September 17, 2012 |
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Energy & Infrastructure | |
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Outlook for Institutional
Investors in Renewables |
This article originally
appeared in the
September 3, 2012
edition of Power Finance & Risk
Participation in
renewable energy projects by institutional investors has been
increasing over the last few years, particularly in Europe. In
a low interest rate environment like the U.S., the return profiles
of these projects are becoming increasingly attractive to these
types of investors reaching for additional yield.
Institutional investors should be interested in a few trends that
are emerging in the renewable energy finance sector.
Renewables & the Bond
Market
Despite general economic uncertainty, the
renewable energy sector has continued to make strides in recent
years. Last year renewable energy facilities (excluding large
hydro-power) made up 44% of all new generation added worldwide, up
from 34% in 2010 and only 10.3% in 2004. But in the U.S. and
elsewhere, the industry is confronting a few substantial headwinds
and uncertainties, including policy uncertainty in the
U.S.
One of the key financing components for U.S. wind
projects, the U.S. production tax credit, currently is scheduled to
expire for projects not placed in service by the end of 2012.
Sponsors are hurrying to install wind projects before the year-end,
and industry forecasts are calling for a dramatic drop-off in wind
installations in 2013 if the production tax credit is not extended.
The U.S. Department of Treasury cash grant in lieu of investment tax
credits only remains available for projects that met fairly liberal
“start of construction” criteria by the end of last year. Although
the investment tax credit is available for solar projects placed in
service by 2016, the recent expiration of the Treasury cash grant is
leading some in the field to forecast a “tax-equity gap” between
tax-equity financing demand and actual investor tax appetite for
financing.
Continuing global macro-economic difficulties and
the near-term prospect of heightened capital requirements under
Basel III are also beginning to constrain the lending capacities of
large financial institutions, the traditional sources of financing
for U.S. renewable energy projects. As a result, several European
banks have recently exited the project finance debt market, and
other bank participants in that market are increasingly inclined to
lend on mini perm tenors with shorter average lives. The notable
exception to this general trend are the Japanese banks, which have
recently increased their lending activity in the renewable sector,
and have shown some preference to lend for longer
terms.
Given these constraints in the tax equity and lending
markets for renewable energy projects, sponsors may be seeking
alternative sources of both debt and equity capital at more
attractive yields. At the same time, the hard costs of developing
and constructing renewable energy projects continue to
decline—Bloomberg New Energy Finance reports that in 2011 solar
photovoltaic module pricing declined over 50% and onshore wind
technology declined between 5-10%. And sponsors are focusing on the
cost of debt and equity capital for these projects as another lever
in reducing the overall installed costs of renewable energy
facilities. This confluence of factors is leading sponsors and
developers to begin to explore non-bank institutional investments
from pension funds and insurance companies through project bond
offerings and direct equity participation.
A couple of large
project bond issuances in 2011 and 2012 have shown that for certain
types of renewable projects, capital markets bond offerings under
Rule 144A or the debt private placement market may present
attractive alternatives to bank financing. These bonds usually have
longer tenors that more closely match the terms of a project’s power
purchase agreements, the interest rates are usually fixed, and the
covenants regarding the day-to-day operation of the project are
often less restrictive than covenants in bank financings.
On
the downside, project bonds typically include a prepayment penalty
or make-whole premium. Because all the funds are drawn at closing
rather than as needed (with some availability for delayed draws in
the private placement market), for projects that have long
construction timelines, they also may impose significant negative
arbitrage costs. And the transaction costs for project bond deals
are also generally higher than bank financings, particularly for
Rule 144A transactions which require ratings and the additional
disclosure that customarily accompanies those offerings.
The
U.S. Department of Energy (DOE) loan guarantee program catalyzed the
resurgence of the 144A and private placement market in the last few
years, although much of the program's capacity to guarantee new
loans expired in September of 2011. These transactions often
employed hybrid financing structures that relied on capital markets
components, bank financing and sponsor equity. The financing of the
845 megawatt Shepherds Flat wind facility is a good example of a
hybrid structure that combined a shorter tenor $675 million floating
rate bank financing facility, $231 million in letter of credit
facilities, and a $525 million private placement of debt that were
each partially guaranteed by the DOE. Another is the 550 MW Desert
Sunlight solar facility that included approximately $600 million in
private placement bonds partially guaranteed by DOE with over 20
institutional investors participating.
Proponents of capital
markets and private placement financing are now able to cite a more
recent deal that did not rely on DOE guarantees as additional
evidence of increasing possibilities: the $850 million Rule 144A
offering to finance the 550 MW Topaz solar facility located 190
miles northwest of Los Angeles. This transaction was heavily
oversubscribed and was upsized from an initial offering of $700
million—the spreads were very tight for renewable project finance
debt at a 380 basis point spread over the corresponding U.S.
