So called ‘sunshine backed bonds’ are one of the newest and most exciting asset classes to enter the asset-backed securities market since the financial crisis. The resurgence of the market has led to a number of esoteric ABS issuances in recent months but it was solar energy that seemed most ripe for applying securitisation techniques (which provide an especially powerful financing tool). Indeed, given how this financing technique revolutionised the mortgage finance market 30 years ago, it now seems poised to play a role in transforming the renewable energy markets across Europe.
The case for securitising solar
In essence, securitisation allows companies to access the capital markets and in so doing to bring down their cost of capital and improve liquidity. Pools of illiquid assets are sold to bankruptcy-remote vehicles which then issue bonds to investors which are backed by the pool of assets. The originator of the assets is able to turn illiquid assets into saleable securities and in so doing shift those assets, and the risk of ownership, off its balance sheet in return for new finance.
Solar energy in many ways is a good fit for this model. Solar photovoltaic technology has improved dramatically and the income stream that can be produced from selling solar generated energy is now reasonably stable. Many European countries are giving a boost to the renewable energy market and choosing to provide financial support for the generation of solar and other forms of renewable energy and this has further brought down costs and made investment in solar assets more attractive. In the UK, the Energy Act 2008 introduced a tariff regime (the Feed-in Tariff scheme, or FIT Scheme) which was intended to reward small generators of renewable energy and which supplemented the existing Renewables Obligation scheme for larger projects. Under the FIT scheme, a qualifying generator of renewable energy is entitled to a set inflation-linked payment for every unit of electricity generated for a guaranteed period of up to 25 years. A smaller payment is available for each unit of electricity that is exported back to the grid but the larger subsidies are available for generation itself.
A look at the market
The FIT Scheme paved the way for the first publicly listed solar securitisations and over the past 12 months the Reed Smith structured finance team has advised issuers and trustees on a number of such ground-breaking deals in Europe and the UK. These first deals have demonstrated the huge potential for the solar energy market. As the FIT has progressively reduced for new solar photovoltaic energy projects, more and more developers have moved to larger schemes in order to take advantage of the Renewables Obligation Scheme and economics of scale; there is no reason why these larger schemes are any less suitable for securitisation.
That said, the deals to date have also shone a light on some of the unique challenges that will need to be overcome if the market is to continue to develop. These challenges include:
- Structuring the cashflows - cash flows from solar energy are fundamentally different to those from mortgage payments and modelling them can be tricky. There are, for example, more aspects that lie outside the borrower’s control such as the technology of the solar equipment and the intensity and levels of sunlight.
- Rating of projects - the credit assessment of a project also presents new challenges compared to modelling a traditional mortgage portfolio. A baseline case needs to take into account the technology risks as well as suitable default rates and recoveries if solar bonds are to be rated appropriately.
- Records - there is nowhere near as much data available for assessing the credit risk of solar projects as there was when the mortgage market was developing; there, participants had years of data to draw upon.
- Standardisation - developing a standardised approach, which was key to commoditising the mortgage-backed security market in the eighties, will be a big challenge for the solar industry. The regulatory environment for the solar industry is also complex and constantly changing and the industry will need to ensure investors understand the risks of entering the market.
- The transaction parties - an important challenge will be harnessing the servicing expertise of energy utilities to administer solar projects, manage the risks of an obligor default and ultimately, to convince financiers and the ratings agencies that the assets are less risky. We are already seeing backup service agreements being put in place in some US deals (for example in the recent SolarCity deal). The role of trustees will also be important for decision making between investors and borrowers and the challenge will be to strike the right balance so that trustee duties don’t go beyond the normal fiduciary obligations of a trustee under typical securitisations.
- Long-term contract risk - particularly in solar lease receivable securitisations, there are contractual arrangements which need to be struck with the land owners to ensure that the underlying leases are not terminated during the life of the transaction. Similar risks apply to the underlying solar equipment which may have been leased.
The road ahead
The signs are very promising for development of the solar energy bond market. The trickle of deals coming to the market show that securitisation techniques can be applied successfully to solar energy. However, most deals are still privately placed and unrated and there are real challenges that will need to be overcome if the market is to develop liquidity. As we have seen, these challenges include a need for standardisation and scaleability if larger public securitisations are to be brought to market.
At a time when bank lending is being squeezed by Basel III and other capital adequacy regulations, the need for the solar energy industry to access capital from alternative sources is only likely to grow. The capital markets could provide a deep source of finance to fill this need which, if some of the challenges outlined above can be successfully met, could ultimately reduce both the cost of capital to the industry and the costs of energy to end consumers. Thirty years from the transformation of the mortgage industry by securitisation techniques, we may be seeing the beginnings of a similar financing revolution in the renewable energy market. Let’s hope the sun keeps on shining on this new asset class!