PV Performance Guarantees (Part 1): Page 3 of 8
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Consequently, some EPC contractors offer only a 100% guarantee. They may feel that they cannot effectively limit their liability because their reputation is at stake. For example, if a project is extremely underperforming, the value of any damage to the company’s brand may potentially be larger than the cost obligated by the guarantee. Therefore, the contractor provides comprehensive coverage regardless of any contractual obligation. This does not come free. In fact, larger EPC contractors may be forced by their internal structures and accounting methods to provide and charge for these larger guarantees.
The concepts of risk and risk mitigation are fundamental to the structure of PV performance guarantees. Risk is what shapes the language of performance guarantees and determines their inherent obligations. To illustrate the intricacies of performance guarantee negotiations, we provide three perspectives on the risks associated with PV projects—the financier’s, the project developer’s and the EPC contractor’s.
The financier. Photovoltaic projects in the US are unique because they require someone to monetize tax benefits to make the projects work. This requires three distinct types of investment: debt (bank financing), tax equity and sponsor equity. A typical utility-scale PV project is financed using 50% debt, 30% tax equity and 20% sponsor equity, as shown in Chart 1 (below). Note that debt and tax equity represent substantially more of the total capital input. This amount of money reduces the amount required from the equity investors, (those investors with an ownership stake in the project), and increases their returns.
As an example, imagine a project that costs $100 and returns $110. If the project is financed with sponsor equity, the equity investors get $10 on a $100 investment, which is a 10% return. However, the math looks quite different if the equity investors get $80 from the bank, and the bank asks for a $4 return. In this case, the bank gets a 5% return, which may be perfectly acceptable provided it is guaranteed to get its money back first. After the debt is serviced, the equity investors get the remaining $6. However, the equity investors put in only $20 ($100 – $80 from the bank), which means they are getting $6 in return for a $20 investment—a 30% return. In this manner, the equity investors are putting in less money and making a higher internal rate or return. In the US today, it is unlikely that PV project returns will be adequate for project sponsors without placing debt and increasing the equity returns.
Bank financing requires a lower rate of return because this debt is senior to sponsor equity, meaning it gets paid off first, and is therefore less risky. This makes debt prices less. Banks also take a much lower risk position by ensuring that there are cash reserves and high debt service coverage ratios. Especially in the wake of the 2008 financial crisis, banks are hesitant to assume unknown risks. Therefore, the bank must have another entity provide adequate coverage to ensure system performance.
The project developer tends to be a smaller, less established player compared to the bank or the EPC contractor. Therefore, the contractor is the natural performance guarantor for the bank. A large balance sheet and the proven ability to fix problems over a period of 5 or more years are essential. Someone must provide a solid and convincing story about the performance of the system to maximize the amount of debt and increase the equity returns. The strength and the structure are highly deal-dependent. While the bank may not be able to give a specific example of the terms required, it knows a good performance guarantee when presented with one.
The developer. The photovoltaic project developer is responsible for bringing together the five essential project pillars: real estate, interconnection, power takeoff, permitting and financing. In the process, the developer attempts to assemble a comprehensive package that has a high chance of success with financiers. While large PV projects have some inherent risk, the developer is in a position to apply low-risk bank philosophy to mitigate it.
The developer generally finds it easier to work with the EPC contractor than with the bank. Bank financing tends to be somewhat binary: yes or no. EPC contractors, however, have a level of flexibility. They are motivated to find a performance guarantee that works. After all, if there is no guarantee, there is no project. In addition, EPC contractors are in a good position to own the performance risk. They design, build and commission the project, which limits or controls their exposure.
Performance guarantees need to be provided by an EPC contractor with sufficient experience and a sizable balance sheet. In European PV markets, EPC contractors provide very strong guarantees. This is in part due to the large size of European EPC providers; they can afford to provide strong guarantees. It is also true that EPC contractors are providing increasingly comprehensive performance guarantees as a means of differentiating themselves from the competition. While financiers are not always clear about a guarantee’s requirements, a project without a performance guarantee almost certainly fails to find bank financing. A project without debt is simply not viable.