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The Advantage in the Waste Industry
Project financings range from relatively simple to comparatively complex. There are several viable credit enhancement mechanisms with others available, which will helP To sTrucTure a bankable ProjecT financing Through The ProPer commercial conTracTual arrangemenTs.
Part one of this article (Waste advantage Magazine, September 2011) outlined an alternative, but growing source of non-recourse project finance debt capital for waste-to-energy (WTE) projects the institutional bond market. Participants in the bond market (including pension funds, insurance companies, mutual funds and high yield investors) look for opportunities to deploy their capital on a risk-adjusted basis. Unlike banks, which often face regulatory or funding constraints and are unwilling to move too far down the credit ladder, bond investors are willing and able to fund projects that may be considered low or below investment grade. Bond investors routinely accept the operating risk of alternative energy projects with contracted cash flows, but if asked to absorb other risks, they will seek additional compensation through higher interest rates and/or additional covenants. These higher rates may quickly erode the financings economics and drive down equity returns. The art and science of project finance is to allocate risks to parties willing and able to bear those risks at the lowest cost. For example, participants in the bond market are generally reluctant to bear construction risk. Many are trying to match long-term liabilities (e.g., life insurance policies) with long-term assets (the bonds they purchase as investments). They do not have the technical skill set or resources to resolve unforeseen construction related issues. If not resolved satisfactorily, underperforming assets will impact their portfolio management and profitability. In order to ensure that the project is built on time and on budget, bond investors generally prefer projects be built under a turn-key lump-sum Engineering Procurement and Construction (EPC) contract with liquidated damages backed by a surety. The EPC contractor, with arguably more knowledge about
building a WTE project compared to an insurance company, essentially absorbs the construction risk and is compensated for that risk through a higher contract price. Currently, the average alternative energy project reviewed by the rating agencies finds itself hovering at the low end of investment grade (BBB) or moving below investment grade (BBB- and lower) based on the credit rating of the off-take counterparty. WTE projects with their feedstock risk (will the waste be made available at the proper economics for the full term of the financing to ensure timely payment of principal and interest?) have additional credit risk relative to wind or solar projects. Mother Nature, their feedstock supplier, doesnt have a credit rating and has no financial incentives to change her behavior. As you move further down the credit ladder your cost of debt increases. The difference in interest rate for a BBB credit relative to a BBBcredit is real and grows substantially with each step down the ladder. When a specific risk cannot be allocated to one of the direct stakeholders in a WTE project at a cost that facilitates the capital formation process (including equity), profit-motivated and other third parties can be brought in to absorb those risks at lower cost.
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the bonds benefitting from the guarantee. Moral obligations are best secured from highly rated entities with an interest in supporting the project for sound policy reasons.
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The Advantage in the Waste Industry
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October 2011
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large loans. There is a minimum equity requirement of 20 percent. Awards are made on a competitive basis. Interest in the program has increased substantially from 2010 to 2011, with the latest round of funding oversubscribed. The 9003 Program will likely need additional appropriations to open another application round in 2012. Federal budget challenges and the political climate in Washington, DC appear to cast doubt on the programs ability to secure an appropriation in the 2012 Farm Bill. Another USDA program that traditionally provides direct loans to power projects is the Rural Utility Service (RUS) whose goal is to support generation, transmission and distribution of electricity in rural areas. The RUS does have the authority to provide credit enhancement through a loan guarantee of a WTE project financing. Privately owned WTE projects accessing the RUS program must sell power to non-profit and cooperative associations who are the traditional customers of the RUS. The RUS program traditionally has ample funding.
Export-Import Bank of the U.S. authorized $363 million in financing to support and export value of $640 million in environmentally beneficial goods and services including alternative energy. The Advantage in the Waste Industry The amount of the loan guarantee from an export finance agency is based on percentage of domestic content (either goods or services) to be exported to a foreign buyer like a WTE project. That loan guarantee becomes a 100 percent unconditional repayment obligation of the export finance agency whose credit rating is equivalent to its national governments credit rating. Similar to the USDA B&I Program in which commercial banks have traditionally provided the funding and servicing for these loans, export finance agency guarantee can be applied to a bond financing, significantly expanding the pools of capital and driving attractive interest rates. Export finance agency financing require goods and service to move across borders. For a WTE project in the U.S., this means securing a guarantee from a foreign country by using foreign technology or a foreign construction services provider. Europe has been a leader in the WTE space as new technologies have been deployed to combat rapidly declining landfill capacity and to meet stricter emissions regulations. Bond investors in the U.S. may not be as comfortable with a technology that has not been commercially deployed domestically despite a rich operating history offshore. Export finance agencies may be more familiar with specific technologies developed or deployed in their country and more likely to support a project financing. They may also support an EPC contractor willing to wrap the performance of the technology that other firms are reluctant to provide.
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guarantees require either an upfront payment and/or an annual payment to the guarantor. However, the all-in cost of capital including these guarantee fees is often significantly less expensive to the alternative of a straight un-enhanced The Advantage in the Waste Industry WTE project financing. As outlined in both part one and part two of this article, the bond market can be a compelling source of debt capital for WTE projects. Part two has covered several viable credit enhancement mechanisms with others available as well. Project financings range from relatively simple to comparatively complex. Project sponsors are well served by securing the advice of a qualified and experienced financial advisor or investment bank early in the development process. This advice will provide detailed insight into how to structure a bankable project financing through the proper commercial contractual arrangements (feedstock, construction, offtake, etc.), and if necessary review the options for cost-effective credit enhancement. | WA John May, Managing Director, is head of the firms Renewable Energy Practice, which he founded in 2003. He can be reached at (314) 743-4026 or jmay@ sternbrothers.com James Dack, Vice President, opened the firms Seattle office in March 2010. He can be reached at (206) 652-3564 or jdack@sternbrothers.com. Adam Pierce joined Stern Brothers in 2010 as an associate in the Firms Alternative Energy group. He can be reached at (314) 743-4003 or apierce@sternbrothers.com.
Note 1. The Organization for Economic Cooperation and Development (OECD) is comprised of 34 democracies with market economies along with other non-members.
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2011 Waste Advantage Magazine, All Rights Reserved. Reprinted from Waste Advantage Magazine. Contents cannot be reprinted without permission from the publisher.
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