Project financing basics in the power sector presentation to School of Engineering Columbia...

Project financing basics in the power sector

presentation to School of EngineeringColumbia University

A.J. GouldingNew York, NY

October 24th, 2014

*** NOT FOR ATTRIBUTION ***

My career, both before and after SIPA, has largely focused on the energy industry

Speaker background 2

20142000199819971996199519931991 2003

Joined ICF Resources, focusing on natural gas resource base and Section 29 tax credit for non-conventional fuels production

Moved to New Delhi, ultimately joined USAID working on bagasse cogeneration and clean coal technologies

Commenced studies at SIPA

Summer associate at London Economics International

Led management buyout of North American operations of London Economics International LLC

Joined London Economics International as senior consultant

Worked with top ten power marketing company on asset restructuring

Control 16 MW of hydro at 11 sites

Set up private equity firm


Ampersand has been targeting one acquisition per year

Speaker background 3

Moretown1.2 MW

Burt Dam600 kW

Brooklyn Dam (under construction)600 kW

Peterborough690 kW

Gilman4.85 MW

Collins 1.5 MW

Brockway Mills500 kW

Sebec Lake876 kW

TTTTT

Hollow Dam900 kW

Mount Ida2.9 MW

Tannery Island1.875 MW


Principles of project finance focus on risk isolation and financing efficiency

Somewhat independently of changes in global financial markets, project finance maintains its own framework of terms and conditions that set long-term expectations among project finance lenders

Project Finance is a specialized practice served by dedicated bankers and lawyers with subject matter expertise

Project Finance is a subset of the global financing markets designed to finance large infrastructure projects

Project Finance is structured to depend solely on the cash flows from the project, and is thus “non-recourse” or “limited-recourse” financing

Project Finance supports the development of new infrastructure projects

This means that the lenders have limited recourse to the owner of the infrastructure project if the project is unable to meet its financial obligations

Reduces the cost of capital for new projects with no operating history Allows developers and lenders to take calculated and managed risks in new or uncertain

markets that require a large upfront investment

4Intro to project finance


Project Finance is available in many forms from a range of sources

Project Finance is available in many forms:

Senior Debt Mezzanine Financing Preferred Equity Tax Equity Project Equity

and from many different sources: Commercial Banks Life Insurance Companies Pension Plans Multilateral Institutions Export-Import Banks Taxable Bond Markets Municipal Bond Investors Infrastructure Funds Hedge Funds

With so many different forms and sources of project

finance, how do we choose?

The goal is always to reduce financing costs and maximize

the return to the Developer

The optimal structure depends

on the project’s details

Q

A



► Typically there will be a special purpose company formed to house one or potentially many projects Generally non-recourse financing is sought for the special

purpose entity The project itself must be creditworthy

► Engineering, Procurement and Construction Contract for the supply of the equipment and construction Consider direct purchase of equipment and performance

guarantee coordination as part of this process Direct purchase may be more economic but potentially sets up

developer to be at risk for non-performance Requires very close coordination

► Operations and Maintenance (O&M) contract Possible to self-perform some or all of the maintenance Economies of scale, geographic presence or specific expertise

► Negotiate site control: land lease or purchase

► Interconnection agreement with utility or grid

► Utility agreements for water and other site infrastructure

► Power Purchase Agreement (PPA)

► Financing Agreements

► Key terms of all of these agreements need to be closely coordinated

IPPs are essentially a stack of interrelated contracts

EPC contract

Loan agreement

Power Purchase

Agreement

Site control

agreement

Manufacturer

warranties

O&M agreement

Permits

SPV



► New projects lack operating history, leaving lenders unsure of performance

► Engineers opine on two key aspects:

► Opinions are critical in terms of new technologies or uncertain resource quality

► Experience suggests that resource quality estimates can be dramatically wrong; data may focus on an impact (wind speed) without knowledge of conversion effectiveness

► While equipment performance can be guaranteed, engineering report influences cost of insurance

