TransformationCleantech: enabling the business

response to climate changeGlobal cleantech insights and trends report 2008-09

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When we think of emerging technology, we think of disruptive technology that can be deployed more cheaply, faster and with less complexity than what it’s replacing.

That is true unless you’re talking about renewable power generation. As with other emerging technologies, there is still a technology risk. Venture capitalists make consistent bets in the tens of millions of dollars that pricing on thin film solar will continue to decline as efficiency increases or that power from waves or tides can be a consistent alternative to coal-based power. Dams, power plants and other large-scale conventional projects are built with access to billions of dollars in project finance capital from insurance companies and the public markets. This is where any similarities end.

Venture capital will sponsor inexperienced management teams with unproven technologies but not to the point of excessive concentrated risk in a single project. Project investors finance billions in conventional power generation worldwide with currency, legal and expropriation risk. But they will not finance early-stage technology companies with performance and scaling risk as well as the lack of experience of prior investors. As clean technologies continue to come to market and the developers of these technologies transition from innovators to operators, the

commercial financing gap will remain daunting. In this article, we examine the drivers of the US market and the basics of project finance, as well as some of the asset structuring required for renewable power finance.

International trendsAccording to the United Nations Environment Programme’s Global Trends in Sustainable Energy Investment 2008, nearly US$150 billion in new money flowed into the clean energy sector in 2007 — a 60% increase over 2006 investment levels. The report goes on to state that investment levels are on track to reach US$450 billion a year by 2012 and US$600 billion a year in 2020.

The majority of the new money (57%) went into asset financing or the actual build-out of renewable power generation as opposed to research and development (R&D) or manufacturing scale-up. Wind power accounted for 43% of all new investment in 2007, which is understandable given the maturity of the technology. Solar experienced a change in investor sentiment in 2007 versus 2006, as large-scale deployment via asset financing increased from 6% of total new investment in 2006 to 21% in 2007. Solar continues to post very strong investment growth year-over-year, averaging 254% since 2004.

Europe led the way in 2007 by attracting the bulk of financing as attractive government subsidies continued to support the build-out of renewable power generation projects. European asset finance totaled US$49.5 billion (78% was new build-out), taking 62% of asset finance worldwide.

The US is not too far behind, however, with 28 states implementing renewable portfolio standards (RPS) and another four with voluntary RPS; California increasing its RPS to 33%; and 10 states in the Northeast launching the Regional Greenhouse Gas Initiative (RGGI), according to the Pew Center on Global Climate Change.

RGGI, the first cap-and-trade program in the US, will auction 100% of the allowances and use the proceeds to incentivize renewable power and energy efficiency. Ernst & Young’s quarterly ranking of US states and their relative attractiveness to a renewable power generator, United States Renewable Energy Attractiveness Indices, indicates that on a prospective basis, the US has more favorable fundamentals than other countries when scoring across all renewables (wind, solar, biomass). With European subsidies declining as renewable power production approaches national capacity caps, expect the investment focus to shift to the United

How cleantech can close the financing gap

by Tony Maull, Mid-Atlantic Cleantech Leader, Ernst & Young, and Michael Bernier, Tax Credit Investment Advisory Services, Ernst & Young

Key points

The UN expects worldwide investment levels in the clean • energy sector to increase from US$150 billion annually to US$450 billion by 2012.

Ernst & Young’s • Renewable Energy Attractiveness Indices identifies the US as having the most attractive investment environment among all countries.

Twenty-eight US states currently have a renewable • portfolio standard.

Unproven technology requires creative structures to get • financed — quality cash flow is key to success.

FIN 46(R) makes the identification of the primary • beneficiary and the consolidation of assets and liabilities very complex — legal ownership is not the answer.

21Transformation Cleantech: enabling the business response to climate change

States to fulfill the RPS and access the state-level incentives. The reduction in subsidies for wind and solar explains part of the accelerated growth in asset financing in Europe in 2006 and 2007 as producers rushed to lock up attractive power rates. The caveat to near-term US renewable power generation is the question of whether the federal production tax credit for wind, solar and geothermal will be extended. It is anticipated that the extension will be passed by both houses in November after the 2008 general election.

