The solar industry has experienced tremendous growth over the past few years. In the early 2000s, the industry was composed of a few specialized players. With the growth of federal and state level incentive programs as well as innovations in financing, more players entered the space. Programs like the 1603 Cash Grant allowed developers and those that did not have access to tax equity to enter the commercial solar space in a meaningful way by offering Power Purchase Agreements (PPAs). But as stocks of safe-harbored modules dwindle, more of these developers are pursuing PPA financing partners as well as external tax-equity.
With third-party financing, developers originate, permit and build the project with the assurance that an investor will buy the project at COD. In some cases a developer will package the project and sell it once the project is “shovel ready” to an investor to build and own. Under this structure, a developer sells the asset outright and receives payment at COD or through milestone payments during construction. By spending more time developing project pipeline, developers can build up sales and therefore tax appetite. Eventually they can take advantage of the ITC and look to re-invest the capital in owning projects and actively investing in other projects as well. Lastly, as the industry consolidates, developing more projects can be a strategy to demonstrate increased value. The more project pipeline and development experience a developer has the more valuable he becomes to a potential investor or buyer.
With the switch to third-party financing comes several benefits; foremost among them, investors tend to have a lower cost of capital. Coupled with falling module prices and reduced balance of system (BOS) costs, building and selling a project turnkey allows a developer to do what they do best, develop projects and build relationships with hosts.
For developers in the commercial and industrial (C&I) space used to owning their projects through programs like the 1603 Cash Grant, third-party financing comes with its own set of challenges. These challenges include: understanding terminology and project valuation, forging relationships with financing partners, competing with other developers, getting comfortable with perceived changes in the host relationship, and packaging a financeable deal.
When discussing pricing with a potential financing partner, it’s important to be on the same page about valuation. In the solar industry, a project’s value can be quoted in different ways with the most common being dollars per Watt ($/W). Many developers will calculate the value of a project or portfolio based on the net present value (NPV) of the PPA, the ITC and depreciation, and the incentive – if one exists. Investors will value these same project inputs but value the project weighed against their cost of capital, factoring in project risks such as geography, technology, and credit risks. Potential differences in expectations of pricing may arise but are not insurmountable. Investors understand the importance of bringing a competitive bid to the table, as much as developers see the value in cutting costs where possible in order to obtain the highest quality bid. In cases where the developer will sell the project for a developer fee, it’s important to have expectations that are in line with the industry standard. Typical developer fees range between $0.05/W to $0.15/W depending on the quality of the project. Defining a common language in pricing and valuation discussions on the first deal leads to smoother negotiations on future deals.
The competitive nature of this landscape requires that developers build strategic relationships with financing partners as opposed to engaging in one-off transactions. Individual solar deals are complicated and creating a model that can be replicated in follow-on deals is what makes the first deal worth it. Knowing the necessary box to hit to get a project financed streamlines the development process and reduces costs. At Sol Systems, we have created an investment matrix that outlines the qualities of financeable projects that we share with our developer clients. In this vein, the most compelling argument a developer can make to an investor is demonstrating extensive pipeline. In this business, pipeline is king.
Competition with sophisticated developers who have been in this space for a long time can be mitigated in a few different ways. Regional developers know their markets very well and often better than competitors. They have developed key relationships with potential host clients that can be leveraged, especially when it comes to repeat business and building pipeline. Local commercial hosts will also often give preference to regional developers as a way to promote local business. Third-party financing makes these players more competitive by allowing developers to do what they do best, focus on creating stickiness in host relationships and packaging financeable projects and portfolios.
In the distributed generation space, forging host relationships that lead to repeat business is the key to staying in business. It can be very expensive and time consuming; as a result these relationships are highly valued. Going from owning projects to selling them can feel like losing control of these relationships. This doesn’t have to be the case. Investors are not in the business of forging new host relationships, this is a developer’s job. The best way for a developer to continue interfacing with host customers after selling a project is to provide O&M services or to continue developing new projects at other sites owned by the host.
All of the aforementioned does not matter unless a developer can provide financeable projects. Some key elements in the C&I space include project size, standardized documentation, quality hosts, and using bankable technology. Ideally, projects are 200 kW and above. In addition to this, while some financiers bring flexible capital to the space and can even finance non-investment grade and non-profit hosts, most have a pretty tight box. Developers should define standard credit requirements for their hosts. Those in the C&I space can take a lesson from the residential space and reduce transaction costs by creating standardized portfolios.
Because of the difficulties in permitting, financing and grid-integration that abounds in utility scale solar, the C&I space will become more crowded and competitive. Developers in the C&I space can more meaningfully engage in third-party financing by adapting their strategy appropriately. Clarifying valuation with the respective financing partner and managing expectations for developer fees is the first step. Taking advantage of their strengths as regional experts with strong ties to local hosts and great pipeline is the strongest competitive advantage for regional developers. Lastly, building identical portfolios lowers transaction costs and makes working with a regional developer more attractive.
Sol Systems’ project finance team works with developers in this space to refine project and portfolios and make them financeable. Our extensive work in structuring transactions with equity and tax-equity investors provides us with the expertise necessary to make this leap successfully. Developers interested in securing financing for projects in the commercial and industrial space should contact our project finance team at firstname.lastname@example.org 888-235-1538 x2.