As the shift from fossil-based energy production to renewable energy sources continues, growth in renewable energy projects under development has been staggering. But moving projects from early-stage development to commercial operations requires navigating complicated methods of financing their development, construction, and operation via structures that vary depending on project ownership, size, technology, and the regulatory environment.
Renewable energy generation assets in the U.S. are largely owned by electric utilities (for-profit, nonprofit, or publicly owned) or independent power producers. Each has different expectations for investment return and different rules governing selling electricity and raising capital. They also have differing abilities to monetize any tax benefits generated by a project.
Understanding financing options requires understanding the typical structure of a renewable project. A “project company”, a subsidiary of a project “sponsor”, will be formed to own the project assets, manage the construction, operation, and maintenance of the project (either directly, or in conjunction with contractors), and generate the revenue. In the context of a renewable electricity project, it will sell the power generated into the wholesale market or through a power purchase agreement (PPA), a long-term contract whereby power is sold at a fixed rate. PPAs provide secure, long-term revenue streams for the project company, making it attractive to lenders and investors.
While a project can be financed through a traditional corporate finance structure, where a single party owns and finances a project with its own resources and receives all the project's benefits, this is not always an available option. Project finance structures involving multiple parties, on the other hand, are popular because they spread project risk among several parties, minimize the use of a sponsor's balance sheet, protect key assets, and isolate liabilities away from the sponsor.
A typical project capital structure consists of both debt and equity, the equity being held by both the sponsor and an investor. Investors include those seeking primarily to utilize the tax benefits of the project.
Short-term and Long-term Debt
Lenders loan money for the development of a project solely based on the specific project's assets and expected future cash flows. This method of financing provides either no or limited recourse against the sponsor. In non-recourse financing, unless a guarantee is required from the lender, recourse will be limited to the assets of the project company, its revenue stream, and equity in the project company held by the sponsor.
The type of debt used depends on the needed timing of advances. Loans can be taken in the form of early- or late-stage development loans, construction loans, bridge loans, term loans, and working capital lines of credit.
Early-stage development loans. These loans are risky for lenders because they are made prior to project commercialization, and thus expensive and often only available from a lender with a well-established relationship with the sponsor.
Construction loans. These loans are made during the construction phase of the project and are intended to be short-term and rolled into permanent financing or repaid with the proceeds of longer-term financing or cash raised from equity investments. Advances are made in stages based on milestones and performance thresholds. Loans made during the construction period will be due upon completion of construction. These loans are secured by project assets. The interest rate on these loans is typically higher than loans in place during commercial operation to account for construction risk.
Late-stage development loans. These loans are similar to letter of credit facilities. They provide much needed capital to developers but command a premium to compensate the lenders for the higher risk. They can often be used to facilitate interconnection of the project or other development purposes.
Bridge loans. In the event capital is needed for preliminary work while permanent financing is being finalized or while the project is waiting to qualify for certain government funds or credits, a bridge loan may be an option. Like early-stage development loans, bridge financing is expensive.
Working capital loans. Typically a revolving loan, these can be used for expenses in the ordinary course of business. The principal amount is generally smaller than other types of loans because working capital loans are not intended to cover substantial upfront construction costs.
Term loans. These are longer term (7 to 10 years), floating rate loans that are repaid from project revenues.
Back-leverage. In most cases where there is tax equity financing, term loans for a project are structured in the form of back-leverage debt in which the sponsor (or some intermediate parent company of the project company) is the borrower rather than the project company. The loan is secured by the sponsor's stake in the tax equity partnership (described below) and is effectively structurally subordinated to the tax equity investor's interest in the project.
Tax Equity Arrangements
Tax equity arrangements involve the sponsor partnering with one or more investors that can take advantage of large tax benefits available to the project because such investors have sufficient taxable income and predictable tax liabilities. These arrangements allow the sponsor to monetize the available tax benefits if it does not have sufficient taxable income to utilize the tax benefits itself.
Tax benefits in a renewable electricity project take the form of investment tax credits (ITCs), production tax credits (PTCs), and accelerated depreciation deductions (Modified Accelerated Cost Recovery System deduction). The PTC is an income tax credit created by the production of electricity from wind turbines, geothermal, solar, hydropower, biomass, marine, and hydrokinetic renewable energy plants. It is calculated using the actual energy production of a project. It can be claimed for a 10-year period once a qualifying facility is placed in service. ITCs allows facilities to claim an income tax credit based on the amount invested in project infrastructure. They can be claimed only in the year that the project is placed in service and are calculated using the cost/fair market value basis of the eligible energy property.
In a partnership-flip model, the tax equity investor and the sponsor each hold interests in the tax equity “partnership” (typically, a limited liability company treated as a partnership) for federal income tax purposes which owns the project company (or a holding company that owns the project company). The sponsor retains control of the project and manages construction and daily operation of the project. The tax equity investor is entitled to a majority of the tax benefits and certain cash payments until certain pre-agreed financial metrics are achieved by the tax equity investor, at which time a “flip” occurs whereby the sponsor is entitled to the majority of allocations and distributions.
Alternative Funding Options
The above options are by no means an exhaustive list of financing methods. Funding may be available from public sources through grants and low-cost financing. Government incentives may also be available to reduce the cost of the project. A project sponsor may also have access to capital markets and have the option to issue bonds or equity to finance a project. Offtakers that want to ensure they have access to the project's output may also provide funding by agreeing to buy the project's output proportional to its investment. Finally, with the passage of the Inflation Reduction Act of 2022, some developers can now monetize tax credits through transferability and direct pay options. A significant number of these transactions closed in 2023, and the numbers are only expected to grow in 2024. These options can be utilized alone or in a hybrid model in conjunction with traditional tax investments. The new options further expanded the market of potential investors developers can look to for financing renewable energy projects.
Navigating financing options includes risk ‐ reward comparisons, as well as an analysis of any given project's development stage, capital needs, anticipated returns, and the regulatory environment in which it is expected to operate, among other considerations. Because financing decisions have long-term effects on a project's success and future access to capital, understanding project financing methods is an essential early step in any development.
Brenda represents clients in the energy and credit union industries, overseeing corporate transactions and providing general corporate counsel.
Brenda has focused a significant portion of her practice on the energy industry for 20 years, working most frequently with clients operating in the energy
Our Commentary & Response
There is great risk, but even greater opportunity present in this field. As Brenda explains, it is valuable to consult with a professional if any of these opportunities are of interest to you.Contact Us