Project financeAccording to the data provider New Energy Finance, financings of renewable energy generating assets grew by 61% in 2007 to US$108 billion from US$67.3 billion in 2006.1 US$84.5 billion went toward building new capacity while the remainder was allocated to refinancing and acquisitions. The allocation remained evenly split between on-balance sheet and off-balance sheet in 2007. Most of the balance sheet financings were completed in China while the off-balance sheet financings were concentrated in the United States and Spain.

Project finance methodsMultiple structures can be utilized to complete an asset financing. They can be levered or all equity; equity can be paid up front or on a scheduled basis (PayGo). The conditions will change, as will the required rate of return, based upon the risk in the technology and the predictability of the cash flow. Sources of cash and tax benefits will typically come from project revenue, renewable energy certificates, tax benefits from accelerated depreciation, federal tax credits (investment or production tax credits) and state incentives.

While the considerations for different kinds of renewable projects, whether wind, biomass or solar, are not entirely the same, the following contract terms capture many of the commonly required items:

Participation agreement• Identifies all parties to the transaction −Funding −Cash flow −Purchasing, leasing, securing or mortgaging assets −Tax indemnification −

1 Global Trends in Sustainable Energy Investment 2008, United Nations Environment Programme, 2008.

2001

US$4.6b(17/103)

IndiaChinaOther OECDEU EuropeUnited States

US$5.1b(38/130)

US$9.3.b(44/197)

US$12.4b(77/267)

US$27.5b(281/502)

US$50.3b(330/547)

US$84.5b(544/906)

US$4.5b(17/103)

US$5.1b(38/130)

US$9.3.b(44/197)

US$12.4b(77/267)

US$27.5b(281/502)

US$50.3b(330/547)

US$84.5b(544/906)

2002 2003 2004 2005 2006 2007

2001 2002 2003 2004 2005 2006 2007

Lease/vendor financingBondProject financeBalance sheet/syndicated equity

Figure 1 : asset finance new investment by region

Figure 2 : asset finance new investment by type of security

Note: this figure represents investment for new-build clean energy projects. Numbers in brackets refer to disclosed/total deals

Source: United Nations Environment Programme, Global Trends in Sustainable Energy Investment 2008

Note: this figure represents investment for new-build clean energy projects. Numbers in brackets refer to disclosed/total deals

Source: United Nations Environment Programme, Global Trends in Sustainable Energy Investment 2008

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Lease agreement (if lease structure is used)• Lessee, lessor, owner trustee or equity participants −Term −Renewal options −Fair market value purchase options −

Facility lease agreement for fixed assets• Easement and access rights to property −

Partnership agreement (if partnership flip used)• Cash flow −Taxable income or loss −Tax credits −Preferred returns −Residual allocations −

Power purchase agreement or energy services agreement• Sale of power −

Construction contracts• Construction loan agreement −

Project finance case study:solar photovoltaic rooftop installation structured as an unleveraged partnership flipThe following case provides a practical example of how the various elements of renewable projects come together in the US, highlighting the important considerations and benefits.

In this case, the sponsor enters into an agreement with a host where the host will lease its roof space to the sponsor. The sponsor and the host will enter into a power purchase agreement (PPA) whereby the sponsor will sell the electricity generated by solar equipment installed on the host’s roof for a fixed price for a period of time. Typically, the fixed price will inflate at a rate of 2% or 3% over the life of the agreement.

Once installation of the solar equipment is complete, but prior to its being put in service, the equipment will be sold to a partnership consisting of the sponsor and the tax equity investor. The equity contribution of each party is negotiated. The contribution on the part of the sponsor can be nominal but is typically 1% to 5%. The ability of the tax equity investor to buy more deeply into

the project is a function of the terms of the PPA and the credit-worthiness of the power purchaser. The partnership will be responsible for the future sale of the electricity and equipment maintenance. The partnership will receive all of the revenues associated with the project including tax credits, state incentives and renewable energy certificates. The amount of capital contributed to the partnership by the tax equity investor is the net present value of the tax benefits and liabilities, and the free cash flow expected to be allocated to the tax equity investor until the allocation flip.

The tax benefits and free cash flow of the partnership will be allocated between the two parties with 99% of all benefits going to the tax equity investor and 1% going to the sponsor until the tax equity investor receives a predetermined return (currently 8% after tax). Once the required return is met, the allocations automatically flip so the sponsor typically receives 95% (negotiated) of all the benefits. The tax equity investor should achieve its target internal rate of return within 15 years. After the flip, the sponsor typically has the right to buy the tax equity investor’s remaining interest at fair market value of the investor’s expected cash flow.

