Community and Renewable Energy Scheme Project Development Toolkit

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1 Community and Renewable Energy Scheme Project Development Toolkit Balance Sheet Equity Investment Community Bond Issues Community Vehicle Crowd Funding Debentures a form of bond Debt Debt Service Cover Ratio Balance sheet equity investors are typically large utilities that finance new renewable projects entirely from their own capital. By providing all of the capital required to build a project, they also take on most or all of the project risks. Balance sheet investors generally look at the internal rate of return (IRR) or the return on equity (ROE) of a project as a metric of profitability. A community bond issue is a form of loan. It is a legal agreement between the issuer of the bond and the purchaser. The agreement usually states the amount of interest to be paid on set dates and also when the loan will be repaid in full. Bonds must be repaid by a fixed date, so money must be set aside to fund these repayments. As a form of debt, bonds give no right to membership or ownership. This is the structure legal structure set up by the community to become involved in the project. There are a number of different legal structure to consider including development trusts, co-operatives, community interest companies. Further information is contained within the Establishing a Community Group Module. Crowd funding is the term for the practice of funding a project by raising many small amounts of money from a large number of people. Local share offers may be classed as a type of crowd funding and there are internet platforms which can offer crowd funding services. A debenture is also a form of debt finance and typically refers to long term security in the project yielding a fixed rate of interest, issued by a company and secured against assets. Debentures can be variable or fixed return and can pay cash returns every year. In order to issue debentures for your project you need to be FCA regulated. There are intermediary organisations that are registered and can issue them on your behalf. Their role is to structure the debentures for the energy projects that issue them and then to market and distribute them to customers. Debt financing is generally a loan. It is money that you do have to pay back (normally with interest). At the end of the repayment terms, the debt provider has no further stake or say in the project. For renewable energy projects the interest rate is often fixed or linked to an agreed index (e.g. Inflation or RPI). Debt financing does not link to any ownership right in the project but does give the lender the ability to recover money should the project not go ahead. There are two general forms of debt finance project finance and secured finance both of which are designed to provide the lender with increased security and reduced risk. In addition, mezzanine finance is a form of debt that can, in some cases, be used to fund equity input into a project. The debt service cover ratio (DSCR) can also be known as debt cover ratio (DCR). It is the ratio of cash available for interest payments, principal loan payments and (if applicable) lease or rent payments. It is a popular benchmark used to identify the ability of a project to produce enough cash to cover debt payments. The higher this ratio is, the easier it is to obtain a loan. DSCR can also be used in commercial banking and may be expressed as a minimum ratio that is acceptable to a lender. This may turn into a loan condition or covenant that you must meet or risk breaching the conditions of your loan. Typically banks require a DSCR between 1.3-1

2 Debt Service Reserve Debt to Equity Ratio Due Diligence Equity Fees Financial Covenants Financial Due Diligence Hierarchy Insurance 1.5. The CARES Project Model can be used to calculate your project DSCR. If your project does not meet the DSCR requirements it is unlikely to obtain finance from a bank. The finance provider is likely to require that enough cash is held in reserve to cover debt payments for items over and above loan repayments. In the case of project finance, at least six months cover may be required, but less for secured finance loans. Usually, finance providers will provide only 70% of the debt and require 30% equity, which can be funding from another provider or the group members themselves, sometimes referred to as gearing ratio or leverage. Any finance provider will want to scrutinise every aspect of your project and your organisation to confirm the things that you are telling them and to identify areas of risk. These may be things that you had not even considered. They will complete this assessment at your expense (see Investment Ready Tool). Equity finance can relate to an ownership right, profit share and project management right. Equity money is provided at risk as it is at the bottom of the project finance hierarchy. Raising equity can help to lever in other forms of finance such as debt. Equity investors will share in the success of the project but also the failures should a project not succeed. When applying for funding, it is important to note that the finance provider will not pay for anything. As a result, the loan provider will likely charge a fee which can be a % of the loan. On top of this will be legal fees and the cost of undertaking the due diligence exercise. This makes it important to consider the level of fees that might be charged when selecting a lender for your project. Some lenders may have a lower interest rate but have higher fees so it is important to take the whole picture into account. Financial covenants are clauses, stipulations, or limits put in place to protect the lender. These become enshrined in the terms of the finance provided. A professionally indemnified assessment of proposed capital and operating costs and associated project lifecycle cash flows, including loan life cover ratio, debt service cover ratio analysis and sensitivity analysis on the main financial variables (e.g. capital cost, operating costs, revenue rates and any variable interest rates). Financial due diligence also requires a comprehensive understanding of the assumptions underlying the project to support the performance of a sensitivity analysis to define an agreed financial base case. This includes quantification of a range of project-specific uncertainties and exceedance probabilities. Where this process shows that the annual energy yield prediction has a 50% probability of reaching a higher or lower annual energy production than predicted, it is called P50. In a similar way, a result of P75 from this process indicates that the probability of the annual energy production being reached is 75%. The risk that the annual energy production of P90 is not reached is 10%. These then become measures of the required energy output not being met. P50 and P90 values over a 10-year period are commonly used by financiers in Scotland. An important concept to consider is that in your project finance is structured in a hierarchy of seniority. The senior lender in the project is likely to have the highest security (first ranking) and if the project was to fold has the right to recoup their finance. Bank lenders will normally want to be top of the queue and ordinary shareholders will be at the bottom. It is likely that any lender to your project will require you to take out insurance through both the construction and operation phases of the project. This will be an added cost to the project but reduce the risk to the lender. 2

