EXPLORING THE CAPITAL MARKETS AND SECURITISATION FOR RENEWABLE ENERGY PROJECTS ETSU K/BD/00215/REP Contractor Impax Capital Corporation Ltd Prepared by M E Haggard M A Thompson S Colonna The work described in this report was carried out under contract as part of the New and Renewable Energy Programme, managed by ETSU on behalf of the Department of Trade and Industry. The views and judgements expressed in this report are those of the contractor and do not necessarily reflect those of ETSU or the Department of Trade and Industry. First published 2000 © Crown copyright 2000 Limitation of Responsibility This document has been prepared by Imp ax Capital Corporation Ltd (“Impax Capital”) with support from CMS Cameron McKenna based on materials and information supplied by various sources believed to be reliable. Impax Capital has made limited independent investigation of such information and makes no representation or warranty (express or implied) as to the accuracy, completeness or fairness of the information, opinions or projections herein. Nevertheless, additional information is available on request. Recipients of this report are not to construe the contents of this report as investment, legal or tax advice. Each recipient should consult its own counsel, accountant, independent adviser or other advisers as to legal, tax, business, financial and related aspects of this report. Except where otherwise indicated, this report speaks as of the date hereof. The delivery of this report shall not under any circumstances, create any implication that there has been no change in the rules or activities of the subjects contained herein since the report’s date. In furnishing this report Impax Capital undertakes no obligation to update any of the information contained herein. ----- Acknowledgements------ Written with support from CMS Cameron McKenna The capital markets are a large and constantly evolving arena. Without the participation and support of many highly skilled practitioners in the market, the value of this report would be significantly diminished. It is only by working closely with people actively involved in the market, that a reasonable assessment of investment potential is possible. The following companies were particularly generous with their time and support: Barclays Capital Financial Security Assurance (UK) Greenwich Natwest Fitch IBCA HSBC Investment Bank Standard & Poor’s Prudential Portfolio Managers UK J Henry Schroder & Co ii 1. Executive Summary > Availability of finance is a function of the renewable energy framework and commercially sound projects; > Capital markets provide a large, long term and liquid source of finance for infrastructure; > Capital markets can be flexible and offer looser covenants than commercial bank debt, however, credit quality of the sponsors in conjunction with the main agreements (EPC, fuel supply, PPA and O&M) is paramount; > Green credentials are not bankable in isolation; > Minimum transaction size for public markets is £100 million; therefore, r- Capital markets/securitisation is most appropriate for the refinancing of renewable energy portfolios owned by a single company. 1.1 Introduction The UK’s renewable energy industry has grown significantly over the last decade, due in large part to NFFO providing a long term bankable contract. As the industry grows, the need for financing also grows and like any infrastructure project, renewable energy needs to raise long term finance economically and with tenors that reflect the asset's life. This becomes even more important when the relatively high costs of renewable energy and the new support regime, which is economically less robust, are considered. 1.2 Task This study looks at the opportunities for renewable energy projects to access the bond market to finance projects or refinance existing projects, and what, if anything, is required to facilitate this. In addition, the study looks at the possible use of securitisation to group projects together as a means of dealing with some of the challenges faced by renewables, such as small size relative to most bond issues and the transaction costs. 1.3 Capital Markets and Securitisation The capital markets provide the largest global source of finance (global bond turnover is over $600 billion per day), they are generally very liquid and constantly increasing the range of deals considered. Finance is provided as debt (bonds) and equity raised in the form of tradable securities principally from non-bank sources, such as pension and life companies, insurance companies, corporate investors and private accounts. Securitisation is a process under which pools of future receivables - that is, contractual entitlements to receive amounts of money - are packaged into tradable securities, usually in the form of bonds. In economic terms, an investor buys a share of the cash flows generated by a specific pool of assets and takes the risk that the assets will not generate the expected cash flows. Diversification of the pool and credit enhancement may allow the owner of the assets to reduce their average total borrowing cost. 1.4 Risks and Constraints Capital markets financing exposes the transaction to global market risk, where appetite for certain tenors, asset classes or credits may change unpredictably, with no obvious link to a project’s specific merits. Therefore, prudent sponsors will run capital market and commercial bank financing options in parallel for as long as practicable, to provide some protection against this. When developing a project the financing options need factoring in at an early stage, particularly if a capital markets option is to remain available. This includes issues of legal structure, credit profile and disclosure requirements. Securitisation provides one potential route for a company. However, it is expensive in terms of transaction costs and management time, therefore suitable professional advice is required before embarking on this and other options considered. 1.5 Bank v. Bond In general, the capital markets are better than the commercial bank debt markets at providing: > longer tenors; > fixed and/or indexed rates; > third-party credit enhancement; > softer covenant packages; > less stringent monitoring. However, the commercial bank debt markets is usually better at: > managing construction/completion risk and post-financial close variations; > offering reasonable certainty (price and completion) when raising finance; > managing proprietary or confidential information (controlled disclosure); > dealing with complex or unusual transactions, or sub-investment grade risks. 1.6 Renewable Energy and the Capital Markets The capital markets will consider renewable energy projects, provided fundamental size and credit quality issues are met: > a liquidity minimum for public placements in the secondary market is £100 million. Less than this and the markets impose a ‘liquidity premium’. Private placements can be much smaller and are only limited by the economics of the transaction costs relative to the deal size; IV > quality requirements are the same for any technology: a proven technology, strong EPC, bankable fuel supply, PPA and O&M agreements; > ‘green’ credentials do not translate into a pricing advantage and may even discourage investors on the basis that “fundamental economics are not viable without subsidy”. Complex deals, whether renewable energy or fossil fuel plants, may be difficult to place into the primary bond market. Few investors, including large institutional investors, maintain the resources to conduct due diligence that goes much beyond a project’s credit rating and its core report from a rating agency. This means that investors often avoid overly complex or unfamiliar transactions. The degree of sensitivity to these factors also depends on the overall level of market appetite at the time. For renewable energy, complexity may come from unfamiliar technologies, fuel supply issues, green certificates or just the number or diversity of assets to be included. 1.7 Credit Quality and the Percentage Obligation While some renewable technologies are approaching a market price based on the recent NFFO-5 bidding, such as energy from waste (2.39-2.49 p/kWh), this does not convincingly demonstrate market convergence or the ability to compete on a standalone basis with fossil fuel generators. Rather, the prices reflect NFPA’s credit strength, the market ’s comfort and understanding ofNFFO, its 15-year term, plus improvements in technology - remove NFFO and renewable electricity prices will increase for three reasons: > capital costs need covering within the shorter power contract time frames (most PPAs are too short and offtakers have little incentive to provide them for third parties); > lower gearing and higher equity is needed, with the associated cost; > higher debt coverage ratios are required in order to deal with increased risk. Renewable generators under the Percentage Obligation face four new risks that NFFO generators did not: > power market risk (price, volume and balancing charges); > term/renegotiation risk (arms length market contracts rarely exceed 10 years); > green premium risk; > off-taker credit risk. An effective and reliable legislative framework is required for a renewables market to work efficiently. Once this is established, it takes a considerable period for investors to research, understand and become comfortable with (or not, as the case may be) the new arrangements. Further legislative intervention also needs minimising, to ensure prices reflect economic