Liquidity risk may be a key concern to renewable energy investors when, for instance, utilities are affected by liquidity constraints or when the timing of cash receipts and payments is mismatched.
1. Liquidity risk mitigation instruments
Liquidity risk mitigation instruments can involve various financial instruments to provide short term cash flow to a project or company or to extend time to improve a project’s liquidity profile. Liquidity facilities are commonly used in project finance, either internally within a project structure or externally alongside the special purpose vehicle (SPV). Put options, although less commonly used in renewable energy investments, can provide an opportunity to extend loan tenors at a cost of option premium. Such liquidity risk mitigation instruments are particularly useful to address the liquidity and credit risks of a renewable energy project developer or power off-taker.
Internal liquidity facilities
Internal liquidity facilities can be employed to advance or support payments to bridge short-term cash flow problems and help ensure timely payment to investors. Examples of internal liquidity facilities include:
» Debt service reserve accounts, which provide a distinct source of funding for a limited period of time in the event of insufficient cash flow.
» Excess spread accounts, which accumulate cash flow above that required for debt service in a separate account supplying a source of funds if cash flow falls short of requirements.
» Over-collateralisation, which provides additional assets which the SPV can draw on to supplement the cash flow available for debt service. It occurs when more collateral than needed is posted to secure financing, which results in a bond issuance that is less than the total value of the underlying assets. For example, when SolarCity issued its first asset backed securities in 2013, about 62% of the value of the underlying assets (solar PVs) was held as over-collateralisation. This credit enhancement, combined with SolarCity’s track record and the credit quality of the household borrowers, resulted in an investment grade credit rating, which helped secure a lower cost of capital (BNEF, 2014).
» Contingent equity, which protects lenders in situations of unexpected cost overruns during project development. By putting equity aside, project owners provide a safety buffer for emergency funding for possible project cost overruns. For example, this was used in a geothermal energy project to cover potential cost overruns related to unexpected drilling costs (see Sarulla geothermal project case study in Section 5.2). Contingent equity tranches were also established to fund cost overruns in the construction phase in an off-shore wind farm project (see Walney off-shore wind farm projects in Section 5.1). Studies suggest that the cost of setting up a contingent capital facility may be more economical than the cost of a credit guarantee as long as the trigger events are well defined (Farooquee and Shrimali, 2016).
External liquidity facilities
Renewable energy investors may have concerns that periods of temporary cash flow shortfalls could arise, which in turn would lead to late or missed payments. Since renewable energy markets are still quite new and the pool of potential buyers is shallow, particularly in developing countries, investors may price in a ’liquidity premium’ (Clean Energy Pipeline, 2015). This compensates for the additional risk of cash flow shortfall or for having to discount the asset if they need to sell. This liquidity premium is added to the financing costs, increasing the cost of capital for the project.
External liquidity facilities can loosen liquidity constraints for power off takers. In developing countries, where many power off-takers experience such constraints, IPPs have a hard time reaching financial closure. Often, they are unable to obtain a letter of credit from an accepted commercial bank without backing from the off-takers. Since the sole income of most IPPs depends on future payments under the PPA, they are not in a position to put collateral into the letter of credit. Most off-takers thus have to provide full cash collateral to back their letters of credit. Yet due to their constrained liquidity, poor credit ratings or financial instability, many off-takers in developing countries are unable to post cash collateral for a letter of credit.
Typical risk mitigation instruments are often unable to provide a coverage against cash flow illiquidity or potential off-taker defaults. A liquidity facility can help fill this gap by providing a short-term letter of credit or credit line to IPPs without additional cash requirements from utilities (Box 8).
The length of tenor can be a key limitation encountered by project developers seeking local financing. Inadequate loan terms expose projects to liquidity and refinancing risk. This occurs when the maturity of the loan is mismatched with the lifetime of the asset, and the borrower is unable to refinance the outstanding loan midway through the life of a project. This is particularly acute in low-income developing countries, where debt of over five years’ maturity is difficult to access.
Some DFIs utilise liquidity guarantees to lengthen maturities of local currency finance. An example is the West Nile Rural Electrification Project in Uganda, where regulations limit maximum loan tenor to eight years. To allow for a longer-term loan, the World Bank structured two separate senior loans for local banks to lend to the project. The first loan expires after eight years when a bullet repayment of the outstanding principal is to be made. This repayment was funded from a new seven-year loan, making the total period loan repayment period 15 years. A liquidity facility guarantee was used to ensure that local banks would have sufficient funds to make the second loan after eight years, thereby removing repayment risk for the project developer. The fees and margin payable to each local bank were designed to incentivise it to continue financing for the full 15 years (Wang et al., 2013).
