From pv magazine USA.
I stared at the slide intently, trying to identify the mistake buried in the math behind the charts. The presentation to our investment committee outlined a portfolio of projects – at this point they were merely seedlings with little more than site control – worth well over $1/W each … in net margin. This was a meeting about an emerging market in the U.S. with projected 2020 in-service dates, not a meeting about rooftops under the California Solar Initiative (CSI) in 2010. I was not buying it, and the body language in the room suggested I wasn’t alone.
“Um, sorry guys, I have to stop you. I’m not saying we shouldn’t be really excited about these projects, and supporting them confidently, but you do realize that at the end of the day, we’re not getting those margins, right?”
I was met with silence, glances around the room and more silence, until a senior developer spoke up.
“I think it’s right. Check the model, tell us where it’s wrong.”
I knew that soon, our team would be inheriting these development aspirations as project finance team expectations, so I accepted the invitation.
I couldn’t find anything “wrong.” The model was thoughtfully constructed and as “right” as it could be, with defensible, moderately conservative assumptions. After years of incessantly lecturing folks not to debate and whine about the outputs of a model just because they don’t like the result, here I was not able to back up my claims at the assumption level. Yet I, and others on the investment committee were still convinced we were right: There is no way those margins would ever hold. How did we know?
With enough time and reps observing the delta between early model value and margin estimates and final results, a clear theme emerges: Projects tend to get sucked back toward the zero-margin zone and, the further away from that baseline they appear to be, the more their projected margins stand to drift over time. Fancy models with bells, whistles and defensible assumptions aside, I was confident the final picture would look much less rosy.
Fortunately, this trend holds on both sides of zero. Just as fat margins thin considerably over time, projects facing a loss often scrape and claw their way into the black. Hence the “rubber-band effect” – all projects feel the gravity of zero margin, regardless of where they start on the spectrum of profitability.
Why does this happen? Why can’t we trust development-stage models replete with high margins and rich internal rates of return (IRRs), or discard nascent opportunities when we realize our initial engineering, procurement and construction (EPC) estimate is low by 20%?
Downward pressure
Let’s first consider projects which seem very rich at the concept stage.
Scarcity forces efficiency and abundance causes waste. That’s simply human nature. This phenomenon manifests itself internally within the walls of the project developer or integrator, and throughout the expansive universe of external stakeholders.
Along the assembly line of developing and building a solar project, every cog in the machine has an opportunity to prioritize speed and progress over efficiency, eroding margin in the process.
Development team
Developers are often measured by their ability to get projects done, as much or more than their ability to generate profitability. Certainly, in a situation where profit erosion is less noticeable because the final margin is still attractive on an absolute basis, a developer could be forgiven for instinctively prioritizing progress and speed. After all, who will complain if a project ultimately clears with an $0.75 development margin instead of the whole dollar? Despite losing substantial value, that would still be a fantastic result. This attitude could manifest itself as particularly generous lease rate offers to a landowner, taking the first bid from an injection study consultant or choosing not to challenge a utility on its feasibility study estimates.
EPC
Without the extraordinary pressures of a razor-thin project, maybe only two bids will be sought for major equipment, instead of six. Maybe the design and engineering team chose “safe” designs which prioritize construction velocity over cost. EPC teams are often asked to perform minor miracles by squeezing costs out of builds on the fly, but the impetus to do usually comes from a project being at risk of sinking underwater. The notion that cash is fungible is easy to forget, so those holding an EPC firm’s feet to the fire may be saving their “please perform a miracle” bullets for tighter projects.
Finance
When a flow of funds with fat margins is on the horizon, there is often a lot of pressure to get to flow-of-funds-day as quickly as possible. Just like everyone else, project finance professionals must make trade-off choices between speed and quality. With less time comes sloppier execution and less room for creativity. The goal becomes completion, not perfection. Like the EPC group, project finance folks have to ration themselves when it comes to applying pressure to partners.
If I’m working on two deals with the same tax investor at the same time and one of them has a $0.04/W margin and the other $0.24/W, which one am I going to beg for higher credit pricing on? Which deal, generally, is likely to get more of my time and attention?
Often the very programs or regulatory regimes which facilitate higher margins come with restrictions and requirements which challenge realization of such figures. Certain Massachusetts programs had nine-month build-cycle requirements and North Carolina state tax credits had placed-in-service deadlines. When staring into the abyss of losing a massive value source, teams working to complete the project are not likely to quibble over a $25,000 change order, nor should they. In the same vein, state and local programs often come attached to local socioeconomic objectives which give preference, officially or unofficially, to local companies which conveniently get overlooked when out-of-state firms consider pursuing an opportunity, only to experience years of headwinds not captured in early models.
