Arguably the most important role of a risk management professional is to measure and communicate risk factors to others within their organization. There are areas that risk managers are measuring to track the financial health of solar investment portfolios:
1. Operational Risk
Projections of future energy production drive the financial model and, in most circumstances, the size of the investor’s financial exposure. Performance Guarantees may be granted to an offtaker or an investor based on these projections, and production insurance policies are underwritten to these projections.
After an investment has been made, the actual energy production can be viewed as one of the most important indicators of risk to an investor. The ratio of the actual electricity generated to the initial projection is called its “Production Index.” Investors need to know if the system is working to an acceptable standard, which is often 90-95% of original projections, and if not, ensure that a plan is in place to remedy the situation.
From a risk management standpoint, the Performance Index is important for the following reasons:
- · Under-production presents cash flow risk in situations where there is a Power Purchase Agreement (PPA) in place with the offtaker, since the cash flows are a direct function of electricity production. However, even when the offtaker has signed a lease or a loan, production guarantees may still be in place that must be paid out if performance dips below certain thresholds.
- · In situations where a direct lease or loan is provided to the energy consumer, the production is an important driver of credit risk, since it is commonly believed that end users are less likely to make timely lease or loan payments if the asset is malfunctioning or materially underperforming. This is relevant in the residential and commercial segments of the market.
- · Production informs the underlying asset’s value, on which investors are reliant for myriad reasons. For example, a lender may look to the collateral as a secondary source of repayment, a mini-perm lender is reliant on an operating asset to support a future refinancing, and a tax-equity investor may need a quality asset to justify booked residual values. The production also drives the resale value for an equity investor in the asset.
- · In projects with production insurance, actual production values are necessary to support the claims process.
Investors also calculate and track a Weather-Adjusted Performance Index, which adjusts the Performance Index to reflect how the project or portfolio performed, independent of the impact of weather. This is important for assets of all sizes, including residential portfolios, in order to separate short-term, non-controllable variances from longer-term, systemic failures that need to be proactively resolved by the solar asset manager. Third party service providers can calculate and/or insure against these risks for investors. This has the dual benefit of enabling investors to quickly access this information for risk management purposes, as well as improving relationships with investment customers by identifying underperforming assets from poor weather without continually asking for explanations from their asset management counterparts.
2. Regulatory and Counterparty Credit Risk
Unfortunately, solar is a volatile market– nearly every large portfolio to date has seen the insolvency of a key vendor or sponsor. The regulatory environment also continues to evolve, with examples of retroactive changes in net-metering policy and changes to renewable energy credit incentive structures. In this context, it is important for investors to get ahead of potential disruptions by, at a minimum, proactively measuring their exposure to potential liabilities.
Reviewing investment allocations and historic operating history may inform a warranty claim, a spare parts strategy, or a modification to O&M practices. But without knowing the risk, investors cannot act.
Many investors track their exposures both at an individual investment level (e.g., a project or a fund), as well as at the entire portfolio level. Common allocation measurements include equipment type (modules, inverters, and tracker manufacturers), state or geographic region, utility, offtaker credit quality, service providers, and sponsor. While some investors may choose to proactively manage their allocations for new investments to achieve portfolio diversification, others may use this information to assess their risk exposure due to a specific negative portfolio event.
Proactively managing allocations--and quantifying the resultant risk--then informs various mitigation strategies that investors may elect to pursue. For example, significant exposure to a solar developer may inform a modification to the approach of asset management, such as outsourcing asset management to third parties or procuring back-up services from independent parties. Large exposure to volatile geographies or equipment types may inform the investor’s approach to production insurance procurement. Similar credit risks that reside in many different investments (for example, funds with credit exposure to the same corporate entity offtakers) may need to be aggregated for reporting and tracking at an institutional level.
3. Offtaker Credit Risk
A key component of measuring credit risk is the financial health of those obligated to pay the bills. This is approached differently in residential vs. non-residential portfolios, but the end goal is the same.
In non-residential portfolios, traditional measures of credit health are typically used to monitor credit risk. This includes traditional financial analysis or, when available, independent credit ratings from a rating agency such as Standard & Poor’s or Moody’s. This task may be managed by specialized credit groups or within a risk management team directly, and is frequently complemented with monitoring of public news releases. If a solar plant is located atop a facility that is closing, for example, the investor can proactively work with the asset manager to devise a mitigation approach or scope the potential impact on the cash flows from the portfolio. A real property analysis is sometimes performed to scope potential recoveries if a facility were to be vacated.