Like liquidity guarantees, put options can be used to mitigate renewable energy investment refinancing risk. DFIs provide a put option to local commercial bank lenders as a way to ensure long-term lending for borrowers. For example, in the Philippines Leyte geothermal project, bondholders contracted a put option to sell their bonds to the World Bank on maturity in return for repayment of the principal. This ensured investors that such long term bonds will be honoured when they reach maturity (World Bank, 2012). This is considered a promising technique for extending the maturity of loans to match the requirements of renewable energy projects (World Economic Forum, 2006).
2. Geothermal resource risk mitigation
The resource risk during geological exploration and drilling in the early stages of geothermal project development is the main barrier to properly assessing the resource potential, elevating transaction cost (Chouraki, 2013). The high cost of locating and confirming geothermal resource, as well as long lead times for project development, are significant barriers to financing geothermal energy projects (Micale et al., 2014). Geothermal project exploration can account for 35%-50% of capital costs before the resource is confirmed (Vlahakis, 2015). The lead time from identifying a project to making a drilling decision on a well with a proven production capacity takes an average of about 5.5 years (Micale et al., 2014), adding several years to the project’s development time. Ten years elapsed between the start and financial closure of the Sarulla geothermal project in Indonesia (see case study in Section 5.2).
A number of risk mitigation instruments dedicated to geothermal energy have thus recently emerged. National governments support the mitigation of geothermal resource risk by contributing to geothermal energy funds that distribute grants and guarantees to eligible exploration projects. Alternatively they share the risk with a private insurer. Dedicated guarantee instruments manage specific challenges of early-stage geothermal energy project development, while portfolio guarantees allow for effective risk management by pooling different wells together.
Grants can incentivise renewable energy development in potentially high risk activities, such as drilling for geothermal well exploration. For example, the African Union Commission, the German Federal Ministry for Economic Cooperation and Development and the EU-Africa Infrastructure Trust Fund via KfW established the Geothermal Risk Mitigation Facility. The facility funds geothermal development in East Africa by providing grants for surface studies, exploration drillings, continuation premium and regional databases (Geothermal Risk Mitigation Facility, 2012).
Some governments and public finance institutions use convertible grants to mitigate geothermal resource risk during the exploration drilling process. For example, the EU, Germany, multilateral and regional development banks established the Geothermal Development Facility in Latin America. The facility has an initial resource of USD 75 million with commitments of an additional USD 1 billion (The Inter-American Dialogue, 2015). The facility offers convertible grants for the entire value chain of exploratory drilling. If exploratory drilling turns out to be successful through the discovery of a resourceful and drillable well, the grant is converted to a loan. The project has to repay 80% of the funds received (KfW, 2015b). However, if it is unsuccessful, there is no financial commitment to repayment, and the grants are not converted to loans. This instrument specifically targets the high risk of exploration drilling, providing a safety cushion for projects to buffer against unsuccessful drills. At the same time it allows funding facilities to recover public funds with successful drilling outcomes.
Guarantee funds are widely used by DFIs and national governments to provide a safety net for developers in the case of unsuccessful drilling results. For example, the Inter-American Development Bank provided funding of USD 85 million to the government of Mexico (The Inter-American Dialogue, 2015). This established a geothermal financing and risk transfer scheme to provide loan guarantees during the drilling and production phase in Mexico (Qbic, 2015). The Indonesian Ministry of Finance also set up a USD 300 million geothermal guarantee fund to mitigate resource risk. It received support from the US State Department in deploying these funds to develop financial structures and risk mitigation instruments in Indonesia (The White House, 2015).
Exploration insurance via a public-private partnership allows a private insurer and government to share the burden of potential failure in geothermal exploration drilling. In partnership with the IFC, Munich Re has implemented an insurance product for exploration risk in Turkey. The insurance covers drilling costs for exploration wells and costs for simulation measures and well development (Munich Re, 2015a). However, the public-private partnership model can be complex to design, implement and monitor, and higher insurance premiums may increase overall upfront costs (Sanyal, 2013).
Portfolio guarantees can cover a proportion of the losses on a group of projects in order to diversify exploration risks across different wells. A multi-well exploration risk cover is provided for the Kenyan Akiira project, developed by Akiira Geothermal. Munich Re is engaging in a series of up to eight drillings, making the project’s financing more dependable and easier to schedule. The premiums become due in instalments as the drillings progress (Munich Re, 2015b).
Source: IRENA (© IRENA 2016)