Engineers play an important role in project financing


resource availability

technical capability


Example project finance structure

Ampersand corporate structure reflects influence of project finance approach

8

Key

ABDH Ampersand Brooklyn Dam Hydro ASLH Ampersand Sebec Lake Hydro LLC

AGE Ampersand Gilman Energy LLC AMIH Ampersand Mount Ida Hydro LLC

AGH Ampersand Gilman Hydro LP ANHH Ampersand New Hampshire Hydro LLC

AHDH Ampersand Hollow Dam Hydro ANYH Ampersand New York Hydro

AHI-P American Hydro Inc. - Peterborough AOHH Ampersand Olcott Harbor Hydro LLC

AMH Ampersand Moretown Hydro LLC ACH Ampersand Collins Hydro LLC

ABMH

Ampersand Brockway Mills Hydro LLC ATIH Ampersand Tannery Island Hydro LLC

Notes:* shows only active subsidiaries** AMIH has similar ownership

structure to ANYH, but is owned directly by AHL

*** AGE has other subsidiaries which hold the former paper mill buildings and associated land

**** represents voting interest; partner holds residual 45% economic interest

Ampersand Energy Partners LLC

(“AEP”)

Ampersand Operations

Company LLC (“AOC”)

Ampersand Hydro LLC (“AHL”)*

ASLH ANHH AMH ANYH AGE***

AHI-P ABDH AGHAMIH** AOHH AHDH

100%

100% 100% 100% 80.1% 55%

51%100%

100%****

controlling interest with AJG

ACH

100%

ABMH

100%

ATIH

100%

► All debt at SPV level

► Operations separate from asset companies

► PPAs at asset companies

► Equity generally at holdco level

► HOWEVER: holdco guarantee in place


Diversity of financing types available depends on stage of project development

Targ

et

Retu

rn

%Fin

an

cin

g

Typ

e

Conceptualization

PPA Signing Construction Operations Retirement

Equity

Preferred Equity

Mezzanine

Equipment

Senior

9Project life cycle and target returns


Example returns to investor classes for highly leveraged project by small developer

-100%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

140%

-40%

-36%

-32%

-28%

-24%

-20%

-16%

-12% -8

%-4

% 0% 4% 8% 12%

16%

20%

24%

28%

Proj

ect R

etur

n

Returns to Investor Classes

Senior Debt

Mezzanine Capital

Preferred Equity

Developer Capital

-100%-90%-80%-70%-60%-50%-40%-30%-20%-10%

0%10%20%30%40%50%60%70%80%90%

100%

4% 8% 12% 16% 20%

Proj

ect R

etur

n

Returns to Investor Classes

Senior Debt

Mezzanine Capital

Preferred Equity

Developer Capital

Example returns to investor classes for

highly leveraged project by small developer.

(Note example uses simplified project returns and disregards investor-

level taxes)

Investor ClassProportion of Capital

Floor Return

Share of Upside

Targeted Returns

Senior Debt 65% 7% 0% 7%

Mezzanine Capital 10% 10% 10% 13%

Preferred Equity 24% 15% 81% 20%

Developer Capital 1% 0% 9% 25-50%

Total/Weighted Avg 100% 9.15% 100% 10.65%

10Project life cycle and target returns


Project DebtCovenants, default, and guarantee

► Project debt is arranged under a core set of terms and conditions that are similar throughout the world

► The details will vary from project to project, but certain key features remain consistent

All of the collateral sits within the four corners of the project company

The project company is fully secured, including assets, shares and assignability of key contracts to lenders

Limitations on modifying key contracts or taking actions outside the ordinary course off business without lender approval

Reserve accounts for debt service, major maintenance or other project risks

► The loan provisions anticipate that an owner will “walk away” from a project once their resources are exhausted, but give lenders the time and tools to assume control of the project and continue operating it for the benefit of the lenders

Owners do in fact “walk away” from projects when prospects for a return on equity have been eliminated

As long as revenues exceed operating costs, plant will remain open, allowing lenders to receive some return on their loans and ultimately for the project capital structure to be rearranged – original lenders may become the equity, with new lenders brought in

11Project debt considerations


There are six key drivers to optimizing Project Finance structures

Changes in financial markets create swings in investor appetite

Euro crisis caused many prominent French project lenders to withdraw from senior debt market

