By Tariq Siddiqui
Premise
Are you choosing a right business model and deal structure for your renewable project? It could significantly impact your profitability! Renewable energy projects are likely to see continuous growth, as environmental pressures build, to meet the net-zero carbon emission. With offshore wind (OSW) industry in US, likely to grow in next 10 years, M&A activity will bring new players, it’s important to understand the business models and deal structures in renewables that best suits your projects. In this article we focus on business models and deal structure aspect in M&A, in future arctice we will focus on other aspects as well.
Business Models
An electricity generation renewable project, like solar or OSW, has three elements in its business models
Revenue Model
Cost & Operating Model
Finance & investment Model
1. Revenue Model
The primary revenue stream comes from cash flow from operations (CFFO), i.e. selling electricity. The secondary revenue and income stream comes from incentives like (feed-in tariffs); Production Tax Credits (PTC), and Investment Tax Credits (ITC). PTC credit is based on the amount of electricity produced, ITC are based on project capital costs. ITC are mostly used in solar but are expected to be used in offshore wind.
The revenue is usually high in first 4-5 years because (see figure-1A):
ITC that kicks-in (valid for example, 4 years)
PTC credits (valid upto 10 years)
Depreciation (4-5 years) and no/low tax liabilities
Between, 5-10 years, revenues decline as ITC and depreciation stop, and between 10-15 years’ revenue become minimum as PTC period is over, but debt liability (interest and principal) continues to be incurred (assuming 15-year long-term debt). After 15 years, revenue picks up again, as debt liabilities are paid off, provided operational costs are kept minimum.
There is an uncertainty around federal tax incentives (ref-1); PTC was extended in 2019, but is valid for only those projects starting construction by December 31, 2020. ITC will begin to phase out in 2020 and end by 2022, the extension of ITC by new administration is not clear. According to JP Morgan, the renewable tax equity market to reach $ 15 billion in 2020 (ref-2).
2. Cost & Operating Model
The main cash outflows during operations are; Operating cost (or OPEX $/kWh), fixed debt payments (Interest & principal) and taxes (figure 1b). The operating cost though, generally smaller compared to debt and taxes, may become significant for offshore wind if structured maintenance program is not developed, and appropriate service operating vessels (SOV) and crew transfer vessels (CTV) are not employed adding to down time and low productivity.
3. Finance & Investment Models
The type of renewable project (solar or wind), its size and its risk profile governs the investment structuring, the financing, JV arrangements and deal structure. Variety of financing and deal structures are available (ref3).
On-balance Sheet finance / Corporate Model
Sale-before Construction
Sale-after Construction
Investor-Developer Flip
Leveraged Investor/Developer Flip
Reverse/back Leveraged Structures
Leveraged Lease
Leveraged Investor/Developer Flip Model
In this article, we will focus on more commonly used 'leveraged Investor/Developer Flip' structure, and explore its features, working mechanism and benefits.
Project based
Renewable projects, especially, the capital-intensive OSW opportunities, carry significant risks and require, a large up-front capital commitments. To limit the Developer/Investor liabilities, a stand-alone ‘project-entity’ structures is suitable.
Developer
The ‘Developer,’ is responsible for all the front-end project development; acquiring lease, environmental assessments, surveys, permits rights, developing feasibility, development concept, and securing power purchase agreement (PPA). Developer may contribute its own capital to the project, but the main source is the investor. Developers investment horizon is usually short-term, and usually, look for a 'developer fee.'
Investor
The ‘Investor,’ is a principal source, providing capital to the project. The ‘strategic investors,’ are in for long-term strategic interest; it could be ‘portfolio diversification,’ as is the case for the utility companies. Or it could be managing transition and transformation plans to meet net-zero emissions, as maybe the case for the super major oil companies. Their interest is more than simply cashflow or returns (IRR) for the investor. The ‘financial investors,’ on the other hand, work primarily for financial gains; i.e. higher returns for their investors, that may include sovereign wealth funds, pension funds, private equity and other institutional investors.