3 Interest Internal Rate of Return Junior Loan Legal Due Diligence Loan Life Cover Ratio Maintenance Service Reserve Mezzanine Non-Recourse Net Present Value The cost of finance offered can be relative to the perceived risk associated with the project. The higher the risk the funder feels they are taking, the higher the interest rate associated with their funds. Interest rates may be offered at fixed or variable (or tracker) rates and can be linked to the Bank of England Base Rate. The internal rate of return (IRR) is the discount rate that makes the NPV of all cash flows from a particular project equal to zero. Because the IRR is a rate quantity, it is an indicator of the yield from an investment. This is in contrast with the NPV, which is an indicator of the value or magnitude of an investment. See mezzanine finance. These are law-specific activities that relate to key legal issues. Examples are shown below: Evidence of unfettered title to land and/or to conduct all necessary activities on the land. Evidence of unfettered access to all necessary lands and resources, including lay-down and over-sail rights, and a resource protection assurance for wind, hydroelectric and solar resources. Evidence of adequate legally binding contractual commitments with suppliers, contractors and sub-contractors in place, and suitable provisions and bonds secured to guarantee performance and/or mitigate default against contractual terms. Evidence that full insurance cover is in place to cover all delays and project failure risks not covered elsewhere by performance bonds and professional indemnity covers in place. This is the ratio of operating cash flow to debt payments over the entire term of the loan. Usually, a ratio of 1.5:1 is required to ensure that the project is profitable and the loan covered. This is similar to the debt service reserve described above, but only three months cover is required. Typically financial lenders may have a maximum lending percentage that they wish to invest in the scheme. Generally this can be around 70% leaving the project to find the remaining 30% from another source. It is normally expected that 30% would be a form of equity. Mezzanine financing relates to using debt to fund the remaining equity in the project. Mezzanine finance is generally classed as subordinated debt and relies on the due diligence carried out by the senior lender. Mezzanine financers are enablers and can be more conformable with the risk but this is reflected in a higher interest rate. This is secured on the asset of the project alone. In this case, the project debt and equity used to finance the project are paid back from the income generated by the project. This requires far higher levels of due diligence to be undertaken and stricter financial controls to be applied. The lenders need to have complete confidence that the project is viable and the income generated by the project will be sufficient to service the loan provided. Typically as the lending institution is only entitled to repayment from the project the loan is funding, not from other assets the loan may have a higher level of interest to reflect this. Net present value (NPV) compares the value of a pound today to the value of that same pound in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative. Because it takes into consideration the future value of money, financiers regularly use NPV as a measure of project attractiveness. 3

