This article comes from law firm Chadbourne & Parke LLP.
The U.S. Army has embarked on a program to enter into $7 billion worth of long-term contracts to buy renewable energy for U.S. Army bases. The other service branches have similar programs. There are special challenges when trying to finance a power project that sells its output under long-term contract to the military, especially if it is on land that the U.S. government has given the developer a right to use on a U.S. military base. Several veterans of financing government revenue streams under energy savings performance contracts and utility energy services contracts talked about the challenges at an Infocast conference on defense microgrids in Washington in April.
The panelists were:
- Jonathan Yellen, managing director of global capital markets at Morgan Stanley,
- Anita Molino, president of Bostonia Partners,
- Tracey Gunn Lowell, VP of renewable investments for U.S. Bank,
- Scott Foster, senior vice president and managing director for federal operations at Hannon Armstrong, and
- Andy Redinger, managing director and group head at KeyBanc Capital Markets.
Program host John Martin: Have you looked at the proposed U.S. Army power contract and, if so, are there any show stoppers in what you have seen so far?
KeyBanc’s Andy Redinger: We financed a wind project that was being used to supply electricity to the U.S. State Department last year. I believe the contracts are similar. That project was not on a military base, so we did not have to deal with the problem that the military insists on a right to terminate its contracts for convenience. I think there are ways to get around such termination rights. If the contract is terminated for convenience, then the military should make a payment that will make us whole as a lender.
Bostonia Partners Anita Molino: I can’t say I have studied the contract in depth, but it is pretty much what we expected. There are a whole host of issues. Termination for convenience is just one.
The Army is proposing a yield maintenance solution, which may or may not work. There is a ton of capital waiting to be deployed in this sector. The question is whether this capital is so anxious that it is willing to adapt to how the government insists on doing business. The government cannot violate the Anti-Deficiency Act. Its commitment to pay for electricity has to be subject to appropriations. There are a lot of issues on both sides, and the challenge will be how they all come together. We saw it happen very successfully in military housing, but we are not there yet on power contracts. Everybody is willing and everybody wants to try to get there, but there is a lot of work still to be done.
Morgan Stanley’s John Yellen: We looked at one service department’s form power purchase agreement. It is based on one that successfully attracted third party capital. The service department reached out to us and others to review the contract with an eye to financeability. The contract was blessedly simple when compared to contracts we see with investor-owned utilities. Key definitions and the schedules were redacted, but we had discussions with the department about termination for convenience and found a workable approach. The surest test of financeability is when a financing is completed with commercial entities like the ones who were involved in the prior project. The workable approach is for the military to compensate both the lenders and equity investors when the contract is cut short for convenience.
Hannon Armstrong’s Scott Foster: The contract should acknowledge that a third party has an interest and is providing financing.
Termination for convenience is a concern. There are contracting officers who refuse to put a termination liability amount in a schedule. A perfect example is the U.S. Air Force Davis-Monthan contract. The contract was unfinanceable. The only reason the deal got done was the North American Development Bank ended up doing it. It is going to take some flexibility by both the capital markets and the government as we work to make deals bankable.
U.S. Bank’s Tracey Gunn Lowell: We have seen a couple deals where the military had a right to terminate for cause, but “cause” covered a long list of items. We are waiting to see more of the top developers engaged in helping work through these issues.
John Martin: You have a federal government credit behind the electricity revenues. How does that affect the cost of debt and tax equity for such deals?
Yellen: The federal government is clearly a very strong credit; maybe not as good as it was a couple of years ago, but it is still better than the utilities and other entities who sign up to buy long term power. The government as counterparty is a very strong positive and probably one of the reasons that many of us have been looking so closely at this sector.
There is a perception that these projects should be able to raise capital at the same cost as a federal borrowing. The reality is that a least-common-denominator approach is applied to the project credit analysis. While the offtaker’s credit is very strong, we still have all the operating and construction risks associated with a power project that brings the overall risk of the asset down typically to a low investment grade level.
Martin: What is the premium to Treasuries for debt in this type of transaction?
Yellen: For assets like these that are structured well with long-dated, fully-amortizing financing against the PPA, assuming one can get past the termination for convenience clause and the other issues, you would probably be able to borrow for 25+ years at somewhere around 5 1/2% fixed.
Martin: What spread would a borrower get with a securitization compared to a bank financing?