For residential portfolios, metrics of financial health are only now beginning to emerge. Whereas in other asset classes a ‘default’ is clearly defined as 90+ or 120+ days of nonpayment, the solar industry is only now identifying the relevant metrics for residential portfolios. Many investors are tracking contracts with 90+ days of nonpayment as materially delinquent, even if an official contractual default has not been called. However, historically, there is a higher probability of consumers becoming current on their payments after material non-payment occurs, which is much less common in other industries. As such, investors are separately measuring contract reassignments, renegotiations or write-offs, as well as resolution statistics, to determine the impact on cash flow. A big challenge facing investors is normalizing these metrics across portfolios, and many are turning to specialized technology solutions to support this process.
Fig. 1: Sample reassignment statistics from a residential developer’s earnings call.
4. Repayment Risk
Ensuring that cash flows meet an investment vehicle’s obligations is a core requirement for any asset-backed investment vehicle. Tracking actual cash flows against projected cash flows, as well as the resultant coverage ratios, is critical to satisfying credit and compliance obligations in all investments, including solar.
There may be differences between pure credit risk, as defined above, and the ability for an investment vehicle to fulfill its payment obligations. These contributing factors include increased expenses, operational issues, and poor servicing quality (such as the inability to send a timely invoice). Tracking cash flows enables a risk manager to measure the extent of the various risk factors within a transaction.
This is often more difficult than tracking a Performance Index. Depending on the financing structure, there may be upwards of five bank accounts per project (such as revenue accounts, reserve accounts, and sweep accounts). For investors that are tracking cash flows closely, and receiving copies of the bank or servicing reports, it’s important to work with the solar asset managers to label transactions consistently within the ledger so that the transactions can be audited at a later date. Cash flows may be categorized in the following types and subtypes:
Electricity Revenue Lease Revenue SREC Revenue Prepayments Rebates
Contract buyouts Reimbursements
(Negative cash flows that are not expenses)
Performance Guarantee Payments Referral credits
Operations and Maintenance Expense Asset Management Expense Insurance Expense
Property Tax Site Lease Other Expense
Transfer to another account Transfer from another account
For transactions that include debt, or for sale leaseback transactions, cash flows and debt service coverage ratios are critical to determining covenant compliance. In these transactions, there are often compliance obligations whereby a portfolio that generates fewer cash flows than expected must deposit cash into a new reserve account for the benefit of the lenders until the cash flows recover. Independently reviewing the financials ensures satisfactory compliance with these obligations.
Some structures, particularly in the debt market, are structured to have a balloon payment at a date certain in the future. In order for their debt to be repaid, they are typically relying on a developer to refinance their loan. To evaluate this risk, some lenders also look at how successful solar companies are at recycling or accessing capital in the market, and running sensitivities based on projected interest rates.
5. Tax Risk
Investors at all levels of the capital stack typically have some sort of exposure to tax credits – whether in the form of basis indemnities, tax recapture insurance, cash sweeps, or extended flip dates. Tax equity investors typically track this exposure closely, and it is best practice for lenders and others involved in the transaction to watch it closely as well. In highly structured, tax- motivated investments, if cash is king, then tax equity may be considered the queen - they form a partnership wherein both have to work together in order for everything to function properly.
Risk managers should be knowledgeable of the tax equity structure and how changes in the realized tax benefits impact return or flow through the project finance model. Typically both need to work in unison for all investors to achieve their target return. The key tax metrics to track are the projected and realized tax benefits, which are themselves a function of the fair market value of the assets, any tax recapture, and the prevailing tax rate.
6. Regular Risk Reporting
Investors who are most focused on compliance management and keeping senior management and credit teams up-to-date on their portfolio generally have a Monthly-Quarterly-Annual review cadence: monthly production look-backs, quarterly portfolio summaries, and annual portfolio reviews.
Monthly look-backs are often focused on production metrics and the Performance Index of a portfolio, with a particular emphasis on identifying underperforming assets and working with asset managers to resolve any problems in the field. Best practice is to report results for both a Performance Index and Weather Adjusted Performance Index.
Quarterly reports may include additional data points such as cash distributions to the investor, a refreshed allocations analysis, or a discussion of material credit events within the portfolio.
Annual reports are often more fulsome in nature and include a refreshed credit underwriting of the important stakeholders, discussion of collateral or residual value, updates of the relationship with each of the third parties, any changes in the broader market, a discussion of third parties supporting the risk management function, and other topics as may be pertinent to the portfolio.
Senior credit managers don’t like surprises, so keeping them informed as issues arise is critical to the success of any portfolio manager.