4 Permitted Value Gains Study Project Project Vehicle Quasi Equity Recourse Refinancing Return on Investment Revenue Participation A Permitted Value Gains study provides some information about the value of your site taking into account the work that has been carried out on the site. The value of a consented site is typically higher than the cumulative costs spend to date developing the project. Market value for consented sites might be k per MW. See Non-Recourse. Sometimes referred to as Special Purpose Vehicle (SPV). This is the legal structure set up to own the project. There may be many different stakeholders coming together to form the Special Purpose Vehicle. This is separate from the Community Vehicle, which would be one of the stakeholders in the SPV. Quasi Equity is neither debt nor equity, but essentially a contract with the project to share in the risk and rewards of the investment. It allows the investor to take a share of the future revenue streams of the project. However, the investment is fully at risk and should the project not achieve its stated financial performance, a lower, possibly zero, financial return to the investor is payable. It the project performs better than expected, a higher financial return to the investor is payable. This requires some form of asset to secure the loan, usually in the form of property or existing business. As a result, more legal documentation is required and asset valuations must be undertaken. It is usually the case that a higher asset value must be put at risk relative to the value of the debt. As the finance is secured then, as a rule, the interest on the finance is likely to be lower than that for project finance. In the case of the community group or rural business, the assets put at risk in secured finance will be community owned land, buildings or farming businesses. Therefore this risk needs to be taken into account before making the decision to opt for this type of finance. Typically where a community group does not own any assets, project based non-recourse finance is likely to be the only option available to them. It is important to note that even for project finance some form of equity is also likely to be required this is because funders want to be sure that the project developers have a good incentive to make the project a success. Once a project has been financed through the construction and early phases of operation, some finance providers provide an option to refinance the project at this stage. The risks may be assessed as lower once the project has been running for a few years and therefore refinancing may save money as a lower interest rate may be possible. At this stage you may be able to shop around for a better rate and it may attract a larger variety of finance providers due to the perceived lower risks. This is a performance measure that is used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate the return on investment, the income from an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio. This provides a snapshot of profitability. While this is unlikely to be used by a finance provider, it might be a good way to compare different options when you are developing your project. For instance, different scales of developments or choices of technology might give different returns on investment. A revenue participation agreement is a legal agreement which allows the buyer to participate in the revenue. As this is Quasi Equity and not true equity the project stake does not relate to any ownership rights in the project. It is essentially a contract or virtual turbine. It is worth noting that investors participate in revenue, not profit. Also, there may be an incentive to manipulate profitability in order to avoid paying out under the contractual agreement. 4

5 Royalty Agreement Secured Security Simple Payback Special Purpose Vehicle Technical Due Diligence Venture Capital Working Capital See Revenue Participation. See Recourse. Security is typically ranked in an agreed hierarchy dependent on the type of finance. As the name implies, this simply compares the total cost of project development with the income after all operating costs, to calculate the point at which the income pays back the development cost. It takes no account of future inflation. While this gives a good rule of thumb as to viability, it is almost never used by finance providers. On the other hand, community business or community groups that are self-financing a project can use this approach to decide if they want to invest their own money into a project. Sometimes referred to as a Project Vehicle. This is the legal structure set up to own the project. There may be many different stakeholders coming together to form the Special Purpose Vehicle. This is separate from the Community Vehicle, which would be one of the stakeholders in the SPV. These are technology-specific activities that relate to key technical areas of risk. Examples are shown below: Geotechnical reports for any foundations (e.g. for wind turbines), hardstandings for biomass fuel storage, and other construction and access improvement works. Design plans that are compliant with the Construction Design and Management Regulations 2007 and site-specific method statements for the construction of all generator and associated infrastructure installations, any new and altered road, and amenity and sea access works necessary to commission the installation. Transport route assessment report and sign off from the relevant competent authorities for any use of public highways and marine facilities etc, and additional marine transport method statements for any proposed novel/nonstandard marine transport proposals. Venture capital investments can be a type of equity funding. Venture capital investments tend to bear the highest risk and expect the highest return. Venture investors tend to make relatively small investments in many early-stage companies, with an expectation that some will grow significantly while others will fail. Some venture investors assess the IRR of their investments while others evaluate the number of times their investment is multiplied by the time they plan to exit the investment. The timing and type of investor exit is a common concern for venture capital investors. Venture capital funds can be looking at high interest rates with short intervention lengths and a predetermined exit plan. Working capital refers to the finance required by the project throughout the construction period. It is likely that your group will have had to negotiate banking facilities to operate during this period. These costs should be factored into any finance applications. 5

6 Commissioned by the Scottish Government and Energy Saving Trust. Produced by Local Energy Scotland and Ricardo-AEA Ltd Queen s Printer for Scotland 2009, 2010, 2011, 2012 This document was last updated May

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