HOW CAN PROJECT FINANCE FOR RENEWABLE ENERGY POWER PROJECTS BE STRUCTURED TO ENSURE THEIR BANAKABILITY? CHIOMA E.

UBAJAKA [email protected] ABSTRACT: Renewable Energy is considered to have various benefits. However, obtaining project finance for Renewable Energy Power Projects (REPP) has been difficult mostly as a result of the high level of perceived risks associated with them. Furthermore, institutional memory of past project failures has made obtaining finance for REPP difficult. This paper discusses how project finance for REPP can be structured to ensure its success. It analyses the main project risks faced by REPP and suggests ways in which they can be mitigated and passed through to other parties involved in the project. This is achieved by using a matrix. This paper contends that with proper risk mitigation techniques, more REPP can be successfully financed thus lowering perceived risks in the long run.

ABBREVIATIONS CTM DTI EPC LD NAO PPA R&D RE REPP RES SPV UNEP Certificate Trading Model Directorate of Trade and Industry Engineering Procurement and Construction Liquidated Damages National Audit Office Power Purchase Agreement Research and Development Renewable Energy Renewable Energy Power Project Renewable Energy Sources Special Purpose Vehicle United Nations Environmental Program

Chioma Ubajaka has earned an LLB Bachelors degree in Law, (University of Nigeria, Nsukka Nigeria, 2003), BL and Certificate of call to Bar ( Nigerian Law School Bwari Abuja ,2004), Postgraduate course in Economic Law and Competition in the European Union (University Institute of European Studies ,2006), Petroleum Law and Policy, (Centre for Energy, Petroleum and Mineral Law and Policy, University of Dundee, Dundee Scotland.)

1 INTRODUCTION The promising solutions to the environmental problems associated with fossil fuels lies in the development and use of Renewable Energy Sources (RES). RES may be obtained from solar radiation, wind power, waves, heat from earths core as well as animal and plant wastes. They also provide diversity of energy supply given that they are products of nature and there is no issue of reserves being depleted. Furthermore, its expansion offers economic opportunities such as regional development and job opportunities. 1 However, the numerous benefits of RES are often ignored as investors have declined project financing Renewable Energy Power Projects (REPP) due to the high level of perceived risks associated with them. Furthermore, institutional memory of the past project failures makes raising capital difficult and costly for developers. 2 Often the only financing feasible for such projects is with participation of multilateral agencies like the World Bank Group. 3 This has left private developers with the choice of relying on corporate financing which for various reasons discussed in this paper is less attractive than project finance. Project finance is a form of finance where lenders look primarily at the cash flow of a project for repayment of the loan and to the assets as collateral for the loan. 4 It typically involves the creation of a project company (SPV) which is the legal owner of the project assets and which has contractual agreements with a number of other parties that include off takers, operators, suppliers, insurers and so on. In most cases such loans are generally non-recourse or limited recourse to the sponsor and therefore do not have a substantial impact on the companys balance sheet or credit worthiness.

National Audit Office, Renewable Energy (Final Report), DTI, available at http://www.nao.org.uk/publications/nao_reports/04-05/0405210.pdf (Last visited 1st May, 2006) 2 Brown, M., Financing Renewable Energy: Obstacles and Solutions, 1994, available at http://www.osti.gov/bridge/servlets/purl/258150-c3YX64/webviewable/258150.pdf (Last visited 24th April 2006) 3 Bronicki, L., Financing Private Geothermal Power Plants Projects: Hurdles and Opportunities. Conference paper presented at the World Geothermal Congress Japan, 2000. available at http://geothermie.de/egec-geothernet/prof/0548.PDF (last visited 23rd April 2006) 4 Nevitt, P., Fabozzi. F., Project Financing, (7th ed) (London, United Kingdom: Euromoney Books, 2000)

