Most energy projects never get beyond the development process. There are many reasons for this, but failure to obtain financing has derailed an increasing number of projects over the past few years. The most common reason is the fundamental economics of the project do not provide confidence in an adequate return being paid to investors. There is effectively no hope for obtaining financing for any energy project if the project developer cannot demonstrate sound economic fundamentals to a potential investor.
Here is an earlier piece I wrote that walks through the building blocks for financing an energy project, which covers the broad principles cover the key aspects of the basic economic story for an energy project.
More challenging to understand than failed economic fundamentals is why some projects do not get funded even where a developer can demonstrate solid financial fundamentals and the potential for returns that appear to reflect the investment risk. Over the past three years there has been consistent talk of how much “money is sitting on the sidelines†looking for good energy projects. Energy investors are commonly heard to say “if the project is really that good, it will get financed,†yet some projects that appear to be good, or even to be very good, don’t ever find financing.
The basic economic equation of whether a project gets funded turns on the level of certainty that an investor will get paid back its investment plus a return for the use of its money. How investors measure risk, formally and unconsciously, varies and many of the explanations for why projects fail to get funded grow out of unrealized risk intolerance. There are obvious risks, like technology or an electricity buyer’s credit worthiness. And there are risks that manifest in less obvious ways.
Here are five recurring reasons why apparently economically viable projects fail to get financing.
1) Wrong Team
Presenting the right team is vital to attracting investors. The person making, or facilitating, the investment in a project has to believe in the people that make up the team (though established brands with solid track records can sometimes substitute). In a conversation last week with a successful energy investor, he told me “it could be the best project I’ve ever seen, but if it’s the wrong people I would never invest.â€
How the wrong team manifests itself can take a number of different forms. It could be that a key piece is missing â€" for example, the lack of natural gas trading experience for a team trying to build a series of congregation plants where the projects will carry gas price risk. It could be that a team seems too willing to take on excess risk â€" that eagerness raises immediate red flags, especially in the conservative investment attitude prevalent following the financial collapse of 2008 and subsequent financial failures in Europe. It could be the other side of risk â€" that a team appears too conservative â€" while not as frightening as rapid and catastrophic loss of invested capital by excessive risk, the likelihood of slow steady losses without progress simply won’t draw investments either.
It could be something much more fundamental (and more difficult to manage) â€" the investor does not like one or more members of the team. Some people just don’t like each other, and in the end, regardless of how analytical anyone tries to be, investment decisions are decisions made by people. Personal dislike can be overcome, but it is worth taking a hard look at the potential for developing an actual connection with an investor. Getting a funding commitment without a personal connection (or worse, a bad connection) will be far more difficult than where a good relationship exists. Smart people with good ideas get passed over every day for the simple reason that an investor does not like them.
2) Projected Economics are Discounted as Overly-Optimistic
Project developers are optimists, so it is not uncommon for an investor to look on the financial assumptions of a project as unduly optimistic. Some investors test project economics by looking at every input assumption in the financial model that is not contractually fixed and then increasing the cost inputs or reducing the revenue expectations. From another recent investor conversation: “…the assumptions are speculative, someone pitching me believes in their story, and so necessarily will make optimistic assumptions, and I correct for those.†It is important to carefully stress-test pro forma inputs and illustrate that the assumptions are reasonable and well defined, and that project economics work against less optimistic scenarios.
This potential adjustment should not be viewed as a reason to make input assumptions more optimistic in order to build a negotiating position on the economics of a project, because unrealistic assumptions lead directly to reason #5 below for the project not getting funded.
3) Market or Policy Uncertainties
Much of the market uncertainties in a typical energy project can be partially managed by a long-term fixed price off-take contract (such as a power purchase agreement), which shields an investor from most price volatility risk. For example, a solar developer can assume payment, at a known price, for electricity it generates if that electricity is sold under a solid long-term power purchase agreement. The project will receive the expected revenue regardless of the price movement of electricity, which allows for revenue certainty and protection for the project in the event prices drop below levels used to calculate project returns. Where a long-term contract is not available, an alternative strategy is to add a hedge (which is an instrument that acts as an offset or guarantee against the price going up or down). However, hedging is generally difficult to do beyond a few years, and since project performance is often measured over 10 to 20 years it often only manages price risk during the early operation of a project.
When building a typical energy project, at least in the current market, a long-term contract for electricity is assumed. Without that long-term contract, securing financing for a power project would be virtually impossible. Long-term contracts for natural gas, crude derivatives, and biomass feedstock are generally not available. Projects subject to markets for these commodities, therefore generally have to have higher margins to provide comfort to investors.
Policy uncertainty can prove even more challenging than market uncertainty. Policy uncertainty occurs in various ways, from the potential for a new regulation increasing emission controls on a coal-fired power plant to the potential expiration of a tax credit for wind power. Hedge mechanisms (and certainly long-term contracts) don’t really exist for policy uncertainty. Additionally, the outcome of policy uncertainty is typically binary, so it represents an all or nothing risk with respect to particular pieces of project economics. While there may be rare instances where a development team could demonstrate an ability to affect the policy making process, as a general matter this is the kind of risk that is outside of a developer’s control.
4) The Project Doesn’t Match an Investor’s Areas of Interest or Mandate
The development team needs to know its audience and needs to know where to focus time and energy. Seeking project funding from a venture capital firm for a biomass gasification unit, even one using new technology, likely is not the best use of time. Similarly, it will likely be challenging to get a regional bank in Florida to provide financing for a Pennsylvania shale development. Not that it can’t happen that an investor will look outside of an area of focus or comfort, and sometimes diversification is exactly what an investor seeks, but matching the ask to an investor’s interest is vital if there is a real hope of getting funding. While a few investors will look at any good deal, the investor’s experience, interest, portfolio fit, stated goals or strategy, and liquid investment capacity will drive most investor or investment facilitator decisions.
5) Lack of Development Track Record or Belief the Team is Otherwise Not Ready
While this reason could fit under wrong team it is really a different challenge. This factor is really about an investor’s view of the potential for execution and operational risk associated with the development team’s ability to manage the “unknown unknowns†specific to the project. This can manifest itself in obvious ways, such as a new development team without project development or management experience.
Where this challenge seems to routinely surprise development teams is with a novel technology, or an application of an existing technology in a new geography or jurisdiction. Countless developers have asked (in one form or another) “how can lack of experience be counted against us, no one has ever done this?†The problem, from the investor’s perspective, is not that the team isn’t the best team to execute and run a project, but that without a record of success with the specific project, there is an unquantifiable risk that something will go wrong and prevent the investor from realizing its return. Sometimes this perception can be overcome by layering related experiences and demonstrating that the team is well-integrated and is aware that there are obstacles yet to emerge in the development, construction, and operation of the new project.
Conclusion
These challenges occur across every technology. While the sophistication associated with larger projects lessens the likelihood of one of these challenges emerging, I have seen these complications ruin very well-conceived multi-billion dollar projects, as completely as small projects seeking “merely†hundreds of thousands of dollars.
This list is, of course, not exhaustive (and please share experiences from either side of the development investment process). These are not hard and fast rules, exceptions do occur. Even with carefully planned energy projects, development teams need to find ways to not only define good project economics, but also to engage and manage the expectations of investors in order to find the necessary funding.
An earlier version of this article appeared in my column Banking Energy over at Energy Trends Insider
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