For SmartPlanet this week, I reviewed the “capital gap” problem in financing clean energy and efficiency, and how a slew of new players and approaches aim to solve it. Move over, mortgage-backed securities, solar-backed securities are the next big thing.
A new wave of investment in renewable energy and efficiency upgrades is being driven by innovation in finance — not in technology, policy or business models.
A new wave of innovation is sweeping the energy transition sector, promising to accelerate deployment and cut the costs of energy-efficiency measures, as well as wind and solar generation.
It’s financial innovation.
If the very words make you clutch your wallet and roll your eyes, I understand. After all, it was the innovation of mortgage-backed securities, credit default swaps and collateralized debt obligations that opened the door to an unprecedented level of financial recklessness and nearly brought down the global economy five years ago.
However, at the risk of incurring the wrath of the market gods: This time it’s different.
The problem: The capital gap
Financial innovation in the cleantech sector is needed for a simple reason: Wind and solar systems (even large, utility-scale ones) and energy-efficiency upgrades are hard to finance. They typically require a homeowner or business owner or renewable project developer to come up with a significant chunk of capital up front, then receive the benefits of the investment over a long time horizon — typically, 20 years or more. They’re all a little different, making it hard to evaluate risk. Even if an investment offers an excellent return over time, coming up with the initial capital can be too high a hurdle. And when a developer manages to raise the money to build a project, it usually needs to sell the project to a long-term investor so it can free up its capital to build the next solar park or wind farm.
The natural long-term holders of assets like these are pension funds, infrastructure funds, sovereign wealth funds, insurance funds, and the like. They are accustomed to investing tens or hundreds of millions of dollars at once and then receiving modest, single-digit returns over a period of decades. This is the so-called fixed-income market, where the investments are usually come in the form of very low-risk assets like Treasury bills, equity positions in historically stable sectors like utilities, or long-term, high-grade corporate debt.
The problem in the cleantech sector has been matching assets to their natural investors.
Over the past year, I’ve heard the same story over and over again. Globally, fixed-income investment entities have trillions of dollars of available capital that they would love to put into renewable energy and efficiency projects. Enough to build a huge chunk of the new infrastructure needed to transition the world from fossil fuels to renewable energy. But the available projects are too small. Whether the investment is $50,000 or $500 million, it still requires about the same level of due diligence effort to evaluate: many billable hours paid to high-priced lawyers, accountants, researchers, and fund managers. That cost can be a killer if the investment is less than (roughly) $5 million dollars; there just isn’t enough margin to justify it.
So the trick has been to find a way to “de-risk” (do the due diligence) and bundle cleantech and energy-efficiency investments, in order to be able to offer a suitably large investment to the fixed income market at an acceptably low transaction cost.
Enter financial innovation.
Solution 1: Standardization
Several recent initiatives are tackling the first part of the problem by finding ways to standardize investments.
The U.S. National Renewable Energy Laboratory (NREL) just this week released a set of standardized contracts for solar projects. The contracts, which include lease agreements for residential solar systems offered by third-party solar leasing companies and commercial power purchase agreements (PPAs) for larger systems, were developed by a working group NREL convened in the spring called Solar Access to Public Capital (SAPC).
Comprising some 20 to 25 companies in the sector — including project developers, law firms, and analytical entities — SAPC analyzed many existing contracts for solar projects and figured out which parts could be standardized and which parts needed to be customizable.
I asked NREL Energy Analyst Paul Schwabe, who headed the contract standardization project, why new contracts are needed. “We see a number of benefits for those leases and PPAs,” he says. “One, lowering transaction costs for entities who don’t already have those documents available; they don’t have to reinvent the wheel. Two, improving customer transparency, particularly on the residential side. By using a standard contract, the consumer can more easily compare multiple projects and know that the contract has been analyzed by a number of industry stakeholders. And three, we think it can help facilitate the pooling of cash flows into a common investment that can access capital markets.”
