After implementing the RPOs mandated by the government of India, the future for renewable energy seems promising. Under the RPO, all electricity companies, and companies that consume significant amounts of power, are required to source 15% of their energy from renewable sources by 2020. Currently, the electricity industry in India has an installed capacity of approximately 250 GW, with 2,132 MW comprising solar. As representatives of the VP of Project Finance for a major bank in Mumbai, we have been approached by a major solar panel manufacturer to provide non-recourse debt for a 100MW solar power project to be built in Gujarat.
While the supply of energy in India barely meets the demand, Gujarat has the highest surplus of power of all the Indian states, with an excess capacity of 1.8GW over its internal demand. When approached by the project sponsor to finance a project for power in Gujarat, we were a bit skeptical. Upon further analysis considering the mandate of the RPOs and the potential for exporting power outside of Gujarat in the event of a surplus, we began crunching some numbers.
Solar power can often mislead us due to the way proponents advertise it. Unlike traditional sources of power, IE fossil fuels, the net capacity for solar energy is significantly lower. Net capacity is equal to the actual output of a power plant over its “advertised” output or peak capacity. To offer a baseline example, the production output for a coal-powered plant is roughly 60%, whereas the output for solar is 20%, respectively.
Naturally, many variables can significantly affect the net output of a plant. For example, solar power depends on sunlight, weather conditions, solar angle, and output loss. With that in mind, potential cash flows for a 100MW solar project can be profoundly smaller when we account for all the variables which can affect the net power production. Below are three modified cash flow statements that offer a best (base) case scenario, a pragmatic scenario, and a worst-case scenario. Each case has different underlying assumptions within them, which we will explain in more detail below.
The average price for non-solar electricity in India is around $0.08USD/kWh. With the large capital expenditures required for solar, the average price per kWh would have to be roughly $0.11USD to break even. For this project to be profitable then, the cost per kilowatt would have to be marginally higher than the base rate of $0.11USD/kWh, assuming outputs stay constant. In our best-case scenario, we price at $0.14/kWh from PPA’s and assume the sponsors are correct in their forecast for spot pricing to go up.
We also assume, rather generously, that power output will be 25%. Based on a $100,000,000USD loan at a rate of 8.20% compounded annually, the amortization schedule in Figure 2 shows annual payments of $11,826,014 required from the sponsors beginning one year after they initiate the loan. In the best-case scenario, the CFADS = $19,922,086.67 with a DSCR of 1.68, so this is good. But let’s move on to the pragmatic scenario, as this is the more likely case. The pragmatic case assumes future spot pricing will hold no benefit, and the price per kWh will be $0.12, just marginally higher than the structured cost. Additionally, this case assumes an output of 20%.
Even with these more stringent assumptions, the pragmatic case seems to show good cash flow. However, as any decent lender must know, the worst-case scenario must always be factored in. In the last scenario (worst-case), we assume output is only a mere 15%, and not locking in PPAs for 50% of our total output would hurt us. That is, the price of solar power is assumed to decline. In this scenario, the project cannot generate sufficient cash flow to repay the loan, even if the sponsors draw upon the reserve account. While this scenario may be less likely, it is something to consider.
You may have noticed some questionable dynamics going on in these mini cash flow statements, specifically regarding the tax structure and depreciation. In 2014, the Indian ministry of commerce called for a tax holiday extending into 2017 for all new solar PV power projects domestically sourced in India. The tax holiday was meant to encourage FDI for solar in India; thus, they lowered the corporate tax rate from 34% to around 21%.
Additionally, India allowed for an accelerated depreciation model to be used for solar projects, which would allow companies to depreciate their capital assets 80% during the first year, and 20% each year after, while also allowing for the standard straight-line method. For this model, we’ve opted for the straight-line method because it allows for more consistent depreciation over the 15 years, allowing us to capture the most efficient tax benefits.
Risks and Mitigation
While the macro-level approach to identifying project finance risks may suffice for general understanding, it fails to identify sensitivity adjustments that may act as a feedback mechanism for mitigating certain risks. That is to say, while a broad approach may look to identify potential risks and offer suitable mitigations from a top-down perspective when you dive into the data and experiment with the numbers, the risks become much more precise and tangible.
After modeling and analyzing the cost structure of the project, along with the loan repayment configurations, we could pinpoint the riskier areas and assess their overall effect on the project’s cash flow. The most substantial risk for this project lies in the operations and environmental paths; here, they go hand in hand.
As previously mentioned, the net production of a 100MW solar plant can vary when exposed to many factors. Thus, it is necessary to ensure that the solar panels are operating as efficiently as they can, therefore requiring an O&M contract from the sponsors to ensure they or a third party keep the panels well maintained and operational. The environmental risk requires more mitigation tactics, from a traditional sense; here, the risk lies in the availability of sunlight.
While we could mitigate natural disasters with the proper insurance, the risk of weather inadvertently affecting the acquisition of sunlight is something we need to hedge based on historical data. Traditionally, this has not been a significant problem in India. The operations risk also creates a supply risk, but not in the traditional sense. The cost of supply for solar is strictly based on fixed expenditures (CAPEX and O&M); thus, the variable aspect is eliminated.
The threat then lies on the operational output side; can the project meet the demand for solar energy? While traditional channels for mitigating the supply risk would involve put-or-pay agreements, the sponsors are in effect the suppliers; thus, such efforts would be fruitless. The best method to ensure the mitigation of supply risk is to safeguard the operations side of the project; a healthy operation means a healthy supply.
