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Navigating the Winding Road of Geothermal Project Financing, Part II

In Part I, we discussed proven financing strategies for the drilling and construction phases of geothermal energy projects. The next stage of financing a geothermal project is the “permanent financing” phase, which is generally attempted once the project has achieved Commercial Operations (COD).

Find Part I here.

At this stage, developers have drilled the reservoir wellfield, installed the geothermal brine gathering system, constructed the power plant unit(s) and tested and synced the turbine generators to the electric grid. In other words, the construction phase is complete and developers start the transition to the operational phase.

The ongoing/residual risks that remain during operations include not just the typical power plant equipment risks associated with running a power generation plant, but also the ongoing subsurface resource risks related to the temperature decline and potential flow-rate depletion of the geothermal fuel (brine) that is being “mined” from the reservoir to support the power generation. However, armed with the right financial approach, these risks can also be effectively managed and competitively priced capital can be sourced and structured in the marketplace. By doing so, the ongoing economics for the project developer can be optimized with significant financial benefits — a just return indeed for their having successfully developed and de-risked the project from its inception through to COD.

So what does permanent financing of geothermal projects entail? Broadly speaking, it involves the structuring of a permanent capital stack designed to replace existing short-term project construction financing lenders with longer-term debt, equity and tax equity investors, who have an inherently longer tenor investment horizon. If this critical financing process is properly executed, there is real ability to provide significant incremental liquidity to the project sponsors/developers (e.g. in the form of a dividend or development fee) in conjunction with the permanent financing transaction, thereby enabling them to recycle capital to new development projects and fund their geothermal portfolio development cycle. More developed megawatts (MWs) equates to higher developer Net Present Values (NPVs) and valuations, of course.

By refinancing the construction lending credit facility with an extended tenor tranche, the projects’ long-term contracted cash flows are now better “term-matched” with the debt liability, resulting in more efficient financing on the debt side. On the tax financing side, introducing a tax-advantaged capital tranche (in the form of partnership tax equity or lease equity) results in a successful monetization of the inherent tax attributes associated with the project in the form of MACRS (Modified Accelerated Recovery System depreciation) and potentially ITC (Investment Tax Credits). It is worth pointing out that in recent years several projects in the US have successfully claimed a 1603 Cash Grant under the Treasury’s 1603 program (expired in 2011, but projects commencing construction prior to that date are still eligible) in lieu of the ITC. Note that a discussion around successful tax monetization strategies to unlock value for geothermal projects in the US would involve a more detailed discussion than currently presented in this paper.

Another important facet of permanent financing for geothermal projects involves obtaining a project rating from one of the rating agencies. Securing a high-quality project rating (typically investment grade) can considerably enhance the debt financing economics for the project by enabling a broader fixed income investor pool to participate in the transaction. This increased liquidity of the security offering in turn helps tighten the pricing and drives favorable issuer terms. Of course, there are many factors involved in being able to structure a project to be investment-grade, and the ultimate determination of this is highly case-specific and subject to expert review. Needless to say, there is also a cost and timing issue for procuring a rating that must be weighed against the benefit of ease of execution for these tricky transactions, but typically the benefit of a favorable ratings outcome outweighs the considerations.

In summary, the steps involved for financing a geothermal project can be outlined as follows:

  1. Match the investor type to the project’s current development stage. Understand various investor classes’ relative risk appetites, risk-return profiles and key investment “threshold” issues.
  2. Early stage development (land leases, permitting/environmental) of geothermal projects is similar to other renewable projects. Above ground footprint of a geothermal plant is much smaller/compact relative to solar or wind; but it’s all about having control/access to the right underground resource. One key item, that is expensive, is 3D seismic, but it may prove a wise use of early-stage funds by reducing the risk of “dry holes” during the drilling phase.
  3. Drilling production field:   Consider doing 3D seismic (per #2 above). Need to fund this stage with equity, typically need institutional/strategic equity capital. Some developers may do first couple wells via individual high net-worth investors, similar to E&P world. Challenge for this model is that payback periods and velocity of capital are not generally comparable to the oil & gas sector.
  4. Construction financing:   Determine when adequate “steam behind pipe” has been proven or drilled out, and certified by resource consultant, to facilitate the release of construction capital proceeds.
  5. Permanent financing:  Structure a permanent capital stack to replace existing short-term financing and potentially provide some liquidity to sponsors/developers, enabling them to recycle capital to new projects. Refinance construction facility to an extended tenor tranche, with better term-matching to the project’s long-term contracted cash flows. Consider tax equity financing, either via a partnership or lease, in order to unlock the project tax attributes (MACRS and potentially ITC).  Incorporate the economic benefits derived from a quality credit rating where possible.

Finally, as mentioned in Part I, some projects and companies have accessed the public equity markets in the past in order to finance the development of geothermal projects. While public markets can efficiently finance a portfolio of operating, cash-flow yielding energy projects, financing the development phase of geothermal projects, particularly the drilling component, can be a very challenging endeavor. This is primarily due to the longer time horizon required to successfully drill a wellfield, the potential for cost overruns above budget and so forth — all of which simply do not jive well with retail/institutional public equity investors who are accustomed to frequent, tangible earnings and cash flow updates.

Such updates are not as forthcoming for a long-term horizon, “no cash” development project whose earnings power will only kick in at some “time-uncertain” point in future (subject to several future development “milestones” being met). This characteristic of geothermal projects reinforces and underscores the need for geothermal development to be funded with patient strategic equity — having both the balance sheet wherewithal coupled with the geothermal development, construction and operations expertise — as the most efficient and effective vehicle for financing the buildout of geothermal projects in the U.S.

Lead image: Road sign via Shutterstock

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