The working group hopes standardized contracts will reduce the cost of capital for project developers, and make it easier for customers and investors to evaluate investments. So far, the prospects are good.
“We’ve gotten buy-in from a large majority of the residential installer community, and we’ve made good inroads in the commercial industry as well,” Schwabe says. “We’ve confirmed that a large percentage of the market will use them.” The working group now has more than 125 members, he estimates, and that number is growing rapidly.
Ultimately, the standardization of contracts will make it easier to assess the expected cash flows from solar projects, and thus make it easier for investors to feel assured that projects will perform as advertised.
Solution 2: Data and metrics
The contract standardization effort is part of a broader NREL initiative to organize the industry and establish collaboration between stakeholders. NREL is also collecting data for solar performance, which will help standardize an understanding of how well various pieces of solar gear perform.
Another industry working group called TruSolar is working on a complementary set of metrics and tools to standardize solar project financing, including rating photovoltaic (PV) projects for performance and establishing credit screening criteria. TruSolar is part of SAPC. It has partnered with NREL to publicize their respective efforts and highlight the synergy between them, Schwabe says.
By collecting historical data on actual system performance and establishing standard credit criteria, the two groups will solve another part of the problem: the lack of a trusted track record.
Whereas the performance of mortgages has a well-analyzed record that stretches back over more than a century, the data trail for solar projects is only a few decades long, and only the last decade of that trail is really representative of how well modern equipment performs.
These investments in collecting data and establishing metrics will make it easier to de-risk solar projects and assign them a credit rating major investors can accept without having to do so much of their own due diligence. This will ultimately reduce the cost of capital and increase the velocity of deal-making.
Schwabe was not at liberty to say whether or not any of the major credit rating agencies are involved in SAPC, but did say that a key conclusion from an earlier NREL paper that led to its formation was that “standardization was needed for securitization and those stakeholders felt it was necessary.”
Solution 3: Securitization
Securitization is the process by which a pool of assets is bundled, graded, sliced and diced, and sold into capital markets. It’s the same process that brought the world the dreaded mortgage-backed securities. But the underlying assets in cleantech are quite different, and far less risky.
Securities in the cleantech sector rely on cash flows generated by stable things: solar equipment sits in the sun, insulation sits in buildings, and wind turbines stand and spin. As long as the gear has been properly evaluated and graded — which is part of what SAPC and TruSolar are doing — and properly maintained, then the only real risk to continued production of cash flow is weather. Fortunately, on an annual basis, insolation (the amount of light falling on a given location), wind, and temperature are quite predictable and have very long historical data records. Averaged over a period of decades, they will not deviate enough from historical averages to constitute a significant financial risk. So the actual risk of non-performance in solar- or wind- or efficiency-backed securities is far lower than the risk of a homeowner who got a “liar’s loan,” lost his job, and then couldn’t pay his mortgage.
Several new approaches to securitization in cleantech are now coming into existence.
NREL, as part of its suite of initiatives, is developing a “mock portfolio” comprising a pool of solar park assets, both commercial and residential, and testing how it might perform as a securitized investment.
SolarCity, one of the largest third-party solar leasing companies, announced this week that it will begin offering $54 million worth of “Solar Asset Backed Notes” to qualified investors. The securities, which will be secured by a pool of the company’s solar systems, leases and PPAs, will pay investors out of the cash flow those assets generate, and free up the company’s capital to invest in new projects.
Jigar Shah, the founder of SunEdison, pioneered the third-party solar leasing model companies like SolarCity and Sunrun have followed. I asked him for his take on securitization.
“The financial innovation that we’re doing now is just an extension of what we started in 2003,” he says. “We popularized it at SunEdison. Securitization is the next step. The first step was to make solar an asset class acceptable to insurance and pension funds. We got Wells Fargo, MetLife, and a few others to give SunEdison $2.3 billion in commercial paper, and something on the order of $1 billion in residential paper. Now we have the right to pursue securitization. But it only happens because the banks believe there’s a multi-billion-dollar market. Until then, the ratings agencies like S&P are not able to participate.”