Local economic development is just one example of sources of external pressure which can combine to create the effect of a feeding frenzy. When there is “room” in a deal, it’s usually either well-known, discoverable or at least felt by a variety of parties who may subtly adjust their choices and behavior to “get theirs.”
Just think about all the different groups who have a chance to grab at what would otherwise be developer margin:
Every one of those parties can seek to extract value that would otherwise go to the developer and has more leverage to get it, because any counter threat of killing the project is not credible. It also feels morally acceptable when the developer is doing just fine and a money grab by other stakeholders won’t put it in the red. That should not be read as a judgement – in an industry riddled with dead deals and thin margins which force every stakeholder to take a hit, we all have to make up for it somewhere.
Fair or not, profit erosion adds up. The important thing is to acknowledge the phenomenon, mitigate it to the extent possible and plan for some disappointment relative to the expectations set by an early financial model.
Upward pressure
Thankfully, there are two sides to the coin.
How many times have you asked yourself how request-for-proposal bidders could possibly offer such an impossibly low price in a power purchase agreement-driven (PPA) tender, only to find out years later the winner got the project done and appeared to have even made a little money on it? No sane bid model could possibly have suggested the price offered was a safe and rational number, yet something made it work.
Similarly, there is that experience of struggling to kill a seemingly underwater project in the pipeline because you have a hunch it’ll find a way into the black.
Ever wonder how it is most of us market participants remain optimistic about the potential to make a living amid simultaneous headwinds from tariffs, sun-setting subsidies, sinking power prices etc? I believe it’s a simple hunch. I don’t know exactly why or how but one way or another, many of those power plants are going to happen, and turn a profit. Anyone who has been participating in this market long enough knows that idea is well-founded, if dangerous, intuition.
Consider the following framework to try and explain why that is so. Which stakeholders will be harmed if this project is not built and who has the most to lose?
The regulatory environment and, to a lesser extent, the prevailing sentiment of voters, shareholders, ratepayers or customers imposes pressure on a variety of institutions which face consequences if not enough renewable and/or storage projects get built. Perhaps more importantly, many stakeholders stand to suffer more economic pain as the result of a project dying than the developer would. In the same way developers lack leverage in high-margin projects, they can credibly threaten to bury a project – and any associated benefits – that stands to lose money.
Taken individually, none of the approaches listed above are reliable behavioral patterns on a single-actor level. For example, utilities rarely change the terms of an interconnection agreement and energy off-takers are loath to adjust terms, once signed.
The overall theme holds though: These are the types of reactions and responses we have seen over the years when thin-margin projects face the chopping block. Anticipating help from other stakeholders which is yet to materialize is not delusional. In some cases, that expectation is mere table stakes. Were the ultimate source of the external “help” known and arrival assured, all players would bake it into their strategy and models. In reality, the renewable energy and storage playing fields are too dynamic and multivariate to enjoy such visibility. Instead, we are often asked to take a leap of faith by assuming there will be a helpful break or two, of unknown origin for us if we sit tight. It is an intimidating proposition that occasionally fails to deliver but here are a few examples from the last decade where help did arrive.
1603 grant, 2009
The financial crisis obliterated the tax equity market as corporate profits, especially those of banks – the primary source of tax equity at the time – evaporated. Unclear about how any project would be financed, many developers froze investment. The federal government, though, made supporting clean energy a priority in the American Recovery and Reinvestment Act bill and instituted the 1603 “grant-in-lieu-of-tax-credit,” which allowed applicants to take the subsidy as cash from the U.S. Treasury instead of a tax credit from the IRS. It served its primary purpose reasonably well, saving rooftop projects and the first utility scale solar project in the country, but it also had the secondary effect of attracting a new class of “cash investors” into the sector. That momentum, first catalyzed by the 1603 grant, is still felt today.
California CSI program, 2008-2014
In the early days of distributed generation, California decided the federal objectives for the integration of clean energy fell short of the state’s ambition, so lawmakers instituted a performance-based incentive to supplement the federal tax credit. It was a very powerful program that served to dramatically accelerate the adoption of solar in the state while providing healthy margins to residential, commercial and industrial developers.
