Battery storage, electric vehicle infrastructure, community solar, micro-grids and fuel cells are emerging markets on which lenders like Investec are focused as potential growth areas.
The challenge is that each has elements of risk that have more in common with late-stage venture capital than typical project finance. It is possible to see through to potential project finance transactions, but it is still early in the lifecycle for a project finance lender.
The project finance market is not set up to take technology risk in any major way, so the early movers in these markets are focused on areas where technology is not a major factor.
The project finance market will take business risk. Thus, the questions project finance lenders are asking about any technology that has been proven are whether the business model makes sense, is it sustainable, and are the elements in place to grow it? How much deal flow is possible if we commit the resources to the market?
The early deals tend to be riskier deals. This is reflected in how a bank will structure them: for example, with less leverage. The deals tend to be at the smaller end of the spectrum which makes them hard to syndicate by bringing in other banks as co-lenders. Bank margins are higher to reflect the additional perceived risk. Some borrowers will have never done project financing before. At the same time, the lender will be looking for a template that is sustainable and scalable.
There are not a lot of project finance lenders that can accept this type of risk or are willing to lend at such an early stage of a developing market. Thus, the universe of potential lenders is small.
Nevertheless, many lenders will try to mitigate the risk by bringing in a couple of other lenders with them.
The loan amounts are often less than $50 million for most such transactions. Any lender playing in this market will want to see an opportunity, by taking development-type risk, to become smarter earlier than the rest of the market and grow with a promising company and the market. Eventually, the higher-cost early-stage debt will be replaced with lower-cost capital as the business model becomes more widely accepted.
Project finance banks see all sorts of deals. Companies that have management teams that understand how to move over time to more of a project finance model come to us before deals are ripe for project financing just to understand what is doable. They want to know what they have to put in place in order to make a project or a portfolio financeable from a project-finance standpoint.
Other management teams come at this from the technology side. Project finance is something with which they are not very familiar. Working with them takes a lot more time for the lender. The scale is often a little too small for the bank market, so lenders will be careful and selective.
The main things on which the lender will focus are technology risk — the project finance market does not take it — and visibility on revenues. It will want a reasonable period of contracted revenues. No one is expecting the equivalent of a 20-year power purchase agreement in these emerging markets, but the longer the revenues can be contracted, the better.
When the residential solar market emerged as a truly bankable market, the issues were initially around consumer credit. For something like storage, the regulatory regime is still being written. One of the challenges in any new market is to figure out what you do not know. Project finance is an exercise in identifying all the risks and then assessing how they can be mitigated or be assigned to other parties in the transaction. A basic rule of thumb in project finance transactions is the person who best understands and is in a position to manage the risk takes it.
Maybe the lender starts with something small like a pilot-scale project where the developer has enough contracted revenue to begin to finance against. Just start putting the pieces together and build over time.
It may be worth a lender’s time to do a smaller and less profitable early transaction because it is a good entry point into a broader pipeline of transactions.
Stem, a battery company, is a good example. It has been one of the early movers in the storage market. It is well capitalized and has brand recognition. It has been working to perfect business models that are financeable, and it is now getting traction with financiers. It announced a deal recently with the Ontario Teachers’ Pension Plan to finance shared savings programs on some of its battery deployments.
The shared savings model is interesting. The battery owner is paid a share of the savings on electricity costs realized by the customer. The challenge for any lender is to figure out how to add value after there is enough experience with the business model to be able to price it properly.
Lenders are trying to crack the code of how to deal with a battery company whose customers are corporations without credit ratings. The battery company may have 10- and 15-year contracts with these customers to share electricity savings from installing a battery. Evaluating the credit risk that the customer will continue to meet its obligations during the contract term is challenging.
Lenders are playing with different tools to try to address this. For example, rating agencies like Moody’s and S&P have proprietary models that effectively produce a credit score. Lenders are assessing whether they can finance off such credit scores. Will the broader market accept such proxy ratings as reliable? If so, it will open a much larger market. Maybe a portfolio is the answer. There is risk diversification in aggregating a lot of corporate credits.
When the bank market started lending to residential solar companies, it had to get comfortable with assessing FICO scores. This was something that was very new and, frankly, some banks even today are not particularly comfortable with consumer credit risk in project finance transactions.
The idea was to focus on higher-rated credits, create baskets of risk, and create a portfolio that has some level of diversification that is able to withstand downturns. As a result, these loans continue to perform well. The goal would be to build something like that for corporate credits.