Although SolarCity’s $54 million offering is tiny in the world of commercial securities, Shah sees it as significant because the company has obtained, for the first time, an investment-grade rating for commercial solar securities. Within five years, he expects the sector to be well into the billions of dollars.
In a detailed Oct. 21 essay about solar securitization for Power Intelligence, energy finance attorneys Elias Hinckley and David John Frenkil wrote that solar asset-backed securities “will enable the solar industry to access a much larger and more diverse investor base, which will eventually help to reduce the long-term cost of capital to a likely range of 3 percent to 7 percent, compared with the 8 percent to 20 percent rate required by some project finance equity and tax equity investors in the current market.”
Securitization is also coming to the building efficiency sector. Massachusetts-based insurance companyEnergi Insurance Services has extended its risk evaluation services for renewables to the energy-efficiency sector, including energy-savings warranties, electricity-generation performance warranties and equipment warranties. It also backstops performance guarantees offered by energy-efficiency contractors through product underwritten by the International Insurance Company of Hannover. Last month, Energi started working with NREL to analyze and quantify risk for small building energy-efficiency retrofits, giving lenders a tool they can use to rate energy-efficiency loans. Ultimately, the methodology could give rise to efficiency-backed securities, which will deliver cash flows to investors much as securitized solar projects do.
Solution 4: Crowdfunding
Oakland, Calif.-based Mosaic also offers solar asset-backed securities. Instead of being based on a pool of assets, they are issued for specific solar projects. Each note issued by the company corresponds to a certain solar installation, and the payment on those notes derives directly from the cash flow generated by the loan obligation attached to that installation.
After less than a year in business, Mosaic has more than 2,500 investors from nearly every state, who have invested as little as $25 for shares in 19 solar projects with a combined $5.7 million in asset value. Investors typically receive 4 percent to 7 percent returns annually, depending on the project. The company boasts 100 percent on-time payments with zero defaults thus far.
Speaking at the VERGE San Francisco conference last month, Mosaic CEO Billy Parish said interest is brisk in his company’s offerings. Investors are disillusioned with conventional financial markets, he says, and increasingly feel that the stock market is rigged against them. With tens of millions of dollars worth of new solar projects in the Mosaic pipeline, he is confident investors will continue to find the low risk and modest return of the notes attractive. “The transition from fossil fuels to renewables is the biggest opportunity for wealth generation this century,” he declares.
Another Mosaic innovation could open up a torrent of new capital: a security that will be eligible for purchase through IRA accounts. There is $17 trillion sitting in IRAs in the United States alone, according to Parish.
A related recent development in financial innovation will give more investors access to the cleantech sector. The JOBS Act, which President Obama signed into law in April, created a new playing field for crowdfunding that makes it easier for individuals who don’t qualify as high net worth “accredited investors” to invest small amounts in small businesses and startups which, in turn, weren’t qualified to offer public securities.
Earlier this week, the Securities and Exchange Commission finally proposed rules defining the new terms. Investors with less than $100,000 in annual income and net worth will be able to invest up to $2,000 a year, or 5 percent of annual income or net worth, whichever is greater. Those criteria are considerably looser than the ones Mosaic has operated under thus far, so it will open a much larger pool of potential investors in renewable-energy- and efficiency-backed securities.
“We’re glad to see financial innovation occurring in the renewable energy sector, including through use of securitized investments,” Parish told me.
And that’s not all. A multi-billion-dollar market in global finance for renewable energy and efficiency is now giving very large investors, like sovereign wealth funds and pension funds, easy access to these new securities. Stay tuned to this space for more on that exciting new sector.
Photo: William Kamkwamba’s old windmill, Malawi (whiteafrican/Flickr)
Nov 9, 2013