Henry Scott, Karen B. Wong and Miguel Duran | Milbank
An extract from The Projects and Construction Review, 11th Edition
The project finance market in the United States benefits from a well-developed legal framework and sophisticated financial markets. The US legal system is generally viewed as clearly codified, stable and efficient, as well as one that is enforced in a regular and open manner.2 Contractual agreements between parties are recognised by law with few exceptions related to public policy concerns. The project finance sector has strong access to both the public and the private financial markets and is in some limited areas even supported – directly or indirectly – by government policies.
This combination of a strong legal framework and financial markets has facilitated the development of a robust project finance sector in the United States. Project finance is premised on the ability of the parties to contractually allocate risks among themselves and to enforce those contractual obligations in a reliable manner. A successful project finance regime is also dependent on commercial laws that allow developers to protect themselves through special purpose entities that benefit from non-recourse financing and that, similarly, allow lenders and investors to obtain security in the project assets and to enforce their claims against the project. Likewise, a sophisticated private financial market has the flexibility to allow the developer and the financing providers to create complex financing structures and to tailor those structures to the specific needs of a particular project.
This chapter discusses various transactional structures available to projects and the legal documentation frequently used to implement them. It reviews the various risks associated with project finance transactions and how parties allocate these risks. It also examines how the US legal framework supports the ability of lenders and investors to protect their interests, including obtaining, perfecting and enforcing security interests in a manner that permits lenders to enforce their rights in the event that a project encounters financial problems. This chapter also considers how the legal framework is influenced and affected by social and environmental considerations. The role of a complex legal framework and sophisticated private financing providers and the public sector is also addressed, followed by a summary of the impact of taxes on investment, which may be of particular interest to foreign lenders and investors. The framework for how dispute resolution is processed in the United States is discussed in the final section.
The year in review
The nature and complexion of project finance in the United States has been shifting, mostly as a result of the expiry of certain government incentives, regulatory changes relating to power plant emissions, declining prices of distributed generation technologies, including battery storage, and lower natural gas prices as a result of increased domestic production. More recently, the sector has been shaped by the enactment of a package of amendments to the tax code at the end of 2017, 3 by the imposition of tariffs on imported solar cells and modules in January 2018 and the covid-19 pandemic. The issuance on 1 May 2020 of an executive order addressing national security threats facing the US bulk-power system, in particular by restricting the acquisition, installation and use of certain imported equipment essential to the power grid,4 could potentially be significant for the sector as the result of the regulatory uncertainty created by the new ban given that clarification on the scope and impact of that executive order on the development and operations of energy projects using equipment from countries deemed to be ‘foreign adversaries’ will depend on the US Department of Energy’s rulemaking process. Furthermore, while the long-term impact of the covid-19 pandemic remains to be seen, the pandemic has already impacted a number of projects with force majeure claims and construction delays, and introduced uncertainty given the turbulence in financial markets and economic recession.