Different generation types have different risk profiles

Larger projects have more options because of the greater liquidity of corresponding financial securities

Lenders ability to enforce remedies drives view of project risk

Many jurisdictions provide tax incentives for debt over equity

Presence of tax incentives for renewable energy projects

Investors and lenders are different in different regions

Management of currency risk

Local bankruptcy and foreclosure laws

Tax lawsCurrency and regional

markets

Global financial conditions

Project type Project size



Closing mechanics and closing costs

► Project Financing is a legally intensive process

Each class of financing generally represented by its own law firm

Attorney for Senior Lenders frequently coordinates documents, signature pages, and the project does not “close” (i.e. fund) until signatures are released by everyone’s counsel

A typical project financing will include several hundred pages of documentation

Legal fees alone can range from $250K to $1 million depending on complexity

Because legal fees do not change much with the size of the project, larger projects enjoy economies of scale

► Lead financial arrangers also receive an upfront fee at close

Fees vary, but arranging senior debt can equal 2% of gross senior debt raised and mezzanine capital can be ~3-5% of gross subdebt

► Upfront fees and legal bills are funded out of proceeds at close and thus indirectly increase the all-in cost of debt

If closing costs are 2% of total debt raised for a 20-year term, this drives up the all-in cost of debt by ~0.37-0.50% (37-50 basis points)



Types of Project Finance availableMezzanine Financing

► Subordinated Debt, often referred to as Mezzanine Financing, sits between senior debt and equity

“Mezzanine” is “an intermediate or fractional story that projects in the form of a balcony over the ground story1”

Similarly, mezzanine financing is paid after senior debt (the ground story in the analogy) but before equity

Mezzanine is used to finance cash flows with too much uncertainty for senior lenders but supported by enough collateral for debt financing

► Funding sources are seeking higher financial returns and thus are willing to accept incremental risk

Cannot declare default without senior lender consent

During distress, senior debt often traps cash until project stabilizes or is refinanced

Mezzanine lender relies on likelihood of recovery in foreclosure process to protect downside risk and some sharing of upside economics

Lenders include specialized funds, hedge funds, insurance companies and some equipment manufacturers

1. Source: Merriam Webster Dictionary



Project DebtCovenants, default, and guarantee

► Project debt is arranged under a core set of terms and conditions that are similar throughout the world

► The details will vary from project to project, but certain key features remain consistent

All of the collateral sits within the four corners of the project company

The project company is fully secured, including assets, shares and assignability of key contracts to lenders

Limitations on modifying key contracts or taking actions outside the ordinary course off business without lender approval

Reserve accounts for debt service, major maintenance or other project risks

► The loan provisions anticipate that an owner will “walk away” from a project once their resources are exhausted, but give lenders the time and tools to assume control of the project and continue operating it for the benefit of the lenders

Owners do in fact “walk away” from projects when prospects for a return on equity have been eliminated

As long as revenues exceed operating costs, plant will remain open, allowing lenders to receive some return on their loans and ultimately for the project capital structure to be rearranged – original lenders may become the equity, with new lenders brought in



Project DebtEstablishment of Debt Service Coverage Ratios

► The Debt Service Coverage Ratio (“DSCR”) is one of the more

heavily negotiated terms

Calculated over a 12-month period as the sum of (i) cash generated

from operations net of any costs that are paid before debt service

divided by (ii) payments to lenders

The “Total DSCR” will include all payments to lenders, including

payments to mezzanine or other subordinated lenders

The ”Senior DSCR” only considers payments of principal, interest and

fees to senior lenders

► Debt is structured around Minimum DSCR and Average DSCR

There is generally a minimum DSCR before cash is trapped at the

project and payments to equity or subordinated lenders are prohibited

There is also a minimum DSCR that can trigger an Event of Default

(often a DSCR < 1.0)

The average DSCR is a measure of the degree of financial risk that the

lenders are willing to assume

► For projects with uneven project cash flows, the amortization

of the debt can be shaped to ensure sufficiently high

minimum DSCR throughout life of loan

Forecasted minimum and average DSCRs reflect amount of leverage project can support:

Highly stable and contracted projects, like Solar PV, might have minimum DSCR 1.125 and average of 1.5, which supports high debt proportion

Projects with higher technology or operating risk will have higher required minimum and average DSCRs and thus a lower proportion of debt (e.g. biomass could have a min DSCR of 1.4 and an average of 2.0)



Are PPAs necessary?

