Microgrid projects are not yet ‘bankable’ from the perspective of certain financiers due to various risks associated with using microgrid technology. Jonathan Strahl, Emily Paris and Laura Vogel discuss strategies project developers and financiers may use to mitigate these risks.
As distributed energy resources (DER) become increasingly prevalent in our electricity system, developers are seeking to optimize their project economics using microgrids.
A microgrid is a platform for co-ordinating various, potentially disparate DER into a single load- or generation-shape that can intelligently interact with the macrogrid (the larger electricity grid). Through microgrids, DERs have the potential to be more adaptable, customizable, and sophisticated than ever, and provide any number of services to the macrogrid. Microgrid islanding capability enables local energy resiliency, and aggregating DER in a microgrid can enable easier valuation of DER costs and benefits. Additionally, microgrids can be effective testing grounds for the latest smart grid technologies.
However, despite potentially significant value streams relative to typical DER installations, microgrids have not attracted much investment beyond public grants and other specialized financial solutions – largely due to microgrid project risks and complexities. While some of these risks are familiar to power project financiers, certain novel nuances of microgrid projects are not yet sufficiently understood and vetted by the market to attract institutional investors.
Additionally, most microgrid applications are highly specific and therefore not scalable, making them more difficult to finance. In fact, the microgrid industry is currently in a situation similar to the Independent Power Producer (IPP) market of the 1980s and 1990s. Facing the same technology, cash-flow, and regulatory struggles as IPP developers, microgrid developers are in a position where they must convince banks and investors to provide financing for an emerging energy enterprise.
Financial support from institutional investors is necessary to sustainably scale up the microgrid market from a series of standalone government-funded projects to a viable asset class. However, few projects are currently considered ‘bankable’ from the perspective of institutional investors. While financial viability (i.e., securing an acceptable rate-of-return on capital) is the minimum threshold for consideration, the project must also address all commercial considerations (i.e., risks that could threaten financial returns) to be truly bankable.
Evaluating a microgrid’s return on investment requires a robust understanding of generation and load characteristics, utility structure, energy markets, regulatory environment, and risks associated with an individual project. Ownership models and financing structures can also significantly alter a project’s economics. This complexity of stakeholders and value streams inhibits the financial attractiveness of the project. Increasing investor familiarity with risks, mitigation strategies and the performance of existing projects will help move the industry toward a standard valuation.
What distinguishes a bankable microgrid from bankable DER?
A microgrid differs from a typical DER project because of the uninterrupted supply of load enabled by its islanding capability. However, islanding requires significant investment which often discourages investors. Engineering and equipment costs to re-synchronize and reconnect to the grid after an islanding event are very costly, and disconnection and reconnection procedures must be extensively tested for safety and proper functioning. Additionally, a microgrid’s islanding benefits are difficult to monetize and are only periodically realized (grid outages are typically infrequent). However, microgrids can capture multiple value streams, which in certain cases can offset the incremental cost of islanding.
Financiers must understand the nuanced values of islanding before they will consider investing in a microgrid over a standard DER project. There are cases in which the ability to island is valuable enough to be monetized. For example, the owner of a data centre may be willing to pay additional costs or fees for uninterrupted power. At the community scale, funding from municipalities and governments is also a payment in part for the societal benefit of energy resiliency. Furthermore, islanding technology can create substantial value during ‘blue sky’ (normal macrogrid) operation. Technology to balance generation and load (e.g., telemetry, load control, and power flow control) enables revenue streams beyond the sale of electricity (see ‘Market value and desirable markets’ for detailed discussion).
|Figure 1. Financing sources for microgrids Source: Navigant Consulting|
Microgrid technology development and project and portfolio development involves a variety of different investors and funding sources. Figure 1 presents a simplified model of these interactions.
Government grants, the largest source of microgrid project funding today, have been crucial in the nascent market. As Figure 1 indicates, public funding currently enters the microgrid project lifecycle at several different stages. In the near term, public funding can play a role in attracting institutional investors to the market by engaging in public-private partnerships or funding the development of new bundled microgrid project portfolios.
In the long term, public funding may continue to play an essential role in financing islanding capability to provide more reliable energy services. Municipalities and government agencies will likely continue to pay for the intrinsic value of a more resilient electricity supply.
