Financing Long-term Hydropower Requires Mitigating Risks Prior to ROI

Financing Long-term Hydropower Requires Mitigating Risks Prior To ROI The long-term, relatively steady amount of money generated from producing power at hydroelectric facilities is alluring to investors, but developers must provide investors clear pathways from conception to return on investment.

By Andrew Landry

Hydropower is a mature technology, but opportunities exist to develop new facilities or expand the output of existing plants. Hydro projects are attractive in that they have low operating costs, do not emit greenhouse gases and offer extremely long service lives. At the same time, they require significant early capital expenditures and have potential long regulatory approval processes.

Investors will commit funds toward the development of an energy project in general based upon the project’s risks and expectations of future revenue streams. Therefore, to access capital, project developers must identify the revenue streams that will be used to service the debt and provide a return on investment to the equity investors. Developers must also have a plan to minimize regulatory and construction risks.

This article explains why developers must identify what revenue streams exist regardless of whether the project developer is an individual or a multi-billion-dollar conglomerate.

Development

Development of an energy project consists of three phases: pre-development stage; from decision to invest to the start of construction; and construction phase.

Pre-development
Pre-development begins with an idea, such as the identification of a quality site for a new hydroelectric project. This stage also involves accumulating pieces of the project and preparing a well-developed business plan.

Typically, this stage is highly risky and any flaw in the project, even a minor one, can kill it. While it is generally useful to minimize the rate at which cash is spent, it is absolutely necessary at this stage to fund as many expenses as possible from existing cash flows.

The pre-development phase will almost certainly include site identification, high-level engineering (including selection of technology and construction technique), preliminary review of environmental concerns, identifying likely revenue streams, and obtaining the preliminary permit from the Federal Energy Regulatory Commission.

A well-developed business plan that estimates licensing cost and timeline, construction cost, operating costs, revenue streams, and pro forma income will initially be necessary for either internal management or outside investors. It will be required to support long-term financing and should evolve based on higher amounts of available information. This information must be sufficient to justify the substantial investment required to move forward with licensing and engineering in the anticipation of construction.

Decision to invest
The decision to invest to the start of construction will include the entire FERC licensing process, as applicable, including conducting the necessary studies identified in a FERC-approved study plan, filing and litigating a license application, obtaining any necessary state and local approvals (e.g. water quality certifications), obtaining ownership or an option to own the project site, conducting detailed engineering, and selecting an engineering, procurement and construction contractor. Due to the potential for significant issues to arise during this phase, funding at this point in development generally must come from equity investors.

Construction phase
Construction commences after the receipt of all regulatory approvals and the execution of an EPC contract. By this point, most risks associated with the project have been eliminated or managed. Given the anticipated revenue stream, a large number of investors, both debt and equity, are likely to be interested at this stage. Some developers will even look to “cash out” at this stage by transferring their project to a larger player.

Revenue streams

Similar to other renewable energy sources, hydro projects potentially have several revenue streams, most notably payments for: energy, capacity and renewable energy credits or certificates. Regional grid operators compensate generators for the ability to restart without outside power since these can be used to restore service following a blackout (black start service). Some hydro projects are capable of providing such service. Federal regulations also require downstream hydro projects to reimburse upstream headwater project owners for an equitable part of the additional energy production possible at a downstream hydropower project resulting from the regulation of river flows by an upstream hydropower project.

Energy payments are the backbone of the revenue streams of most hydro projects. Typically, banks and other investors will not invest in a new project unless there is certainty in the power purchase agreement.1 A number of states, including California, Connecticut, and Massachusetts have enacted long-term contracting programs to support development of renewable projects, including hydro projects policies obviously vary from state to state, so it is critical to understand the program in the state in which your project is located. It is also worth understanding those programs in neighboring states because they may accept projects from neighboring states and may offer prices and terms that are more advantageous than those offered in host states. The programs frequently include a request for proposals and the requests have fixed deadlines, so early investigation is key.

A more recent policy development relates to group or community “net metering.” Several states, including New York and New Hampshire, allow multiple customers receive net metering benefits from a single renewable energy project, including hydro projects. This policy allows generators to sell their wholesale energy at retail energy prices without becoming a licensed competitive energy supplier.

Pursuing legislative or regulatory strategies is an option if your project does not neatly fit the existing state program. For example, in 2009, Maine tidal and offshore wind developers successfully lobbied for a change in the law to provide funding for ocean energy via the Maine Ocean Energy Act. This legislation resulted in a long-term contract for Ocean Renewable Power Company’s (ORPC) hydrokinetic project to be installed near Eastport, Maine.

Organized and non-organized markets
For projects located in regions that have wholesale markets administered by Regional Transmission Organizations, which FERC refers to as organized markets, another option is to rely on market revenues. Commercial lenders are increasingly willing to accept forecasts of market prices to support project financing. I have represented a major regional bank in financing acquisition of an existing hydroelectric project based on market forecasts and have also seen project upgrades financed in this manner. In most regions, natural gas generators tend to set the market clearing price for energy in most hours, therefore forecast prices are going to track the cost of natural gas generation. Lenders will want a forecast from a reliable source and will err on the low side to be conservative.

For projects not located in organized markets, utilities retain their obligation to purchase energy from small power production facilities under the Public Utility Regulatory Policies Act, including hydro projects of 80 MW or less. However, even in organized markets, hydro projects under 20 MW are presumed to continue to be eligible for contracts as qualifying facilities. In particular, in adopting Order No. 688, FERC established a rebuttable presumption that qualifying facilities with a capacity lower than 20 MW do not have nondiscriminatory access to markets. Of course, in organized markets, avoided costs are likely to equal projected market clearing prices, on which lenders may offer financing in any event.