Lenders have recourse only to the underlying assets of the project which include contracts and guarantees from third parties. 5 Capital for project financing energy projects can be raised through a combination of debt and equity investment. Debt may be obtained through bank loans, institutional debt or through public markets. 6 Conversely, equity can be procured from internal sources or external sources in public and private markets. Active equity investors, referred to as sponsors, include developers, contractors, equipment suppliers, operators, offtakers and fuel suppliers With this background, this paper seeks to suggest ways in which project financing for REPP can be structured to ensure its bankability. Chapter 2 gives a broad overview of REPP and project finance, highlighting some vital issues lenders take into consideration before proceeding to lend to REPP. Chapter 3 discusses the major project risks associated with REPP with particular reference to technology, construction, fuel/resource supply, market and regulatory risks. Chapter 4 analyses how these risks can be mitigated or passed through to other parties. This will be achieved through the use of a contractual project matrix. The paper then concludes with the thoughts of the author.

2 OVERVIEW OF REPP FINANCING 2.1 BACKGROUND 2.1.1 IMPORTANCE OF PROJECT FINANCING FOR REPP For REPP, neither the developer nor the purchasers can self finance. Majority are not sufficiently capitalised and do not have enough track record to attempt corporate balance sheet financing. 7 The public sector which has invested a considerable amount of tax payers money in the technology through Research and Development (R&D) is typically not

Chance, C.,(Firm) Project Finance, (London, United Kingdom, IFR Publishing, 1991) p 3 Wiser, R., Pickle, S., Financing Investments in Renewable Energy: The Role of Policy Design and Restructuring, 1997, Available at http://eetd.IbI.gov/ea/ems/reports/39826.pdf (last visited 28th April, 2006) 7 ibid
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appropriate as the source of finance. The funds that are available are also not adequate for such large scale deployment efforts. 8 In the private sector the traditional form of energy finance which is venture capital, is too expensive to use for financing the REPP. 9 Developers may not want to solely bear risks associated with the project. Since it is an off balance sheet loan, small sized developers would be free to pursue several projects at the same time with limited negative balance sheet impacts. 10

2.1.2 FACTORS LIMITING PROJECT FINANCE OF REP PROJECTS. Many projects are perceived by the financial community to have high resource and technology risks. These real and perceived risks result in financing that is more costly than that available to more traditional sources. Since RE technology is relatively new, financial institutions lack experience in evaluating risks associated with REPP. Furthermore, rapidly changing technology and a shortage of RE technology engineers means that lenders do not have the technical know how to assess and monitor many REPPs. 11 Consequently, financers are reluctant to invest in technologies that have not been followed closely. The renewable industry and REP projects are small compared to traditional power plants. Lenders are usually not interested in small transactions. Even where finance is available, the transaction costs are much higher for smaller REPP because many of the same financing and documentation processes must be followed irrespective of the size of the project. REPP are often capital intensive and require a higher up front investment than competing traditional power plants with lower capital costs. Consequently, their power prices are often initially more expensive. Thus, while a lender may be willing to invest in a traditional power project like a natural gas-fired plant, it will find it difficult financing a REPP unless additional mechanisms exist to support the above market costs. 12

8 9

Bronicki, supra note 3 Fleming, S., Goldman, D.,et al, Financing Projects that Use Clean Technologies: A summary Overview of Barriers and Opportunities, Undated, Available at http://www.nrel.gov/technologytransfer/entrepreneures/pdfs/techcomm_pjf_summary2.pdf (last visited 30th April 2006) 10 Bronicki, supra note 3. 11 Brown, supra note 2 12 ibid

REPP can only operate when their resources are available. The intermittent nature of RES means they generate less cash flow than fossil fuel fired plants. This provides lower margins for project financing and puts pressure on costs associated with overhead and maintenance costs. 13 Government policies greatly affect the economics of REPP. Such policies are often unpredictable; for example tax policies change frequently which discourages financers from investing in REPP. Furthermore, in deregulated markets, recent oversupply of electric capacity from merchant power plants has made project finance in these markets very difficult to obtain. 14