The second significant risk of this project lies in price and demand, and they too can go hand in hand. After conducting a sensitivity analysis on price within the pragmatic case (see Figure 1), every incremental change of $0.01USD on the cost per kWh, translated into a variance of approximately $700,000.00. Although the base case assumes spot pricing will allow for increased margins on the price per kWh in the future, a real consideration has to be made whether that assumption is feasible. Historical data, along with power price forecasts, seems to suggest the opposite; solar power will become cheaper.
With 50% of the future supply left to open pricing, the risk for a price drop is significant. While conventional price drops in power typically meant cost reduction, the cost of solar depends on its initial capital expenditure. As such, a dip in the market price for solar electricity will translate into lower CFADS, with the possibility of driving the DSCR below 1, though unlikely in the pragmatic case (price would have to drop to $0.06USD). The demand risk then equates to: lower your price, or lose 50% of your market to lower-cost solar power, provided by more recently established solar plants.
While there is potential for an incremental profit via spot pricing, from a lender’s perspective, we can mitigate these risks by securing buyers for all the supply at a fixed price. Thus the ideal mitigation technique here is to establish a fixed price PPA for a term of 15 years with multiple buyers.
Other risks for this project include construction, country, regulatory, and to a milder extent, currency. The construction risk is relatively mild, given the confidence in sponsors (i.e., they are experts in the field) and feasibility of solar power. Based on a typical timeline, a 100MW plant should complete construction within a year, enough time for cash flow generation after the grace period.
What’s more of a concern, however, is the risk of cost overruns. While the sponsors have $134MM in financing (25% Equity / 75% Debt), the typical budget for a 100MW plant is around $150MM, though prices vary. These risks can be mitigated via the sponsors signing an EPC contract, along with providing a pre-completion guarantee in the form of a completion bond. Country and regulatory risks lie in the corporate tax structure allotted to companies in the renewable energy sector. While presently, the Indian government welcomes renewable energy with open arms, this welcoming behavior is not guaranteed in the future.
It is possible that the tax structure can change, or they can put new regulations in place that would make solar power less profitable (e.g., liberalizing the RPO). Mitigating these risks would be an iterative and dynamic process requiring specific contractual language, ensuring these risks remain stable.
Leveraging political relationships would not be a terrible idea here either, explicitly forming a coalition of solar energy suppliers to ensure they minimize regulatory risk. Finally, currency risk may be a factor depending on the scope our client has in mind. For this memo only, we translated all currency into USD for reference. The subsidiary, our client, will conduct transactions in Indian rupees, cash flow from the projects will also be in rupees. If the exchange rate is a factor we are considering, then we can mitigate this risk via derivative products and coverage instruments.
Criteria for Non-recourse debt
Given the significant risks of this project mentioned above, as representatives of our principals, there are specific criteria we require before agreeing to finance Gujarat Solar (GS) via non-recourse debt. First, GS must establish an EPC contract to ensure project completion and that it will complete the project to optimal standards.
We also require a pre-completion guarantee in the form of a bond, as we believe there lies a slight risk of cost overrun. Based on the company profile of GS and its sponsors, we are confident that they have vast experience in the solar industry, along with extensive experience in working in India, and are aware of the laws and regulations they must follow. However, as a lender, we need to ensure they have a well-regarded team of financial and legal advisors who will be with them throughout the initial phases.
Second, the operational risk is high for this project, given the capacity constraints mentioned earlier. With already a significantly low capacity ratio, we need assurances that these plants are maintained and running as efficiently as they can. For this, an O&M contract must be established with a third party to ensure the facility is maintained and the risk to supply is minimal. The terms of this contract require our principals to periodically send an independent specialist who will ensure the O&M contractual obligations are met.
Third, we require a fixed PPA at $0.12USD/kWh for the term of the loan for 90% of all power output supplied. This is to be sourced to multiple buyers, though the State of Gujarat Electric Company will handle all transmissions. While we know this goes against the initial plan to monetize on spot pricing, the price risk is just too high to allow for a speculative marginal increase in profits down the line. A fixed PPA would ensure that cash flow will remain stable, and GS will service its debt. Finally, we require a DSRA with an inflow of $400,000USD annually (as seen in Figure 1), to be made in monthly installments (400K/12) to the account. This is to ensure short-term fluctuations in cash flow do not adversely affect GS’s ability to service its debt.
Terms and Conditions
- 15 year fixed rate construction loan of $100,000,000USD at 8.2% compounded annually
- Payments will be made in quarterly installments of $2,956,503.50, with the compound balance decreasing after ever 4th installment. The first payment is due one year after the loan is issued.
- Late payment will result in a flat fee of $100,000USD added to the principal balance.
- In the event of a default, our client has rights on all capital assets of GS and will determine at the time the most financially feasible option in handling the assets.
- An initial disbursement of 20% will be granted to GS to begin construction. After that, any draw upon the loan must document proper construction estimates.
- In the event 100% of the loan is not used for construction, any remainder will be placed 30%/70% into an operating/recourse account, respectively.
- Before any initial shareholder distribution of profits, GS must ensure the quarterly installment is paid in full, and the monetary equivalent of at least two installments remain in the DSRA at all times.
- GS must have, in effect, an insurance policy for its capital assets equivalent to a long-term manufacturer’s warranty, which would provide sufficient coverage in the event of panel failure.
- Failure to comply with any of the conditions set forth are subject to increased fees. Our client reserves the right to enforce compliance of these terms through the use of random third-party audits. Additionally, if it is determined that GS is consistently non-compliant with these terms, defined by two or more instances of non-compliance, our client reserves the right to increase the interest rate to 11.2% for a proper re-assessment of GS’s risk.