Second of Two Parts

A Project Finance Alternative: The Bond Market

Project financings range from relatively simple to comparatively complex. There are several viable credit enhancement mechanisms with others available, which will help to structure a “bankable” project financing through the proper commercial contractual arrangements.

John May, James Dack and Adam Pierce

Part one of this article (Waste Advantage Magazine, September 2011) outlined an alternative, but growing source of non-recourse project finance debt capital for waste-to-energy (WTE) projects—the institutional bond market. Participants in the bond market (including pension funds, insurance companies, mutual funds and high yield investors) look for opportunities to deploy their capital on a risk-adjusted basis. Unlike banks, which often face regulatory or funding constraints and are unwilling to move too far down the credit ladder, bond investors are willing and able to fund projects that may be considered low or below investment grade. Bond investors routinely accept the operating risk of alternative energy projects with contracted cash flows, but if asked to absorb other risks will seek additional compensation through higher interest rates and/or additional covenants. These higher rates may quickly erode the financing’s economics and drive down equity returns. The art and science of project finance is to allocate risks to parties willing and able to bear those risks at the lowest cost.

For example, participants in the bond market are generally reluctant to bear construction risk. Many are trying to match long-term liabilities (e.g., life insurance policies) with long-term assets (the bonds they purchase as investments). They do not have the technical skill set or resources to resolve unforeseen construction related issues. If not resolved satisfactorily, underperforming assets will impact their portfolio management and profitability. In order to ensure that the project is built on time and on budget, bond investors generally prefer projects be built under a turn-key lump-sum Engineering Procurement and Construction (EPC) contract with liquidated damages backed by a surety. The EPC contractor, with arguably more knowledgeable about building a WTE project compared to an insurance company, essentially absorbs the construction risk and is compensated for that risk through a higher contract price.

Currently, the average alternative energy project reviewed by the rating agencies finds itself hovering at the low end of investment grade (BBB) or moving below investment grade (BBB- and lower) based on the credit rating of the off-take counterparty. WTE projects with their feedstock risk (will the waste be made available at the proper economics for the full term of the financing to ensure timely payment of principal and interest) have additional credit risk relative to wind or solar projects. Mother Nature, their feedstock supplier, doesn’t have a credit rating and has no financial incentives to change her behavior. As you move further down the credit ladder your cost of debt increases. The difference in interest rate for a BBB credit relative to a BBB- credit is real and grows substantially with each step down the ladder. When a specific risk cannot be allocated to one of the direct stakeholders in a WTE project at a cost that facilitates the capital formation process (including equity), profit-motivated and other third parties can be brought in to absorb those risks at lower cost.

Technology Risk Transfer

The WTE industry has a base of time-tested (but challenging to permit) equipment along with a rapidly growing group of emerging technologies. These new technologies have a short list of deployments at various scales (pilot, demo, or commercial) domestically here in the U.S. and offshore. Until multiple commercial scale deployments have established operating histories, EPC contractors are unlikely to offer “wraps” that guarantee the performance of the technology. This introduces technology risk that bond investors may not be willing to take or in a position to properly price, resulting in prohibitively high interest rates for debt.

Third party insurers with both the technical expertise and balance sheets bond investors consider investment grade, have begun offering highly tailored technology warranties that may support a bond funded project financing. These policies are designed to transfer various technology risks like product defect, serial defect, performance issues (power, volume or other design outputs) and availability away from bond holders for a premium paid at project finance close. Structured as a guarantee or warranty, these policies are relatively short-term at up to five years. WTE projects, with long-term PPAs ideally have a financing period roughly matching the off-take.

Although the term of technology risk transfer is not co-terminous with the financing, any material issue related to the technology would likely emerge and be addressed early in the term of the debt, providing comfort to bond investors that they are sufficiently insulated from technology risk. These insurance products are often priced as a percentage of the capital cost of the covered technology. WTE projects using new technology often have a substantial number of components (handling, pretreatment, turbine, engines, etc.) with well-documented operating histories. Therefore the policy may only need to cover a small portion of the total capital cost of the project. Applying a policy premium of 5 to 10 percent of the cost of the new gasifier technology to transfer the technology risk to an insurer may often result in a lower cost of financing.

Sometimes re-allocating risk is not possible and the resulting credit profile is prohibitively low to secure cost effective capital. This may be because there are multiple risks that cannot be mitigated or there is not a third party willing or able to assess and absorb the risk in a cost effective manner. In this case, rather than address a discrete risk with a targeted solution like a technology warranty, it is possible to secure credit enhancement at a more macro level.