Foster: A securitization requires volume. Assuming volume, if you use energy savings performance contracts as a guide, the spread would probably be 150 basis points over average-life Treasuries. It would be very cheap money. It is a well-developed market. What must happen is we need more volume with a consistent set of terms and conditions from one deal to the next.
We are much more comfortable with a federal government contract, if we can get the right terms and conditions, than we are with a commercial contract. The government can contract for up to 30 years. We are comfortable that the government will be around in the long term or we will have bigger problems. We are willing to do 20- and 25-year contracts with the government when we would limit the contracts to 10 and 15 years in a commercial setting.
Martin: We are talking about two types of projects. There are the small utility-scale projects of 10 to 20 megawatts and there are rooftop solar installations, for example, on military housing. What sort of coverage ratio would you need for the debt?
Yellen: We have seen the bank and bond markets converge to about 1.4 times coverage.
Redinger: I think the coverage ratios are between 1.3 and 1.5 tiimes, depending on size of the project, using P50 numbers.
Martin: We have several financing options represented at this table: debt, tax equity and securitizations that are a form of debt. Which type do you think this market will gravitate toward? I would have thought tax equity, because you have 56% of the cost of the project being paid by the federal government through tax subsidies. That’s the reason for third-party ownership structures where a power company owns the project and the military merely buys the electricity.
Redinger: The financing strategy depends on who owns the project. Somebody who has a tax appetite obviously does not need to access tax equity, so it will finance projects differently than another developer who lacks tax capacity. The more important question is whether the projects will be able to attract equity. Lenders and tax equity investors want to see real equity investors behind them in the capital structure. The returns on these projects do not look high enough for the equity market.
Martin: What do you think the returns will be?
Redinger: It is really hard to say. Every project is different. I suspect equity returns will be in the high single digits.
Martin: These are small projects. Returns are low for the equity, so why chase them? I assume because you guys are ahead of the equity in the capital structure?
Yellen: That could be one reason. We are also chasing them at times because we may have a relationship with the developer, and the developer is doing other things as well that could be of interest.
Martin: Anita Molino, you mentioned non-appropriation risk. Any payment from the federal government is subject to annual appropriations. How do you arrange long-term financing in the face of that risk?
Molino: Very carefully.
We have spent decades educating the institutional investor market about what the risk is and isn’t. With proper due diligence, investors can get comfortable. They will extract a premium for the risk, but that is not a huge concern because we have been dealing with non-appropriation risk for so many years in many different types of securitizations with the federal government.
Redinger: I agree with that. Due diligence is obviously critical, but non-appropriation risk is something that has been placed successfully in the market for decades. Deal volume is an issue. The stronger the forward calendar of deals and the more dependent the government is on its ability to continue to finance these projects, the less likely it will be to do something that will harm its ability to continue to secure financing.
Yellen: The analogy is often made to the military housing program, which was an extremely successful program over a period for more than a decade. It raised tens of billions of dollars and is probably the most successful global example of public-private partnerships, and it was done by the service departments within the U.S. military, so it is a great model to follow.
Base closure risk is another issue that those deals often faced. Some of the early deals had guarantees to address it. The services were willing to take that risk and not put it on investors. Over time, as people got more comfortable that the risk could be quantified through diligence, it became an issue that investors would take. They would assign a price to the risk. In some extreme examples where there was a greater risk of a base closure, the government had to provide a guarantee. The experience showed there are ways to deal with even the most difficult risks.
Martin: Scott Foster, Hannon Armstrong has had experience dealing with government paper over many years. What has the default rate been on your securitizations?
Foster: We have not had any defaults. The transactions have been primarily energy efficiency transactions, energy savings performance contracts and utility energy service contracts. We also finance submarine fiber optic cable and information technology in aircraft. We get comfortable that the risk of the agency funding being cut off is minimal. Where we have more risk is non-renewal. Non-renewal is very different from non-appropriation. It is the risk the agency will decide not to extend the arrangement.
Martin: What’s the difference between an ESPC, or energy savings performance contract, and a UESC, or utility energy services contract?
Foster: A UESC is similar to an ESPC, but there is usually no performance guarantee, and a utility is allowed to be the sole source the base approached for a contract if the base is within the utility service territory. The government can contract directly with a utility for demand-side management. The big difference between the two forms of contracts is that the military procurement regulations state clearly that ESPCs can have terms of up to 25 years while the permitted term for UESCs is somewhat grey. The procurement regulations say the permitted term is 10 years, but that has been interpreted as a UESC contract awarded to a utility can be valid for 10 years and then renewed, and the Department of Defense can grant special approval for terms of up to 30 years. Civilian agencies are limited to 10 years.
