The downside of the develop-and-flip model in an overly saturated energy market
The solar industry is expected to install a cumulative 324 gigawatts DC of new capacity over the next decade according to Wood Mackenzie’s 10-year forecast. At the end of 2020 there were nearly 500 gigawatts of solar and 200 gigawatts of storage in the interconnection queue across the United States1. This number is only growing. The question is, who will own and operate all of these projects if and when they are contracted?
Many project pipelines fail in the development process due to fatal flaws or inability to find an offtaker. However, even if the development plan is sound and an offtaker is found, there is still another critical component to project completion – financing and ownership.
The ultra-competitive solar and storage market has forced some developers to offer low contract prices and stomach more PPA risk in order to win contracts
Forwards and futures contracts are most liquid in the near term—about one to three years out. It is difficult for many energy buyers to commit to signing long term contracts without visibility into pricing 10+ years down the road. When a buyer expresses interest in a long-term product between 10-25 years, a flood of developers race to win their business.
Over the past few years, the energy market has become a buyer’s one. Simply put; supply has outgrown the demand. Renewable project developers have saturated the space, fighting for the small pool of investment-grade offtakers interested in signing long-term power purchase agreements. Recently, project developers have started looking beyond traditional energy buyers like utilities, to new buyers like CCAs, corporate customers, and universities for project offtake. Even with the expansion of customer diversity, renewable project development seems to be growing faster than demand for long-term renewable products.
Requests for Proposals (RFPs) have become swarmed with developers who feel pressured to offer rock bottom pricing and take on PPA risk just to have a chance at contracting their project. The influx of offers into RFPs has led to an overall price depression and a race to the bottom mentality. Many solar projects are getting contracted at below $25/MWh because that sticker value piques offtakers’ interest.
To achieve such low pricing, many companies are making aggressive assumptions around CAPEX and OPEX as well as omitting various model costs and inputs. Under these low-priced scenarios, many developers are not seeing a positive return within the contracted period. Instead, companies rely on merchant revenues to boost project returns.
In order to differentiate themselves as a result of this ultra-competitive landscape, developers have been pushed to stomach more contracting risk to get a PPA executed by taking on things such as basis, volume, shape, tenor, and credit risk. These contracting trends have led to massive mispricing and underappreciation of inherent contract risk in the PPAs, resulting in potential problems when it comes time to sell the project to the ultimate owner because the contract is “unfinanceable.”
This shift in contracting terms has left many industry asset buyers (long-term owners) with a market that yields slim margins, unfavorable operating contract terms, and potentially risky exposure to the merchant curve.
The PPA is executed… now what?
Once a contract is executed, there are still many steps to ensure a project gets built – completion of development items like permitting or siting, construction of site, timely delivery of equipment, and financing for the project.
Financing can be viewed as the main risk of all aspects of project development. In order to close financing, the project will undergo close scrutiny by lenders and investors. To receive approved financing, all development aspects must be squared away, and the project and contracting status must result in a strong revenue-generating project returning sufficient value to the investors.
Project financing is largely centered around risk mitigation. The deal structure must mitigate risks that could negatively affect the project’s cash flow. When contracting a project, each participant will attempt to shift various risks to the other party while retaining the benefits that the participant seeks from the transaction. These can range from tenor length to basis risk to price floors to curtailment provisions. As of late, the scale is tipping in favor of the customer winning these negotiations.
Consequentially, developers have been left with a double whammy, a low PPA priced contract with slim project margins and risky operating terms that could wildly swing PPA revenues over the course of the PPA.
Many renewable developers operate under a develop-and-flip model. Once a developer has executed a contract, they will turn around and sell the project to a long-term owner at Notice to Proceed (NTP) or Commercial Operation Date (COD).
If a developer cannot find an end buyer or financier, the project will not get built. The developer will most likely need to return to the customer to renegotiate various aspects of the contract such as price or term, to increase the value of their PPA for potential buyers. Renegotiation will often result in a delay of the project. The inherent risk in the develop-and-flip model has become more prevalent over the years as project margins have become slimmer due to the race to the bottom nature and shift for developers to take on more PPA risk.
Without strong cash flow revenues and favorable terms for the developers, it is difficult for a project/developer to differentiate themselves from other projects in the market, and ultimately sell the project to the end owner.
How to increase execution and financing certainty?
Developers that own and operate projects after COD, or have partnerships with firms who do, remove the pain point of a project sale. Because the company is also the end operator, the project risk profile and project returns are well understood before signing a contract, eliminating the potential of misalignment between a developer and the investor community.
Long term owners better recognize what it takes to make a contract and project financeable, because they are the ones financing and taking the operating risk during and after the PPA contract. Because
contracting terms are priced appropriately from the get-go, companies with vested interest to own projects can more confidently stand behind an offer they put forth.
Crossover Energy Partners works exclusively with KKR for financing and ownership of our renewable and storage projects. KKR is instrumental throughout the contracting process to ensure the project and contract is acceptable. The established partnership is anchored on expertise and execution certainty to deliver firm, competitive renewable offers to our clients.
The competitive nature of the energy market has compelled some developers to offer bottom of the barrel pricing and take on unfavorable terms in their contracts. While an offtaker may believe they have scored the best contract, the develop-and-flip model bears the risk of a contract being unfinanceable or not being modeled correctly to hit acceptable returns for investors. Instances where the developer is a long-term owner will reduce ambiguity and risk around financeability of the project and provide more execution certainty at the time of contract.
If you would like to speak to one of our originators, please send us a message by clicking on the "Contact Us" button at the footer of this page.
Subscribe and stay up to date
receive essential emails.