Happy New Year! Welcome to the latest edition of FairGreen where we talk about LDES commercialization in the context of the energy trilemma.
This newsletter is packed with insights on LDES manufacturing, financing and deployment.
Model constituents
Our anchoring question today is: what would a repeatable financing model for LDES look like?
The regulated availability and technology backstop (RATB) model detailed herein is designed to lower the financing costs for LDES projects while protecting ratepayers.
To answer the trillion-dollar question of repeatable financing, let us begin a few minor ones:
What does the capital stack of a repeatable financing structure for utility-scale energy storage projects look like today?
The proportion of debt financing in the capital stacks of utility-scale lithium-ion battery projects is 70 - 80%. Various forms of equity financing (sponsor, tax etc.) provide the remaining 20 - 30%.
What is the current structure of the capital stack of LDES projects?
Dominated by equity and government grants/subsidies. Senior debt only features when guaranteed by the government.
Why debt financing?
Debt is usually cheaper than equity in a capital stack thus an optimal debt proportion that offers the lowest weighted average cost of capital (WACC), defined as minimum return required by a project to meet its financing obligations.
What are the major risks considered in an LDES project financing transaction?
a. Technology risk: performance and reliability shortfalls of major equipment
b. Revenue risk: probability of the failure of available revenue streams to cover financing obligations
c. Construction risk: probability of project’s failure to meet its contractual timelines such as commercial operation date (COD)
What are the major risk treatment approaches?
a. Risk allocation: assigning risk to the party best-suited to handle them
b. Risk socialization: sharing risks across project stakeholders to prevent overexposure for any particular party
What is the connection between risk allocation and project financing?
Traditional project financing structure works because of the discipline enforced by risk allocation.
As laid out here, pure risk allocation is not favorable to projects leveraging emerging technologies such as LDES. A dose of risk socialization can support project financing of LDES projects in 2 ways:
Lowering the barrier to debt financing
Reducing project WACC
Here are some prominent examples of risk socialization for new technologies in the energy industry:
Historical examples of risk socialization in energy infrastructure
Importantly, risk socialization requires that LDES be an infrastructure asset to justify the exposure of rate payers. How does LDES qualify as infrastructure?
System-critical function: provides grid reliability services
Long asset life (20-30 years): suitable for long-term capacity and availability contracts
High capex and low opex: due to scale, maturity and technological innovations
The next subsection divides into the mechanics of the 2 components of the RATB model.
Regulated availability
The regulated availability (RA) portion of the model mitigates revenue risk by providing fixed availability payments determined by the regulator. Availability payment will be based on the annual revenue requirement (ARR) formula:
ARR = RAB_WACC + Depreciation + Fixed O&M + Insurance + Taxes
Where RAB = regulated asset base and WACC = weighted average cost of capital
As such,
Monthly availability payment = ARR*AF/12
Where AF = availability factor
The availability factor is determined by performance metrics such as capacity availability, duration availability, roundtrip efficiency (RTE) and response time. Each metric is tested regularly (e.g. bi-annually) and penalties applied for shortfalls beyond contractual thresholds. For example, a project with a > 95% capacity availability threshold might attract a 1% payment reduction for each 1% shortfall. Payment deductions can turn into liquidated damages if the project underperforms beyond a certain floor.
Technology backstop (TB)
Payment deductions and liquidated damages link the RA portion of the model to the TB one by curtailing downside risk.
In classic project finance, technology risk is allocated to the project special purpose vehicle (SPV) which relies on performance guarantees provided by the technology vendor/original equipment manufacturer (OEM). The performance guarantees are typically backed by either the OEM’s balance sheet for a mature vendor or insurance for an early-stage OEM. Insurance cost thus WACC is inversely proportional to perceived project risk. Project SPVs default to more familiar technologies to minimize WACC.
The technology backstop (TB) portion of the model entails spreading technology risk among the OEM, project SPV and a government agency through a risk waterfall structure. The structure has 3 layers of responsibility as follows:
Layer 1: OEM’s warranty covers 10% of performance shortfall
Layer 2: SPV equity covers the next 10% of performance shortfall
Layer 3: Government backstop covers performance shortfalls exceeding 20% (tail risk)
The gamechanger here is that government backstop means tail risk is not priced into WACC thus lowering project financing cost.
Division of responsibility
Risk socialization is an incentive-based approach to guaranteeing stakeholder collaboration thus project success. Understandably, an incentive-based system is rarely the most effective mechanism to assure ratepayer dollars. The table below provides an overview of some anticipated risks of the RATB model to rate payers and corresponding mitigation measures.
Ratepayer protection measures for RATB model
The key observation on the protection measures is risk socialization does not negate the risk exposure of stakeholders. It establishes a loss floor for each risk while enforcing stakeholder discipline by assigning mitigation responsibility to the stakeholders with the highest risk exposure and/or relevant regulatory or contractual mandate. In some cases, the mitigation measure is assigned to more than 1 stakeholder to minimize chances of self-preservation behavior.
RATB model in application
Project details
Location: vertically-integrated utility territory
Capacity: 500 MW / 5000 MWh (10 hours)
Technology: Flow battery
Commercial operation date (COD): 2032
Asset life: 30 years
Regulatory model: cost-of-service and availability payments
Financial parameters
Total capex: $3B
Debt/equity: 70% / 30%
Allowed WACC: 7.5% (nominal)
Annual fixed O&M: $45M
Depreciation: straight line ($100M/year)
Taxes and insurance: $30M per year
Regulated asset base (RAB) at COD: $3B
Availability factor: 80%
Total ARR: $400M per year
Monthly payment: $26.7M
Conclusion
The RATB model is a blueprint for scaling commercial LDES deployments leveraging historical risk socializing mechanisms that have been utilized to derisk new energy infrastructure. We posit the following 3 major arguments:
Treatment of LDES as an infrastructure asset rather than a merchant one
Proper structure for the regulated availability and technology backstop portions of RATB for maximum impact
Proper risk mitigation measures to protect rate payers from poor investments
Would you use the RATB model to deploy LDES? Why? Your feedback will be highly valued.
In Case You Missed It
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Until next time :)