Private investment is much more limited than public investment. Venture capital funding may support microgrid projects through investment in innovative new technology and solutions underlying microgrid-enabling technoliges. Banks may issue debt to finance microgrids as a ‘pure play’ based on the DER technology (typically combined heat and power) used in the microgrid and the terms of the power purchase agreement. Investments in microgrids at the project level often come from vendors also functioning as project developers and financiers to prove their proprietary technology in the early-stage market. Still, these large vendors (e.g., Siemens and Schneider Electric) understand that finding third-party financiers willing to take on the risks of microgrid projects would establish a stronger market for microgrid products. For example, Schneider Electric is undertaking further work to identify investors in the commercial microgrid space for both equity- and debt-financing solutions and offer a standard template tool to facilitate investment decisions.
In Figure 1, bundled microgrid project portfolios debt-financed by institutional investors are highlighted as a future development for the microgrid industry. To expand beyond the current demonstration projects into full-market commercialization, microgrids must attract institutional investors such as retirement and insurance funds. As in the project finance market for IPPs, lower-cost debt financing offered by institutional investors is most critical for establishing a scalable and robust microgrid industry. Because microgrid projects are typically small, and transaction costs for institutional debt financing are high, bundling similar projects into a project portfolio or YieldCo may be a promising avenue for securing financing.
Mitigating Risk and Appealing to Financiers
A project or portfolio of projects must be of scale (i.e., large enough to provide an investment value worth financiers’ time and consideration) and scalable (i.e., standardized through a replicable framework to manage various risks and cover debt service associated with the diverse mix of generation assets) to attract institutional investors. While a single microgrid project is not likely to meet this size requirements, developers could bundle multiple smaller projects to achieve an attractive total asset value (see ‘Choosing a business model’ for detailed discussion).
However, an investor ultimately is attracted by low-risk projects or projects with well-understood risks and higher returns, and risk tolerance requirements could pose serious challenges in attracting institutional investors to a microgrid project. Microgrids often contain novel or unproven technologies such as software load/generation management systems, energy storage, and two-way power flow controls. Because these technologies must operate together to deliver the full range of energy services offered by the microgrid, the entire system bears the technology risk.
Furthermore, even the existing track record of established technologies may not always apply to a microgrid development. For example, in a grid-connected context, a CHP plant may be considered a proven, reliable asset with a long life. However, in a microgrid with solar PV, a CHP plant must consistently modulate its power output to match load with intermittent solar generation. This can shorten the typical lifetime of the CHP plant and affect the power output quality.
Another risk that is relatively unique to the microgrid sector is that it involves two offtakers – the utility and the islandable load. Utilities are not typically perceived as risky offtakers, but the economics of the microgrid can be adversely affected if load is reduced on the microgrid. Retail customers can be unreliable offtakers, as they generally are able to change their operations or locations, which affects local energy loads.
Microgrid project developers can proactively mitigate these risks through strategic project design and financing. For instance, to run the CHP on a consistent basis to preserve its performance, the microgrid could leverage the macrogrid and other intermediate resources (e.g., energy storage) to balance the power output. If proven technologies are not available to alleviate investor concerns, strategic partnerships and creative project financing can help mitigate technology risk for certain investors. For example, grant funding or government funding can be used to finance the newest, least-proven components of the project. Ideally, some of the funding from a grant should be reserved to fix any issues with the technology during operations.
With regards to the offtake risks, microgrid developers should choose host facilities with permanent electricity demand. Otherwise, lenders will expect a charge or penalty to cover the cost of any unexpected load reduction. The microgrid can also be designed around an “anchor” offtaker, the most established customer who bears the highest percentage of risk.
Project developers could also maximize the project’s resource utilization by monetizing multiple value streams (e.g. electric, thermal, ancillary services, and the ability to provide backup power).
In Hamden, Connecticut in the US, developers of a microgrid project conducted a cost-and-benefit analysis to examine two technology scenarios. The first scenario was a backup generator to serve the critical load in emergencies only. This option had lower upfront costs yet a much higher cost per kilowatt-hour as the generator would rarely be utilized ($3.3 million up front; $0.95/kWh over a 20-year lifetime). The second scenario was a microgrid option that offered the ability to serve multiple loads continuously at a lower cost per kilowatt-hour. Although it required a much higher up-front investment ($7.7 million up front, $0.115/kWh over a 20-year lifetime), this scenario proved more economical, particularly given the electricity rates in the Hamden area. In this scenario, approximately 86% of the customer load would come from microgrid generation assets and 14% from the macrogrid. This ratio hit the ‘sweet spot’ for economical operations, with the utility primarily serving shoulder operations in the late morning and early evening. The developers expect the cost per kWh to continue to decline as more resources and customers are added to the microgrid.
