Energy Finance 101: What is Project Finance?
Published May 7, 2014
Let’s pretend you’re the CEO of Big Energy Corporation. Your company has been around a few years, has some intellectual property and other assets, and you are thinking about doing a new project. But projects can be risky - what happens if that project goes wrong? You can’t lose these other assets you’ve worked so hard to develop, but this project looks like a great investment. What’s an energy company to do? Well, maybe project finance is the answer.
What is Project Finance?
Project finance is essentially a way to get a project done while protecting the other assets a company might have. As the project sponsor, your company, Big Energy Corp., that wants to build the project, would essentially set up a second company that will build the project. This smaller company is known as the project company; we’ll call it Little Energy Co. Big Energy will own most or all of the equity in Little Energy and likely will run the day-to-day operations, too. Additional funding will come from independent lenders, who will give Little Energy loans. If the project goes wrong for any reason, Little Energy will go bankrupt, but, as the project sponsor, your company, Big Energy, won’t be responsible for repaying any of Little Energy’s debts. Although a little complicated, this kind of arrangement is used all the time in energy, infrastructure, and construction projects. In the case of energy projects, let’s break it down a little further.
As the project sponsor, the company looking to do the project, Big Energy, could be a wind developer planning to build a new wind farm, an oil company starting development of a new resource, or a transmission company planning a new transmission corridor. An established company, this business has assets, liabilities and equity on its balance sheet. It would also have the in-house expertise to evaluate projects in the field and the connections to get them done. Even so, the equity holders in companies like Big Energy Corp. want to limit their risk in case the project doesn’t work out
A Note on Balance Sheets
A balance sheet is a snapshot of a company’s assets, liabilities and equity at a particular point in time. It must always “balance” the assets with the liabilities and equity. For example, for your personal balance sheet, if you borrow $5 from a friend, your liabilities would increase by $5, but the cash in your wallet, an asset, would also increase by $5. This is one of the 3 main types of financial statements (along with the income statement and cash flow statement) that are used to convey the financial health of a company.
Assets = Liabilities + Equity
To limit the risk to investors, a project sponsor will create an independent project company, whose equity they own (at least in part). This independent (from a business and legal perspective) project company will own all the assets associated with the project, such as real estate or equipment, and be able to enter contracts and take loans for the project. These loans, based on the predicted cash flows of the project, are what is usually referred to as “project finance." Often the project company will cease to exist after the loans are repaid, leaving the assets to the project sponsor to be put on its balance sheet.
The capital to build the project is loaned to the project company by lenders, often with a small amount also provided by the project sponsor, like Big Energy. Although each project is different and many different types of loans (working capital loans, construction loans, bank credit facilities, etc.) may be necessary, these lenders can be relied on to loan you the money, as long as you give them a return that makes it worth the risk. Lenders may also be looking to gain tax benefits from their investment, for instance, gaining tax credits that can’t be used by you or your project company due to the lack of profits.
Finally, the project company has many suppliers under contract for things ranging from capital equipment to labor to the utility that will purchase the energy generated. These companies provide labor or other services, but in each case they will work under a clear contract that helps the project company predict expenses or, in the case of a utility offtake (or power purchase agreement, PPA) agreement, predict revenues. These relationships with reliable suppliers lower the risks to the investors, and as a result, the cost of the loans to the project company.
What Can Use Project Finance?
Although project finance is common in the energy field, not all projects in energy are an ideal fit for this kind of financing. When deciding on the right kind of financing to pursue for a particular project, the criteria generally have to do with profits, size, and risk. However, projects that fit the general profile of project finance may not find the needed capital.
One of the first and more important evaluation criteria is whether the margins of the project are right for a project finance situation. In our hypothetical example: will Little Energy generate sufficient revenue to pay back your lenders and provide a return to investors? Are the costs and revenues predictable or, ideally, contractually guaranteed (e.g. under a power purchase agreement)? Investors will look for contracts or historical data that demonstrate that the revenues will be sufficient to cover both the original loan amount, plus the additional required return, plus a cushion, just in case anything goes wrong.
A second important factor for consideration is the size of the project. Although you might have lots of different kinds of investors, the overhead costs of setting up this kind of financing makes it prohibitive if the amount of capital needed is too small. On the flip side, requiring too much capital may scare off investors or raise the cost of capital for the project. These costs mean that if your project requires less than $50 million in loans, it’s probably too small and not ideal for this form of financing.
Finally, most other evaluation criteria can be classified as risk. While we’re planning to explore risk in depth later this year, many factors determine the riskiness of the project. Are there enough physical assets to cover the loans in the case of bankruptcy? Is the technology well established? Are the suppliers reliable? Who has ultimate control over the project? How transparent are you willing to be? The answers to each of these questions affects the willingness of lenders and investors to commit money for a given return, ultimately making or breaking the project.
Why use Project Finance?