2.2 IMPORTANT CONSIDERATIONS FOR THE LENDER 2.2.1 THE IMPORTANCE OF EQUITY Equity investors frequently take high risk investments if the potential rewards are large. On the other hand, lenders are not in the venture capital business and are always seeking to minimise their risk exposure. 15 The main focus of the lender is on the negative potential of the project and on ways in which the project can be structured to give security to the lenders against such negative potentials. Consequently, lenders will adjust interest rates and default terms to the level of risk and most lenders will require some form of equity investment in the project. Equity is the key protection against risks and banks will want to see equity contributions made in the early life of the project. 16 It acts as a cushion against risk as equity will be hit first in the event of any problems before debt.
17

The riskier the project, the more

equity investment will be required by the lenders. Hence, as a result of the perceived risks associated with REPP, some lenders will require as much as 25% in equity. 18 Lenders also consider equity investment as a form of commitment by the developers and sponsors. Lenders like to see that the sponsors have a financial incentive to keep the project running and are unable to abandon the project whenever they desire. 19

13 14

Fleming, supra note 9 ibid. 15 Wiser, supra note 6 16 Vinter, Project Finance, (3rd Ed.) (London, United Kingdom: Sweet and Maxwell, 2006) P53 17 Donaldson, T., Project Lending, (London, United Kingdom, Butterworths, 1992) 6 18 Brown, supra note 2. 19 Nevitt, supra note 4 at 23

2.2.2 THE IMPORTANCE OF SECURITY Lenders will seek to ensure they are able to take over the project at any time as in most cases, it is only by these means that lenders can seek to recover their loan. 20 Therefore, lenders will look for a fixed charge over the project site as well as an assignment of principal project contracts. They will also want a floating charge over the assets of the project company which would enable them appoint a receiver to protect their interest in the event of default. 21 After completion, lenders will look to the revenue of the project to cover payments of interest and capital. Effective security of cash flow can be guaranteed by requiring that all cash flow be paid into a project account with imposition of control over the way the cash is paid out. Lenders by this will seek to have a security interest over this account. Finally, lenders are likely to require contingency funds to be set aside to create reserves to cover unforeseen problems. 22

2.2.3 THE EXPERIENCE AND CREDIT WORTHINESS OF ALL THE PARTIES INVOLVED. In assessing the risk of default in relation to the project, lenders will consider the experience and the financial strength of all parties involved in the project. These include the sponsors, off takers, the suppliers, insurers, contractors, and guarantors. Lenders will focus on the ability of these parties to carry out obligations stated in their respective contracts with the project company. 23

3 PROJECT RISKS Project risks affect the amount, timing and availability of funds for project finance. It limits the size of the loan, increases the interest rate and shortens the term. For equity investors, risk increases their targeted internal rate of return. Therefore the identification and management of risk is very important in project finance. For RE

20

Bulman, D., Cooper, W., et al, Commercial Agreements and Documentation Relevant for Financing Renewable Energy Schemes, 1997, Available at http://test.netgates.co.uk/nre/pdf/KFR00032/REPORT.pdf (last visited 23rd April 2006) 21 ibid 22 supra note 16 at 44 23 supra note 4 at 14

technology, each technology will have a slightly different risk profile especially as regards fuel risks. Each of these risks will be identified below.