► Greenfield merchant plant is very difficult to finance, unless on balance sheet

► Project financing is non-recourse to sponsors; if non-recourse, need something to prove credit-worthiness

current market will support 5 to 7 year contracts; is this in turn enough to support new construction?

depends on whether equity will accept back-ended returns

► Question of whether contracts are necessary depends on what bank will accept and whether you believe that prices will be allowed to signal supply shortages

► Plenty of other capital intensive industries show massive capital investment without long term contracts

► Clearly, however, larger facilities are less likely to proceed without some sort of long term contract backing

► So called “gentailer” models pairs retailer with IPP; retailer load may substitute for PPA

Key PPA clauses

parties involved

output guarantees

length of contract

cost allocation of interconnection facilities

tariff rate

billing, invoice, and payment terms

force majeure conditions

settlement of disputes and arbitration

termination of contract

Role of offtake agreement 17


Well designed PPAs effectively allocate risk and reward in an administratively straightforward fashion

TABLE OF CONTENTS TABLE OF CONTENTS(continued)

18Role of offtake agreement


Structure of the PPA incorporates number of key terms

3025

15

2520 20

05

101520253035

Brazil California Connecticut India Saudi Arabia -WEC

Quebec

► PPAs can be lengthy – upwards of 60-80 pages (including schedules)

► Two parties: Buyer and Supplier (Developer) Payment period length varies between different jurisdictions, but typically in the range of

20-25 years r Buyer’s eligible renewable technologies PPA length is intended to match up with expected useful life of equipment and

repayment period for project financing In Ontario, the length of all renewable power PPAs is 20 years, except for hydroelectric

power which has a 50-year payment period (better aligning to the life of hydro assets)

► Main objective is to establish price paid to the Supplier for electricity

► PPA also defines the allocation of risks and responsibilities between Buyer and Supplier

Language from draft PPA:

20-year length: “ending at the beginning of the hour ending 24:00 hours (EST) on the day before the 20th (twentieth) anniversary of the date that is the earlier of (A) the Milestone Date for Commercial Operation and (B) the Commercial Operation Date”

Energy-only structure: “For each hour in a Settlement Period, the Contract Payment shall be an amount expressed in $US and equal to the Hourly Delivered Electricity multiplied by the Indexed Contract Price applicable during the corresponding calendar year”

Examples of PPA length

19Role of offtake agreement


Initial screening model evolves into project pro forma to support financing

Develop estimates of all project parameters based on experience, industry data and vendor quotations

Multiple sites and technologies will be considered at this stage

Narrow alternatives through iterative process

Initial Screening Model

Discounted cash flow model that assists project team from initial screening through project financial close and even into operation

All projects contain common risks Capital cost overruns O&M cost overruns Production shortfalls Force Majeure risks Schedule delays Conversion efficiency

Evaluate what resources should be expended to mitigate risk

Communicate to investors key aspects of the project

Project Pro Forma

Initial Screening

Model

Resource Evaluation

Site Acquisition

Cost

Technology and Vendor

cost estimates

Vendor performance guarantees

Operation and

Maintenance Cost

Interconnect Cost

Revenue

Cost of Development

Financing Assumptions

20Project financial modeling


Pro forma underpins range of contract negotiations

Finance» Leverage Ratio» Debt Rate / Term» ROE» Reserve Req’t

Project Specific» Capacity» Capacity Factor» Degradation

Factors

Construction» Term» Debt Cost

Capital Costs» Pre-construction» Construction» Technology Cost

Improvement Rates

Operating Costs» Fixed O&M» Variable O&M» Fuel Costs, inc.

