This is a guest article from Chris Lord, Managing Director at CapIron, Inc. He’s a former lawyer with extensive banking experience who now consults with solar developers and investors. I’ve never met anyone else who can, seemingly, answer any financial or legal questions about financing commercial solar projects.
In the article, Chris shares some of his experiences about how to understand and mitigate the risks that you don’t know exist in commercial solar development. Unknown unknown risks are extremely important to understand because they can have large negative impacts on profits and relationships with investors and clients. These risks are especially important for firms that are experienced in solar but new to financing larger commercial solar projects.
I found this article extremely interesting and if your work revolves around selling or financing commercial solar projects, I’m sure you’ll love it. If you have questions about the article, please leave a comment. If you’d like to connect with other professionals focusing on best practices for financing commercial solar projects, join our LinkedIn group on Best Practices for Financing Mid-Market Solar Projects.
Chris Lord also teaches our 6-week Solar Executive MBA that starts on Monday, September 15th. In the course, you’ll work a commercial solar deal from start to finish with expert guidance. The course includes financial models, legal contracts, and development tools that are indispensable.
Enter Chris Lord
Not long ago, I spoke with an experienced developer who told me about a small utility-scale project undertaken by a team within his company. Although experienced with distributed generation projects, the team and its leader had never developed a third party financed, utility-scale project. They knew that they had to learn more about the technical and procedural requirements for interconnection with the local utility and delivery of the solar power to the grid. Over the course of development, the project hit many roadblocks and challenges before finally arriving successfully at COD. Throughout the process, the team modeled the project early and often, generally showing a tight but acceptable profit margin for the project. At COD, the company collected its profit and moved on. Less than a year later, the third party investor in the project made a call on the developer’s tax indemnity required as part of the close. It turned out – to the utter surprise of the project manager and his team – that they had incorrectly assumed the federal ITC would apply the interconnection costs paid to the local utility for equipment on the utility’s side of the transformer. The error – when finally caught – cost the company more than its small profit margin on the project and constrained the company’s cash flow.
This articles focuses on the most dangerous and difficult threat to successful project development: the risks, issues, and challenges that you don’t know that you don’t know. These “unknown unknowns” are not the items that you know you don’t know. When you know you don’t know enough about a risk, issue, or challenge, you can remedy that ignorance by focusing on the problem and calling on experts – colleagues, advisors, consultants or lawyers – to help you learn what you must learn to overcome, hedge, or eliminate it. In the example above, the team knew it had to learn more about the technical and procedural requirements for interconnection with the local utility, and they did so successfully. What the team did not know was that it did not know enough about the ITC’s definition of “eligible equipment” and its application to their project.
Understanding the Challenge of Unknown Unknowns
Developers by nature have to be optimistic and confident souls, if they are to make their way through the minefield of project development. Without that optimism and confidence, a developer would never get started on the daunting task of taking a green field site from start to finish. In fact, the persistence that everyone tends to think of as the critical ingredient in developer success is actually just a manifestation of optimism and confidence.
But as life shows us, our greatest strengths are also our greatest weaknesses. That very same optimism and confidence necessary for successful project development often blinds a developer to the biggest risks of all. These are the risks – that through optimism, confidence, and ignorance – are simply not on the developer’s radar screen. These are not the known or expected risks. A successful developer manages a known risk by minimizing and staging investments of time and money until more about the risk is known or its threat neutralized. There are a lot of surprises in the life of a development project, and, because developers are an optimistic lot, it is rare that these surprises add to a project’s upside. More often than not, these “upside” events were already incorporated into project economics as “good to average assumptions.”
So what really can kill projects are the unknowns and the unexpecteds. We will just call them the “unknown unknowns.” These items consist of issues, events, or results that a developer does not even know that he does not know. And while a wealth of experience and education can reduce the potential unknown unknowns, they are always there. Nassim Nicholas Taleb (author of The Black Swan and several other books on risk) and many other investors specialize in investment strategies designed to capitalize on unexpected and dramatic events, such as the mortgage meltdown crisis of 2008. These strategies involve multiple small bets on a wide variety of extreme outcomes. But a project developer is betting on not having unknown unknowns occur, and that is a lot harder to do.