3.1 TECHNOLOGY RISK For REPP, this is the major risk which lenders worry about and may take various forms. Technology risk exists when the technology proposed for the project does not work according to specifications or works at too high a cost 24 and thus, may not generate cash flow that repays the loan. It is also the risk that the technology is made uncompetitive by a newer technology too soon. Obsolescence becomes an issue when a project is part of an industry like the REPP industry, whose technology changes quickly. 25 For RES, this includes the risk that there may not be experts experienced in this field to report on the proposed project as such technology is relatively new. 26 However, project finance is not in the business of funding new and untried technology as banks will only assume measurable risk. 27 Lenders will not finance the first project to use new technology and would rather wait until the technology is tried and proven by others before investing their funds 28

3.2 CONSTRUCTION RISK This is the risk that the project is never completed at all and thus never generates revenue to repay the loan. 29 Construction risk includes the risk that the project is not constructed in accordance with specification leading to a shortfall in capacity and efficiency. 30 It includes the probability of cost overruns and delays in completion resulting in increased interest and lengthening of repayment profile. 31 It also includes the risks that required permits will not be granted, the probability of extra costs imposed by the regional or local governments or of protests which may delay or even prevent completion.

24 25

Donaldson, supra note 17 at 9 Fleming, supra note 9 26 Bulman, supra note 20 27 ibid 28 Brown, supra note 2 29 Donaldson supra note 17 at 9 30 Chance, supra note 5 at 42 31 Donaldson, supra note 17 at 9

An important decision to be made in energy projects is to decide the type of construction contract to be used. For REPP, the choice will be between a turnkey contract (Engineering Procurement and Construction contract (EPC) and other construction contracts. Under a Turn key contract, the contractor employs the subcontractors directly and bears the risks of their performance. On the other hand, the sponsor has the option of employing independent contractors. In this instance, there is no single entity to claim damages from in the event of default. 32 He will have to prove that one of the contractors was responsible for the default and claim directly from that the relevant contractor.33

3.3 FUEL/RESOURCE RISK This is the risk that there is no adequate fuel or resource to power the project, thus reducing cash flow needed to repay the loan. It is argued that some RES including wind, solar and hydro have no fuel costs as they are gifts of nature and therefore this characteristic makes them less risky investments than oil, gas or coal which are subject to disruption by disputes, politics and so on. However, due to the intermittent nature of RES, lenders consider RE fuels as unpredictable, less dependable and more expensive than gas delivered in a long term contract. 34 The fact that the REPP has zero fuel costs does not diminish the risk that the resource needed to power the plant is not available. 35

3.4 MARKET RISK Market risk is the risk that the project company may not earn sufficient revenue to service its debt, operating costs and leave an adequate return for investors. It consists of volume risk and price risk. Volume risk is the risk that there is not enough demand for the output or that power produced cannot be sold. On other hand, price risk is the risk that the price of the energy produced from the REPP fluctuates to the detriment of the project. Lenders want to be repaid in the manner and at the time specified. Fluctuation of energy prices tends to create uncertainty which increases perceived risks associated with the project. This is
32 33

Vinter, supra note 16 at 96 ibid. 34 Brown, supra note 2 35 ibid

because; the power price determines the projects ability to meet its financial obligations. 36 REPPs often have higher capital costs than traditional power projects and thus their power price tend to be more expensive than the later. 37

3.7 REGULATORY RISK Policy stability is essential to REPP developers in order to succeed in getting project finance. Regulatory risk is the probability that the regulator or relevant sector of the government may change the rules of the game in the future to the detriment of the project. It includes the risks that licences/permits granted and fiscal incentives such as tax credits may be withdrawn before the full repayment of the loan. This risk is crucial to REPP as the commercial viability of the project may depend on the stability and certainty of policy.

4. RISK MITIGATION AND PASS THROUGH Successful project structuring is about identifying, mitigating and sharing risk which is largely accomplished through contractual agreements in a matrix. 38 These contracts define the relationships between the parties and state their respective rights and obligations to the project. Risks are allocated to the parties who are best able to bear them and lenders structure project deals to have predictable cash flow with little risk to its investment as possible. 39 This does not mean that lenders refuse to bear any risk at all; rather they seek to ensure that each risk is mitigated to the least amount or passed through to other parties.

