With project financing remaining one of the most prevalent financing structures in the renewable energy sector, we are seeing lenders take a more active role in the development of projects. In this article, we explore how lenders’ requirements impact the allocation and management of risks in contracts for the delivery of renewable energy projects.
Overview of project finance in the renewable energy sector
Project finance is a type of limited recourse debt finance whereby projects are funded based on project-specific cash flow and project asset collateral, rather than the developer’s balance sheet and other non-project assets. This structure offers several benefits for both developers and lenders. For developers, project finance reduces balance sheet exposure in the event of a financing default. For lenders, reduced collateral justifies the charging of higher fees and interest.
Developers often achieve the ‘quarantining’ of project revenues and assets by utilising a special purpose vehicle (SPV) for the project. An SPV can be in a range of forms, including a joint venture, partnership, limited company or trust, with the choice of structure dependent on legal, tax, accounting and regulatory considerations.
In addition to charging higher fees and interest, lenders will seek to mitigate additional funding risks through various strategies, such as the sharing of credit exposure across a syndicate of financial institutions, taking security over project assets and entering into direct deeds with key project counterparties such as (during the construction phase of the project) the head-contractor and (during the operation phase of the project) operators and key off-takers.
In addition, one of the key risk mitigation measures implemented by lenders is effective due diligence. This includes vetting the construction contractor’s qualifications and ensuring that the construction contract itself is robust enough to deliver the desired outcomes.
Risk allocation in project financed construction contracts
Lenders’ objectives in a project financing arrangement generally aligns with those of developers: ensuring the project is completed on time, within budget, and with the required performance capabilities.
However, given lenders’ limited recourse against the developer, lenders are understandably keen to ensure that as much delivery risk as possible is borne by the contractor rather than the developer.
As such, lenders will typically (but not always) require the developer to enter into a single fixed-price lump sum engineering, procurement and construction contract (EPC contract) with an EPC contractor who assumes the responsibility of designing and delivering a fully completed ‘turnkey’ solution to the developer.
Other common lender requirements for the EPC contract are set out below.
Bankability issue: Security
As well as taking security over the project assets, lenders often have stringent requirements for performance security under the construction contract, including in terms of form (preferring bank guarantees, but with insurance bonds becoming more widely accepted) and amount (typically sitting between 5% and 15% of the contract sum). Lenders will also typically require the EPC contractor to procure guarantees from its parent entity (depending on the contractor’s corporate structure).
Bankability issue: Tripartite agreement
It is typical for lenders to require some type of tripartite agreement with the developer and the contractor which modifies termination rights and provides for the lenders’ rights to step in to complete the project and / or assign and novate the developer’s rights and obligations under the construction contract to a new developer in certain circumstances.
Bankability issue: EOTs and delay liquidated damages
Lenders will generally seek to limit the contractor’s entitlements to extensions of time in order to maximise certainty as to the timing for project completion. Lenders also typically require liquidated damages to be set at a level to allow for the recouperation of a reasonable amount of lost project revenues for late completion (subject to market-standard caps on the contractor’s aggregate exposure to liquidated damages).
Bankability issue: Performance guarantees and performance liquidated damages
Similarly, lenders require certainty as to the performance of the completed project through robust performance guarantees, supported by performance liquidated damages (again, subject to market-standard liability caps).
Bankability issue: Warranties and indemnities
Robust warranties (including fitness for purpose warranties) support the performance guarantees provided by the contractor, and are important to ensure that the project is constructed in a manner that will allow it to generate revenue sufficient to recover loan repayments.
Bankability issue: Subcontracting and assignment
It is important to lenders that the developer is not restricted in its ability to transfer, or grant an interest in, the project to the lender. Similarly, lenders generally require that the contractor is prohibited from granting any security interest, mortgage or other right over the project assets (or, at a minimum, that the lender’s rights will take priority). Lenders will otherwise often require approval rights in relation to key suppliers and subcontractors and may also require a ‘direct deed’ to be entered into between the developer and those parties in order to support lenders’ step-in rights.
Bankability issue: Payment
With payment milestones widely used in the construction of renewable energy projects, many lenders will want to ensure that payments are reflective of the value of work being performed (i.e. are not front-loaded).
Bankability issue: Insurance
Lenders will often have prescriptive requirements for the insurances to be procured by the contract parties, including to be a named insured under each of those policies.
Bankability issue: Liability caps and exclusions
Liability caps and exclusions of consequential losses in favour of the EPC contractor will generally be accepted by lenders, provided any liability cap is set at a reasonable level and market standard carve-outs apply to the cap and exclusion.
Bankability issue: Defects liability
Lenders require a robust defects liability regime, including with respect to serial and latent defects. While a 12 month defects liability period is common in other sectors, a minimum of 24 months is often seen in the renewable energy sector (including for serial defects), with a latent defects liability period extending beyond this (often 36 months or more).
Impact of lender positions in the current market
In the wake of the COVID-19 pandemic, there has been a notable shift in contractual risk allocation across multiple sectors to a more ‘contractor friendly’ position. However, the stringent bankability requirements associated with project financed projects has impeded this shift within the renewable energy sector. This has impacted the availability of contractors in the renewables sector, as more favourable contracting conditions may be available in other sectors.
Fixed price lump sum contracting also incentivises contractors to include additional contingencies in their pricing for risks outside their control. This can inflate construction costs for risks that may not materialise during the project.
Furthermore, an onerous risk allocation strategy can set a confrontational tone between developers and contractors. As both parties work to protect their legal positions, administrative costs increase with the need for the parties to issue and respond to contractual notices (and, in the worst case, trigger formal dispute resolution processes).
Finally, a product of the shift in contractual risk allocation in other sectors has been a rise in collaborative contracting in those sectors. Unsurprisingly, lenders generally remain adverse to collaborative contracting given the perceived lack of price and schedule certainty. As such, we are not yet seeing any meaningful shift towards more collaborative contracting in the delivery of renewable energy projects.
Looking ahead
The prevalence of project financing in the renewable energy sector continues to shape risk allocation in construction contracts for renewables projects. While there have been some steps towards more ‘contractor friendly’ and ‘collaborative’ contracting in other sectors, these steps have been somewhat tentative in the renewables sector because of lenders’ requirements.
That said, we have seen examples of lenders in the renewables sector becoming more inquisitive about alternative contracting approaches, which suggests they are open to considering these approaches going forward. It remains to be seen what effect this may have on construction contracts in the future.