Despite fears that the approval of the US tax reform (particularly the reduction in the corporate tax rate from 35 per cent to 21 per cent and the implications of the base erosion anti-abuse tax to certain international financial institutions active in the market) would curtail the availability of tax equity financing in the market in 2018 and beyond, tax equity investors have maintained a substantial presence as financing sources and renewable energy projects continue to remain a significant component of the market. In 2019, approximately 30 per cent of the total value of project finance transactions in the country was invested in the renewable energy sector.5 For example, 9,143MW of wind energy (a 20 per cent increase from the 2018 level)6 and 13.3GW of solar energy (a 23 per cent increase from the 2018 level, and including approximately 8.4GW of utility-scale installations, which represents a 37 per cent increase from the 2018 level) were installed in 2019.7 Approximately 24,690MW of wind capacity (the highest amount on record) was still under construction at the end of March 20208 and nearly 20GW of solar capacity is expected to be completed in 2020.9 Additionally, hydroelectric capacity could increase from 101GW to approximately 150GW by 2050, not only through the construction of new power plants but also through the upgrade and optimisation of existing plants and by the increase of the pumped storage hydropower capacity.10
Throughout 2019, much of the project financing activity in the United States involved energy projects that were able to qualify for a production tax credit (PTC)11 or the 30 per cent investment tax credit (ITC)12 by meeting certain requirements. Additionally, developers of clean energy projects employing new or innovative technology that was not in general use were able in 2019 to request loan guarantees pursuant to Section 1703 of the Department of Energy’s loan guarantee programme,13 including for advanced fossil energy projects that avoid, reduce or sequester greenhouse gases14 and for renewable or efficient energy technologies.15 In December 2016, the Department of Energy announced a conditional commitment to guarantee up to US$2 billion of loans to construct a methanol production facility employing carbon capture technology in Lake Charles, Louisiana, which would represent the first loan guarantee made under those solicitation programmes.16 In February 2018, Congress enacted the Bipartisan Budget Act of 2018,17 which substantially increased the value of the Section 45Q tax credit available for carbon capture, utilisation and storage projects, and significantly expanded the universe of companies that would be eligible for this federal subsidy (which was originally made available in 2008) by increasing the eligible uses, decreasing the carbon capture threshold and eliminating the prior programme’s limitation to the first 75 million tons of carbon captures. The Section 45Q tax credit will be available for eligible projects placed in service after 9 February 2018 and for which construction begun prior to 1 January 2024 and can be claimed over a 12-year period.18 In February 2020, the Internal Revenue Service (IRS) issued guidance with respect to the determination of the beginning of construction for purposes of the Section 45Q tax credit19 and the allocation of the Section 45Q tax credit by partnerships,20 which is expected to increase the development of carbon capture and sequestration projects.
Furthermore, the Protecting Americans from Tax Hikes Act of 201521 and the Further Consolidated Appropriations Act of 202022 extended the PTC programme for certain eligible facilities for which construction began before 1 January 2017 and for otherwise qualifying wind facilities for which construction began before 1 January 2021 (with a progressive phase-out reduction if construction begins after 31 December 2016) and the ITC programme for qualified solar facilities for which construction began before 1 January 2022. Current IRS guidance provides for certain safe harbour provisions with respect to the beginning of construction requirement, requiring the performance of certain specified actions (based on either physical work or the incurrence of costs) prior to the applicable qualification deadline and placement in service of the facility within four years of the qualification deadline. On 27 May 2020, the IRS modified its prior guidance and extended the four-year safe harbour requirement by one additional year to address the unforeseen interruptions experienced by developers because of the covid-19 pandemic.23
Propelled by extended federal incentives, advances in green technology that decrease investment costs, state incentives and regulatory policies implementing renewable energy portfolio standards (RPS) on utilities, and the positioning of renewable energy as a key component for strategic energy independence for the nation, the development of renewable projects is expected to continue moving forward. As at June 2019, 29 states, the District of Columbia and three US territories have enacted RPS programmes, and eight additional states and one US territory now have voluntary goals for generation of renewable energy.24 For example, California’s RPS programme, one of the most ambitious in the United States, requires that utilities derive 33 per cent of their energy from renewable sources by the end of 2020, 44 per cent by the end of 2024, 52 per cent by the end of 2027 and 60 per cent by the end of 2030 (with the ultimate goal of obtaining 100 per cent of the retail sales of electricity to end-use customers and the electricity to serve all state agencies from renewable energy resources and zero-carbon resources by the end of 2045).25 While all three of the largest California utilities have enough renewable energy capacity under contract to meet the 2020 threshold, the generation forecasts that those utilities prepared in 2019 (risk adjusted to account for a certain degree of project failure) show that, in the aggregate, there will be a deficit beginning in 2026.26 Other states, such as New Mexico and Washington, have similar 100 per cent carbon-free goals in the next few decades and Hawaii has gone further by requiring 100 per cent renewable energy generation by 2045.27 As a result, there is a need for additional renewable energy generation in California and the rest of the United States. As the existing fleets of wind generation projects developed before 2000 approach the end of their useful lives, it is also expected that repowering investment will significantly increase during the next decade.
