Could the US CHP industry learn lessons from the much younger solar industry in the finance deals it offers its customers? Yes, says Larry Thrall, who outlines the options and components of lease and long-term agreement financing arrangements.
The US CHP industry is poised for a boom in business due to the low cost of natural gas and the high and ever-increasing cost of electricity. In addition, CHP technology has become more reliable, remains comparably inexpensive, and creates efficiency. In the US, the spark spread – the difference between the cost of burning natural gas for electricity and buying that electricity from the grid – has never been larger and looks set to grow. For the purpose of this article, we are addressing CHP systems that can take advantage of this spread.
The principal barrier to the sale of CHP is finance. The majority of potential sales are constrained by their available investment capital. We estimate that nine out of 10 potential clients will be prevented by their capital budget from buying a CHP system. So far, the CHP industry has been actively pursuing this well-funded 10% of the market. Other major target market sectors, such as municipalities, hotels and hospitals are not as flush with cash. These markets continue to limp along with the economy.
Further, most companies have other priorities for the limited use of their capital. In addition, CHP is an unfamiliar technology for most potential clients. As a result they are unlikely to be aware of their financial options when purchasing such a system. Last, these systems come with other risks such as gas price risk, operations and maintenance costs, and equipment failure risk.
What can we learn from the solar industry? The solar business has developed very quickly over the last three years into a thriving industry. This happened in part due to market conditions, tax incentives, rebates, lower costs etc. The primary mover was the ability for the financial sector to quickly develop products that could wrap all of these benefits up into a tight little package called a power purchase agreement (PPA). This is how traditional utility energy projects have been financed for years.
The PPA opened the door to financing these capital-intensive projects over a larger portion of their useful life. Innovators in the solar industry realized that they could structure smaller commercial and residential installations in the same way.
The solar PPA was born and has been one of the primary reasons for the solar industry’s immense growth. The solar PPA offers the end user the ability to buy solar power with little technology or finance risk. It is off-balance sheet, which allows the finance companies to monetize the tax incentives and rebates while passing along some of these benefit to the customer in the form of a lower cost of energy.
Solar projects with paybacks of 7–10 years and useful lives of 25+ years are financed over 15–20 years. The investors are given an above-market return and the customers are given a lower cost of electricity; everybody wins. The majority of solar customers would not have bought solar without this structure.
PPA CONTRACTS AND OPERATING LEASES
The CHP industry needs to offer PPA or off-balance sheet finance to its customers in order to compete. The customer needs to be convinced that they are not buying hardware, but instead buying a lower cost of energy. Inherently, CHP has different risks associated with it. These risks need to be addressed and assembled into an attractive package for the customer.
Fuel cells, internal combustion engines or turbines all have a technology risk. Manufacturers usually offer performance guarantees on their products to help ensure the production on heat and electricity on projects. For smaller and/or newer technology providers, additional insurance may be available to cover default on any performance guarantees that may be offered.
Figure 1. CHP – cost benefit breakdown
Natural gas contracts
The risk of natural gas prices during the life of the contract needs to be mitigated. Long-term natural gas contracts can be secured to match the term of the finance offered. Below are a few of the options offered by suppliers in how natural gas contracts are structured.
- Flat-rate contract – pay the same price for the life of the contract. This locks in a set price for the life of the contract, passing on more benefit towards the end when prices are more likely to have risen much more than the end years’ contracted price.
- Escalating price contract – start with a base rate, and increase it over the life of the contract. This allows the customer to know what they will be paying and take more of these benefits up front while increasing the cost at a pace that the client is comfortable with. Usually the escalator is set at or below the projected escalated price of competing electricity prices.
- Floating rate with collar – the price will fluctuate with the market, but the client will have a ceiling set for the price during the life of the contract. This allows the client to benefit from the potential lower market prices while paying a premium to hedge their ultimate risk of paying a price above that ceiling, which may be set at their estimated competing electricity prices.
Operations and maintenance (O&M) of the CHP equipment is an important area in which the client does not want to undertake any risk. The customer wants to pay for electricity and heat, not equipment, which may or may not work. This risk can be reduced with a comprehensive O&M agreement. O&M contracts should be full service, helping eliminate downtime. The O&M contracts should match the term of the finance offered.
Once we have developed the bundle of offerings above, we can then offer capital leases, operating leases or PPAs that match the same term as their service bundle – see Table 1. The longer the tenure, the higher the returns, which increases the probability of closing a deal.
The current market supports up to a 10-year tenure on operating leases and PPAs. For projects over 10 MW, structured finance is available matching equity or tax equity investors, as well as lenders for the debt component. Credit is still not easy to obtain, but more lenders are now interested in lending into this industry. Ideally, the client needs to have shown profit for two of the last three years, in addition to having a strong balance sheet. Debt service coverage ratio is expected to be at or above 1.25.
Rates for operating leases can be as low as 2% on a 10-year operating lease. This includes the 10% US Investment Tax Credit (ITC) given to the bank. Certain lenders are more comfortable with certain industries, so finding the right person at the right bank is important to finding the best deal.
There are a few brokers that specialize in energy related finance that can help to secure the best possible finance for a certain type of client. For instance, a client may want to use their existing banking relationship and be declined, or offered a shorter tenure or higher rate than what they may obtain from the same bank through a broker that is specific to this type of finance.
In summary, the key to expanding the CHP market is creative, off-balance sheet finance offered through power service agreement and power purchase agreement structures that properly address the associated risks through: technology guarantees, solid O&M agreements, long-term natural gas contracts and additional insurance if needed. These new financial structures are now in place and are only limited by the industry’s ability to market them properly to their quickly expanding customer base.
Larry Thrall is the managing director of Vireo Energy Finance, California, US. Email: firstname.lastname@example.org