Lending in a Disruptive Energy Market
Demand for renewable energy projects is high, despite market headwinds including supply chain uncertainty and raw materials spikes. Strong government and corporate policies aim to decarbonize the electric sector, and purchase power agreement (PPA) demand is high across the geography and clean energy technology.
However, there are several factors that have made it difficult for investors to provide capital in this once stable sector. These include the unpredictability of equipment prices, rising interest rates, congested interconnection queues, and uncertainty of incentives, such as the solar investment tax credit (ITC).
One piece of good news arrived June 5: President Biden halted solar tariffs for two years, while allowing domestic project developers to use foreign-solar equipment while U.S. manufacturing gains ground.
Historically, renewable energy contracting has been very straightforward, absent the consistent challenges of permitting and other land development risks, but the current disruptive environment has made lending strategies more difficult.
A Look at Lender Strategies
There is a lot of uncertainty on the durability of the recent increase in module and raw material costs. Investors trying to navigate this new normal must now pivot to the following strategies in this disruptive environment:
Find De-Risked Projects
First, lenders must find developers that have all the moving parts worked out – project permits secured, interconnection approved, and bilateral contracts with creditworthy customers.
Development risk challenges occur in project siting, permitting, and transmission access. For example, communities in the Commonwealth of Virginia have been pushing back on large projects spanning hundreds of acres. Some Virginia counties enacted temporary moratoriums on projects, and recent Virginia state policy requires analysis of new issues, such as the impact of a clean energy project on prime farmland.
Interconnection queues are jammed with projects, and PJM recently implemented a two-year hiatus on all new projects until the current backlog of 1,200 projects has been addressed. New transmission lines are needed to take renewable resources to high load centers – something that the federal infrastructure bill is hoping new investment will address.
Support Diversified Developers
Lenders should look to developers that build resilience in their operation and supply chain. Diversification occurs in both clean energy technology and geography. New asset classes are emerging with electric vehicle infrastructure, green hydrogen, and renewable natural gas. Lenders should turn to these assets if project finance faces uncertainty of equipment and supply with solar and energy storage.
Geographic diversity of projects is helpful when public policy is more supportive for development in certain states. Utility-scale energy has different environments, depending on the regulatory system. In regulated markets like Colorado, vertically integrated utilities can be the market maker, signing power purchase agreements with independent power producers.
At the other end, there are competitive power markets where electricity is sold in five-minute increments with the help of a day-ahead auction. Projects may be much easier in one geography than another, based on the utility business model and state policy environment.
If resilience is not built into a developer’s business strategy, lending agreements may be structured so that if the price of equipment goes up, the lending terms go up as well. For example, in energy storage, original equipment manufacturers are indexed to metals, so if a project developer needs batteries, the company must agree to these terms.
Focus on Smaller Projects
Finally, lenders may also want to focus on smaller projects where equipment price risk may be smaller on an absolute basis. For example, there is greater lending risk with a 100 MW project, versus a 10 MW project. In addition, lending for large projects is riskier when there are uncertain payback timelines for projects hampered by long interconnection queues or an endless paper trail for securing permits.
In the interim, institutional investors, such as pensions and insurance companies, may exit the market given the disruption. This in turn may create opportunities for investors with higher costs of capital – those who may feel comfortable taking more PPA merchant tail risk – that have been previously squeezed out of the market.
What is happening is a progressive maturation of project economics. As the underlying project economics deteriorate, because equipment won’t show up or capital gets canceled, larger operators and developers will become more sophisticated – driving consolidation and forming better project teams with thin returns. For financiers, this means that the investment community will deploy less capital or people will develop capabilities to manage risk.
An extension of subsidies like the solar ITC and higher natural gas prices may make renewable energy economics more favorable, although it is still too early to tell how permanent this current disruption will be.
Leyline Renewable Capital will be watchful in the face of this disruptive lending environment. Stay tuned as we continue to share our insights in the coming months.