Start-up

Contract» Term» Escalation

Taxes» Income Tax Rate» Foreign Owner’s» Depreciation

INPUTS OUTPUTS

Levelized Cost of Energy First

Year Contract

Price

Post-Contract» Asset Life» Terminal Value

Debt Service Coverage Ratios

Weighted

Average Cost of Capital



Such models can be extremely detailed, and examine the project from a variety of perspectives

► Discounted cash flow model

► Main cost inputs are the capital, O&M and financing costs

Updated iteratively as inputs change from assumptions to actual numbers

► Coverage ratios are critical element

► Primary output is expected bid price

► Can be calculated for different sensitivity scenarios (contract term, technology, and size of project)

► Accounts for relevant taxation regimes

Indicative Snapshot of the Output Sheet of a Solar PV Financial ModelLevelized Cost of Generation CalculatorInputs

Assumptions [Units] [Value] Outputs Levelized Cost of EnergyType N/A Polycrystalline Weighted Average Cost of Capital 9.2% SAR/MWh USD/MWhProject Capacity MW 10 NPV for Equity Return (SAR '000) 0.0 Total 782.5 208.6 First Year Capacity Factor % 20.0% Levelized Contract Payments (SAR/MWh) 777.4 Fuel - - Year 1-5 Degradation Factor % Decline 0.50% Levelized Contract Payments (USD/MWh) 207.3 O&M 79.5 21.2 Year 6-10 Degradation Factor % Decline 0.50% Year 1 Contract Price (SAR/MWh) 743.2 Debt 504.0 134.4 Year 11-15 Degradation Factor % Decline 0.50% Year 1 Contract Price (USD/MWh) 198.2 Zakat 2.5 0.7 Year 16-20 Degradation Factor % Decline 0.50% Minimum Debt Service Coverage Ratio 1.31 Equity 196.5 52.4 Year 21-25 Degradation Factor % Decline 0.50% Average Debt Service Coverage Ratio 1.36 Year 26-30 Degradation Factor % Decline 0.50%Year 31-35 Degradation Factor % Decline 0.50% Uses of FundsAsset Life Years 30 SAR ('000) SAR/kW USD/kWPre-Construction Expenses 2012 US $/kW 299 Pre-Construction Expenses 11,437.7 1,143.8 305.0 Construction Expenditures 2012 US $/kW 2,300 Construction Expenditures 81,119.4 8,111.9 2,163.0 Financing Fees % of Debt 2.0% Interest During Construction 2,433.58 243.4 64.9 Closing Costs % of Debt 2.0% Financing Fees 1,527.2 152.7 40.7 Minimum Closing Costs 2012 US $ '000 1,000 Closing Costs 3,750.3 375.0 100.0 Maximum Closing Costs 2012 US $ '000 10,000 O&M Reserves 457.7 45.8 12.2 O&M Reserves % of Y1 O&M 50% Initial Debt Service 4,103.7 410.4 109.4 Initial Debt Service % of Y1 DSC 50% Total Capital Expenses 104,829.5 10,483.0 2,795.2 Fixed O&M 2012 US $/kW 23.0Percent of Fixed O&M Escalated % 100% Income StatementKSA or USA Inflation for Fixed O&M KSA or USA KSA COD 1 2 3 4 5 10 15 20Variable O&M 2012 US $/MWh 0.00 Project Capacity (MW) 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 Percent of Variable O&M Escalated % 100% Capacity Factor (%) 20.0% 19.9% 19.8% 19.7% 19.6% 19.1% 18.6% 18.2%KSA or USA Inflation for Variable O&M KSA or USA KSA Annual Generation (MWh) 17,520.0 17,432.4 17,345.2 17,258.5 17,172.2 16,747.2 16,332.7 15,928.4 Heat Rate Btu/kWh 0Fuel Type N/A N/A Contract Payments (SAR/MWh) 743.2 747.1 751.3 755.6 760.2 787.1 822.0 867.1 Start-up Fuel Consumption MMBtu per Start 0 Post-Contract Payments (SAR/MWh) - - - - - - - - Start-up Fuel Type N/A N/A Gross Operating Revenue (SAR '000) 13,020.3 13,023.8 13,030.7 13,040.9 13,054.7 13,182.4 13,425.3 13,811.6 Start-ups per Year # 0Construction Term Months 9 Fixed O&M (SAR '000) 915.4 963.9 1,015.0 1,068.8 1,125.4 1,457.0 1,886.2 2,441.9 Construction Debt Rate % 8.0% Variable O&M (SAR '000) - - - - - - - - Leverage Ratio % 80% Total O&M Expenses (SAR '000) 915.4 963.9 1,015.0 1,068.8 1,125.4 1,457.0 1,886.2 2,441.9 Debt Rate % 8.0%Debt Term Years 20 Start up Fuel Costs (SAR '000) - - - - - - - - Finance Structure Mortgage or Shaped Mortgage Operating Fuel Costs (SAR '000) - - - - - - - - Target Equity Return % 15.0% Total Fuel Expenses (SAR '000) - - - - - - - - Depreciation Structure Straight-line or Tax Straight-lineDepreciation Term Years 20 EBITDA 12,104.9 12,060.0 12,015.7 11,972.1 11,929.3 11,725.4 11,539.0 11,369.7 Contract Term Years 20Portion of Contract Escalated % 10% Depreciation (SAR '000) 5,013.4 5,013.4 5,013.4 5,013.4 5,013.4 5,013.4 5,013.4 5,013.4 KSA or USA Inflation for Contract Escalation KSA or USA KSAInclude Post-contract Revenue Yes/No No EBIT 7,091.5 7,046.6 7,002.3 6,958.7 6,915.8 6,712.0 6,525.6 6,356.3 Terminal Value 2012 US $/kW 0Reserve Account Interest Rate % 5% Debt Interest Payments (SAR '000) 6,709.1 6,562.5 6,404.1 6,233.1 6,048.5 4,878.3 3,159.0 632.7