Government Loan Guarantees

Oftentimes, federal, state and local governments have an interest in supporting various policy goals, ranging from saving citizens’ money (lower taxes or power rates) and economic development goals (jobs, jobs, jobs), to explicit energy related motivations (alleviating dependence on foreign oil or reducing emissions). Rather than fund projects directly, governments with an interest in a project can provide credit enhancement through a loan guarantee. When a governmental entity provides a loan guarantee, the credit profile of the debt obligation changes from the risk that the project is able to meet its debt service obligations to the risk that the guarantor is able to meet its obligation to pay if the project falters.

State and Local Government Credit Enhancement

State and local governments have a history of supporting alternative energy projects in which they are not a direct stakeholder as sponsor or power purchaser. The form of support can range from relatively small like accelerated permitting to substantial support in the form of guaranteeing the debt. These guarantees are often structured as a “Moral Obligation” on a Revenue Bond in which the governmental entity is not legally obligated to make any payments should the project falter, but morally obligated. This moral obligation is generally accepted by bond investors as binding given the negative impact failure to pay would have on its credit rating for other financings. Securing a Moral Obligation from a state or local government can take significant time, but permits the WTE project to borrow based on the guarantor’s credit rating for the bonds benefitting from the guarantee. Moral obligations are best secured from highly rated entities with an interest in supporting the project for sound policy reasons.

The United States Department of Energy

The U.S. government has a variety of departments and agencies with both the authority and resources to provide credit enhancement to bring down your cost of capital. Recently, the U.S. Department of Energy (DOE) has been administering a couple of high profile loan guarantee programs for energy related projects known commonly as 1703 and 1705. Developers working with these programs may be deploying commercially proven technologies but face funding challenges due to the the large project size (multi-billion dollar projects) or less than ideal credit profiles. In some cases developers may be trying to deploy innovative technology that lenders are unwilling to support at interest rates that permit the project move forward. The DOE is stepping in to absorb some of the credit risk as a matter of public policy, through guaranteeing loans. The current political climate coupled with the statutory authority and available appropriation funding the DOE’s 1703 and 1705 programs, projects that have not already applied are not likely to get funded in the near future.

The United States Department of Agriculture

The U.S. Department of Agriculture (USDA) has a portfolio of programs with long histories, like the Business & Industry (B&I) Program, and relative newcomers like the 9003 Biorefinery Assistance Program supporting innovative technologies and the 9007 Rural Energy for America Program (REAP). In these programs the USDA guarantees a portion of the debt to elicit private sector funding of projects that would not have otherwise secured financing. A wide spectrum of factors likely contribute to the challenge of securing a loan (technology, feedstock, offtake, EPC contract, etc.) but all boil down to lenders’ perception that the risk-adjusted returns do not justify making a loan. Recent program changes have transformed these programs from commercial bank centered funding to permit bond funding. This change is enabling the creation of a new market for WTE project financings, moving away from banks that are unwilling to lend at any rate to bond investors willing to accept a lower credit profile with support from the federal government.

The B&I Program, with decades of history supporting rural businesses of all kinds, will have ample funding for the foreseeable future. However, the program has limits regarding the maximum amount of senior debt and a sliding scale of guarantee as a percentage of that debt. B&I loans of up to $10 million with up to a 60 percent guarantee can be approved at the state level. B&I loans between $10 million and $25 million can only receive a guarantee of up to 60 percent and would require approval from the national office and cabinet level approval. Projects using a B&I loan guarantee cannot have more than $25 million in senior debt. Due to the financial crisis, the current popularity of the program, and its use for many types of businesses, sponsors seeking B&I loans will likely have their senior debt capped at $10 million as a matter of policy through the 2012 fiscal year. This may present challenges for many WTE projects due to the capital expenses associated with these projects.

The 9003 Biorefinery Assistance Program is supporting the commercialization of innovative biorefining technologies that produce fuels and other products. Companies that use waste as feedstock qualify for the program, which has a maximum loan amount of $250 million. Similar to the B&I program, 9003 has a sliding scale for the percentage of the loan guaranteed, ranging from 90 percent for smaller loans with significant sponsor equity and 60 percent for large loans. There is a minimum equity requirement of 20 percent. Awards are made on a competitive basis. Interest in the program has increased substantially from 2010 to 2011, with the latest round of funding oversubscribed. The 9003 Program will likely need additional appropriations to open another application round in 2012. Federal budget challenges and the political climate in Washington, DC appear to cast doubt on the program’s ability to secure an appropriation in the 2012 Farm Bill.

Another USDA program that traditionally provides direct loans to power projects is the Rural Utility Service (RUS) whose goal is to support generation, transmission and distribution of electricity in rural areas. The RUS does have the authority to provide credit enhancement through a loan guarantee of a WTE project financing. Privately owned WTE projects accessing the RUS program must sell power to non-profit and cooperative associations who are the traditional customers of the RUS. The RUS program traditionally has ample funding.

