Renewable Energy And The Resurgence Of Project Finance

Editor: Please describe your practice in Ballard Spahr's Washington office.

Hoffmann: Our energy and project finance group is headquartered in our Washington, DC office with seven of our ten offices actively participating in the group. We have a two pronged practice in Washington: a regulatory practice that is focused on independent system operations of clients like the New England ISO as well as transmission regulation nationwide; and a transactional group that is focused on project development and finance, representing project developers, underwriters and lenders. The debt finance side is based in our Philadelphia office although the DC office is very active in that practice as well. Our strategic focus today is on renewable energy, coal-fired projects, buying and selling of existing electric assets and the whole regulatory area, such as the independent system operators. We have 18 attorneys who are very active in the group and another 15 attorneys who are somewhat active.

Editor: The energy practice has changed considerably in the last few years from an emphasis on carbon-based fuels to renewable energy. What has spurred the recent growth in renewable energy technologies? Are the changes likely to be long-lived?

Hoffmann: Most probably the changes are going to be long-lived. Three things have triggered growth. Going back five years, a tremendous surge of interest in environmental issues in Europe gave a big boost to the renewable energy industry, specifically in Europe. That began to spill over into the U.S. The boost in the U.S. in particular was spurred by the surge in oil prices worldwide, driven by a combination of things such as the war in Iraq and the increasing demand for oil in India and China. In the last two years in the U.S., a very keen interest in global warming and a desire to begin to diminish the reliance on carbon-based energy has played a part. Those are the main drivers. With the exception of the war, I do not believe any of those will go away.

Also, a number of state legislatures are active supporters of renewable energy, such as Colorado, California, New York, and Pennsylvania. A majority of states are moving in the direction of strong state law incentives for renewable energy.

Editor: What trends are you seeing in the financial markets for energy companies in the U.S.?

Hoffmann: There are four main trends. The biggest is an incredible growth in the number of investment funds - equity funds, hedge funds, private equity funds - that want to invest in energy. In the last 12 months the fad has become renewable energy. There are a few of these funds that are immersed in the energy business and know it well. Most of these funds are general purpose equity funds that are trying to move into the energy space as quickly as they can.

There is a flood of equity funding available for projects right now. Stepping back from that, traditional non-recourse project finance is making a come back although it is tricky. In the late 90s we had five years where almost all new construction was financed on the balance sheets of deep pocket sponsors and developers. Then came Enron and the collapse of that particular project development business. Project finance has come back for renewable energy but this requires long term power sale contracts. The key to project finance for renewables is application of renewable energy portfolio standards which are being enacted state-by-state around the country. These require utilities to achieve a certain percentage of renewable energy in their supply portfolios by a particular year. The only way that the utilities can do this is by signing contracts with renewable energy power producers, hence the resurgence of the project finance market with new dimensions to it.

The third finance consideration for renewables in particular is that some projects cannot get done on a project finance basis for technology-risk reasons, even if you have a portfolio standard available. Some cutting-edge technology faces this issue. There are some deep pocket sponsors - a couple of U.S. utilities, a number of European companies - who are providing balance sheet finance for construction and who are planning on refinancing after construction is completed when they can demonstrate to the debt markets that the technical risk is under control.

The fourth trend I see is back-to-the-future. This is the use of undivided interest ownership structures so that each participant in a project brings its own construction financing to the table. Most big utility projects that were owned by more than one utility were financed this way prior to 1980. Almost all nuclear power plants were financed this way. Subsequently, the undivided interest ownership financing structure disappeared. After PURPA was enacted, we saw 20 years of finance that was dominated by non-recourse structures. The undivided interest structure is being driven by the fact that we have complex ownership structures with municipal power entities and electrical operatives participating as co-owners in a project with project developers and investor-owned utilities. Each of the owners has a different type of financing available so they are bringing their own money to the construction table. That makes for some challenging and interesting intercreditor agreements.

Editor: Are there federal or state incentives that are driving this phenomenon?

Hoffmann: The federal and state statutes and regulations that support renewable energy fall into five major categories. There are production tax credits, accelerated depreciation schedules for renewable energy equipment, business tax credits for installing energy efficient equipment in commercial buildings, which includes distributed generation, a federal ethanol production mandate, renewable portfolio standards at the state level driving the trend towards more projects in wind, solar and biomass.

There is currently no federal renewable portfolio standard but with the Democratic Congress, it will be actively debated in the coming year. There will certainly be legislation introduced to this effect.

Another factor to mention is renewable energy credits. Sometimes that is called "green tags" or tradable renewable certificates. This is the mechanism that allows the sponsor of a renewable energy project to sell the renewable energy aspects separately from the electricity itself. It is an accounting mechanism to disaggregate project features and allow various transactions to contribute to the financing of a project.

In the 2005 tax law, there was a provision for clean renewable energy bonds, a mechanism set up for electrical cooperatives and municipal entities to take advantage of their tax-exempt status. A nationwide volume cap was placed on these bonds by Congress. The demand for these bonds overwhelmingly exceeded the supply in the first year of processing by the IRS, and I suspect that Congress may increase the total volume of supply this coming year.