4.1.1 CONSTRUCTION AND TECHNOLOGY RISKS Lenders seek to ensure that the construction phase of the project is completed in accordance with specification, on time and within budget. The most important form of mitigation here is to ensure that the contractor has the skills, the management strength and the financial strength to handle the technical difficulties of the REPP. 40 Technical specification is of great importance and lenders will be concerned to have it
36 37

ibid Fleming, supra note 9 38 ibid 39 Brown, supra note 2 40 Donaldson, supra note 17 at 13

thoroughly investigated by independent engineers and consultants.41 Lenders consider technology risk an unacceptable risk and any liability payable as a result of delay or performance of the plant is passed to the contractor as much as possible. 42 This is done by signing a turnkey design and build agreement where a single and reputable contractor is responsible for the design and construction for a fixed price.43 The contract usually deals with concerns about design and technology and assigns obligations to the sponsor and the contractor for engineering, obtaining permits and insurance. 44 Where the contractor fails to meet such obligations as specified in the contract, he may be required to pay compensation in the form of liquidated damages (LD) to the sponsors 45 assigned to the lenders as a form of security. Liquidated damages may be specified for particular events. A delay LD will compensate the lenders for failure to complete the project by the completion date and will cover interest costs accumulated over the delay period. Conversely, a Buy Down LD will cover failure to meet the projects operating criteria e.g. output, and efficiency and may include some form of formula for reduction of the contract price. 46 However, the contractor will be concerned to limit his liability and will insist on a liability cap usually a percentage of the construction price. In order to protect their interest, lenders will seek to ensure that the liability cap is as high as possible Lenders will be concerned to secure the performance of contractors obligations by requiring performance bonds from banks or reputable surety companies. 47 The bonds will usually require on-demand payment obligations in favour of the project company by the surety bank in the event that the contractor fails to carry out the obligations under the contract. Lenders will take assignment of these bonds to ensure that they can make demand for payment if the need arises.

41 42

Brown, supra note 2 Vinter, supra note 16 at 82 43 UNEP, Financial Risk Management Instruments for Renewable Energy Projects: Summary Document. (Oxford, United Kingdom: World Publications, 2004). 44 Ruster, J., Mitigating Commercial Risks in Project Finance, the World Bank 1996. Available at http://rru.worldbank.org/Documents/PublicPolicyJournal/069ruster.pdf (last visited 24th April 2006) 45 Vinter, supra note 16 at 82 46 Bulman, supra note 20 47 Vinter,supra note 16 at 101

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As a result of frequent delays in collecting LDs and performance bonds, the contract may provide for a percentage of the construction payments to be retained in an escrow account. This gives the contractor the incentive to remedy any defects 48 and back stops the contractors payment obligations in the event of default. 49 Where the contractor is also the supplier, he will be required to give adequate warranties on technical performance which will cover hidden defects discovered after completion.
50

Lenders will seek to ensure that warranty periods are extensive and

that warranty caps are limited or non existent. Remedies under the warranties may include replacement or repair of the equipment. Lenders will seek some form of guarantee from the REPP sponsors that completion will occur on the specified date as defined by the performance tests stipulated in the construction contract. The sponsor will be required to pay a fixed sum to the lenders which will include principal and interest if completion does not occur by a specified date. 51 Where lenders are concerned about the credit worthiness of the sponsor, they may accept standby letters of credit from reputable banks which will act as security for stated obligations. Finally, banks will use a controlled drawdown of funds to minimise their losses. Each advance will be received on the condition that the work has reached a certain stage and has been done according to specifications. This gives the bank the opportunity to check the technology before releasing more funds. 52

4.1.3 FUEL/RESOURCE RISKS In discussing the mitigation of fuel/resource risk of REPP, it is pertinent to separate these resources in two groups; (i)Biomass and waste which can be supplied by third parties at any time. (ii) Wind and solar which can only be supplied when nature permits.

