Thanks to Chris Lord and Keith Cronin for providing all of the insights in this article. Chris and Keith teach our Solar Executive MBA course (the next session starts on September 15th). Together, they have advised investors, owners, and other developers on more than 150 MW worth of distributed generation solar projects. While there is no standard for defining bankable projects, I trust their on-the-ground experience to provide these insights.
Introduction – Why is Bankability Important?
The majority of large-scale US solar projects are done through power purchase agreements. The key to power purchase agreements is having investors who buy into these projects. As SREC prices and policy continue to fluctuate while project IRRs and installed costs continue to drop, project investors are most interested in investing in bankable projects that have good returns and minimal risk.
One of the most common question we get in our Solar Executive MBA course is, “How can I build a bankable project?”
In other words, “How do I structure a project so it’s very easy for an investor to want to invest in or purchase the project?” For commercial solar, the answer is of course “it depends” because there are so many moving variables that go into projects and everything is negotiable.
In this article, we’ll define and go into three keys to developing bankable projects. Then we’ll go into what developers need to keep in mind to stop wasting time on chasing bad projects.
This article will be useful to a professional who needs to get good at or keep up to date with best practices for financing mid-market solar projects. The goal is to go deeper than most articles on the Internet, but it will be impossible to provide the deep dive necessary to make you an expert. If you have any questions about the content, please leave them in the comment section of the article.
If you’d like to get more resources on the subject, here they are. We will reference all of these articles in the article, but I wanted to provide a simple list for ease of use.
- Paid Course: Solar Executive MBA. In this 6-week course you’ll work a commercial solar deal from start to finish with expert guidance. The course includes financial models, legal contract, and development tools. The financial model itself is worth $1,500, and, paired with the legal contract, development tools, and time with instructors, this course is underpriced.
- Free Course: Commercial Solar PPAs 101
- Modeling Solar Production Risks – P50 vs P90 Production
- Advice from a $20MM Solar Project Investor
- The Most Common Solar Modeling Mistake, The Fix, and A Free Tool
- Pricing Cash Equity vs Tax Equity Risk in a Partnership Flip Deal
- How to Calculate the Buyout Price of a PPA
- Calculating Pre-Tax vs Post-Tax Returns
- The Impact of SREC Assumptions on Project IRRs
- Finance 101 for Solar PV Professionals
Article Outline and Learning Objectives
The article will be split into four major sections. After reading this article, you should understand the most important factors that go into developing a bankable solar project. The goal is that you’ll become familiar with these variables and will be able to start screening your existing projects to find the bankable ones and will also be better at screening new potential customers.
Technically speaking, bankable projects mean investment-grade projects. These are the projects that are the economically strongest and most reliable (i.e. low-risk) projects. These projects are able to win the most conservative and lowest-cost capital.
Economically strong is defined as a project that uses reasonable or conservative assumptions and documented facts to create a healthy economic cash and tax flow that comfortably hits or exceeds the investors’ target IRR.
Economically reliable is based in part on the strength of the developer/construction entities and also on the confidence of any state subsidy. But is also heavily based on the quality of the design and construction of the project. Investors want to know that the project was built to a rigorous standard so its economic performance may be reliably predicted to actually generate the forecast numbers in the pro forma over a twenty or twenty five year term. That is a long time by anyone’s standards. Imagine if a project were a car. In twenty years, do you expect to be driving the same car you are driving today? Probably not. A high-quality project is not a project built to meet minimum performance standards at the lowest possible cost.
- Economic performance is most commonly addressed by establishing production guarantees. Oftentimes, investors will negotiate for the developer or EPC to guarantee a certain level of project, this is especially true if the equipment is being finance under a PPA and not a lease.
- The other item that impacts economic performance in modeling is the use of P50 vs P90 production levels. Investors will typically want to use P90 production numbers because they are the most conservative. Read more about production modeling 101 here.
First Key to Bankability – Understand How Investors Evaluate Projects
Solely on a 20-year discounted cash and tax basis.
Investors value a project based solely on the cash and tax benefits that will flow from the project. Similar to how you might value an annuity, they are paying good cash for the right to receive the cash and tax benefits from a project. Project the annual benefits over a twenty or twenty five-year term, and discount each year’s value back to the present using your target return rate.
This valuation method creates a problem for developers.
- Developers’ first instinct is to cut construction costs to the bone. Why not? After all, the difference between the development/construction cost and the sale price to the investor is all margin for the developer.
- Projects are also judged on their quality – performance and reliability. In fact, successful developers have learned to fight the instinct to indiscriminately attack costs and to focus instead on managing costs intelligently with an eye to longer-term value.
- The key learning here is that it’s not the project with the lowest installed costs that wins, it’s the projects with the highest returns. This takes into consideration installed costs, the amount of power that an array will provide, and the confidence that the installed costs and power production will be very close to what’s expected.
A Second Key to Bankability – Have a Strong Economic Model
It’s key for commercial solar projects to have a comprehensive economic model. You need to know what kind of return you are really offering your investors before you show them the project.
It’s okay to start with a simple model for initial project screening and early development, but the sooner you move to a comprehensive and robust model the sooner you know where your project’s strengths and weaknesses are so you can then develop the project accordingly.
It is extremely important to use reasonable assumptions on all variables of the project economics. This includes: installed costs, PPA price, sales tax, property tax, interconnection costs and timelines, and SREC prices.
It’s important to lock in the “knowns” or “facts” of a project. This means variables that are documented and that you are close to 100% certain of their value. Be clear about which variables in the project are known and unknown.
