Guarantees have been a topic of conversation as the industry moves away from large-scale utility projects and toward distributed generation and smaller commercial and industrial (C&I) projects. When the solar industry was comprised mostly of large-scale utility projects, guarantees were a given component of a project’s structure. As the industry experiences the growth of C&I projects and distributed generation, stakeholders and project participants are re-evaluating the value of guarantees. Are guarantees appropriate for smaller solar projects? This blog discusses five basic commercial considerations when structuring a project and whether to include guarantees in a project’s structure.
1) Types of Guarantees:
There are several types of guarantees, sometimes used inter-changeably, for solar projects. The primary purpose of guarantees is to protect the asset owner from the risk of breaching any off-take agreements and to protect the asset owner from operational risk to ensure the project operates as designed. A review of the different types of guarantees and their value is helpful.
- Performance Guarantees – a performance guarantee is based on equipment performance and offered by equipment manufacturers to mitigate technology risk. The equipment for a given solar project is guaranteed to perform in a certain way, such as performing to a certain standard or producing a certain level of energy. If the equipment does not perform to a certain standard, or degradation occurs more quickly than expected, then the manufacturer is liable for either repairing the equipment to the acceptable standard or replacing the equipment. The performance guarantee can be viewed as being based on external factors outside the control of project stakeholders. Often the performance guarantees do not sufficiently mitigate against the risk of a project underperforming, given that there are several factors involved in a project meeting expected performance. While underperformance due to defective equipment can be a cause of underperformance, it is often due to more than one factor.
- Production Guarantees - a production guarantee is based on the entire set of properly-designed project equipment working together to produce a certain level of energy output. The benefit of a production guarantee is that there is financial compensation paid to the asset owner if the annual production is less than an agreed upon target level of production. The production guarantees are offered by EPC providers or O&M providers to protect the asset owner or investor from defects/negligence in how the project was built and operated. Often when discussing guarantees from a commercial perspective, the production guarantee is the type of guarantee being discussed.
- Availability guarantees – an availability guarantee is based on the entire set of project equipment working together to ensure a certain level of output is available - or uptime. Using this definition, availability guarantees are focused on both equipment and energy available to produce output. This guarantee is based on what is available and not the level of energy actually produced.
2) True Cost and Value of a Guarantee
The true value of a guarantee can be measured by first identifying the risks that the guarantee is supposed to protect against. Guarantees are beneficial to asset owners or investors because the guarantees protect parties from the risk that the project will not perform as forecast – or in other words, that the project will not produce the energy output, and ultimately revenue and cash flow, as the project was designed to do.
The cost of a guarantee can be determined by comparing the risk of expected lost revenue against the cost of maintaining, measuring and tracking a guarantee. This is a difficult exercise due to the difficulty involved in estimating lost revenue on an annual basis beyond using a discount factor. For maintaining a guarantee, the responsible party, be it the EPC, O&M or equipment manufacturer, must calculate the measurements that determine a guarantee threshold and deploy remediation action at certain decision points. Does the cost of rolling a truck outweigh the financial penalties of the guarantee? This is where the interests and incentives of the participants diverge in relation to guarantees. The alignment of participant interests could be a separate blog topic but in summary, the provider of the guarantee is attempting to minimize cost while maintaining the guaranteed production output but is not attempting to realize the asset owner objective of maximizing output. This begs the question of whether the guarantee provides significant value to the investor or asset owner if the guarantee ensures the project is operating as designed but not maximizing output, and ultimately revenue and cash flow, for the investor or asset owner?
3) Appropriate Parties to Provide Guarantees
Consider the appropriate party to provide the guarantee - the EPC Provider or the O&M Provider, or an integrated company serving as both the EPC provider and the O&M provider. In this situation, the guarantee tends to work best because the skill-set and incentive are aligned. Integrated companies offering both O&M and EPC services have both the skill-set to track a performance guarantee and the incentive to implement the guarantee.
EPC providers may not have the incentive or skill-set to track and maintain a guarantee. Once the project is built and has achieved Final Completion, there is minimal incentive for the EPC provider to ensure the project reaches a certain level of output. Thought reputation risk may be incentive enough. Additionally, the EPC provider may not have the skill-set or required staff to track performance or production output.
The O&M provider typically has the skillset required to track and maintain a guarantee. Yet the cost of tracking and maintaining a guarantee is usually high because the O&M provider is offering a guarantee on a project they did not built or design. This may not be the most cost effective way for an asset owner to protect themselves against the risk of a project underperforming or complying with off-take agreements. If the O&M provider is providing a guarantee, it may be best to use an availability guarantee, as the availability guarantee aligns the incentive with what the O&M provider is able to control – the availability of power.
For performance guarantees, the equipment manufacturer provides the performance guarantee. This guarantee protects the asset owner from equipment degradation, defects or malfunction. However, this may be more aptly named an equipment warranty. Warranties are a separate category and we won't go into detail on warranties in this blog.
The measurements and metrics used to determine the guarantee thresholds are critical because the measurements and metrics will be calculated continuously throughout the life of a project. Keeping it simple is the most beneficial to all parties. Complicated calculations and formulas typically lead to disagreement about whether the guarantee was breached. Additionally, it is important for project documents to accurately reflect the language of a guarantee and it is more difficult to do this if the formulas are complex. One last note on measurements is to ensure the accuracy of baseline figures that the guarantee calculations will be compared against. At closing, and periodically throughout the life of project, it is important to do a quality control check on the energy model. The energy model needs to be accurate if it is to serve as the baseline for determining whether guarantees have been breached and damages are due.
5) Alternative Options for Guarantees:
- Combination of Guarantees
There is not a set rule or standard that an asset owner should receive only one guarantee. Often, a combination of guarantees, or using all three, will adequately protect an owner from system design risk, production risk and equipment defects. This option will be expensive and may not fit into the economics of the project.
- Reserve Accounts
If the purpose of guarantees is to protect against underperformance and lost revenue, it may be more cost effective to fund a reserve account. A reserve account or major equipment replacement account, funded over the course of several years, could serve as a fund for replacing lost revenue due to underperformance or as a major equipment replacement reserve.
- Insurance Backed Product
Another option gaining traction in the solar industry is an insurance backed product. This mitigates bankruptcy and operational risk of the party providing the guarantee.
A guarantee that financially penalizes providers for underperformance may not achieve the asset owner objective of maximizing output. Providing incentives to EPC providers or O&M providers, may be a more cost-effective method of aligning project participants’ interests to maximize performance and not only mitigate the risk of underperformance and off-take requirements, but eliminate these risks.
In conclusion, it is inevitable that the solar industry’s view of guarantees change, as project characteristically move away from utility scale and towards non-utility scale commercial and industrial projects. Now is a good time to evaluate the value and cost of guarantees, as well as the utilization of guarantees, to determine whether there are other solutions to protect asset owners from off-take and operational risks.