A decade ago, before the advent of utility-scale solar and residential solar lease programs, commercial solar had a project finance problem: affordable money was hard to find. This was not surprising given that credit default swaps and mortgage derivatives were considered safe, profitable bets while 100kW solar arrays and 20 year PPAs were exotic beasts from strange lands, not to be trifled with.

 

Time passed. Global module manufacturing capacity grew to exceed demand while raw material prices fell. Modules became a commodity. Climate change was becoming obvious. A global financial crisis readjusted risk outlook, leading to rock-bottom interest rates. And, key to the equation, it was found that solar actually worked as described, both physically and financially.

As a result, the solar atmosphere flipped from one of many projects chasing little money to one of lots of money chasing few projects. As dynamic as the environment sounds, the goals and processes behind project diligence have remained fairly stable. It is the position of the diligent that has changed.

 

The Project Risk Pyramids

Gauging project development risk comes down to the value placed on money, time, and goodwill. All three are finite so wasting them is never desirable. The value of each, however, is a matter of perspective, and understanding the viewpoints of the principal players contributes to the success of a project.

 

By taking a look at these core players in a renewable energy project, it is possible to understand the risk each assumes. Image 1 shows the layers of renewable project development; developers at the base (development risk), financier/owner at the peak (operating risk), and in between is Engineering, Procurement, and Construction (EPC)/project management (execution risk). The pyramid is generic but adaptable to all manner of development structures. A developer expends resources to build a base upon which an EPC commits capital that is eventually paid for by the owner/financier. The developer, EPC, and owner each assume the risk of the former. More specifically, an independent developer spends time and money maneuvering through dozens of hurdles—any one of which can lead to a dead stop—until reaching Notice to Proceed (NTP). Regardless if they hold or sell the NTP project at this point, the owner then assumes all of the developer’s risk plus, eventually, the risks to be incurred by the EPC in procurement costs and deadline responsibilities. As the project moves further to COD and beyond, operating risk, i.e. weather, off-taker, technology, etc., get piled on top and are borne by the final owner. The failure points reduce in number but the risks expand as the project advances and more capital and time are spent.

 

An inverted pyramid, or “V”, represents the concentration of risk through the project timeline. The width of the “V” at the top—or the owner’s position—varies depending on many factors summed up as “depth of accurate knowledge”; knowledge of all facets of the project and the competency of those involved. A narrow “V” means more knowledge and less risk while wide means the opposite (Figures 1 & 2). The “V” can never go away due to the variable nature of renewable resources, but it can be kept thin with proper diligence. Unknown mistakes or omissions will inadvertently widen the “V”. If not caught early, the error will grow and increase risk as it concentrates upwards (Figure 3). Conversely, catching the error early can revert the “V” to an acceptable degree (Figure 4). Catching it too late or not at all can kill the project.

 

       

Figure 1                  Figure 2                Figure 3                                                   Figure 4

 

Diligence and The Diligent

Due diligence is a fuzzy term. Most in this business consider it “checking others’ work” as it applies to purchasing or financing a project. But, the applicable scope should be expanded beyond the buyer to include everyone involved in a project from start to finish, and broaden the definition to mean “working with careful and close attention to detail and thoroughness.” In other words, miss nothing, and make no mistakes. Through this redefinition, diligence is given its due.

It doesn’t matter where one stands in the project pyramid, due diligence and determination are key. A project can fail if deprived of either, so everyone involved needs to perform their role with great care. Developers bear the brunt since they typically start from scratch, deal with the most hurdles, and their work will be scrutinized repeatedly by others in later stages.

 

Developers

A developer focused on build-and-flip utility solar projects is typically responsible to:

These aren’t necessarily taken in progressive steps; many things run concurrently or supersede one another. An interconnection agreement usually requires a prior feasibility study, or an early tax opinion could determine whether a new market is worth pursuing. The notable point is that the outlay of time and capital begins early and increases as the project clears potentially project-killing hurdles, both recognized and overlooked.

 

EPC / Project Owner

Once a project reaches NTP, an EPC contractor is brought in to make the project a physical reality. The typical job of the EPC is to:

Not all EPCs handle the procurement of capital goods; it is a substantial financial burden to carry. But most EPC contracts are built upon milestone payments, often with timing obligations. Failure to meet timing requirements will usually trigger liquidated damages that can ruin the EPC’s returns. In addition, considerable costs, including labor, equipment, engineering, and permits are incurred by the EPC between the milestones. 

 

Smart EPCs take the first stage very seriously because all subsequent steps rely on it. Price too high and never win a contract. Price too low, win the contract, and risk an unsuccessful completion. And beyond a successful completion lies the EPC warranty period often overlooked in the EPC pricing and regarded as a corporate expense. Subsequently, it frequently receives grudging support and has been known to sink the fortunes of many EPC contractors. It is the duty of the project owner when negotiating the EPC contract to ensure the warranty language is watertight and that the EPC is willing and financially capable of meeting its obligations.

 

Long Term Owner /Financier

In this build-and-flip scenario, all of the risk gauged and mitigated by the developer and EPC eventually gets re-evaluated by a prospective buyer of a completed project and any financial partners who may provide equity and debt. This is the classic due diligence typically thought of: reviewing the work of others. These entities are looking at the:

economic viability of the deal;

The costs of due diligence for the long-term owner are not negligible. They are mostly wrapped up in legal and independent engineering review, but there are expenditures associated with every step of the project diligence from initial screening through the deal close. In addition, there are often non-refundable exclusivity fees or deposits that place great importance and time limitations on the long-term owner’s early diligence efforts.

 

For established projects purchased prior to NTP, the long term owner assumes all of the known development risk plus the completion risk tied to the action items yet to be completed. There is never a guarantee of successful completion so assuming this responsibility requires an all-encompassing comprehension of the project and what transpired up to the point of purchase.

 

Financial institutions or individual investors tend to deflect a majority of diligence costs to the long-term owner (or lessee). They mandate the use of a particular 3rd party independent engineer, legal team, and sometimes an auditor to review the records of the project and the owner. Smart long-term owners will work closely with their finance providers and utilize the same 3rd parties early in the diligence process—before finance diligence begins—to avoid redundancy and added costs.

 

Described above are the most basic functions involved in a project from initial development through final completion. They appear distinct and separate but in reality are blended, interdependent layers. Even the pointy top of the Renewable Project Pyramid that is inferred to be the project Final Completion point, is a false cap. The operating life of the facility extends well beyond that point with performance dependent almost entirely upon the strength of the underlying fundamentals. The process of evaluating these fundamentals is the topic of part II in the September/October issue. 

 

Bryan Banke is the managing director for asset management at Renewable Energy Trust Capital, Inc. 

 

Renewable Energy Trust Capital, Inc. | www.renewabletrust.com