Tax Equity Investor (TEI)
There is also a special class called ‘Tax-equity Investors (TEI),’ that primarily invest for special tax benefits (ITC, PTC Renewable Tax certificates or RTC) available to investors to incentivize investments (ref 4). The investment horizon of TEI is medium-term.For example, a Developer, seeking funds for $150 million renewable project generating $100 million tax credits, may find a, ‘tax-equity’ investor, usually a Tax Credit fund, that will buy the tax-credits for a price, say $90 million from developer (a return of 10/90 ~ 11.1 % for tax investor). The $90 million received by developer, covers partly for the $150 million investment outlay, the remaining $60 million, is either contributed by developer or leveraged through debt (project company).
Debtors
The debt financiers provide the cash debt and get risk adjusted repayments and interest incomes.
The Deal Mechanism
The leveraged Investor/Developer deal is a flip mechanism (title slide) whereby agreed split on returns between investor/developer is flipped from investor to developer, once a target internal rate of return (IRR) is reached, it could also be time based (5-6 years) . The developer, develops and construct the project. The tax-investor, provides the initial capital-outlay in exchange of PTC, the remaining ‘gap’ in capital-outlay is bridged through a ‘bank debt’ given to the project company.
Once production commences:
All production tax credits (PTC) go to tax-investor
Cashflow from operations (CFFO), services debt (interest & principal)
Any remaining distributable cash & tax benefit are split between developer & investor on a pre-agreed split (developer/investor), for example:
Before-flip; 35 % / 65%
After-flip; 90 % /10 %
Advantages of the structure
The low-cost debt reduces the WACC and improves the IRR
Large size of the project (ex: OSW) favors the ‘project structure’ (transaction cost)
Before-flip split distribution allows for early returns to the investors
Interest payments are tax deductible & reduce Levelized Cost of Energy (LCOE)
Offsets large depreciation common in early years in capital projects
Understanding Value Drivers
It is critical to understand the value drivers and critical success factors for the renewable project upfront before choosing a investment structure, in an opportunity framing exercise before starting the project to achieve alignment and integration by all stakeholders in the project. The value drivers could be, but not limited to; PPA, tax-credit strategy, asset-allocation, portfolio strategy, construction finance and many others.
Development & Financial Modeling
Developers and financial modelers require requires; understanding risks & uncertainties, bounding design envelope (scenarios), generating development scenario forecasting revenues, estimating costs (CAPEX/OPEX) and schedule and incorporating finance / deal structure. The modeling methodology and strategy is very similar oil &gas capital projects , one that are used in to manage risks and uncertainties.
Key uncertainties and risks are identified and data is collected to manage uncertainty
Range of development realizations are created (wind speed, Turbine size/height, water depth etc.) against a range of development options, generating discreet scenario
A parametric study (tornado chart) is done to determine key impacting variables
A most likely (P50) case is generated; i.e. commercially/technically viable (+NPV)
A monte-Carlo simulation is done on say NPV or IRR; by providing a distribution on key variables and generate a distribution of NPV /IRR (P90/P10)
A target scenario (IRR or revenue) is compared with distribution for reality check
All results & key metrics are benchmarked to industry standards for robustness.
Competitive Advantage
There are significant barriers to entry in offshore wind, due to capital intensive nature, project management complexity, operational challenges, creating a competitive advantage to offshore developers and oil & gas companies. The available talent in the oil & gas offshore industry is quick way to build capabilities by new entrants in OSW, which has less crowded competitive landscape.
Bottomline
A well managed renewable capital project, with a right business model and effective financing structure is a recipe for long-term profitability for all stakeholders.
Reference:
"Renewables and Hydrogen Update - US Market and Regulatory Developments," Sullivan & Cromwell LLP, November 19, 2020.
Tsarouhis, F; "Financing Markets for Renewable Energy Rebound, tax equity could top 2019," S&P global Market intelligence. September 11, 2020.
Green Rhino Energy: Financing structures
Tax Equity Financing: An Introduction and Policy Considerations; EveryCRS Report Apr 2017