Debt Principal Payments (SAR '000) 1,832.6 1,979.2 2,137.6 2,308.6 2,493.2 3,663.4 5,382.7 7,909.0 Total Debt Expenses (SAR '000) (83,863.6) 8,541.7 8,541.7 8,541.7 8,541.7 8,541.7 8,541.7 8,541.7 8,541.7

Debt Service Coverage Ratio 1.42 1.41 1.40 1.40 1.39 1.37 1.34 1.31

Zakat Tax Base (SAR '000) 382.4 484.1 598.1 725.6 867.4 1,833.7 3,366.7 7,389.3 Total Zakat Expense (SAR '000) 9.6 12.1 15.0 18.1 21.7 45.8 84.2 184.7

NET INCOME 372.9 472.0 583.2 707.4 845.7 1,787.8 3,282.5 5,538.8

Free Cash Flows

Net Income (SAR '000) 372.9 472.0 583.2 707.4 845.7 1,787.8 3,282.5 5,538.8 + Depreciation (SAR '000) 5,013.4 5,013.4 5,013.4 5,013.4 5,013.4 5,013.4 5,013.4 5,013.4 - Debt Principal Payments (SAR '000) (1,832.6) (1,979.2) (2,137.6) (2,308.6) (2,493.2) (3,663.4) (5,382.7) (7,909.0) + Disbursement of Reserves (SAR '000) - - - - - - - 4,561.3 + Terminal Value (SAR '000) - - - - - - - - Free Cash Flow to Equity (SAR '000) (20,965.9) 3,553.7 3,506.2 3,459.1 3,412.3 3,365.9 3,137.9 2,913.2 7,204.6

SOLVE for LCOE

Indicative Snapshot of the Output Sheet of a Solar PV Financial ModelIndicative Snapshot of the Output Sheet of a Solar PV Financial Model



Concluding remarks

► Project finance is the norm rather than the exception for new infrastructure projects

► When markets are liquid, sponsors can achieve greater amounts of non-recourse financing

► Unexpectedly low gas prices caused many merchant project financings to fail; rising interest rates will pose refinancing risk

► Successful project financings require creativity and flexibility from participants

► Teams of bankers, lawyers, engineers, and developers with strong working relationships help to reduce costs

23Conclusion

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