Market value and desirable markets
Markets with the following characteristics are ripe entry points for the bankable microgrid:
à¢€¢ High electricity prices and low fuel prices. The business case for a microgrid generally relies on the most basic measures of arbitrage profitability: the spark spread. Markets with high electricity prices, low natural gas prices, and abundant renewable resource potential are likely to yield a more favorable spark spread for microgrid developers.
à¢€¢ Demand charges. One of the main drivers of value in the microgrid market is demand charge reduction. In markets where a large portion of the electric service charge is based on peak demand (e.g., New York), there is a large incentive for users to reduce demand. Microgrids can accomplish this by minimizing the demand from the macrogrid through active management of on-site resources.
à¢€¢ Time-varying rates and/or net metering. By the same token, thermal and electric energy storage can be used for price arbitrage in markets with differential retail electricity rates throughout the day, by storing energy when the rates are low and discharging when high. Net metering allows microgrids to sell excess generation at higher retail rather than wholesale rates.
à¢€¢ Ancillary services. Microgrid developers can monetize ancillary services such as frequency regulation and voltage control in certain markets. It is difficult to construct a bankable business case from these revenue streams today, as they are highly variable, market-dependent, and potentially short-term. However, need for the ancillary services a microgrid can provide may increase as more intermittent renewable resources enter the grid. The market for ancillary services could be de-risked through price hedging contracts.
A market that includes all of the above monetized value streams would be attractive to the microgrid financier due to the sheer diversity of revenues. Other value streams available to a microgrid that are independent of market context include:
à¢€¢ Diverse energy services. A microgrid is more bankable if it provides more than just electric energy services. With current technology costs, it is difficult to produce on-site power at a cost lower than the macrogrid. However, the addition of thermal energy for space conditioning, process heating or water desalination results in more reliable revenue streams from the microgrid. Thermal energy loops have the added benefit of being subject to fewer regulations than electric service infrastructure.
à¢€¢ Tax credits. On the development side for taxable equity investors, tax-driven cost savings for certain technologies (e.g., solar and battery storage) are available through a US federal investment tax credit (30% through the end of 2019 and a decreasing percentage thereafter).
Choosing a business model
The question of choosing the appropriate business model and financing structure boils down to scale. Third-party project finance comes with high transaction costs, so investors are attracted to large-scale projects that provide a worthwhile investment value. The majority of early microgrids have been funded through government grants but, increasingly, large companies such as SolarCity, SunEdison, and Siemens are financing smaller projects on their balance sheets. Once market players develop a replicable model that can be bundled and offered as a securitized solution, microgrids can move from balance sheets to institutional financing.
Developers can similarly package projects into sufficiently large securities that can be sold to institutional investors. While commonplace in mortgage lending and other commercial loan obligations, this strategy has not yet been used for microgrid projects. Successful aggregation of transactions that share a similar structure and underwriting standards could make for lower-cost financing and mitigate risk through diversification.
Microgrids and the emerging Energy
Cloud Credit: Navigant Consulting
The industry is also poised to see a surge in large-scale project development (i.e., $50 million and above). These microgrid projects are similar to any other large-scale infrastructure projects. Energizing Co and Stonepeak Infrastructure Partners are leading developers, which have established a special purpose vehicle (SPV) to work with municipal and investor-owned utilities through a standard public-private partnership. The SPV takes on all development costs and manages construction and long-term O&M contracts in return for a monthly fee. This structure offloads a significant amount of risk from the city/utility.
For this young industry to realize its full potential, developers need to adopt strategies to mitigate risks and accurately quantify value streams. This will attract mainstream financing from institutional investors and qualify microgrids as a bankable asset class.
Jonathan Strahl and Laura Vogel are Managing Consultants, and Emily Paris is a Senior Consultant, at Navigant Consulting, Inc www.navigant.com This article is available on-line. Please visit www.decentralized-energy.com