Module cost curve, 2010-2015
Cost reductions for solar modules exceeded even the most optimistic projections during the first half of the last decade. The Chinese government’s desire to bolster a burgeoning solar module manufacturing industry which was a major source of domestic jobs, fueled rapid cost declines. The China Development Bank and quasi-governmental financing institutions pumped incredibly cheap capital into module companies. Volume, market domination and job creation were the goals, rather than profitability. The math was simple: economies of scale plus minuscule margins plus abundant cheap capital equals great module prices. Developers who took a bet on aggressive cost curves in 2009-2012 reaped major rewards.
YieldCos, 2013-2016
Renewables company Terraform Power started a short-lived, but incredibly powerful trend of publicly traded asset-ownership vehicles which dominated the asset-ownership market, driving project values way up in the process. Its appetite propelled both volume and profitability across the market for a few years. But for a few folks inside rival Sunedison – and some bankers who like to retroactively reframe their optimism about “securitization” as prescience for yieldcos – few would claim they saw that market phase coming.
ITC extension, 2015
Most of us were preparing for a world without the 30% Investment Tax Credit (ITC) in December 2015. Little did we expect the holiday miracle in a bill many believed dead: Democrats and Republicans horse-traded a lift of the oil export ban for a huge extension to the solar ITC and a one-year extension to the wind Production Tax Credit. The impact that surprising development has had on the industry since cannot be overstated.
Environmentally conscious off-takers, 2017-present
Just as many regulated utilities across the country started to reach renewable portfolio standard targets – reducing their appetite for renewables PPAs – corporate and municipal off-takers began to step up and directly procure sustainably generated electricity on a large scale. Google, Amazon, Microsoft, Starbucks, Facebook, Intel, Apple and many others have offered economically viable solutions to what looked like a looming dearth in renewable electricity off-take while injecting competitive demand into a market getting stale from years of, mostly regulated, subsidy-driven growth.
Equity cost of capital, 2017-present
Throughout the previous decade, a staggering amount of “cash equity” investors – private equity, public infrastructure vehicles, pension funds, sovereign wealth funds – entered the renewable power plant asset ownership market. When the collapse of the yieldco market caused a brief cost-of-capital increase, many of us feared projects we underwrote to aspirational yieldco IRRs would die in the red. Alas, these huge institutional pools of money quickly filled the void and continue to play a pivotal role in keeping the industry healthy today.
Bifacial modules and battery storage, 2018-present
A calamitous combination of module import tariffs, deteriorating tax equity terms and falling electricity prices left many solar projects staring into the abyss heading into 2018. Though plenty did die, many have been saved by the emergence of production-boosting bifacial solar panels and/or the integration of storage technology into system design and revenue strategies.
From an investment point of view, arming inherently optimistic developers with the “upward pressure” argument is, frankly, a bit terrifying. Applied irresponsibly, the idea could be used to justify objectively awful decisions. Any way you slice it, there’s a difference between taking calculated risks and gambling. A thoughtful, intentional application of the optimistic assumption above would probably ask questions like: ‘What do I need to believe for this project to end up working?’ or ‘what kind of “breaks” would need to fall my way for this to have value and what is the probability of those things coming to pass?’ Such demands would enable the judicious weighting of risks versus potential reward.
Shrugging off an indicative model that says a project (or PPA rate) needs multiple miracles to make five cents of margin, though, is nothing more than a stubborn, reckless gamble.
Conclusion
For better or worse, that low or zero margin zone holds a lot of gravity. No doubt there are exceptions, though, and ironically the example I chose to use at the top of this article is arguably one of them – while many of the forces described put downward pressure on the margins for that project, they proved to be an exceptionally good fit for a particular acquirer who paid prices within earshot of those I questioned. However, developers have often made the mistake of planning for, and around healthy margins coming to pass – building large teams, taking on debt, throwing self-congratulatory parties at the Solar Power International trade show – only to find themselves in deep trouble when their $0.35/W expected margin actually came in at $0.21/W.
Whether manifested as a little extra patience with a laggard project, or tempering expectations for richer projects, all developers and investors concerned with project profitability would be well served to remember forces always tend to pull margins back toward zero.
David Riester is a partner at Lacuna Sustainable Investments, which invests in pre-construction (all-stages) renewable energy and storage projects and companies in the U.S. Lacuna is dedicated to creating strong partnerships with management teams in opportunities where capital and experience will accelerate value creation.
The views and opinions expressed in this article are the author’s own, and do not necessarily reflect those held by pv magazine.
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