48 49

ibid 99 Ruster, supra note 44 50 Bulman, supra note 20 51 Vinter, supra note 16 at 245 52 Donaldson, supra note 17 at14

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Biomass and Waste: Lenders require certainty of supply and will need to be satisfied that long term supply contracts for these fuels are in place in order to ensure that the project continues to operate and thereby generate revenue. Lenders will seek to ensure that the supplier must be a credible party with guaranteed assess to such fuels over the duration of the contract. 53 The fuel quantity and duration of the contract must also be sufficient which lenders will insist at a minimum, covers the debt repayment period. 54 An important provision is the calorific value of the fuel which must be within the range for the project design. Where it is too low, the electrical output cannot be achieved and revenue is reduced and if it is too high, the throughput of the waste is reduced. 55 Thus, lenders will ensure there are provisions that impose penalties on the waste or wood supplier which compensates the project in the event of default in calorific value or interruption in fuel supply. On the other hand, where the project cannot accept fuel offered due to unscheduled outage, the project is likely to be required to compensate the supplier for alternative disposal. 56 It will be expected that the project protects itself from the consequences of short term supply disruption. Thus, the project would be required as a condition subsequent, to stockpile the relevant fuel for a fixed period to cover supply disruptions. In countries where transportation is an issue or where a transportation company controls the only feasible method of transporting the relevant fuel to the project, lenders will want to see a long term transportation contract with its duration matching the term of the fuel supply agreement. 57 Banks will also assess whether the fuels require special handling and pre-processing. This could be problematic and expensive for the project, leading to reduced cash flow and lengthening of the loan term. 58 Fuel price risks in this case, will be expected to be passed to the off taker through a price formula in the Power purchase agreement (PPA) ensuring the off taker pays for any increase in fuel costs.
53 54

Nevitt, supra note 4 at 14 ibid 55 Bulman, supra note 20 56 ibid 57 Nevitt, supra note 4 at 14 58 Brown, supra note 2

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Wind and Solar: Lenders will seek to ensure there are detailed assessments by independent experts as proof that the relevant resource is available and adequate. 59 Since there is no possibility of a long term contract with nature, lenders may require a premium over the interest rate than conventional energy projects would pay. 60 Furthermore, lenders will seek to have contingency reserves to cover cash flow shortages which may arise due to resource intermittency. 61 Such contingency accounts can be established through equity contributions, sponsor guarantees and standby letters of credit.

4.1.4 MARKET RISKS Volume Risks In the optimum, volume risks are passed to the off taker through a long term PPA with a firm take-or-pay clause. The T or P clause requires the off taker to pay for the service (electricity) regardless of the off takers take. Lenders will seek to restrict the use of make up and carry forward rights and ensure that the take or pay levels are high as this would guarantee a higher level of cash flow available to the project. Lenders will investigate the credit worthiness of the off taker and will also look at the off takers history and its record of attempting to renegotiate existing PPAs. Where the lender is not satisfied with the offtakers credit rating, the government may be required to guarantee the performance of the offtakers obligation in the contract. Furthermore, sponsors may also agree to purchase minimum quantities of the projects power for a minimum period (at least the loan period). Though price here is the market price, a minimum volume sale is guaranteed, thus creating certainty and predictability. 62 However, in recent times with the restructuring and deregulation of energy markets, the incentive for power purchasers to sign long term contracts of 20 to 30 years is

ibid ibid 61 Morris, E., et al, Asia Pacific Economic Cooperation Guidebook for Financing New and Renewable Energy Projects, NEDO 1998, Available at http://www.nedo.go.jp/english/archives/apec.pdf (last visited 30th April 2006) 62 Feo,et al, Financing of Renewable Energy Projects, Conference paper presented at the 17th NREL Industry Growth Forum, October 2004.
60

59

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diminished. 63 The dilemma faced by such markets has been solved by segmenting the market and creating different rules for REPP. The Certificates Trading Model (CTM) 64 which is rapidly becoming popular in restructured markets tends to reduce the volume risks faced by REPP. It works by guaranteeing a minimum volume sale of renewable energy by obliging utilities to ensure that a certain percentage of their energy comes from RES. In exchange for the purchase, utilities receive certificates which are proof of compliance with the regulation. Utilities that are in default pay a penalty above the certificate price which is distributed among generators of RES or conforming utilities. This way, lenders have an idea of the annual volume sale for REPP.