Tackling the Problem of Unknown Unknowns
The image above illustrates the problem. If we begin with the blue box, then that is the complete universe of all issues, risks or challenges. At the very center of the box is the yellow circle that illustrates what we know (sometimes called the “known knowns”). These are the items that, through education and experience, we know how to handle and are comfortable wrestling with them. The orange cloud surrounding the yellow circle represents the items that we know we don’t know. Within this nebulous cloud are the issues, risks, and challenges that we know just enough about to know we must anticipate and manage them, but we don’t know enough to define them and consider the solutions, hedges, or alternatives. In other words, we know that we can expect the item to arise, and that to manage that item we must either educate ourselves, find an expert to manage it for us, or some combination of the two. For example, most developers know that they must consider whether a project will be subject to property tax over the course of its existence. Property taxes are a set of arcane rules that vary not just from state to state but also from county to county. Moreover, solar PV projects may be characterized and taxed as real property in some jurisdictions, but they may also be taxed as personal property in jurisdictions that make the distinction. In this case, when a developer begins a new project in a new state or county, he or she knows to consult local counsel early – before even meeting with local taxing authorities to discuss abatements or PILOT agreements.
Image: Universe of Issues, Risks, and Challenges
Specific Actions to Address Unknown Unknowns
So, turning back to our unknown unknowns, how does a developer guard against something that by its very nature is unknown and unexpected? Not easily, of course. But a couple of options come to mind. The key to all of these options is to work on expanding the known knowns and the unknown knowns. If you look at the illustration above, we are talking about expanding our knowledge and leveraging the experience of others to make the yellow circle as large as possible and grow the orange cloud outwards as well. In effect, we want to shrink the blue portion of the box – the unknown unkowns – by expanding the circle and cloud. Of course, we can never eliminate the blue, and should not imagine that is where our efforts should focus, but the faster we can grow the yellow circle and orange cloud, the better hedged against the unknown unknowns we will be.
Here are a few things that you can do. First, a good developer is always trying to learn more about the nature of the field in which she or he works. For solar energy, this means attending conferences, training seminars, or courses. Here is a case of “penny wise, pound foolish.” Often developers on a constrained budget of time and money don’t want to invest in these activities. The real truth, of course, is that you cannot afford not to invest in those activities. In fact, as the example at the opening of this article illustrates, “If you think education is expensive, try the cost of ignorance.” (Quote often attributed to Derek Bok, a former president of Harvard.)
It is true that you are spending money on something that does not immediately produce a payback, but the way to think about these expenditures of time and money is that they are critical investments in capital and know-how. If you don’t invest in these broadening experiences, you are doomed to move more slowly up the learning curve because you are limited to learning solely from your own direct experience. The fundamental nature of our time is that it is limited. By looking to boost your knowledge and understanding through conferences, training seminars, and courses, you are leveraging your knowledge with the learning and experience of a multitude of others.
Secondly, look hard at your team and your company if you are larger than a single team. Do you have a breadth of skills and experience? As you grow and add more people, make sure that you are adding skills, knowledge, and experience that fills in gaps on your team. If you are in an organization large enough to have multiple development teams, and specialized departments, make sure to vary the membership of individual project teams so that knowledge and experience does not accumulate in separate silos. It is also important to have cross-team meetings and internal seminars. Too often, busy people forego or ignore these events – yet those are the very people most likely to benefit from newer, more efficient ways of working, and a better knowledge of how to address risks, issues, and challenges quickly and more effectively.
Thirdly, read the trade press regularly, and research the issues that have potential relevance to your project. Much of the daily electronic news feeds are focused on specific events, such as project completion announcements, new partnerships, etc. As a consequence, you will probably find a greater source of learning in the periodicals – whether electronic or hard copy – where the writers tend to focus in more depth on new trends, emerging issues, and changing technology.
Fourthly, over the course of development, guard against overconfidence. This is, of course, easier said than done, because you must weigh the frivolous against the real threat often without sufficient knowledge to distinguish between them. But the point is to be aware of potential issues and open-minded to the potential for the issue to arise to the level of a problem so that you can address it as early as possible in the development cycle.
Notwithstanding your natural, internal optimism and confidence, as a developer you must guard against the threat of risks, challenges, and issues that you are not even aware might exist. While this sounds like an impossible task – guarding against the unknown unknowns, the truth is you can constantly work to reduce such a threat by expanding your team’s knowledge and experience. To do so, take seriously opportunities to attend conferences, trade shows, seminars, and courses; be sure to cross-fertilize knowledge and experience of your team members and others in your organization; and, stay current with trade publications, particularly periodicals with detailed articles. Above all else, guard against overconfidence and take threats seriously as early as possible in the development cycle.
Christopher Lord is Managing Director at CapIron, Inc., a strategic development and financing firm focused on renewable energy. He is also a co-instructor of HeatSpring’s popular online Solar Executive MBA course.