Comprehensive and accurate documentation of variables is essential. The fastest way to lose the trust of an investor is not properly performing your due diligence by gathering information on all the necessary variables or not accounting for them correctly. For example, interconnection costs and real estate are not eligible for ITC and MACRS depreciation. Did you remember to exclude them? Not properly discounting the ITC is the single most common modeling mistake, even in large projects.
A Third Key to Bankability – Weighing Capital Costs Against Operating Expenses to Maximize Project Returns
This links directly to having a proper economic model. In your model, you need to know and understand what saving $1 on the operating side means relative to $1 on the capital side. The impact is different and depends on the facts.
- For example, on a 5 MW (AC) project on the East Coast, cutting the construction cost by $.10 a watt (or $500,000) raises the project IRR by approximately 0.4%.
- On the same project, cutting $6,500 of annual expenses by finding a lower-cost property raises the IRR by almost the same amount. The greater impact comes from the recurring impact of the lease rate reduction. In other words, the $6,500 is realized every year over the term, not just the first year.
- Effective and valuable cost-cutting involves weighing capital cost reductions against operating expenses – and this is where good development and good design can help.
- Energy efficiency in buildings offers a very easy way to see this trade-off. Imagine a developer looking to build a commercial office space. The developer might consider a highly-insulated and energy-efficient window solution but reject it because the cost is “too high.” Instead the developer goes with a very cheap but not very efficient window solution. After the building is completed, the operating cost of the building with lower efficiency windows is higher because of the additional energy required to warm and cool the interior space. Had the building owner gone the other way, the capital cost would have been higher, but the operating cost would have been lower. The trade-off is never an easy one to make, but in the building example, if the tenant is not the developer/owner, then the trade-off involves shifting costs from capital (owner/developer) to the tenant (who pays the energy bill).
- A solar project requires the same trade-offs on the design, choice of materials, and construction. And, as we saw in connection with knowing your model, the impact of changes can vary considerably depending on whether you are cutting capital costs or cutting operating costs. In both cases, you need to know how the IRR is impacted and whether cutting the capital cost makes for a lower life cycle cost.
The Developer’s Perspective
After Chris Lord provided this advice on the modeling and legal aspects of developing solar projects, I asked Keith Cronin a simple question, “This advice seems so clear, why are developers not following it? What are they chasing around bad projects? What advice do you have for them?”
Here’s an excerpt from his response:
Developers around the globe all want to seize opportunities in the solar industry, as they see gold in their eyes. This has been happening for almost a decade now in various iterations. Small and large developers are always looking at incentives, pulling out their spreadsheets, and eagerly looking to secure properties to park these opportunities on them.
What developers often overlook is the identification of a good versus a bad opportunity. As Chris Lord points out, determining bankability is essential. Discovering that a project can’t be financed is a large source of disappointment for developers after they’ve invested hours of time chasing deals.
This stems from a host of variants, but these are the most likely primary offenders:
- Developer runs into unforeseen conditions at a project’s location and the additional costs make the investment economically unattractive.
- Cost for construction and interconnection delays decreases project returns. Projects in the Hawaii market that have been involved in the FIT program have experienced 18-plus month delays from a host of parties involved in a project. For example, if you look at a 500kW AC PV system producing $23,000 per month in revenue, how many developers can afford to lose $400,000 during that time period, and how many investors have that level of patience? If you look at Chris’s example with capital expenditure versus operational expenditure and how this impacts project returns, any hiccups with construction delays can substantially decrease project returns.
- Uncertainty around interconnection makes some projects impossible. If programs become oversubscribed and circuits on the grid become saturated, how do you explain to investors that you will not only see additional cost overruns, but the likelihood of waiting until the infrastructure can be modernized to impact the project timeline?
As Chris Lord points out, the cost of a project, versus the recurring costs for land, insurance, taxes, leases etc., should be carefully scrutinized. As developers, we all want to build a project for less than what we planned for. What is the best strategy for the short term and long term?
- It is advisable not to cut corners on solar equipment because arrays have a useful life of 20 to 30 years. Make the long-term investment and build that into your budget. Be prepared to tell the investment community “why” your costs are higher and they are usually thankful for the insight and your long-term thinking.
- What is your O&M strategy? These numbers fluctuate radically. It can be anywhere from $10 per kW to $25 per kW per year on larger scale projects. The bigger question is what is included in this service that will be provided and what isn’t? Remember, the PV system’s output will not go up over time and only go down with degradation, so plan for the impacts of time on a system and understand how your investors are looking for less lumpy returns and more stable forecasts.
- Bundling other complementary services offers a unique angle on getting your project to the finish line. With the cheap cost of capital, investors are looking for low-risk returns, and adding in energy efficiency will stabilize returns for the investment community. Access to this money today is easy to find. In places with high-energy costs, it makes the amalgamated deal more attractive and often can give a developer the margin they were originally looking for at the onset.
Project risks often burden developers in the early stages of a project’s introduction and inception. Engineering, permitting, site control, and negotiations with landowners all consume a lot of in-house resources. Getting better at selecting projects that have a higher probability of being developed requires experience and knowing the market you’re entering. Finding local partners that can help you traverse the nuances of the market is essential in maintaining your expectations as well as the expectations of the investment community.
This article outlined the knowledge you need to develop and screen existing and new bankable solar projects. You now know what you need to keep in mind to stop wasting time on chasing bad projects.
The most important factors that go into developing a bankable solar project:
- Understanding how investors evaluate projects (solely on a 20-year discounted cash and tax basis)
- Strong economic modeling
- Weighing capital costs against operating expenses to maximize project returns
If you have additional knowledge to share, please leave it in the comment section below.
If you’d like to get more resources on the subject, please review the following resources (they were also included in the article). Please leave comments in the comment section below if you have questions or additional knowledge to add!