Price Risks Lenders will seek to ensure there is a long term PPA where the off taker agrees to purchase power produced at a fixed price which guarantees predictability and certainty of cash flow. The PPA is the sole source of revenue for the project and lenders will seek to ensure that its term covers the loan term. 65 The power price will be made up of the Capacity Charge 66 which covers all the fixed costs of the project i.e. operation, maintenance costs, debt service and after tax equity investment. This is an availability payment and will be paid to the project irrespective of dispatch. The price will also include the Energy charge which consists of the projects variable costs including fuel costs. 67 However, in competitive energy markets, purchasers are less willing to sign long term fixed price contracts since there is some sort of hope for reduced power prices in future.
68

The CTM described above leads to volatility of prices since prices depend

on demand and supply of certificates. Prices tend to be high when the supply of certificates falls and prices fall when there is an oversupply of certificates. In such cases where power prices may vary, it is less attractive for the lenders and may lead to payment of premiums on interest rates. 69 On the other hand, the feed-in pricing
63 64

Wiser, supra note 6. Also known as Renewable Portfolio Standards (RPS) 65 Brown, supra note 2 66 Also called the availability charge 67 Vinter, supra note 16 at 79 68 For countries with sufficient capacity. 69 Brown, supra note 2

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system; where the government guarantees a minimum price above market prices for power generated by RES has been considered more successful than its counterpart due to the certainty and predictability of cash flow it offers. 70

4.1.6 REGULATORY RISKS Policy stability is essential to REPP developers if they are to be successful in finding and retaining investors. Lenders will want to be satisfied that regulators do not change the rules of the game in the near future, at least for the duration of the loan. They will seek to ensure that consents and permits granted will remain in place and that they run with the project and not the project company. 71 Lenders also want to see that regulators respect the sanctity of contracts and will seek guarantees from the relevant department that long term PPAs signed with off takers will be fulfilled irrespective of changes in policy. Many REPPs continue to rely on renewable policy incentives including tax incentives and subsidies. Such incentives can be used as debt security as well as included in financial evaluation of the REPP. 72 Lenders want to see long term certainty in such policy design and this can be given by issuance of comfort letters from an issuing authority. 73 Furthermore, Graham Vinter suggests that lenders may require an agreement which provides that the relevant authority continues to pay the project company even without providing the relevant service, so long as the reason the service was not being provided was the unjustifiable modification in the terms and conditions.

4.2 RISK MANAGEMENT INSTRUMENTS. Recent innovation in finance have provided sponsors with new ways for managing certain types of project related risks more cost effectively. These include Options, interest rates caps, swap and futures. The major aim of these derivatives is to hedge the risk associated with REPP by buying certainty and predictability. The above are briefly discussed below.
Meyer, N., European Schemes for Promoting Renewables in Liberalised Markets, 31 Energy Policy ,(2003) 668 71 Vinter, supra note16 at 149 72 Wiser, supra note 6 73 Vinter, supra note 16 at 152
70

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Weather Derivatives This is the most widely used form of derivatives in the RE industry. These are used to protect REPP against the financial uncertainty associated with wind and temperature unpredictability. 74 Resource risks associated with adverse weather conditions can be hedged using a wide range of over- the- counter (OTC) structures. Wind farm Indices are also available to developers in areas with sufficient data to create an index linked to the wind flow 75 and so are precipitation indices.

Put Options. Here, the project is provided with a financial put option but not the obligation to sell power at a future date. This guarantees a certain minimum price level at which the energy from the plant can be sold and thus gives the project the option of selling to the market when market prices are higher.