Treasury security.
Each of these transactions benefitted from
being well structured projects by well known, experienced sponsors.
Many other sponsors are increasingly looking at this deal as a
potential model for accessing the more liquid and deeper Rule 144A
and private placement markets typically inhabited by pension funds
and insurance companies. As wind and solar become more mature
technologies and investors and rating agencies become more
comfortable with renewable energy projects, we expect to see more
activity in the Rule 144A and private placement markets for well
structured, utility scale deals with strong offtakers and
experienced, well-known sponsors.
Direct Equity
Investments
In addition to the recent successful
capital and debt markets renewable energy issuances, institutional
investors, particularly pension funds and insurance companies, may
also have a greater role to play in direct equity investments in
renewable energy projects in the future.
Although a few major
insurance companies in the U.S. have been notable participants in
the U.S. renewable market for several years and have made sizable
direct equity investments in renewable generation, much of the
recent growth of institutional investing in renewable energy has
been in Europe by European pension funds and insurance companies.
The vanguard of this trend is PensionDemark, one of Denmark’s
largest pension funds, which has said that it aims to hold more than
10% of its assets in renewable energy investments. European
insurance companies have shown interest as well; Munich Re and
Allianz both recently announced plans to invest over €2.5 billion
and €1 billion in renewables, respectively. And Canadian pension
funds have also been looking to make direct investment in U.S.
renewable energy projects. Whether this recent growth in European
and Canadian insurance company and pension fund renewable
participation will gain traction in the United States is an open
question.
At present global pension funds hold less than one
percent of their assets in infrastructure investments, and renewable
projects are only a percentage of those holdings. With U.S., German,
Japanese and UK 10-year yields at around or below 2%, institutional
investors are seeking higher yielding products out on the risk curve
with low correlation to the returns of other assets. With the recent
global focus on sustainability, an added benefit of these
investments is that they allow institutional investors to burnish
their green credentials.
Because renewable energy investments
have low operating costs and often zero fuel costs, the return
profiles of direct investments can be more or less predictable and
can resemble the return profiles of other infrastructure investments
such as toll roads. The risk profile of renewables can also be
attractive: institutional investors like pension funds or insurance
companies may choose not to participate in the development or
construction financing but could look to invest in completed
projects that may have some operating history.
Significant
barriers to entry exist for institutional investors that have not
been major participants to date. Some types of highly structured
renewable investments—especially tax equity investments—can be
complex, and the ability to execute successful investments in this
area requires a strong understanding of the energy industry and
specialized legal and accounting structuring or working with
experienced advisors familiar with these types of
transactions.
For pension funds, which are not taxable and
thus would be looking to take cash equity positions, co-investment
in projects employing tax equity also poses some problems. For
example, these investments are usually structured to provide tax
equity investors a preferred return until a predetermined internal
rate of return is achieved. This structure defers cash distributions
to cash equity investors for some period, which can extend to 7-10
years depending on the success of the project. Transfer limitations
imposed by tax laws and typical project partnership agreements also
make these investments less liquid than institutional investors may
prefer. These problems may be mitigated through transaction
structuring or delaying investments in projects until the tax
credits are exhausted.
Some organizations such as private
equity funds and fund arms of some development banks are tailoring
unique investment products designed for pension funds to overcome
these hurdles. This development may go a long way to resolving the
“learning curve” problem associated with renewables. For pension
funds, the essence of the “learning curve” problem is that examining
project specific risks is really very different than analyzing a
publically traded stock, or for that matter, the management team and
track record of a private equity or hedge fund. Analysis of
renewable project investments requires a dedicated team that is
specifically trained to spot values in the industry. Pension funds
may be reluctant to invest in-house teams, but may be comfortable in
relying on outside expertise (including the kind of expertise of a
private equity fund specializing in renewables) with a proven
management team or track record.
These trends highlight a
growing need to address the liquidity constraints that are prevalent
in the bank debt and tax equity markets, which have historically
been the principal source of funding for renewable energy projects.
Sponsors and their advisors are beginning to look to new, cheaper
sources of financing and transaction structures for their renewable
energy projects. These include sources like the project bond markets
and non-bank institutional investors. Other sources of funding also
receiving consideration include master-limited partnerships, real
estate investment trusts and securitization of cash flows through
asset backed financing. As the industry matures, we expect that
non-bank institutional investors will play a substantial role in
financing new renewable generation through participation in the
project bond market and direct equity investments. |
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