The rise and rise of the energy transition

April 2023  |  SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE

Financier Worldwide Magazine

April 2023 Issue

2022 was a record year for energy transition investments, with a reported $1.3 trillion invested globally over this period. These increased investment levels are being driven by strong government policy toward low carbon investment and supported by an intense effort on the part of governments around the world to create the regulatory regimes and incentives for low carbon technologies to attract investment.

Combined with this, most energy and infrastructure companies and funds have now set their own bold net-zero commitments and revamped their strategies to prioritise energy transition investments. There has never been a stronger signal for clean energy project developers around the world to hunt for quality projects and bring them to the market.

While current investment levels are impressive, they still need to significantly increase to get the world onto a net zero by 2050 pathway. BloombergNEF in its ‘New Energy Outlook 2022’ estimates required expenditure of over $5.5 trillion per year up to 2030, increasing to $7.4 trillion in the 2040s to hit net zero by 2050. These numbers are intimidatingly high, but there is unlikely to be a shortage of investment capital.

The main constraints are more likely to be around creating enough projects to invest in and in ensuring that these projects can practically be developed and be bankable. This is going to require major changes to planning systems, major upgrades in infrastructure (especially grids and power networks), significant expansion of supply chains and carefully designed incentive mechanisms. Sponsors, financiers, governments and service providers around the world will need to build significant additional capacity in these areas to enable the pace of the energy transition to accelerate.

We are seeing this increase in activity spread across the full spectrum of clean energy assets (including renewables, electric vehicles and hydrogen). Some of the biggest corporate deals in this space in Europe and the UK have involved ‘platform and people opportunities’ involving investments by major companies in opportunities involving multiple offshore wind, onshore wind, solar and battery assets, grouped together in a portfolio. Examples include the sale of Mainstream Renewables, Brookfield’s Irish renewables portfolio and Elgin Energy’s UK sale processes, to name a few, as well as large offshore wind joint ventures.

Renewable energy portfolio deals are extremely competitive and attract interest from a very wide range of companies and funds. They allow scale to be achieved quickly for the buyer and also provide an ability for the buyer to achieve ongoing and sustained growth, through development of the assets in the portfolio and through the ongoing sourcing of opportunities into the portfolio. They are very appealing to oil & gas companies and utilities in particular, given their desire to grow and to demonstrate to the market that they are genuinely committed to the energy transition.

The motivation of the developer to sell is normally driven by a desire to monetise the value created in the portfolio by the developer or to bring in the necessary capital to further develop the portfolio. The sale can be outright (in which case the developer exits completely and shifts priority to other assets in its broader portfolio) or it can be a partial sale, where the developer stays involved in a joint venture with the incoming buyer, and benefits from the additional capital.

For outright sales, the developer’s main objective is normally to maximise the value of the portfolio and to achieve a clean exit from the business. To maximise value in these sale opportunities, sellers need to design sale processes that keep as many buyers in the process for as long as possible. To do this, sellers need to present a highly organised and complete data room, produce top-quality vendor due diligence and present fair and comprehensive sales terms.

If the seller lacks financial capacity (or willingness) to stand behind the warranties and indemnities (W&I) given in the sale documentation, then some form of credit support is needed for the W&I that support the sale. This is typically the case where development companies are acting as seller. W&I insurance is an incredibly popular choice to provide credit support to a buyer. It is also commonly used where fund entities are involved on the sell-side, where their structure makes it difficult to give direct credit support. There is a ready market of W&I insurers that are familiar with the renewable energy business and able to step into and support these deals.

Ideally, this insurance is sourced by the seller and ‘stapled’ as part of the sale, or at least that a number of non-binding indications are sought from insurers and provided to the buyer. It is rare to find the perfect combination here, but if the sale process and sale documentation is lacking in any of these respects, the buyer will need to do additional work to diligence the assets and source its own insurance.

Naturally, buyers are reluctant to do significant due diligence work unless they can get exclusivity and go bilateral with the seller, so this means that less organised processes that require significant additional diligence and significant interactions with insurers have a tendency to go bilateral earlier than well-organised processes. This can result in serious loss of competitive tension in the seller’s process, and ultimately a diminution of value for the seller.

The need for insurance puts additional pressure on the sales process, as warranties will only be covered by insurers where they have been verified by the buyer. The nature of many of the warranties on renewable energy development projects can make them difficult to verify – as the buyer is ultimately trying to determine the future development potential of the assets being sold, and to ensure there are no material impediments. Also, where there are multiple assets in a portfolio, it can be a significant undertaking to verify all warranties across all assets.

A failure to satisfy the insurer will lead to exclusions in respect of specific warranted matters, or even exclusions of entire subject areas. Due diligence has to be extremely thorough to meet this standard. This can cause tension in the sales process, given the costs incurred by the buyer in performing this diligence and the lack of certainty of a deal until the end of the process. However, the insurer and the buyer are usually highly aligned, as both are rewarded by thorough diligence.

Ultimately, the buyer needs to know that each of the development opportunities being purchased in the portfolio is able to be practically developed. This requires rigorous due diligence on real estate, planning, permits, access roads and grid connections, as well as development of a clear route to market strategy for the power generated. The buyer ultimately needs to make its own assessment of this. Where there is uncertainty over the development of specific projects, a deferred consideration structure can be used where a portion of the agreed consideration can be held back and made contingent on specific events (e.g., the granting of a planning permit or the award of a licence).

Where the developer is undertaking a partial sale and seeking to stay involved in the development portfolio after the sale to the investor, the terms of the joint venture agreement need to be agreed. This is often a challenging process, as the perspective and financial position of the smaller development company and the (usually larger) international energy company are often very different.

For the developer, one of the main issues is the ongoing funding of their share of the portfolio. The developer therefore needs a source of revenue in order to continue to contribute. To facilitate this, the developer often provides ongoing services to the joint venture (under a development services agreement) and may receive ongoing earnout payments for the sale, as mentioned above.

As time passes, and the capital contribution expectation increases, the developer will usually want the ability to sell down further, and will also express a strong preference for using project finance once a final investment decision is taken on the development of any of the opportunities. The larger partner will usually want a degree of control over who else comes into the project and will want flexibility to fund their share as they see fit. ‘Failure to fund’ mechanisms need to be built into the joint venture agreement, and these often lead to a dilution by the developer or enhanced lending terms for the investor.

In addition to renewable energy deals, we are also seeing a significant uptick of interest in low-carbon hydrogen projects and carbon capture and storage (CCUS), where companies are forming project consortia and developing the early structures and models, in anticipation of further government incentives and clearer regulatory frameworks.

The companies developing these projects are testing the limits of the investment structures and are working closely with government to ensure the incentives and regulations are designed in a way that will promote the development of these new industries. Given how nascent these new technologies are, and how much regulatory support they need to succeed, sponsors, governments and their advisers are working very closely together to create the investable frameworks for these projects.

 

Lewis McDonald is the global head of energy at Herbert Smith Freehills. He can be contacted on +44 (0)7935 085 898 or by email: lewis.mcdonald@hsf.com.

© Financier Worldwide

BY

Lewis McDonald

Herbert Smith Freehills

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