BY Edwin F. FEO

Over the past few years, the distributed solar generation industry has adopted the third party provider model for delivery of service to customers. The principal vehicles for third party service have been power purchase agreements or leases. These permit a third party to own and to utilize the tax benefits associated with the solar energy system and the customer to gain the benefit of the solar energy without a large capital commitment. While the third party model has expanded the options available to customers by solar energy developers, the model has also created a new set of issues related to contractual complexity and the need for third party capital. These issues have increased uncertainty of execution and increased cost very formidable enemies to a broader acceptance of the third party service model. This article discusses specific areas for improvement in commercial contracting and financing.

Contracting

The third party provider model introduces greater contractual complexity whether a lease or power purchase agreement is used. In the transaction for a sale of a system, the contract structure is fairly direct, with a purchase contract, warranties, and the additional documentation related to net metering or other arrangement with the customer’s utility. The contractual relationship in the sale model deals with a limited term relationship the period of installation and warranties for a defined period. The actual interaction of the customer and the provider is during the installation period, potentially just a few weeks.

In the third party provider model, the relationship with the customer expands to cover years, if not decades. The contract needs to deal with all of the major issues that can arise when one party owns equipment on the property of another. No longer is the discussion solely around size of system, cost, and dates of installation. In the third party provider model, the points to address include real estate easements, access, maintenance and repair, interference with insolation, long-term performance warranties, security for performance, remedies for failure to perform, site restoration and more. Indeed, this is a more complicated and longer relationship.

An issue arising from contractual complexity is the amount of time spent in negotiation. The customers often are not familiar with the nature of the transaction. Their reaction can be to reject the third party model entirely (and unfortunately not at the same time agree to buy a system). Or on larger transactions, the reaction can be to carefully negotiate every term of the agreement. This latter approach results in both delay and greater transaction expenses for both the provider and the customer. We have seen transactions fail because of the time and expense of the contracting process. We have seen other transactions proceed but the return to the provider suffers as a result of the higher transaction costs.

Another challenge we have found in the third party contracting model is uncertainty among customers regarding the terms of the agreements, and specifically whether the offering by the proposed provider is “market” The contract forms offered by various providers have a fair degree of variation, with providers making the claim that their version is better than others. This sought for differentiation has led to more confusion than benefit in the eyes of consumers. So much so that we have had inquires from developers to act as a reference for their customers as to the reasonableness and market acceptance of the proposed contracts.

Gaining Control of Contracting Process

There are several actions that service providers can take to gain control over the cost, time and uncertainty of the contracting process:

● One major action is to develop standardized forms for all aspects of the transaction. Using a format where the basic commercial terms--location, size, price, etc.--are in a schedule (or on the front cover) helps keep the negotiation focused on those issues instead of boilerplate terms. Having the contract written in plain English also helps. Heavy documentation for small systems is excessive and counter productive.

● Another step is to develop good explanatory materials over how the power purchase agreement or lease works, written in clear English and with good examples of the benefits and costs of this approach. It is also important to have a sales staff well educated in the third party provider contractual terms and the explanatory materials, with a good understanding of the benefits and the ability to properly prequalify the customer for the product before incurring the time and expense of contracting.

● Another step is to have a well trained staff for handling contract documentation. Developers using the third party model should recognize that contracting is a core competency. Outsourcing ultimately means the knowledge of the contracts is not retained internally and is expensive in the near term. The viable business model mandates ownership by the developer of the contracting expertise.

Of course, the development of a good contract form, and in house expertise, by the developer does not address the concerns of the customer regarding its cost and the uncertainty of how reasonable the developer’s form really is. To address these issues, we believe the distributed generation solar industry must develop industry wide standard contracts. Other industries--natural gas, oil, wholesale power, among others--have developed forms of contracts that have been accepted by the industry as a whole and, more importantly, recognized by the customers as being reasonable. We recently worked with SolarTech (www. solartech.org) in developing a model power purchase agreement, which was presented at Solar Power International 2009. The initial feedback from industry participants has been positive. More feedback from industry participants is expected in order to gain wider acceptance of the form. Outreach to customer trade groups, such as those for shopping centers, industrial centers and manufacturers, will also be critical. Ideally, those groups will understand the benefit of a market standard contract, provide their input, and adopt the market standard. From that point the negotiations will only be around the specifics of the individual project--how big, when, how long and how much--with the remainder of the contract being largely accepted as presented. Execution costs and time will drop significantly.

Financing

The principal reason to use to the third party provider model is to optimize the use of capital and tax benefits. For the model to work well, the solar energy system needs to be owned by an entity that can use the tax benefits at a cost that makes sense for the customer. If is not available, or is too expensive, then the third party model fails. The current financing market for small solar energy facilities is challenging. The number of investors are able and willing to monetize the tax benefits has shrunk to slightly more than a handful. The number of lenders providing installation and term financing is equally small. Those financing parties in the business are besieged with requests for capital. Understandably, they are inclined to be choosy and are targeting the larger developers with more potential projects, and the more robust projects.

