WACC (again, all else being equal) is used as a threshold for accepting the project for investment.

The cost of each capital component and risk factor premium is "weighted" by its proportion in the overall capital structure of the project, which is determined by the debt/equity ratio, otherwise known as "leverage ratio" of a project. To illustrate, the weight on debt in a 60/40 leveraged ratio would be 0.6, multiplied by the interest rate on the cost of debt (i.e. loan) for a project. The cost of equity component is calculated similarly: the "weight" on the equity portion is multiplied by the return on equity derived through the application of CAPM. The formula for WACC calculation is provided below:

WACC = we*re + wd(1-T)*rd

Where re is the cost of or required rate of return on equity, rd is the cost of debt, we is the amount (weight) of equity, wd is the weight on debt, and T is the tax rate for tax-free debt environments.
While it is easy to determine the cost of debt represented by the interest on the loan, it is more challenging to calculate the cost of equity. This is what the investor will expect as a return from your project plus a risk premium. In either case the more risk your project offers due to lack of track record or weak financials your WACC will skyrocket destroying your return. What can you do?

Lowering the WACC and getting on the road to more value

Allocate risks to the parties most suitable to manage/control the risk (Partner with someone bankable). In competitive markets, it is crucial to identify and allocate risks to the relevant parties in the project. For example, partner with a larger company perhaps a foreign company that is aggressively looking at entering your home market. Typically they will provide cash, equity access to financing and share the work with you and help you build a track record and strengthen your financials. You will provide invaluable local knowhow and negotiate to provide part of the work. This will start you on the road to your own track record and stronger financials. These can be provided by international boutique advisors.

Source: Aswath Damodaran

Consider adjusting the leverage ratio to reduce the overall cost of capital to the project. Lenders ultimately determine the amount of leveraged debt in the financing of a project, which is normally less costly than equity. Lenders will demand that there is adequate equity component in the capital structure of the project, which serves as insurance and an indication of commitment on part of the project sponsors in the outcome of the project.

Consider less capital-intensive or tried and true technologies. Finally, in the process of reducing costs and becoming competitive and reliable service providers, power utilities will be forced to consider new fuel and technology options, giving preference to the choices with least cost, safest technologies and shorter construction periods. New long-term investors will favor environmentally sound technologies in renewable energy resources, which will become more of practice than innovation in the years to come.

Utilities and government must demonstrate a commitment to cost reduction and cost recovery programs. Power market liberalization should provide incentives for utilities to minimize their costs in order to be able to successfully compete in the market and make sufficient margins. Utilities are likely to seek more favorable fuel arrangements, labor management strategies, cost effective O&M planning, etc. It is important for utilities to be able to demonstrate to potential investors and lenders that they have a viable plan in place to reduce the costs and achieve cost recovery under all scenarios and that the government will fully support such reform initiatives.

Reduce regulatory risks. One of the goals of market liberalization should be reduced regulatory risks faced by utilities that are normally providing the PPA and signing the long term REC contracts. It is important to operate in locations where governments and regulatory bodies clearly delineate the regulatory functions and manage/rule in a consistent and effective manner. This will only increase the confidence of all stakeholders in the regulatory processes and allow the consumers to reap the benefits of liberalization.

 

Comments

[Form ADV]

Bigger incentives from the state would help alot too.

[stock ideas]

I agree w/ the above. Incentives are the best to get development started.