The other dimension is tax-exempt finance generally, which is a critical part of energy project finance. Biomass projects qualify for tax exempt financing because they have a waste management attribute. Some renewable energy projects, such as wind and solar do not qualify for traditional tax-exempt financing because they do not have any waste management function. Coal-fired power plants do very well in the tax-exempt arena because there is an enormous amount of waste management function within a coal-powered power plant. Our firm handles a large number of these tax-exempt financings for generation projects.

Editor: Do you see biomass expanding in the future?

Hoffmann: Ethanol production has been expanding exponentially for the last two years. There is an incredible boom in the construction of corn-fed ethanol production facilities in the Midwest and Plains states. There are probably a couple hundred projects in the total pipeline in development and construction. A lot of debate surrounds the issue as to whether the amount of energy content that goes into producing ethanol makes it worth the energy value that emerges. In the medium term we will see a real surge in bio diesel projects - first from waste products and then from crop products. There is debate on the impact on the food supply of getting into crop products for bio diesel.

Where I think that the long term growth will be is crop products that are specifically grown and or bio-engineered for energy production. Cellulose-based ethanol will be the big feedstock component for ongoing growth in ethanol production. If you contrast cellulose-based ethanol with corn-based ethanol, a very small percentage of the corn crop is the ear, the edible part which goes into ethanol production. The majority of the corn plant is waste product. Cellulose-based ethanol is manufactured from a plant that is 100 percent feed stock for production, such as fast growing grasses that grow to 10 feet tall that will be the next big feed stock for ethanol production.

There are some wood-fired plants being built around the country. There will continue to be a handful of those in development near the wood industry at any one time.

I think the sleeper is waste-fired electrical plants, which I believe will make a comeback. Municipal solid waste projects were a big thing in the 1980s and early 1990s. We are going to see a new generation of environmental containment waste handling technology.

Editor: What has occurred in the U.S. regarding recent financing of coal-fired plants?

Hoffmann: Coal-fired projects have three characteristics that make financing a daunting task. One is that coal-fired projects by their nature take a long time to develop, i.e., a minimum of five years. The development cost is a minimum of $20 million and up.

The second aspect is that because of a surge in construction of coal-fired plants in the last three years, it has become a hot vendor's market. If you want to build a coal-fired project based on a schedule, you should plan on spending at least $50 million to place early equipment orders with vendors so that you have a place in their production pipeline. If you add those two amounts, betting $70 million up front is a big challenge. There are probably 150 coal-fired projects in development in the U.S today. Of that number, only one-third are far enough along to be facing these financing challenges and addressing them seriously.

The third barrier is that almost every coal project in the U.S. attracts environmental opposition to the issuance of construction permits under the Clean Air Act. Several settlements between environmental intervenors and coal project sponsors have been negotiated allowing construction to go forward when the sponsor agrees to take on energy efficiency measures. The debt markets love coal-fired power plants because they are perceived to have very low technology risk. The basic technology has been in existence for some 90 years, except for cutting edge IGCC (integrated gasification combined cycle) technology which has some distance to go before being acceptable for non-recourse financing.

Editor: How can an experienced attorney in the energy and project finance arena help guide a client through the process of securing financing?

Hoffmann: For five years I ran a small project development company so that I understand both sides of the equation. There are certain fundamental basics that any good lawyer will follow but there are two things that many project development lawyers often fail to do. One is to understand the client's development and construction schedule and take the initiative to integrate it with the regulatory plan and due diligence schedule, pushing beyond the boundaries of lawyering and becoming a part of the development team. Then the lawyer should protect the development schedule by issuing warning alerts and red flags when he sees regulatory activity or contract delays that will impact the schedule. That is important since in the development and construction budgets, the assumptions about debt costs and interest rates all depend on the schedule. Getting way behind schedule can kill a project even if it was fundamentally sound at the beginning.

The second thing that lawyers do not often do is understand the project's economic model, something some clients do not want to share with their lawyers but which I try to insist upon. The reason that the lawyer has to understand the economic model is that client assumptions are buried inside it - assumptions about tax structure, risk allocation, construction costs, lender behavior, anticipated lender behavior, debt service coverage - all of that is inside the model. If you are going to integrate those things with project documents, you have to find them in the model. The models for most developers are done by the least experienced people at an entry level in the company, which can lead to miscommunication.

You need to watch the regulatory cutting edge. Permits for coal-fired projects are a particular challenge because the environmental opposition for coal-fired plants means that each project, all over the U.S., has to perform at least as well as the project most recently permitted anywhere in the country. You are chasing a moving target.

Contracts need to be a tight fit in keeping with the requirement that non-recourse financing for renewable and coal-fired projects is back in force. It is a discipline that any energy project finance lawyer knows if he has been doing this for any length of time. The final point is to be a pessimist - something clients do not like. Developers are optimists and they like to work with optimists but clients appreciate pessimism in the end. The lawyer's job is not to be the cheerleader.

Published January 1, 2007.