Swaps Variable interest rates present a risk for projects particularly after construction. Lenders insist such risks are managed by a swap agreement which effectively changes the variable rate for a fixed rate at a price.76

5. CONCLUSION Project financing renewable power projects have been uncommon due to the high level of perceived risks especially technology risk and fuel/resource supply risk. In order to obtain project finance for REPP, investors and sponsors must understand these risks and seek to find ways to mitigate them. It is clear from the foregoing that the risk profile of each REPP will differ from the other. The intermittent nature of wind and solar energy makes their fuel risks an unmanageable risk proportion. However, in the presence of long term supply contracts for biomass and waste, lenders are assured that there is enough resource to run the project thereby avoiding
UNEP, supra note 43 ibid 76 Bulman, D., Exploring the Private Finance Initiative as a Route to Finance for Renewable Energy Projects., DTI, available at http://test.netgates.co.uk/nre/pdf/KBD00216.pdf (last visited 16th April 2006)
75 74

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the problems of irregular cash flow. Furthermore, though project finance is considered more suitable to tested technology, lenders may agree to lend on the condition that extensive guarantees of performance are in place. Firm contracts will need to be provided before lenders will release funds. The success of project financing for REPP depends on the future existence of a market for the power produced. Governments can lend support through fiscal incentives such as tax holidays and credits as well as guarantee sale of a particular volume of power at a premium price. This improves early cash flow and provides better risk cover for REPP. In the absence of schemes which segment the market by creating different rules for REPP, it is doubtful if lenders will be willing to touch such projects. However RES schemes such as the CTM which may lead to volatility of prices is unattractive to lenders due to unpredictability of revenue stream. Long term certainty of these policy designs must also be guaranteed as it helps minimise perceived risks and encourage lenders to finance REPP at reasonable costs. To reduce transaction costs associated with project financing REPP, it has been suggested that similar smaller projects that meet particular financial criteria could be bundled together and considered as a single larger project costs. Investors must also keep abreast with risk management instruments in order to determine effective ways to successfully manage project risks. As satellite monitoring technology becomes less expensive, weather data will be more readily collected creating innovative opportunities for derivatives. Finally, banks must be willing to give REPPs a chance because as more REPP become successfully financed, perceived risks and costs associated with RES become reduced.
77

thus reducing financing

77

Morris, E., supra

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BIBLIOGRAPHY Books Chance, C., (Firm) Project Finance (London, United Kingdom: IFR Publishing, 1991) Donaldson, T., Project Lending (London United Kingdom: Butterworths 1992) Nevitt, P., Fabozzi. F., Project Financing, (7th ed).(London, United Kingdom Euromoney Books, 2000) UNEP, Financial Risk Management Instruments for Renewable Energy Projects: Summary Document (Oxford, United Kingdom: World Publications, 2004) Vinter, G.,, Project Finance, (3rd Edition) (London United Kingdom: Sweet & Maxwell, 2006)

Articles Meyer, N., European Schemes for Promoting Renewable in Liberalised Markets, 31 Energy Policy, 665-675 (2003)

Others Conference Proceedings Feo, et al, Financing of Renewable Energy Projects, Conference paper presented at the 17th NREL Industry Growth Forum, October 2004

Internet Brown, M., Financing Renewable Energy: Obstacles and Solutions, 1994, available at http://www.osti.gov/bridge/servlets/purl/258150-c3YX64/webviewable/258150.pdf (Last Visited 24th April, 2006) Bronicki, L., Financing Private Geothermal Power Plants Projects: Hurdles and Opportunities. Conference paper presented at the World Geothermal Congress Japan, 2000. Available at http://geothermie.de/egec-geothernet/prof/0548.PDF (Last visited 23rd April 2006) Bulman, D., Cooper, W., et al, Commercial Agreements and Documentation Relevant for Financing Renewable Energy Schemes.1997 Available at http://test.netgates.co.uk/nre/pdf/KFR00032/REPORT.pdf (Last visited 23rd April, 2006)

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