Of course, comfort for renewables has been rather thin on the ground recently. Brexit aside, over the last year or so, the UK’s renewables sector has experienced a period of deep uncertainty. It’s probably fair to say that the current Tory government has so far been a lukewarm friend at best to this sector. Twelve policy decisions in the last six months of 2015 removing various incentives took the industry by surprise; the predictable end result being a nosedive in investor confidence.
The hits included decisions on the Renewables Obligation and feed-in tarriffs, as well as removing the climate change levy exemption. And if this wasn’t bad enough, swift on the tail of removal solar subsidies in 2015, on-shore wind subsidies died a premature death in March this year (the termination date having been brought forward). The fallout from the Brexit result undoubtedly doesn’t help matters. However, arguably this is only salt in an open wound.
So what words of cheer could Ms Leadsom provide to the renewables sector? The short answer is: not many. Her key message was that the government makes no apology for balancing cost to the consumer with the need for investor security. However, that was pre-23 June.
Not all doom and gloom
Post 23 June, we are in a different world and happily it’s not all doom and gloom for renewables. Ironically, one of the first things the government did following Brexit was to re-affirm its commitment to the renewables sector through the medium of the fifth carbon budget, which was set at a level many thought might be in doubt: a cut in carbon emissions by 57% by 2032 (based on 1990 levels). Amber Rudd, Energy Secretary, provided the comfort to investors that Ms Leadsom had refused to give stating:
We must not turn our back on Europe or the world…. So while I think the UK’s role in dealing with a warming planet may have been made harder by the [Referendum] decision, our commitment to dealing with it has not gone away.
Autumn will be a busy time for renewables activity with the government’s review of tidal power set to conclude and the launch of the next Contracts for Difference (CFD) auction (which awards subsidy contracts for renewables developers). However, we’re not quite out of the woods yet. Questions on the CFD auction remain as to budget size and eligible technologies and there is even some talk that the auction timing may be delayed.
Given that the renewables sector clearly has a future in Britain, albeit marred by Brexit and subsidy uncertainty, what do lenders need to think about when considering whether to invest in this sector?
Effect on lenders
For those that do continue to lend in the sector, undoubtedly the level of scrutiny for those projects receiving project finance will increase and the “bankability” of such projects will be affected.
A project is “bankable” if lenders are willing to finance it. The EPC contract usually represents the largest expenditure in a renewables development. In project financed deals, risk allocation issues are driven to a greater or lesser extent by the lenders and issues around bankability. In an uncertain market, such issues are magnified.
While there has been a drop off in new deals, there has been a significant increase in refinancing activity in the UK over the first half of 2016. It remains to be seen if a weaker pound will increase appetite for acquisitions from foreign investors.
Those drafting contracts would do well to remember that even if lenders are not involved in the structuring of a project at the outset, this does not mean that the same project will not need to attract finance in the future, either by way of refinancing or through finance-backed acquisition of the asset. If the banks are not directing negotiations at the outset, care must be taken to ensure that developers maintain positions that will provide the comfort required by investors financing a project at a later date.
What do lenders look for in a “bankable” EPC contract?
This will vary depending on the timing of investment. A lender is looking for project risks to “pass through” to the party most able to bear or manage them. In practice, this means limiting risk taken by senior lenders and the owner-borrower and allocating it to equity investors, contractors, guarantors and insurers.
This can be achieved by procuring the project on an EPC turnkey basis and backing off the owner’s liability, and its obligations under a power purchase agreement or concession agreement, to the contractor. Typical provisions that “flow down” through the contracts include force majeure, unforeseen events, ground condition risk, change of law, grounds for termination, indemnities and administrative procedures.
Additional protection will also need to be included within the EPC contract. Lenders will be looking for adequate provisions regarding the following as a minimum:
- Direct Agreement. This is the lender’s direct contractual link to the contractor and will allow the lenders to step-in to the project in certain circumstances.
- Performance security. A robust security package by way of suitable parent company guarantee and/or bond to protect against contractor breach or insolvency.
- Performance guarantees and performance liquidated damages. The performance criteria the facility is required to meet and the consequences of performance shortfall are critical. Performance LDs are often linked to lost revenue for the underperforming facility.
- Fixed completion date and delay liquidated damages with a right to terminate upon reaching any cap on delay LDs or a longstop date.
- No/limited technology risk and preferably a wrap of the FEED (front end engineering design).
- Defects liability and warranty period with an adequate retention. Any interface with the operation and maintenance contractor running the facility following hand over should also be considered.
- Testing and commissioning. Clear procedures for acceptance must be set out and may include provisional acceptance tests on handover, periodic reliability testing over a period of time post-completion, final acceptance or all of the above.
- Caps on liability. Lenders will require these to be at market acceptable levels and with suitable exclusions.
- Insurance. Lenders will be particularly concerned that the project’s exposure to various risks is backed by adequate insurance cover.
- Consistency with other contract documents in particular the technical documents. MT Højgaard A/S v E.on Climate and Renewables UK Robin Rigg East Limited and another highlights the problems which can arise when the level of design responsibility stated in the contract conditions is not consistent with the technical schedules.
In this post Brexit world, little is certain. However, what is clear is that the government is committed to renewables. This is not to say that it will be plain sailing, but there is a level of commitment and this may be good enough for some investors. Others will be waiting to see if forthcoming policy decisions will provide meaningful support to enable the UK to meet the challenge of the carbon budget.
For onshore wind and solar energy, no longer backed by government support, removal of subsidies does not mean an end to development. The rate of technological progress, allowing increased power output through technological efficiencies and commoditisation of products counterbalancing risk in the market, means that lenders will continue to look for opportunities to invest in a variety of renewable energy technologies in the UK. The key is to ensure that the contractual documents are in order and that the “bankability” hurdle is met.
This blog post has first appeared on PLC Construction Blog, 12 July 2016.