The parties to this structure are as follows:

Sponsor• — the project developer, who typically plays other roles within the transaction including PPA provider, panel supplier and panel installer

Tax equity investor • — the entity that can readily utilize the tax benefits generated by renewable energy facilities

Host• — the provider of the property where the solar installation is sited; typically acts as the purchaser of the generated power

Renewable energy credit (REC) market• — the local utility in the state with an RPS is typically the buyer of the credit

State and local government• — provide local incentives such as California’s Solar Initiative (US$3 billion to promote the installation of 3,000MW by 2016)

23Transformation Cleantech: enabling the business response to climate change

US accounting and tax considerationsThe Financial Accounting Standards Board (FASB) Interpretation No. 46(R) (FIN 46(R)) addresses the consolidation of off-balance sheet entities. Ernst & Young’s Financial Reporting Developments booklet on FIN 46(R) identifies in detail the application of its complex provisions. The FASB concluded that guidance should be based on residual risks and rewards in certain cases — measured by variability in returns — rather than legal control and thus introduced the concept of the variable interest entity (VIE). An entity is defined as a VIE when:

The total equity investment at risk is not sufficient to permit the 1. entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders

As a group, the holders of the equity investment at risk lack 2. any one of the following three characteristics of a controlling financial interest:

The direct or indirect ability through voting rights to make a. a decision about the entity’s activities that has a significant effect on the success of the entity

The obligation to absorb the expected losses of the entity b.

The right to receive the expected residual returns of the entityc.

The voting rights of some investors are not proportional to their 3. obligations to absorb the expected losses of the entity, their rights to receive the expected residual returns of the entity or both, and substantially all of the entity’s activities (for example, providing financing or buying assets) either involve or are conducted on behalf of an investor that has disproportionately few voting rights

FIN 46(R) requires that the primary beneficiary of a VIE consolidate the entity. It is possible that the purchaser of the power under a fixed-price, long-term contract that exceeds 80% of the useful life of the asset and does not own a share in the project could be deemed to be the primary beneficiary. Under this circumstance, the purchaser would consolidate the asset and its related liability in its financial statements. Determining whether a purchaser is a primary beneficiary is very complex and requires review of the power purchase or the energy services agreement and an understanding of the risks the entity was designed to create and distribute.

If no party is found to be the primary beneficiary of a VIE, each equity owner would recognize its share of the project company’s earnings below the line as “equity investment in an unconsolidated subsidiary.” When the share is below 20%, neither consolidation nor the equity investment method may be required if certain conditions are met. If the investor is a pass-through entity, the owner’s equity investment is required to be below 3% to avoid the equity method. Power purchasers must also evaluate whether their purchase agreements constitute a lease pursuant to Emerging Issues Task Force (EITF) Issue No. 01-08, Determining Whether an Arrangement is a Lease.

As shown in the financing example, tax benefits from accelerated depreciation, interest deductions, R&D, investment and production credits and noncapitalized start-up expenses are a significant contributor to the overall return of a project. The consolidation issues that pertain to FIN 46(R) do not apply to income tax accounting, but 80% control requires tax consolidation, and in the case of foreign subsidiaries, 50% control may require consolidation. Careful consideration has to be given to who owns the asset and can utilize the tax benefits. The structures discussed earlier are not for the exclusive use of venture capital-backed companies that are years away from paying taxes. Even significant global entities that have emerged from bankruptcy or are in a low-tax situation should profit by bringing in a partner that can put the tax advantages to greater benefit, thereby lowering the total cost of the project.

ConclusionThere are multiple project structures that can be deployed and no one structure is best for all situations. Issues related to cash flow, revenue recognition, primary beneficiary status and risk have to be considered in the proper context. Some market participants believe the market has lost confidence in complex structures. The questions of complexity and number of participants certainly increase the difficulty of completing a transaction, but as long as the ownership and risk are transparent and the cash flow is clearly identified, the project has a good chance of getting financed.

We believe that the impetus of higher power rates, renewable portfolio standards and cap-and-trade programs will spur more renewable power generation projects and even greater financial considerations as renewable power project cash flows are securitized and more financial derivatives are created to mitigate risk and attract new investors into the market.

Ernst & Young

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