Payment types
Capacity payments are the second major potential revenue stream. In organized markets, these can be substantial. The most recent forward capacity auction conducted by ISO New England, the clearing price for capacity was $9.55 per kW each month. FERC rules relating to capacity markets have been evolving quickly due to the perceived lack of firmness of many currently qualified resources. In general, it appears that these rules will favor stable projects and that prices are likely to increase.

Renewable energy certificates (REC) are a state-created product intended to achieve clean energy goals. There is typically a bilateral market for REC, but many contracts tend to be of short duration, typically one to three years). It has been my experience that lenders are wary of relying on these revenues because RECs are a product of state policy, and state policy is always subject to change.

However, two recently completed hydro projects in Maine were able to obtain long-term contracts for REC sales. The 2.3-MW Stillwater B project obtained a REC-only contract for 15 years with a Massachusetts utility. Its sister, the 3.75-MW Orono B project, obtained a bundled 15-year contract with a Rhode Island utility for energy, capacity and REC. Their success in obtaining such long term deals likely results from the anticipation that the renewable policies of these states are stable and that hydro projects are likely to be reliable

Production tax credits under the Internal Revenue Code have historically been a desirable revenue stream to investors. However, this incentive was the subject of periodic review by Congress, and in 2014 the program was not renewed. It is possible that this program could return or that other programs could emerge such as “hydroelectric production incentives” previously authorized, but not implemented.

Finally, individual projects could qualify for a variety of grants or incentives. The U.S. Department of Energy has periodically offered programs for emerging technologies such as hydrokinetics. The U.S. Department of Agriculture, through Rural Development and the Rural Utilities Service, offers incentives for traditional technologies, generally on a regular basis. States offer a wide variety of economic development and renewable energy incentives that may be applicable to energy projects. The Database of State Incentives for Renewables & Efficiency at www.dsireusa.org is a particularly useful resource for finding current programs that may be applicable to your project.

Eliminating risks

The perception of risk can kill even a promising hydroelectric project. Developers must work vigorously to identify and manage any and all risks associated with intended projects.

Because the FERC licensing process can be long and expensive, some strategies are available to reduce risks associated with this process. First, two types of projects are exempt from licensing: Small hydropower projects, 10 MW or less, that will be built at an existing dam, or projects that utilize a natural water feature; and projects on an existing conduit (e.g. an irrigation canal) up to and less than 40 MW.

In addition, Congress has directed FERC to investigate the feasibility of a two-year licensing process for projects at non-powered dams and closed loop pumped storage projects. For existing projects scheduled to relicense, the process provides a low-cost option to expand a project. The Stillwater B and Orono B hydro projects, which are now owned by Brookfield Renewables, were approved as part of a larger scale relicensing process. Amended licenses for efficiency improvements at existing projects, such as new turbine runners, can generally be obtained at moderate expense. For other projects, FERC’s integrated licensing process is generally available and reduces the licensing burden as compared to the traditional licensing process.

Obviously, most key licensing issues are likely to be environmental in nature. Therefore, it is vital to determine the fisheries and other biological species likely to be affected by your proposed hydro project, as well as the status of ongoing management efforts. Review existing literature regarding impacts of your technology on these or similar species.

Public opposition
Communication with local public officials early in the process is critical. It is also useful to begin broader public outreach as soon as the preliminary permit is in hand. Public meetings can be conducted at minimal expense where potential opponents can be identified and developers can begin making good faith efforts to develop positive relationships. Grassroots efforts can cultivate supporters that may otherwise be silent. Active supporters can create positive momentum at public meetings conducted by FERC and state agencies.

If investors are sought at the pre-development stage, be extremely careful regarding the terms offered. Investors may request a disproportionate share of the ownership of or control over your project. Consult with your attorney and a financial advisor to determine whether a particular proposal represents a fair balance between the value that you bring to the transaction and the value that the investor brings. Keep in mind also that you may require additional funding later, so any transaction must include sufficient flexibility to allow further investors to participate.

Know what expectations are reasonable. If you do not know, obtain qualified legal and financial advice. Agreements that promise too much to early investors can become an albatross that deters second stage investors from providing funding.

Technology
Investors will prefer a proven technology. If you are proposing novel technology, be prepared to address in detail how and why this new technology will operate as advertised and can be constructed on time and on budget.

Understand the electrical interconnection characteristics of your proposed project site, as well as the local review process. An engineering firm that is knowledgeable about the local grid should be able to provide a reasonable assessment at a modest expense.

System impact studies can be expensive. Depending on the early recommendations of a good engineer, this process may be deferrable to the second stage of project development.

Site control
Obtaining a FERC license will provide the right of eminent domain only if the project developer has made good faith efforts to obtain site control through arm’s length negotiations. Further, the process of obtaining site control over state or federal waters (i.e., for a hydrokinetic project) may require additional regulatory steps. Locking down site control, through an option or otherwise, will provide greater assurance of the viability of a given hydropower project.

In general, my best advice is to build a team of experienced engineers, environmental consultants, contractors, attorneys, and other professionals that compliment your organization’s existing capabilities and provide prospective investors with confidence. Together with a well-developed business plan, this team will attract investors to good hydro projects.

Note

1Weiss, J., and M. Sarro, “The Importance of Long-term Contracting for Facilitating Renewable Energy Project Development,” The Brattle Group, Cambridge, Mass., 2013, page 8.

Andrew Landry, Esq. is a Partner in the Augusta, Maine office of Preti Flaherty. Landry assists clients with respect to energy regulatory matters before Federal Energy Regulatory Commission and state commissions, as well as energy project development, M&A and financing.