Renewable energy projects present unique risks to lenders and require oversight


Energy

Sung Je Byun and Joe Kneip

April 12, 2022

Commercial renewable energy projects, driven by the rapid growth of wind and solar energy over the past decade, present unique risks for lenders who have gained exposure to credit in the sector. In addition, these risks evolve as electricity markets evolve and technology evolves. Maintaining an active risk management program enables lenders to react to changes in the industry that may affect credit performance.

Renewable energy projects involve significant up-front capital expenditure, according to the US Energy Information Administration. Average construction costs are $1,661 per kilowatt for wind and $2,921 for solar PV, both considerably more expensive than the $696 for a natural gas power plant.

Independent power producers predominate in solar and wind projects

Independent power producers are major players in solar and wind projects and face distinct risks (Chart 1). These generators have two notable characteristics: they produce electricity for public consumption, and they are not classified as electric utilities.

Chart 1: Independent power producers dominate US solar and wind generation

Downloadable Grid | Chart data

Independent power producers are not vertically integrated like utilities in traditionally regulated markets. Instead, they are solely engaged in power generation, although they are still subject to some oversight. Risks exist at different stages of the electricity value chain. There is “resource risk” for commercial solar and wind projects: the risk that the sun won’t shine or the wind won’t blow as much as expected and less electricity will be generated than expected. The light winds in the North Sea during the summer and autumn of last year illustrate how resource availability affects revenue from renewable projects.

Forecasting project performance is another area of ​​risk. Overly optimistic solar output estimates can hurt project cash flow, says 2021 Solar Risk Assessment by kWh Analytics, a San Francisco solar data analyst. Projects with persistent resource underperformance could push cash debt service coverage ratios – a measure of cash available to make debt payments – below those used when underwriting.

Challenges of transferring energy from generation to customer

Once the electricity is produced by an independent renewable energy producer, it must be moved from the point of production to the point of consumption. This process is called transmission and distribution. As electricity moves to the point of consumption, there are a few key risks, particularly congestion and curtailment.

The risk of congestion stems from insufficient network capacity, the equivalent of a motorist stuck in rush hour traffic. The risk of congestion is important because it can create a divergence in the levels of settlement prices on a market, i.e. the difference between the price of electricity at the time of production and at another time of its delivery to the market when it may be subject to market repricing. This settlement price difference is called basis riskand this can negatively affect a borrower’s ability to repay.

Curtailment risk is the possibility that a project will not produce even though resources are available to generate electricity. There are two main reasons for the reduction: congestion and an imbalance between supply and demand.

This could happen on a fall day when the sun is shining, the wind is blowing, but people have the windows open and the thermostats off, and therefore the supply of electricity exceeds the demand.

In 2019, this happened with some regularity, according to data from the Lawrence Berkeley National Laboratory. The wind reduction rate in the Upper Midwest service area of ​​the Midcontinent Independent System Operator’s Electric Grid was 5.5% during the year, while within the Electric Reliability Council of Texas, which accounts for about 90% of Texas’ electrical load, it was 2.7%. percent. In the United States, the wind reduction rate was 2.6%.

Outages can be significant during certain seasons in certain regional electricity markets. The loss of production due to curtailment affects a producer’s revenue stream and, in turn, can reduce cash flow available to repay lenders.

Counterparty risks for suppliers

Independent power producers also face financial risks, including counterparty risk and market risk.

Counterparty risk stems from the fact that generators are often paid for the electricity they produce through a single “offtake agreement” — covering everything they produce — with a utility or company. The impending bankruptcy of California’s largest utility, Pacific Gas and Electric, in 2019 impacted the Topaz solar farm, which sold power to the power company and whose the debt was later downgraded.

Market risk arises when part of a power generation company’s output is sold on the wholesale market, exposing the generator to volatile market priceslike those who were present in February 2021 when Texas suffered from unusually cold temperatures.

Need for careful loan underwriting, ongoing monitoring

There has been a rapid growth in investment in renewable energy and in the installed capacity of solar and wind power generation facilities. A vigorous risk management program can mitigate potential problems faced by banks and non-bank financial institutions engaged in funding these facilities, whether as agents, loan participants or direct lenders.

The scope and level of the risk management program may be influenced by the level and complexity of the debt agreements and should be sufficient to provide the lending institution’s management and board of directors with adequate information on the market to make informed decisions about the risks involved.

Establishing prudent underwriting standards and ongoing credit monitoring processes enables lenders to identify, measure, monitor and control the credit risks associated with these projects. Periodic review of project performance is essential to assess continued repayment capacity over the life of a project.

Such a credit review should allow lenders to update credit risk ratings based on changing market fundamentals or payment performance.



about the authors

Sung Je Byun

Byun is a Research Economist in the Risk Supervision and Supervision Division of the Banking Supervision Department at the Federal Reserve Bank of Dallas.

Joe Kneip

Kneip is a Bank Examiner in the Risk and Supervisory Division of the Department of Banking Supervision at the Federal Reserve Bank of Dallas.

The opinions expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.

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