Author: Sara Howard
Contributors: Simon Holmes à Court, Martin May
The funding for your community energy project is likely to come from three different sources — equity, debt and government grants. In this article, we look at how you can make sure your project is ‘bankable’. At what stage should you approach the bank? What do you need to show them to prove your business case? What should you look out for before you sign a loan agreement?
When will you need a loan?
There are costs for arranging banks loans. These cost may include an arrangement fee for the bank, along with legal fees for the creation and review of the loan agreement. The cost of the loan will be at a spread above where the bank can borrow funds. Once all these costs are factored in, it is unlikely that small community renewable projects will need or want debt funding. It is likely to be cheaper and more efficient to raise 100% equity financing for a 100kW solar project for example. For larger projects, such as wind farms that are multiple megawatts in capacity, debt financing may be appropriate.
Banks are primarily concerned with risk – their risk. The more risky they deem a project to be, the more they will work the terms in their favour. In other words, the sooner you go to them with your business case, the more interest you're likely to pay. It follows that the more certainty you can demonstrate in your business plan, the more likely banks are to provide funds. For example, it helps if you have a market for your output, which will service your loan. In addition, the more credit-worthy your likely energy buyer is, the more interested your potential banker will be. For the bank, certainty of revenue is key.
So ideally, wait until you’re ready to put down a deposit on your capital equipment before you go to the bank. They'd rather lend against a tangible asset than say, a feasibility study. By then you'll also have a substantial amount of proven data, which makes your business case stronger.
At this stage, you should have also secured some equity funding from other investors — angel investor groups, partnerships with developers, or co-operative membership shares or bonds. This may be in the form of a future funding agreement, where members will guarantee their commitment to purchase shares. Any legally binding agreement to this effect will make the bank more comfortable with the level of debt you plan to have compared to the level of equity ratio or the 'debt to equity ratio'.
In the case of a wind farm development, once the turbine manufacturers ask you to place a deposit you'll enter into a contract that requires a guarantee for progress payments. This is when you'll need access to a bank loan.
As soon as you start drawing down on that capital debt, you start to incur costs, and this usually happens before the project is generating revenue. You need adequate capital or a flexible lender structure to get through this phase.
Dos and don’ts of borrowing money
Do
- Have a clear, confident business plan. See Building the business case.
- Explain the market opportunity clearly, including your revenue plans (for example, a Power Purchase Agreement (PPA) with a major retailer under negotiation).
- Have a clear cash flow plan and financial plan. See Developing the financial model for the project.
- Raise community equity or seek other equity investors first. See Funding the early stages of projects.
- Be clear about what you'll use the loan funds for.
- Place share or bond holders below debt financiers in the business plan.
Don’t
- Ask for a loan too early in the development process.
- Ask for a loan to fund intangible costs, such as planning and permit consultants.
- Be vague about your business plan, goals, objectives or timeframe.
- Sign before you factor in interest rate rises. Interest could potentially become a draining cost over time, so think about how that will affect your return to investors and financial viability.
Is your project bankable?
When a lender assesses your business proposal, they look at several things.
- Projected cash flows: This tells them when you'll need to start drawing down on the debt, and your ability to repay it. What assumptions have you made? Can you meet your debt service ratio?
- Realistic energy assessment: Is your energy resource good quality? For example, will the wind energy provide enough power to generate revenue in both good and bad production years? Does your business plan address how you'll manage those fluctuations?
- Major stakeholders: Who's already involved in the project? This includes your board members. What expertise do they have? Have you selected a power purchaser and turbine (or capital equipment) supplier?
- Terms of third party contracts: This could include landowner lease agreements, developer partnership agreements, Power Purchase Agreements (PPAs) and any ongoing maintenance agreements.
The importance of data
The entire financial performance of a wind farm development depends on your projection of how much energy the wind turbines will generate, so the quality of your wind resource is paramount.
Wind energy varies from year to year, so by the time you go to your lender you should be able to quantify typical annual variations and how that will affect your revenue and cash flow.
Essentially, this will give the bank a solid indication of the risk involved, which will determine their willingness to lend and the interest rate (and other terms) they offer to mitigate that risk.
Choosing your lender
Australian banks are becoming more aware of the opportunities for bio-fuels, and understand that a new energy infrastructure needs capital. However, every bank has a different approach to managing risk.
Your bank will become an integral partner in your project, so look for one that understands the goals and objectives of your community energy project.
If you're working as a co-operative, look for a bank that also understands your business structure. Many commercial banks may not, so talk to like-minded banks or your local credit union.
Take the time to develop a relationship with your banker. They understand financing and can provide more than just the money. Ask them for ongoing financial advice as your project develops.
Control your debt to equity ratio
Banks prefer, on average, a 40/60 debt to equity ratio with community energy projects, as it means they're sharing a reasonable amount of risk with other investors.
This also benefits your project. The lower your debt to equity ratio, the more control you will have over future financial decisions, and you’ll pay less to service that debt over the long-term.
As an example, the Hepburn Community Wind Park Co-operative in Victoria was able to raise 71% of its funding as equity, and only needed 23% from Bendigo Bank. This has given them more control over how they eventually sell their energy.
Banks are attracted to PPAs (Power Purchase Agreements) because they guarantee regular revenue. But if you have a higher level of equity, you may not need an upfront agreement, which allows you to compete on the spot energy market instead.
This is an advantage, because as a small producer you may have difficulty negotiating a fair deal with a retailer through a PPA. You can achieve better margins, albeit at higher risk, on the spot market.
A similar, but larger, project in the UK, Westmill Wind Farm Co-operative, had a 50/50 debt to equity ratio. Returns are expected to range between 7% and 11%.
Summary
Banks prefer established technology, strong commercial partners and a straightforward business model.
They're concerned with downside risk management — what's the worst-case scenario for your revenue? And how will that affect your ability to service your debt?
Only take your business plan and cash flow projections to the bank when you're ready to order your infrastructure, not before. Try to avoid financing more than 60% of your project with a bank loan, as excessive debt servicing costs will impact your cash flow and your ability to make your own financial decisions.