Foundations of Project Energy Finance pt. 2

We continue the topic started last time on the key components in raising money for an energy project (as opposed to an energy technology company.)

A business plan that describes the opportunity, the need and the prospective financial performance

Control of the land for the project by ownership, right of way or most likely, option

All necessary permits

Knowldege and cost control of the inputs (feedstock, fuel, process chemicals)

A well-established, proven energy conversion technology

Credit-worthy, long term buyer for the output

Established, deep-pocketed EPC contractor

Experienced project operator and maintenance contractor

I described the rational for business plans in a recent post, but suffice it to say here that investors who are being asked to put in millions of dollars have every right to expect to see a thoughful document that explains what you have in mind, why it costs what it does and how it will make money.

The need to have control of the land is important because once word gets out that a developer has something in mind for the property, the price and availability become much less agreeable to the developer. The investors use this as a gating function, asking about land control early in the process to see if they want to spend any more time looking at it. Land control is a must-have.

Permits are important, not only because the project will have to have them but because they are sometimes not available for hard to fathom reasons. The permitting process can be subject to changes in the political winds and local opposition. If you have them, you have them. That will be comforting to investors.

Having an understanding and ideally some control over your input costs is the greatest hurdle to getting good projects financed. It is also a big reason for the surge in wind and solar power. The fuel is free and relatively predictable over a yearly basis. Consider, by contrast, corn for ethanol production.

The need for a proven conversion technology is another area that trips up would-be renewable energy developers. So often I see or read about inventors who have developed and sometimes patented a new energy conversion technology. Sometimes it's a new type of wind turbine. Sometimes it is wave power. Unfortunately, every time it is unsuitable for being deployed as part of a commercial energy project.

The reason for this is that the most common way that these projects can offer the returns that investors expect is to borrow money from big banks in addition to the private equity that the investors put in. Banks are more risk adverse than project equity investors (who, in turn are more risk adverse than venture capitalists). If the project intends to use new technologies then, in general, the banks won't loan against it.

Consider this; if a windfarm is built with a new type of turbine using a ten year loan. The turbines work great for seven years but then start failing. Soon, the project can't pay its debts. In theory the bank can repossess the wind farm but without reliably functioning turbines, there isn't much to repossess. Hence, banks stay away from first or second commercial use of new technologies. How does a new technology get into commercial use? That is a topic for a whole separate post at a later date.

The next box to check off for project finance is the sale of your energy (power or fuel) to a credit-worthy buyer for a time period that matches the length of bank loan you seek. Here the independent power industry has a big advantage over biofuels as many utilities are readily buying renewable power and most of those are considered "credit worthy" i.e. they have enough financial strength to weather any foreseable economic storms.

Given that for many projects, the biggest risk in the early days is going to be "completion risk." Completion risk is simply the chance that a given project will not be able to enter commercial operation or will not pass some completion test or commissioning. The reasons can be varied but most often come down to blown budgets for manpower and or material. This is why the financiers like to see a big name as the EPC contractor (Engineer, Procure, Construct). If Bechtel underbids a contract that they have promised to fulfill, you can be pretty sure that they can and will make good on it out of their own pockets. One can't say the same about very small firms. It may not seem fair, but again, it's about fairness as much as it's about wringing out risk.

After the project is in service the remaining risk to investors is that it may be operated poorly or poorly maintained. Depending upon the technologies involved the relative importance of these can vary. The "operator" of a windfarm has more of an accounting role than engineering. Maintenance is where the focus will be and often equipment manufacturers can and will be strong contenders for maintenance contracts. In the case of biofuels plants, the operator and maintainer are often one in the same and the combined role is much more technical than administrative.

I close with a reminder to entrepreneur developers not to be discouraged if you don't have all of these factors covered. You should however, have all of these factors considered and to cover as many as possible. I'd like to see all of them well covered, but then again, I'd like to see a ten pound butterfly! It doesn't mean that I can reasonably expect to.