Given its complicated nature, why would you choose to utilize project finance instead of other options? In general: to protect your assets. Because project finance sets up an independent company with an independent balance sheet, your other assets aren’t at risk in the case that something goes wrong. Additionally, by having your project company, in this case, Little Energy Co, take on the debt, the sponsoring company, Big Energy, doesn’t have to carry these loans on its balance sheet, making Big Energy more attractive to potential investors and giving them more debt capacity. Finally, especially important to renewables, this kind of structure can allow a company without taxable income to capture the value of tax benefits created.
On the downside, a sponsoring company gives up a substantial amount of control and potentially raises the cost of capital for the project by creating a project company. If Little Energy fails and defaults, Big Energy will not get anything back, because the lenders will take control of Little Energy. Without Big Energy’s assets as collateral for any debt that Little Energy assumes, lenders can, and generally will, demand a higher return. Even with these downsides, many projects still utilize project finance.
In the end, project finance is just a way for you, as the leader of an energy company, to get lenders to help you build the project you’ve had your eye on, but limit your risk if anything goes wrong. It might not seem the most straightforward option, but you get your project, lenders get their returns, and the world gets wind farms, oil pipelines, and natural gas plants.
What about the PTC?
Just when you thought you understood project finance, it turns out there’s more. This overview has been pretty straightforward, but we mentioned that investors might be in it for the tax benefits. Many energy projects offer special tax benefits, from the production tax credit (PTC) for wind, to exploration benefits for oil companies. In many cases, these projects may not generate enough taxable income to have to pay taxes, but your investors may be trying to lower their tax liability. Utilizing even more complicated mechanisms, such as a sale-lease-back or a partnership, the project company can transfer the tax credits to investors, who will then require less of a return on their investment because their taxes will be reduced.
Different Electricity Markets
In addition to the general requirements for a project company, in power, specifically, the market matters. In the U.S., we have two basic kinds of markets – regulated and merchant. Simply put, in regulated markets, the costs of a project are generally approved by the utility commission and can be recovered through charging customers. In merchant markets, there’s more risk to building generation projects, as there’s no guaranteed cost recovery. As a result, projects in merchant markets generally require a long-term power purchase agreement with a local utility to be financially viable.
Asset – anything a company owns that will bring it future economic value; can include cash, intellectual property, or equipment, among other things.
Balance Sheet – a snapshot of a company’s assets, debts, and equity at a single point in time.
Capital – a fancy word for money, it can refer to both debt and equity investments.
Cash Flow – the amount of cash being generated by the company; it is often different than the profits as there are non-cash expenses like depreciation in profits.
Cost of Capital – when taking on either a loan or an equity investment, this is how much the company will pay for the privilege of taking the money; in the case of loans, it would be the interest rate.
Credit Rating – a rating provided by a third party that reflects the likelihood of a company paying its debt, it will determine the interest rate on loans made to that company.
Debt Capacity – a company can only take on so much debt before it affects their credit rating and becomes difficult to find investors willing to make it loans.
Debt – money lent to a company that will have a timeline for repayment and a guaranteed rate of return for the person loaning the money.
Equity – shareholders’ equity or stock; money invested in a company on the belief‑but not guarantee—that it will do well and pay returns.
Liability – something that a company is obligated to pay in the future, like loans, pensions, or money owed to suppliers.
Profit – the amount of money a company is making after paying out all of its expenses and accounting for things like depreciation.
Revenue – the amount of money a company is earning before taking into account expenses.
Risk – the factors that determine how much investors expect to get paid (we plan to do more on how risk is determined later in the series).
Working Capital – money needed for day-to-day expenses at a company, like paying salaries, keeping the lights on, or buying raw materials.
For more detail on project finance, see:
Chris Groobey, John Pierce, Michael Faber, and Greg Broome, "Project Finance Primer for Renewable Energy and Clean Tech Projects," Wilson Sonsini Goodrich & Rosati, August 2010. Accessed May 5, 2014. Avaiable at: http://www.wsgr.com/PDFSearch/ctp_guide.pdf.
National Renewable Energy Laboratory, "Analysis of Project Finance," Energy Analysis, January 21, 2014. Accessed May5, 2014. Available at: http://www.nrel.gov/analysis/key_activities_finance.html.
For more detail on debt, see:
Lauren Oppenheimer and David Hollingsworth, "A Primer on Borrowing," Third Way. Accessed May 5, 2014. Available at: http://www.thirdway.org/publications/506.
For more information on financial statements, see:
Brian J Bushee, "An Introduction to Financial Accounting," Course, The Wharton School of the University of Pennsylvania. Accessed May 5, 2014. Available at: https://www.coursera.org/course/accounting.
For more on electricity markets, see:
Mark Pruitt, "Energy Market Overview and Electricity Markets," Energy Resource Center, University of Illinois at Chicago. Accessed May 5, 2014. Available at: http://www.ecw.org/mwbuildings/presentations/072407pruitt.pdf.
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