We advise many developers on the financings of these projects. Time and again the same issues arise: the difficulty of reaching the right investors; the difficulty of getting a commitment; and the high cost of transactions if one is fortunate enough to find an investor. Here are a number of tips to finding the right financing and to controlling costs:

First, don’t approach the financing market without a deal. General discussions at conferences are great, but understand that bankers and investors are subject to the same 24-hour day as the rest of us. They get paid to close deals, not to talk about them. They will be interested in a deal where the power purchase agreement is signed, the customer is credit worthy, the panels are available and the deal can be closed in the near term. Financial parties will listen about a deal once. The story needs to be solid.

Second, think volume. From an investor’s perspective the amount of time to analyze a small project is the same as a large project, but the dollars put to use and the dollars returned on the latter are that much greater. More return equals more profit and a bigger bonus for the banker. In that vein, a portfolio of small projects is more complicated than a single large project, but still has the benefit of more dollars put to work. Lenders and investors will establish a minimum size for financings, which can range as low as US$5 millions (rare) to US$20 million (more common). So our advice generally is to develop some scale before seeking third party financing.

Third, understand that all lenders and investors are not the same. Some lenders will focus on smaller projects. Some investors will focus on investments with customers in particular industries. Some investors prefer to invest through partnerships, others through leases. Approaching the financial sector as an undifferentiated group wastes the developer’s and the financial party’s time. And it has the potential to create a reputation of being unprepared and ill informed.

Fourth, learn the key financing structures and terms. The terms of transactions vary between different types of debt and equity products:

● In the debt market, there are three products currently offered: revolving lines of credit from a few banks; single project installation loans offered by banks and certain pension funds; and term debt funded by very few banks and life insurance companies. The pricing on each product is different. Bank revolving lines price based on the London interbank offered rate, with a spread of 350 to 500 basis points. The pension funds price at a fixed rate, currently about 10%. The life companies price off of the Treasury rate for a comparable maturity as the loan, with a margin in the vicinity of 250 to 350 basis points. All of the loans are secured by the project and the interests in the project company. All will have significant covenants that restrict the ability of the developer and the project company to do any significant action without consent. All will require some level of commitment by the developer with respect to the installation and operation of the project.

● In the tax equity market, a disproportionate allocation partnership has both the developer and investor as partners in the entity owning the solar energy facility, and requires complicated provisions on capital accounts and gain and loss allocations. The economics of the investor will be relatively transparent to the developer because the target rate of return of the investor will be built in to measure when the flip in equity interests occurs. In the current market, that hurdle rate of return is ranging between ten and twelve percent on an unleveraged, after tax basis. In a lease transaction, the investor will be the lessor of the solar energy facility, leasing it to the lessee (which may be owned by the developer or may be the customer). The return to the lessor will not be transparent to the developer what will be clear is the term of the lease, the rent, and the option to purchase the asset back from the lessor at the specific dates during the lease.

There are provisions in each of these transactions which are driven by the Internal Revenue Code, such as tenor, price or rent, price on purchase options and the like.

Fifth, the developer that has not closed a third party financing needs outside advice. The point of the discussion in the prior paragraph is that these are complicated deals--tax equity transactions especially are complex legal, tax and accounting beasts. A developer will gain credibility by hiring the right advisors, who can identify the appropriate financing sources, prepare a detailed and accurate model of the economics, and credibly represent the developer’s story to the financial community.

Sixth, speed of execution on a transaction is critical to controlling costs. Speed to close starts with preparation. That means all contracts are ready, all permits are in hand, panels are purchased, and the installer is hired, or in each case nearly so. It also means having the ability to respond on termsheets and financing contracts quickly, addressing the real issues, and having knowledgeable human resources dedicated to the transaction.

Finally, as with the commercial contracts, the developer must evolve standardized documentation. While there is benefit to customization of each financing transaction, the transaction costs can be huge. In our experience, the ability to develop a particular structure and set of terms, and then to replicate them in subsequent transactions can result in a huge cost gain to the developer. In some cases, the transaction costs have been reduced by eighty percent from the initial transaction simply by sticking with the same format.

Distributed solar generation has a great future, if the industry can deliver an understandable, cost-effective service to customers. That goal can be achieved, at least in part, by implementing practices to standardize documentation, controlling costs, and having a well planned and executable financing plan.

Edwin F. Feo is a partner and co-chair of the Global Power, Energy & Utilities Group at the international law firm Milbank, Tweed, Hadley & McCloy LLP.

For more information, please send your e-mails to pved@infothe.com.

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