The institutional bond market can be an effective financing source for energy-from-waste projects.
As many landfills across the United States approach their capacity, local authorities and waste management companies are facing a significant issue. Property owners, municipalities and environmentalists are resisting new landfill developments, putting landfill owners in a precarious situation.
However, some local authorities and waste management companies have turned to waste-to-energy (WTE) and waste-to-fuel (WTF) alternatives. This industry sector is accelerating as players big and small attempt to turn these growing mountains of waste products into valuable commodities. They are partnering with a robust and growing pool of technology companies to end the flow of waste to landfills and increase their bottom lines.
WTE or WTF projects are capital-intensive undertakings tied to long-lived assets. One common practice in the energy space is funding the construction and operation of projects with a non-recourse debt, often referred to as “project financing.” In project financings, lenders are granted a security interest in all of the assets of the project. Lenders look past the credit of the sponsor’s balance sheet and base their credit assessment on the material contracts associated with the development, construction, operation and management of the financed assets. Due to the limited amount of assets securing the loan, the “art” of project finance is allocating the associated risks of the project to a party willing and able to bear or mitigate those risks.
Because of market turbulence in recent years, securing project financing has become more challenging than it once was. The well-publicized problems in the bank market have led this traditional source of capital to become even more risk averse and less willing to loan money to the entire spectrum of alternative energy projects. Even the experienced European banks, which have financed alternative energy projects for years, are reducing their exposure in the space.
The credit profile of alternative energy project financings, lacking a claim on the sponsor’s balance sheet, often falls below the threshold that banks are willing to fund regardless of the interest rate. WTE and WTF projects, sometimes using technology that has not been as well established as wind or solar, can present additional credit risks. This, coupled with the smaller pool and appetite of tax-equity investors, has led WTE and WTF developers to seek new sources of capital to fund projects. For the past nine years, Stern Brothers & Co. has been actively establishing a new source of capital that developers should consider for WTE and WTF project financings—the institutional bond market.
A key advantage the bond market provides developers is a broader and deeper pool of available capital. Bond buyers include insurance companies, pension funds, mutual funds, hedge funds, private equity funds, and other strategic investors. Bonds can be the sole source of debt for projects or can provide a complement to bank debt.
Compared to banks that have significant regulatory issues and a shorter investment horizon, many bond investors need to put money to work over longer investment horizons. This creates the opportunity to structure debt with maturities that more closely match the useful life of the physical assets and the commercial arrangements associated with both feedstock and off-take agreements. Bonds also are a single financing vehicle that provides both construction and permanent financing at fixed rates, eliminating the interest rate risk associated with construction or mini-perm bank financing.
More investors interested in a broader credit profile offering better terms at fixed rates will drive better and known returns for the developer and their equity partners. In addition, many WTE and WTF projects may qualify for tax-exempt financing through solid waste disposal bonds or other tax-exempt bonds available to both privately and publicly held sponsors. Tax-exempt bonds provide a lower interest rate relative to taxable alternatives. Although the bond market is more adept at understanding and accepting riskier projects than the bank market, there are certain key credit characteristics that a project must exhibit before bond investors are willing to consider investing in a project.
Contracted Cash Flow
To address the timely payment of principal and interest, bond investors require a contractual arrangement that will generate sufficient cash flow for a reasonable debt service coverage ratio over the term of the financing.
WTE and WTF projects are designed to take waste flows and convert them into other valuable products. Most projects generate revenue from the sale of their end products (electrons or fuels) and also generate material revenue from tip fees. As the main revenue generators for the project, agreements for tip fees and product sales are pre-requisites to securing project financing. These agreements must be financeable in that they are with credit-worthy counterparties and that there are limited terms under which the contractual obligations are terminable.
Bond investors are willing and able to bear well-defined operating risk. However, the recent troubles of some first generation ethanol plants have left institutional bond investors sensitive to this issue. Bond investors will look for long-term agreements that establish the tipping fee for waste and the sales price of the end product over the term of the debt.
With revenues fixed, the risk of debt repayment once the project is built boils down to the cost of operating the project and ensuring it is properly maintained over the term of the financing. Without contracted cash flows, fluctuating spot market prices for tipping fees, electricity or fuels may fall. This can lead to the project being unable to make principal and interest payments regardless of how well the management team operates the project. Investors want to know that once a project begins taking in and converting the waste that they will receive timely payment of principal and interest.
Construction and Technology Risks
Bond investors are sensitive to other types of risk, including construction risk. Bond investors want to know that there is sufficient capital on hand to construct and commission the project. Bond financings can have a single closing in which all the capital (both debt and equity) is funded and held by a trustee for disbursement during construction. Bond investors also want to know, if there are any issues during the construction and commissioning of the project, there are resources to promptly solve them.
Lenders, including both bond investors and banks, generally prefer that the projects they fund are developed under a turn-key, lump-sum engineering procurement and construction (EPC) contract. The EPC contract allocates various risks to a single entity, the EPC contractor, who has the expertise and resources to absorb them. This gives the sponsor a single counterparty under the contract. These EPC contracts are usually backed by a payment and performance bond with liquidated damages. This gives bond investors comfort that the EPC contractor is confident that it can build the project on time and on budget. If issues arise, the payment and performance bond provides access to the additional resources needed to resolve them, either technically or financially.
In addition to construction risk, WTE and WTF projects involve various degrees of technology risk. Technology risk encompasses the risk that the physical assets as designed and/or built will not perform at the required capacity or specifications, jeopardizing the project’s ability to operate and generate cash flow. Bond investors are wary of technology risk and cost effectively mitigating this risk is an important part of project financing.
However, sometimes re-allocating risk is not possible, as there may be multiple risks that cannot be mitigated or there is not a third party willing or able to assess and absorb the risk in a cost-effective manner. In these cases, it may be possible to obtain credit enhancement for the project from a local, state, or federal government.
Securing funding for WTE and WTF projects through traditional means such as bank loans and tax equity has proven difficult due to the recent turbulence in the financial markets, but the bond market has opened up for these projects and has provided an alternative source of project financing capital.
Although bonds have become a more liquid source of capital for project developers, there are still certain key credit characteristics that these projects must exhibit in order to get bond investors attention at competitive rates. However, for projects that lack one or more of the key credit characteristics there are local, state and federal government guarantee programs that can enhance the credit profile of the projects allowing the bonds to be priced at competitive rates that make sense for the project and its developers.
Co-author John May is a managing director with Stern Brothers & Co., St. Louis, and can be contacted at JMay@SternBrothers.com.
For information on how energy-from-waste projects can tap into government funding, see “Government Guarantees,” at www.REWmag.com/0412-rew-government-gaurantees.aspx.