This weeks Industry Current is written by Elias Hinckley, head of energy finance and David John Frenkil, an attorney in energy finance at Sullivan & Worcester in New York.
The introduction of solar asset-backed securities, commonly referred to as solar securitization, has been the next big thing in energy finance for the past three to four years. Whether the first real solar securitization happens this year or in the near future, securitization is coming to solar finance.
This article provides an understanding for how these deals will come together, what some unique challenges are to solar securitizations, and what to expect on the horizon after the first securitization is issued. In the second installment of this Industry Current, we will address issues surrounding harmonization of tax equity investor limitations with solar securitization.
As state and federal support for renewables shrinks, the industry must find ways to continue to reduce costs, and access to less expensive capital will be a vital piece of this process. The use of solar ABS 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% to 7%, compared with the 8% to 20% rate required by some project finance equity and tax equity investors in the current market.
The U.S. Department of Energy estimates that securitization will lower the levelized cost of energy by between 8% to 16%. For investors who seek to exit portfolios of solar assets or remove the assets and accompanying risk from their balance sheets, securitization will increase liquidity for solar projects and free-up cash to make additional investments.
How Securitization Works
Securitization gained popularity in the 1970s with home mortgages in the U.S. and has since expanded to other income-producing assets, including credit cards, shipping containers, and aircraft.
In the most basic form of a solar securitization, the holder, or originator, of a portfolio of solar assets identifies and isolates contracted revenues from a series of solar projects. The originator then bundles the contracted revenues into a reference portfolio, and sells the revenue stream (but not the physical solar asset itself) to an issuer, typically a special purpose vehicle. The SPV then issues a tradable, interest-bearing security to investors in the capital markets. The revenues generated by the reference portfolio fund a trustee account that passes through payments, either fixed or floating, to the investors in the new security. These investors are senior to equity investments and for stable income producing assets like solar projects represent a relatively low risk investment.
In order to obtain an investment-grade rating for the securitization, as required by the investors best positioned to buy long tenor fixed-rate securities, such as pensions and insurance funds, the sponsor will need to develop a large enough portfolio with geographical diversity and a credit worthy source of underlying revenue (the buyers of the solar electricity).
The solar industry will need to manage several challenges before entering the market with ratings high enough to attract the lowest cost capital (ideally higher than the A to AA range expected of the initial solar securitizations).
· Scale and Geographic Diversity. For securitization to work, assets must hit a critical mass and must be pooled from over a geographically-diverse area, such as numerous states in different regions. This reduces the risk that regulatory regimes and market forces will materially effect the value of solar assets in the pool.
· Standardization of Asset Structures and Documentation. It will be absolutely vital to manage the structure and supporting documentation of assets in a far more consistent manner than has historically been done in the industry (with the notable exception of certain retail aggregators over the past couple of years). Pools will need to be standardized in order for underwriters and investors to have comfort in the underlying revenue streams without needing to consider a diverse range of ownership structures and contractual terms.
· Off-take Risk. Most residential solar sponsors manage off-take risk by limiting their eligible pool of potential customers to homeowners with a minimum FICO score. For sponsors selling power to commercial and industrial customers, off-take risk is managed in a less standardized way, which makes the C&I solar asset more difficult to securitize. A recent report shows that 25 leading corporations in the U.S. have installed a total of 445 MW of solar facilities, so sponsors are managing off-take risk by installing solar on multiple sites of large rated and creditworthy counterparties.
· Technology Risk. Distributed solar asset revenue streams have tenors of 15 to 20 years, but there is currently less than 10 years of historical data upon which to rate the performance of most solar panels. Passage of time and improved operating data will enable further de-risking of solar securities.
· Sponsor Risk. Sponsors are still relatively new to the market. Even leading sponsors who are likely to securitize their assets such as Solar City, SunRun, Sungevity, and Viridity have been operational for less than a decade. One way to overcome sponsor risk is to take the approach that Solar City is pursuing as it prepares an initial securitization i.e., put in place a backup service agreement to ensure that if the sponsor is not able to service its agreements, there will be a well-rated, larger company to take over.
· Market Risk. There is also the risk that solar energy might be less economical than traditional energy sources during the tenor of the asset. Sponsors will need to find ways to convince the capital markets that their solar assets will continue to generate electricity at a price that is competitive to traditional energy, or find other ways to ensure that market risk wont jeopardize the value of the asset. While hedges on the aggregated pool of assets may offer a short-term solution, the duration of any available hedge (generally three to seven years) will typically be much shorter than the tenor of the asset.
· Regulatory Risk. In order to facilitate the growth of solar securitizations, government agencies will need to update regulations, such as disclosure and liability rules. Also, assignee rights under government energy programs such as net metering rules may need to be updated to ensure that investors in solar securitizations are protected against risk of obligor default. The government may also provide credit enhancement through various methods, including loss reserves, or investments through entities like a government backed green bank program.
What to Expect After the First Securitization
Once the issues discussed immediately above are resolved to an extent that allows the capital markets to feel comfortable with the risks associated with solar securitizations, many issuances will follow. In the residential solar space, with less than 1% market penetration among credit-worthy homeowners, there is significant room for growth in the industry.
Also, after overcoming the challenges centered on standardization of agreements, commercial solar assets will also be securitized. Eventually, securitizations might also include a mixed pool of residential and commercial assets, particularly for companies like SunEdison and Sunpower with a diverse portfolio of both types of solar assets.
Securitizations may also follow among loans provided by the Property Assessed Clean Energy program, which facilitates the financing of clean energy retrofitting in municipalities. In the PACE program, property owners repay their loans as part of their real estate tax bill. Because PACE obligations are senior to mortgage liens, the Federal Housing Finance Agency has put a hold on the residential PACE program pending further review. However, commercial PACE programs are increasingly funding energy efficiency improvements around the U.S. in cities such as San Francisco and Washington, D.C. Once sponsors achieve the same level of standardization, geographic diversity and scale as their solar counterparts, these too may be good candidates for securitization.
Further, the U.S. military will likely enable some risk reduction facilitating solar securitization. The Army is preparing to buy up to $7 billion of energy from projects that private sponsors build and finance, part of a goal to add 1,000 MW of renewable-electricity capacity by 2025. The agreements for these projects will be standardized, and political games over government default notwithstanding, the U.S. Department of Defense is a very creditworthy counterparty. Sponsors of solar facilities at Army installations will be well positioned to securitize a large portfolio of assets.
The capital added to the market by securitization will accelerate growth, geographic diversity, and standardization across the solar industry and this will in turn drive significant consolidation among players old and new at all levels of the solar industrys supply chain. This securitization process and impact will not be restricted to the U.S. and will expand to markets abroad.
In the next installment of this Industry Current, the authors will examine the role for tax equity in the solar securitization, and will also examine structures for harmonizing tax equity investor obligations with securitization commitments.