Sometimes known as non-recourse finance, project finance emerged as a popular technique in the 1980s primarily as a means of supporting new energy projects. The concept consists of financing specific projects with recourse only to a ring-fenced project company (for example, a public utility that financially separates itself from a parent company that engages in non-regulatory business to protect consumers from losses), supported by a strong contractual framework including a fixed-price power-purchase agreement (PPA).
Until the financial crisis of 2008, this model proved remarkably enduring. And even in the post-crisis environment, it has been relatively stable, at least compared to other syndicated lending structures. Yet the landscape is changing, which will have a significant impact on renewable energy financing.
In a recent white paper Making the Difference, Siemens Financial Services described its view of the way these changes will impact the role of project finance as a financing technique for future energy projects, including in the renewables sector.
Bank Appetite Constrained
Of the changes underway, the paper outlined that the most significant change involves the disruption in the bank credit markets for energy projects. The crisis has had a profound impact on the ability of banks — especially in the U.S. and Europe — to maintain large lending portfolios. This has affected their appetite for taking on new, long-dated project finance loans.
Typically, project finance requires long-term funding at a predictable cost — a need that has become increasingly difficult to satisfy as banks have retrenched from “riskier” financings in order to strengthen their balance sheets. Significantly, this — perhaps cyclical — situation is likely to be reinforced by regulatory proposals such as Basel III (impacting all OECD banks), as well as more local regulatory regimes such as the Dodd-Frank Act in the U.S. While an understandable, and appropriate, reaction to the systemic threat posed by the 2008 crisis, these stipulations are likely to further reduce bank appetite for project lending, and have already led to some banks re-orienting away from pure balance-sheet lending and more towards a distribution-based model.
Indeed, even before the crisis many of the large project finance banks had been moving towards an “originate-to-distribute” model, where banks originate and structure major financings before distributing the financial assets to a wide group of investors. Banks retain the role of underwriter and (partial) investor, and, in fact, may be a major participant for the construction phase of the project. However, the aim is to — post-completion (or earlier) — sell almost their entire credit exposure into the secondary debt market. This allows banks to widen their pool of investors to include institutions such as pension funds, insurance companies and specialist funds, which attracts more capital into the project finance space while reducing their balance-sheet exposure.
However, while part of the solution, the originate-to-distribute model is not a panacea. Project sponsors remain eager to see major lenders not only originate deals, but also hold significant debt exposure until maturity. A key reason for this is that corporate treasurers of project sponsors — aware of bank limits — are careful to guard their allocated lending capacity from the banking community.
Project bonds (the route that institutions are most likely to buy infrastructure assets) are inevitably distributed to a wide number of investors, which may have an impact down the line. However, negotiating with a select group of bank lenders to reschedule a loan is easier than with a bondholder group. A project bond (if that’s the route chosen) also requires a rating. This means a ratings agency will — inevitably — adopt a risk-analysis approach that includes a “look through” to the underlying consortium of the project sponsors, which can make some sponsors uncomfortable.
The originator-distributor model is, therefore, a fine balance between the bank’s desire to move towards capital markets-style issuance for project debt and the sponsor’s desire for long-term funding from a reliable group of relationship lenders.
Technology Risk A Concern
The fluctuating bank appetite for project financing impacts another area crucial for success: technology. The early energy project financings supported well-established technologies, while the newer generation of project financings are often for renewable technologies, such as offshore windpower, that have yet to win a long-term operational track-record.
Interest from Institutional Investors
The heightened perception of technology and political risks are important because of another major trend underway. The low interest-rate environment since 2008 has led many institutional investors, such as pension funds and insurance companies, to diversify their fixed-income asset base in order to seek yield. And infrastructure financing is one area many of these non-bank financial institutions are keen to explore.
Added to the institutional investors are specialist infrastructure funds that have grown in number in recent years. Often staffed by former project finance bankers, they are tapping alternative sources of financing (hedge funds for example) in order to build funds that can take both equity and, increasingly, debt positions in project financing.
However, even the leading institutions are only slowly developing the necessary evaluation skills with respect to assessing project (including technology and political) risks. Many are building their expertise, although this is a long-term commitment that will take time and may be limited to only the largest institutions. Another route is to partner or collaborate with a major project finance bank in order to develop risk-sharing models that help institutions gain comfort.
Certainly, the leading project finance banks are now interested in pursuing partnership risk-sharing agreements (for example, the recently-signed partnership between French bank Natixis and Benelux-based insurer Ageas), as are some of the leading project sponsors.
The Role of the “Captive” Financier
And it’s here where the “captive” financiers can play a leading role. Project developers — whether private consortiums or public entities — have for many years awarded contracts to original equipment manufacturers (OEMs) or engineering, procurement and construction (EPC) contractors based as much as the financing as on the technology, and this has increasingly involved both debt and equity elements.
Meanwhile, projects such as offshore wind make equipment supply the most significant element of the project, which includes erecting the wind turbines and developing the associated infrastructure. For this reason, it makes sense that technology suppliers such as Siemens became major stakeholders (i.e., equity investor) in the projects they supply, and captives should view projects as long-term investments rather than short-term equipment supply contracts.
Yet this is not a role captive financiers should offer reluctantly. They can become a catalyst for helping generate financial solutions that mitigate the technology and political risks and bring in new investors — helping them over their potential knowledge-gap by showing strong commitment through significant financial investment in their own technology.
Siemens’ captive financier, Siemens Financial Services (SFS), is certainly keen to play such a proactive role in energy project financings. Indeed, the restriction of bank liquidity to support smaller entities has had an impact on the Siemens “value chain” involving both clients and suppliers, meaning that SFS has, since the crisis, been playing a more active role in financially-supporting its value chain.
Of course, this is a role SFS was set up to undertake, although it has increased in intensity since the 2008 crisis. With respect to large-scale project financings, however, SFS does not see itself as a backstop provider of liquidity. It envisages a role as a key stakeholder — bringing confidence to other stakeholders, especially those still in the process of developing their project-evaluation expertise.
SFS, as Siemens’ captive, views its role as supporting the company’s technology supply — partly as a catalyst to ease the passage of the transaction, but also as an investor making a clear statement of confidence in Siemens’ technology: one intended to assist others in seeking the comfort they require to support the transaction.
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