Export Finance Agency Loan Guarantees

Oftentimes, WTE projects are using technology or technical expertise from foreign countries, opening the opportunity for accessing credit enhancement from an export finance agency. Most OECD1 member countries have an export finance agency whose goal is to support the export sales of goods and services from their country. Playing a key role in short-term trade finance, most have project finance programs that can guarantee loans. Many have a policy of supporting alternative energy and sustainability. For example, in 2009 the Export-Import Bank of the U.S. authorized $363 million in financing to support and export value of $640 million in environmentally beneficial goods and services including alternative energy.

The amount of the loan guarantee from an export finance agency is based on percentage of domestic content (either goods or services) to be exported to a foreign buyer like a WTE project. That loan guarantee becomes a 100 percent unconditional repayment obligation of the export finance agency whose credit rating is equivalent to its national government’s credit rating. Similar to the USDA B&I Program in which commercial banks have traditionally provided the funding and servicing for these loans, export finance agency guarantee can be applied to a bond financing, significantly expanding the pools of capital and driving attractive interest rates.

Export finance agency financing require goods and service to move across borders. For a WTE project in the United States, this means securing a guarantee from a foreign country by using foreign technology or a foreign construction services provider. Europe has been a leader in the WTE space as new technologies have been deployed to combat rapidly declining landfill capacity and to meet stricter emissions regulations. Bond investors in the U.S. may not be as comfortable with a technology that has not been commercially deployed domestically despite a rich operating history offshore. Export finance agencies may be more familiar with specific technologies developed or deployed in their country and more likely to support a project financing. They may also support an EPC contractor willing to wrap the performance of the technology that other firms are reluctant to provide.

A foreign export finance agency guarantee used in the United States is uniquely attractive because the WTE project would benefit from both a higher credit rating and the ability to issue bonds on a tax-exempt basis. Projects in the U.S. benefitting from a federal loan guarantee usually have to issue bonds on a taxable basis. The current financial crisis in Europe is placing some sovereign credit ratings in doubt, but many are likely to remain or return to high investment grade in the future.

Bond Structure with a Loan Guarantee

A project benefitting from a loan guarantee may have a portion of the debt guaranteed due to policy motivations (like at the USDA to encourage the private sector to support projects without putting taxpayer on the hook for the whole loan) or program regulations like in the case of export finance agencies who are limited to guaranteeing a portion of domestic content based on an OECD fair trade practices. Bonds are well suited to partial guarantees because they can issue two tranches of bonds, each with a parity interest in the physical assets and other project collateral. One tranche will be fully backed by the guarantee for the timely payment of principal and interest to the investor and the other tranche will fully expose the investor to the credit risk of the project.

Guaranteed bonds will price close to well known market indexes of highly rated liquid securities, providing transparency to the project sponsor on the interest rate associated with that tranche of debt. Unguaranteed bonds will price based on the underlying credit of the project, whether low investment grade or below investment grade. Closed simultaneously with similar terms, the project sponsor will secure a blended total cost of debt capital. Most loan guarantees require either an upfront payment and/or an annual payment to the guarantor. However, the all-in cost of capital including these guarantee fees is often significantly less expensive to the alternative of a straight un-enhanced WTE project financing.

As outlined in both Part one and Part two of this article, the bond market can be a compelling source of debt capital for WTE projects. Part two has covered several viable credit enhancement mechanisms with others available as well. Project financings range from relatively simple to comparatively complex. Project sponsors are well served by securing the advice of a qualified and experienced financial advisor or investment bank early in the development process. This advice will provide detailed insight into how to structure a “bankable” project financing through the proper commercial contractual arrangements (feedstock, construction, offtake, etc.) and if necessary review the options for cost-effective credit enhancement if necessary.

John May, Managing Director, is head of the firm’s Renewable Energy Practice, which he founded in 2003. He is a seasoned project finance investment banker who has financed more than $1 billion in loan and par values for over 100 clients in his 20-year banking career. He can be reached at (314) 743-4026 or [email protected].

James Dack, Vice President, opened the firm’s Seattle office in March 2010. He brings a unique perspective to project finance, having participated as an investment banker, a developer and an equity sponsor deploying institutional capital in highly structured investments. He can be reached at (206) 652-3564 or [email protected].

Adam Pierce joined Stern Brothers in 2010 as an associate in the firm’s Alternative Energy group. Prior to joining Stern Brothers, he spent three years as an analyst at Wells Fargo Securities in its Energy and Power investment banking group where he was involved in a broad range of equity, debt and M&A assignments. He can be reached at (314) 743-4003 or [email protected].


  1. The Organization for Economic Cooperation and Development (OECD) is comprised of 34 democracies with market economies along with other non-members.