Last month, I wrote about the challenges facing project finance in the clean energy sector—the label for the kind of financial structure that most developers use to deploy clean energy and infrastructure. Project finance involves a developer setting up an independent financial entity that raises finance for and earns revenue from an individual project, where those revenues are the only asset backing the solvency of the entity rather than the range of assets on the developer’s balance sheet, which remain shielded from the risk that this individual project goes bust.
This is the gist; you can read more about it in the issue brief. I argue that project finance is hard to scale up for new infrastructure, particularly clean energy, because (1) credit rating agencies will harshly judge any projects that have volatile cash flows and low debt service coverage ratios and (2) institutional investors themselves find it hard to fit clean energy infrastructure into their portfolios, insofar as these assets have a risk-return profile that’s out of whack relative to the rest of their portfolios.
Immediately after publishing the issue brief, I came across two podcast episodes that lend a lot of credence to this argument. The first was an interview with Quinn Pasloske, a principal at a renewable energy fund called Greenbacker, hosted by Norton Rose Fulbright’s Currents podcast. The second was an interview with Dawn Lippert, the CEO of climate tech investment firm Elemental, about her participation in the Greenhouse Gas Reduction Fund financing ecosystem, hosted by Heatmap’s Shift Key podcast. Both are full of great quotes attesting to the challenges investors face moving from a successful technology investment into a risky longer-term deployment investment. I recommend listening to both. But here’s a preview.
Pasloske discusses how Greenbacker’s growth equity fund is looking for infrastructure assets with “asymmetric return profiles” that have both “captive demand” and can “capture outsize returns.” These assets include battery storage systems with contracted capacity and the ability to buy and sell electricity in merchant markets. This fund has a higher cost of capital, given the risk it’s taking to structure assets. It targets unlevered rates of return between maybe 8 and 15 percent (“high single digits to low to mid double digits of unlevered returns”). However, unlike most infrastructure funds seeking to earn returns from the asset’s cash flow, Greenbacker plays an intermediary role, using its structuring capacity to package and sell off good assets to longer-term investors with lower costs of capital. Unlike normal infrastructure investors, they are, in the words of the interviewer from Norton Rose Fulbright, “not looking for just the run-of-the-mill kind of coupon-clipping-type fully contracted asset.”
Greenbacker is the kind of investor that my project finance report is not talking about: a growth strategy infrastructure fund. It’s worth quoting how they frame it in full:
There is a dearth between the folks who have kind of high-octane growth capital but in small dollar amounts and people who really understand the infrastructure space where you need big dollars in low risk amounts, and so we can kind of fill that valley of death where it’s like, you’re a company with a good idea, you have a good widget, your unit economic makes sense—but no project financier is gonna invest in that today because it’s just too confusing, and no equity sponsor is gonna be buying these widgets for the same reason. So what we can do is we can give you 40 million bucks. … all of a sudden you have $33 million of stable cash flowing assets. Now that’s something that the market can say, oh gosh these guys have a great idea that got cash flowing assets, they’ve got a de-risked profile.
To be clear, this fund is an equity fund, not a project finance investment vehicle, which is why it’s only targeting investments “between 15 and $50 million” and mostly from the equity side. But it has explicitly stated that project financiers and other conventional equity investors are shying away from confusing investments until Greenbacker can help prove that those investments can generate stable cash flows. In the meantime, if those investments have a “big pop” in valuation from market trends, it’s good for Greenbacker.
Lippert at Elemental is in a similar space: “we’re a nonprofit investor, we always want to be at the edge of where we think capital needs to come into this space.” She observes that “innovation and technology is outpacing innovation and financing,” and “as these companies are growing the support in the capital is just dropping off dramatically as companies need to move from being technology companies to actually deploying projects. … A lot of climate companies right now are capitalized with venture capital, which is like a very specific financing mode that’s very well, you know, built for software businesses, but maybe not well-built for the kind of challenges we’re trying to deal with”—the challenge of deployment.
She wants to use Greenhouse Gas Reduction Funds to support Elemental in taking a project through this valley of death in deployment. Lippert sees Elemental’s value-add as providing “operational expertise: how you develop, how you permit and get entitled to how you structure the financing, but also just do the actual construction of projects … [their team] found that only about less than 30 percent of companies in climate right now have some deep project expertise on their team to build stuff.” Project finance is full of different institutions with different mandates than the VCs that climate tech entrepreneurs are likely used to.
Elemental wants to bridge this gap because existing investors and developers cannot do so very easily. And the Greenhouse Gas Reduction Fund helps a lot, insofar as it provides a level of capital to awardee financial institutions that allows them to “play ball with the big private investors and pull them into this conversation in a way that the smaller local banks have not been able to do.”
Pasloske and Lippert confirm the general thrust of our project finance issue brief—that there’s a point in the development and deployment of infrastructure where developers need to replace investors seeking asset value appreciation with investors willing to provide the kind of longer-term debt financing that can underwrite project deployment. Yet those investors are few and far between in the world of bespoke clean energy infrastructure because the risk-return profiles of these projects very much do not fit into the typical institutional investor’s portfolio. Funds like Greenbacker and Elemental can do some work to bridge this gap by structuring assets in a way that derisks them to broader institutional investors—and they highlight exactly where policymakers could most catalytically deploy public capital, particularly through the Greenhouse Gas Reduction Fund. Perhaps this is where public underwriting capacity is most necessary.
(Postscript: This past week, Heatmap’s Katie Brigham wrote about this problem from a similar angle, with one fun quote from Frank O’Sullivan, the managing director of S2G Venture Investments: the lack of project finance for first-of-a-kind infrastructure is “a flaw of the structure of capital allocation at the very highest level.” True that.)