Severe cuts to the incentives available to renewable projects are already spurring innovations in US power finance. The investment tax credit cash grant, which has buoyed the market since early 2009, is about to expire, and sponsors will need to put forward projects whose economics can survive without it. But the closing months of 2011 required sponsors to exercise considerable ingenuity simply to deal with the risk that they might not receive the grant that they were expecting.

The US market has always been more fortunate than Europe in having access to non-bank sources of capital. But these sources are, to varying degrees, expensive, intolerant of construction risk, and tax constrained. Developers, particularly of smaller projects with unconventional risk, will need to become more familiar with them. Developers in a hurry already are.

The financing for Enova Energy’s $240 million Plainfield biomass project in Connecticut included not one but two sources of non- traditional debt. The Carlyle Group’s recently-established Carlyle Energy Mezzanine Opportunities Fund is in the senior position and SAIC, the project’s engineering, procurement and construction contractor, is the holding company debt provider.

SAIC’s mezzanine looks a lot like equity, while the Carlyle mezzanine looks a lot like a senior construction bridge. Both providers are eager to build market share, Carlyle while it increases commitments to its fund, and publicly-traded SAIC while it builds up the EPC business it acquired with Benham. Both have deeper pockets than many of their competitors.

The deal had one main aim – to allow the project to start construction before the end of 2011. If the project could not demonstrate substantial progress on construction by the end of the year – not to mention come online by the end of 2013 – it would not be eligible to receive a cash grant equivalent for 30% of its cash costs.

The project has a 15-year power purchase agreement with Connecticut Light & Power, which the original developers, Decker and NuPower, won after responding to a request for proposals from the utility. The two developers, which had a site but little else in the way of a concrete project, sold the bulk of the project to Enova, which includes former KGen management among its founders.

The project has been in front of potential lenders since 2006, but the developers could not act on any comments that they had about the quality of the offtake contract. The PPA is for a project that runs on waste wood from the construction and demolition industry (with a capped 30% green wood component). The state of Connecticut has changed the law so that such fuel is no longer considered renewable for the purposes of meeting utilities’ renewables targets since the project was bid. The Plainfield PPA was grandfathered but could not be modified so much that it would attract regulatory scrutiny, or it might be voided. Most importantly, the PPA does not include a pass-through of fuel costs, unlike most other recent biomass projects. However, Plainfield can assume that any rival generator that comes on the scene later will not enjoy the same incentives.

Some of Connecticut’s neighbours do offer economic support of older waste wood-fired plants. Massachusetts, for instance, has a

ban on the placing of waste wood in landfills, and waste management firms will charge up to $60 per tonne to dispose of it, usually by trucking it over state lines. If a biomass generator is willing to pay $6 per tonne at the door of the plant, this is a meaningful reduction in disposal costs.

But there are additional costs to burning pre-owned wood, including the use of manual sorting and additional mechanical

sorting to remove items like painted wood that cannot be burned. Plainfield must also deal with a large number of small suppliers, usually waste management firms, and work from the assumption that, given that the market is roughly 3x oversupplied, it will be able to offer the best price for waste wood. At the moment the project has fewer than 10 suppliers lined up, but the sponsors plan to make sure that by start of operations no single supplier will account for more than 10% of the project’s fuel needs.

The deal is SAIC’s second big-ticket power EPC contract to benefit from a vendor finance loan. The first was construction financing in support of its work on US Geothermal’s 8.9MW San Emidio geothermal plant. Biomass construction promises to be an important line of business, particularly as utilities look to replace or repower coal units. SAIC and the developers worked closely on the financing for the project and was willing at a comparatively early stage in the project’s development to offer the construction financing.

SAIC, which is looking to diversify away from defense and government contracting work, has ample sources of liquidity. These include a $750 million corporate revolver, roughly $450 million in annual Ebitda and an A3/A- (Moody’s/S&P) rating. It is deferring $115 million of payment for the contract, turning it into a note payable by a holding company for the project. In the event that the more senior piece is repaid but, if the project struggles to meet the SAIC obligation, SAIC becomes owner. Enova is providing almost no cash equity, but SAIC has a chance to maintain ownership if every part of the project performs as planned.

The developer originally approached the Carlyle energy mezzanine group to see whether it could provide a bridge financing to the cash grant. Societe Generale held the mandate to arrange the project’s senior debt at the time. Project finance lenders have usually been able to offer bridges to cash grants, though they have been most comfortable doing so for wind and solar, technologies with shorter construction times and technology with which they are more comfortable.

When SG was unable to close the financing as the Eurozone crisis began to feed through into debt markets in August 2011, the sponsor approached Carlyle to see if it would take on the expanded debt role. Carlyle responded with a $125 million loan, which splits into a $70 million tranche A due February 2016, and a $55 million tranche B due April 2014. If the project receives its cash grant as planned, then at commercial operations $80 million of that commitment gets paid down and the Carlyle debt has only a residual operational exposure. SAIC started construction on the project before the loan closed, meaning that the process is now running a little ahead of schedule.

The financing benefits from a full cash sweep, but can be paid down at any point, subject to limited make-whole provisions early in the debt’s life. In this respect it looks more attractive than the mezzanine loan that TCW (now EIG) provided Nevada Geothermal's Blue Mountain project in September 2008, in order to meet a notice-to-proceed construction deadline, which only allowed the borrower to pay down some of the principal balance, with the residual mezzanine staying in place (and now in the throes of restructuring). But the TCW debt priced at 14%, and while the Plainfield rate has not been disclosed, investors in Carlyle-managed funds typically expect to see high-teens returns on their capital.

The loan, however, is not designed to stay outstanding for long. SAIC’s quasi-equity position gives it every incentive to get the plant online on budget and in time to receive the cash grant. The liquidated damages provisions are also strong enough to compensate the more senior lender in the event of a delay. A successful completion of construction and entry into operations would allow the sponsor to refinance the Carlyle debt, as well as some of the SAIC obligation, either in the bond market or through an outright sale of the project.

The Carlyle product falls somewhere between a construction B loan, along the lines of the deal that Astoria Energy closed for its first plant in the middle of the last decade, and the high- priced mezzanines from niche energy lenders. The private equity manager is not alone in sensing new opportunities to replace bank lenders – Blackstone and Energy Capital Partners are both working on debt funds, and energy funds may look to build on the small scale convertibles that they have traditionally offered developers. There is likely to be room for competition on pricing and potential dilution if developers are able to hold their nerve.

Plainfield Renewable Energy
STATUS: Closed December 2011
SIZE: $240 million
DESCRIPTION: 37.5MW construction and demolition waste wood-fired biomass gasification plant located in Plainfield, Connecticut
SPONSOR: Enova Energy
CONSTRUCTION CONTRACTOR AND SUBORDINATED LENDER: SAIC
MEZZANINE DEBT: $125 million
CONTRACTOR DEBT: $115 million
LEAD ARRANGER: Carlyle Energy Mezzanine Opportunities Fund
LENDER LEGAL COUNSEL: Chadbourne & Parke
CONTRACTOR LEGAL COUNSEL: Milbank
DEVELOPER LEGAL COUNSEL: Fulbright & Jaworski
OWNER’S ENGINEER: RW Beck (now SAIC)
INDEPENDENT ENGINEER: Black & Veatch
FUEL CONSULTANT: Resource Recycling Systems
INSURANCE ADVISER: Moore-McNeil