As a proven technology with high availability and the promise of additional Government support, biomass energy is attracting the attention of a growing number of power utility companies and is set to play an increasingly significant role in Europe’s energy generation mix.
In the UK, we have seen a marked step up in biomass development activity since May, 2007, following the release of the Government’s energy white paper, which proposed enhanced legislative support for biomass and biomass CHP in comparison with favoured technologies such as onshore wind.
However, in the current economic climate – where debt finance has become a prized commodity and the capital markets are in turmoil – transforming this technology from concept into development is fraught with challenges that require careful financial and contract structuring in order to overcome.
The deteriorating situation in the debt market results in both fewer lenders and reduced facility sizes, making it difficult to gather sufficiently large clubs of banks for large biomass transactions. This reduction in market capacity is making it difficult for biomass sponsors to put committed financing packages together during the procurement process, even on relatively small projects.
The latest batch of bank bail-outs, including those active in the project finance market, should help ease the pressure, but it may take some time. Ernst & Young’s experience suggests that restricted lending appetite and a marked increase in funding costs is likely to make it more difficult to implement large projects in the short to medium term.
With particular reference to the biomass market, developers should shortlist and mandate banking teams to fully appreciate the robust macro-economic and regulatory drivers underpinning the sector and, more importantly, the downside risk-mitigation tools to shield debt repayment. The accelerating increase in debt pricing is being driven by inter-bank liquidity constraints.
This shift from projects being funded by banks acting as sole or joint underwriters to several banks forming a club has led to renegotiations of debt facilities and agreed-term sheets that have gone beyond a change in margins and fees. Determining the overall increase in the cost of financing is now about understanding the implication of the changes in the small print. For example, lenders have increased their scrutiny on the construction subcontractors, leading to a requirement for greater levels of third-party liquidity support such as performance bonds and letters of credit. This is putting greater pressure on equity returns.
The banks’ due-diligence procedures, and their appetite to lend, continue to focus on and scrutinise feedstock contracting, both in terms of the availability of supplies over the project life and the sensitivity of the project to fluctuations in price, quality, calorific value and moisture levels. Linking the feedstock costs to the power export price appears to be an attractive risk-mitigation strategy to banks.
Larger facilities that are reliant on imported feedstocks may be perceived as higher risk by the finance community due to sustainability and logistical issues that have beset the biofuels sector. Lenders are increasingly likely to view smaller-scale facilities supplied by locally based feedstock supply chains as the preferred biomass operating model.
At present, the syndication and infrastructure bond markets appear closed and the only way to be assured of a successful fundraising is via a club deal. Even then, the success of the transaction is dependent on involving sufficient banks to permit fall-out while ensuring a critical mass to commit and take the deal to completion.
As credit conditions in the wider economy deteriorate, we are observing a significant tightening of banking covenants and increased due diligence by lenders. This is prolonging the time and raising the cost of reaching financial close. In the medium term, these trends point to likely refinancing gains as liquidity and a competitive lending environment return.
Some commentators talk of improving conditions in January as a result of it being a new bonus year and allowing time for the rescue packages to be implemented and take effect. In our view, the market shows little sign of improvement in the near future, with an increasingly limited number of project finance banks with the balance sheet capacity to lend for long loan periods. We expect this to result in a further increase in pricing, tighter covenants and possibly a push for shorter loan periods.
Looking at the equity markets, it is important to be aware that utility companies – who are often willing investors in biomass projects – are now under greater pressure to rationalise their capital. Whereas 12 months ago there was sufficient available credit to fund sizeable capital expenditure budgets, the availability of credit is becoming increasingly sparse. As a result, we expect to see utility companies applying significant pricing pressures to future biomass project investments.
However, we expect competition for the best projects to enable developers to achieve the proper market value.
In addition, the cost of funding biomass projects is increasing, due to reduced capacity to exploit financial leverage, more conservative deal structures and an increasing cost of debt.
The restricted remit of infrastructure funds has always limited their ability to take development risk, albeit with a number of exceptions. Therefore, development equity has traditionally been provided through strategic investors, private-equity (PE) and venture-capital (VC ) funders – provided the investment is pre-IPO – or other key exit finance.
Over the past 24 months, the renewable energy sector has attracted more interest from such funders across the whole value chain – from service, technology and development of infrastructure. This has resulted in a small number of deals reaching completion – for example, in December, 2008, the funding of a 2.5MW facility developed by Bioflame, for which Climate Change Capital put up the initial capital through its Ventus VCT fund.
However, despite the increased interest in biomass from PE and VC funders, due to the highly leveraged nature of their funds, this type of financial backing is still extremely difficult to secure.
From our experience, there are some basic guidelines that can help to increase the attractiveness of a developer’s application for funding, whether seeking backing from a bank, utility company or private-equity firm.
In this market, a successful financing requires the following:
High-quality sponsors with a proven track record and an attractive portfolio.
Adopting a dual-tracked transaction process, providing sponsors with flexibility to follow a finance-and-operate strategy or a disposal strategy.
Well structured deals in terms of debt package, cover ratios, cash sweeps, and so on.
A robust level of equity finance.
A banking strategy that involves adequate clubbing/consortia to deliver the required debt levels.
There can be little doubt that the current economic climate poses major challenges for the renewable energy sector, as it does for most other industries.
Developers of biomass energy will need to navigate their way through financing difficulties, more contractual red tape and enhanced due diligence in order to see their project through to fruition.
Nevertheless, overall, the future for biomass energy looks rosy and those developers that are able to overcome these obstacles are sure to find opportunities out of adversity.
Dane Wilkins is a transaction advisory services director with Ernst & Young