If you want to do power contracts with civilian agencies, you have to start thinking outside the box of how are you going to deliver green power at brown power cost and work with a contract limit of 10 years. Congress is unlikely to change the law to facilitate financings as was done with military base housing. We have imaginative people in the market. Someone will figure out how to do this.
Martin: What was the effect of budget sequestration on the military’s readiness. How big an issue is sequestration for this market?
Yellen: It is having a near-term impact. I attended a conference in San Diego, and the Department of Defense personnel were not able to attend. From what we understand, a lot of their activities are considered administrative costs and have been curtailed. The longer-term impact is tough to assess at this stage.
Foster: At least on the energy efficiency side in small renewables, we have not been affected yet by sequestration. We have actually seen the opposite of more deals coming through the pipeline because these transactions are budget neutral. The military would like there to be no net cost to the government. It wants PPAs to look a lot like ESPCs or UESCs and try to have the green power be at the same price as brown power, or close to it.
Molino: I think we have started to see a bit of an effect from sequestration. These renewable energy projects require a lot of due diligence on the services side in terms of figuring out what projects to pursue, and we are hearing talk of some layoffs of contractors who do these evaluations. The result may be a slowdown in the program.
Termination for convenience
Martin: Scott Foster, you mentioned Davis-Monthan Air Force base. Most of us saw the contracts with the Air Force and figured that it was impossible to get the Air Force to agree to a termination value schedule showing what the Air Force would pay in the event it terminates the contracts for convenience. Why do you think any other service branch will do so?
Foster: I think each contracting officer has discretion. Some will agree to such a schedule. We see it all the time in ESPCs and UESCs. We did two biomass transactions under ESPCs — one at Oak Ridge and one at Savannah River — and at Oak Ridge, the government took fuel risk, and at Savannah River, it refused to do so, with the result that the cost went up for that reason. I wish I could tell you that every deal is going to be the same from the top down, but I think there will be a lot of negotiation with the local base and contracting officer.
Martin: Can you finance a project without a termination value schedule showing what the military will pay if the deal is cut short?
Foster: No one wins if the deal is cut short. We would still need to be comfortable that the base needs our electricity for the full duration of the contract.
Molino: I do not think such a project is financeable, or at least we would not consider it prudent to finance. There is no reason for the military not to agree to such a schedule.
Martin: These projects are built on military land. There may be a default at some point. How do lenders realize on their collateral? What is the collateral?
Redinger: It is no different than with any other project that we finance. We want access to that collateral, whether it is on a military base or otherwise. I cannot think of a project with the government where we have not had some issue on third-party consents allowing the lender to step into the developer’s shoes to gain access to the collateral for whatever reason, and if we do not have that, it is a deal stopper for us.
I have been wondering how the military will deal with that, because I am sure it will have heartburn about just having any Tom, Dick or Harry roll onto U.S. military bases to collect his collateral. This will have to be worked out as we move forward.
Martin: If you’re dealing with a utility-scale project, is it satisfactory just to be able to come on to the base and remove the equipment?
Redinger: Is that realistic? No. It is just one of those things that lenders require to check a box. Going onto the base and removing that collateral is not something that we would do in practice. We would want the ability to leave the project in place and sell it to someone else.
Molino: We financed a solar array under an ESPC for the Army at White Sands, and there we had to do it on the basis of a site license, and it cost us a lot of legal fees to figure out how to get the project done. It materially shrank the universe of interested lenders. Lenders want their rights. They want the access, and the fact that access can be denied to them eliminates a lot of lenders.
Electricity price cap
Martin: The Army would like to pay less for electricity under these RFPs than it pays the local utility. But you are talking about technologies that cost more to generate electricity than gas, which the local utility might be using. In addition, the Army wants the renewable energy credits that are supposed to bridge that gap to the developer. Suppose you enter into a 20- or 30-year contract. The electricity price is below what the military base is paying the local utility for electricity, but over time, the contract price becomes higher than the local retail rate for electricity. Do you about worry about the political risk that the contract will be cancelled?
Foster: All you can do is try to end up with good terms and conditions from the perspectives of both parties so that the power contract can withstand that type of test.
Chadbourne & Park LLP