The big picture with storage is that the industry is still waiting to understand how these resources fit into the grid. The Federal Energy Regulatory Commission issued Order No. 841 in February which will help, but there is plenty of work to be done.
Beyond that, the opportunities vary by region. California, New York, Ontario and New Jersey, for example, have introduced incentives to promote standalone storage. The financial community is still getting its head around the standalone business model.
Storage in conjunction with other types of assets is getting more traction quickly. An example is where battery storage is added to a utility-scale solar project. A lender is not particularly concerned about whether that storage is economic as long as the solar project can cover the debt service.
With standalone storage, lenders are still trying to understand the revenue model, the technology and the use cases. Financing becomes easier to the extent there is a contract requiring capacity payments or a reservation charge for use of the storage facility. The financing becomes even more interesting where there are potentially multiple revenue streams and the bank is relying on some contracted and some market-based revenues and, in some cases, shared savings. There is room for creativity in such situations.
Lithium-ion batteries are the name of the game today. There are many other technologies competing for market share. Lithium ion enjoys scale and continues to ramp up. It benefits from the build out of cell production capacity to serve the electric vehicle market. At the moment, it is the most aggressively priced and has the backing of larger industry players.
Having someone like a Samsung or LG stand behind the performance warranty for a lithium-ion battery is a big plus from a project finance standpoint. As we move into other technologies like flow batteries, they tend to be backed by smaller companies. They lack the economies of scale, so they are more expensive. They are farther away as a technology from being ready for project financing, but may gain traction in specialized applications.
What are the necessary predicates to get a storage project financed? One is to have a major battery supplier involved. Another is a 10-year warranty. At this stage in the technology lifecycle, lenders want to lend for a term that is shorter than the warranty. Next is an experienced project manager with a track record. Next is a satisfactory business model. It is easiest to lend against a capacity payment. If the revenue is shared savings or ancillary services payments from the grid for providing things like voltage regulation, it becomes more time consuming to evaluate, and financing costs are likely to be higher.
We have seen scenarios, like with PJM, where the rules of the game changed and some types of technology could deal with it and some could not. Lenders who have gone through that will want to make sure the technology is solid enough to back up the revenue case.
Lenders are pretty aggressive currently. There are more banks chasing deals than there are good projects to finance. Plenty of banks are looking to do a battery deal. A battery transaction with a stable revenue stream should get a significant number of takers. A transaction that relies on revenue from ancillary services will face more of a risk premium, but those are also attracting a number of bids in the current market.
There is a lot going on behind the scenes in the EV charging area. A major push is expected in the United States to build out charging infrastructure. The key questions are what adoption looks like and what is the revenue model.
Some of the basic elements required to do a project financing are starting to emerge.
Electrify America is a Volkswagen initiative that came out of the diesel-emissions settlement. It has made a commitment to deploy $2 billion over 10 years in charging infrastructure.
One of the planned projects is to electrify the interstate highway network. The interstate highways would have a charging station every 50 to 70 miles. This would help address range anxiety that is an impediment currently to wider adoption of electric vehicles.
At the same time, Volkswagen (along with most other automakers) is introducing a series of electric vehicles that can use the charging network.
When a lender starts to look at financing a portfolio of such charging stations, the first question is what the revenue looks like. It may be possible to contract with a fleet operator for use of the charging network. Public transit will be an early adopter of electric vehicles. It could be such a user.
The revenue models are still very much in the formative stages. Maybe there is an opportunity to co-locate storage with charging stations. The higher the speed of the chargers, the greater the potential for grid deficiencies that might hamper their deployment. Storage can help.
These are the ideas that are being discussed. The goal is to start configuring business models early with an eye toward something that is project financeable. Maybe the answer is a revenue-stacking model where there is possible revenue not only from the EV charger but also from a battery, and maybe a solar array can be looped in as well.
We may be looking at EV charging as a standalone with the proper types of contractual arrangements, or at multiple technologies bundled together in a hub or a unit in order to create a more certain base revenue stream that is high enough to justify the expense of the bundled equipment.
There are no hard-and-fast models yet. The era where financing required a 20-year PPA to be bankable is fading quickly. As technologies become more distributed and the revenue streams become more diverse, lenders will have to deal with multiple contracts and a mix of fixed and market-based revenues. Such arrangements are likely to become the norm in the future.
The biggest mistake lenders make in new areas is to take on risk that they do not understand fully. New areas take time to develop. Lenders will need to do deep diligence, catalog the risks and identify a finite set that they understand well enough to price and underwrite.