While still in its early stages, the US offshore wind energy sector recently experienced noteworthy developments. In 2018, Vineyard Wind LLC’s 800MW offshore wind project was awarded six long-term power purchase agreements with Massachusetts utilities through a competitive process,28 which represents the largest single procurement of offshore wind in the United States.29 Besides the mere size of the award, the most significant feature of those power purchase agreements is perhaps the energy purchase price, which is substantially lower than the price in prior reported transactions and confirms the increased competitiveness of offshore wind energy. The first offshore project to be constructed and achieve commercial operations is the 30MW Block Island Wind Farm, which has a power purchase agreement with a starting price of US$244/MWh and the reported price in other subsequent offshore power purchase agreements ranged between US$132/MWh and US$160/MWh.30 In contrast, the starting price under the Vineyard Wind power purchase agreements is US$74/MWh for the first 400MW phase and US$65/MWh for the second phase.31 While the Vineyard Wind project experienced an unexpected permitting delay in the summer of 2019, the US Bureau of Ocean Energy Management anticipates its final decision by 18 December 2020.32
Fuelled in part by improvements in technology (lowering costs and reducing risk) and government support, particularly on the north-east coast of the United States,33 offshore wind is becoming widely seen as a notable opportunity;34 it was brought to the industry’s attention with Ørsted’s acquisition of Deepwater Wind (the owner of the Block Island Wind Farm) in November 2018.35
In recent years, the US Environmental Protection Agency (EPA) has attempted to implement regulations aimed at limiting greenhouse gas emissions from existing fossil fuel-fired electric generating units in part by setting state-specific goals for reducing emissions from the power sector. The final rules were released in August 2015 (the clean power plan) but were confronted by immediate legal challenges from a large number of affected states and state agencies, utility companies and energy industry trade groups. After a protracted legal process (including actions before the US Supreme Court), the EPA’s final repeal rule became effective on 6 September 2019.36 Numerous affected parties (including 22 states, multiple cities, power companies and non-profit organisations) immediately filed petitions for review before the US Court of Appeals for the DC Circuit. The petitioners’ opening briefs were filed on 17 April 2020 and the briefing is expected to continue until 13 August 2020.37
Going forward, most renewable energy projects will increasingly rely upon commercial banks and capital markets to satisfy capital demands. For larger projects, mixed bank–private placement transactions with two or more tranches of funds may provide a preferred financing structure. In the past couple of years, the market has seen an increase in the amount of available capital for project financings combined with a reduction in the number of projects seeking funding, as a result of which financiers have been driven to offer almost unprecedented conditions (including a significant downward trend in pricing for capital) to remain competitive. This environment has allowed sponsors to refinance existing facilities with inexpensive long-term capital sources and has fostered an increased interest in the acquisition of operating assets.
New financing tools have also become increasingly important for renewable energy projects, particularly in the field of structured finance. For instance, approximately US$1,600 million was raised in 2019 as part of the securitisation of thousands of residential and commercial solar energy contracts.38 As other solar developers increase their portfolios, they may choose to follow this lead to secure financing.
After several years of uncertainty and doubt about its staying power, the ‘yieldco’ model has started to gain stability and remains a prominent feature of the US market. A yieldco is a publicly traded corporation similar to a publicly traded master limited partnership (MLP) vehicle except that its assets do not qualify for MLP status. In the renewable energy sector, a yieldco is expected to obtain stable cash flows from ownership of operating projects that have entered into long-term power purchase agreements and minimise corporate-level income tax by combining recently built projects that are still producing tax benefits with older projects. Yieldcos started achieving prominence in 2013 for energy companies and increased their presence exponentially until the downfall of prominent sponsors of yieldcos, such as SunEdison (TerraForm Power Inc and TerraForm Global Inc) and Abengoa (Atlantica Yield, formerly known as Abengoa Yield), turned investors’ attention to, and increased investors’ concerns about, yieldcos. After years of sharp declines in the value of shares of yieldcos and a flurry of dispositions by sponsors that led to the conversion of some yieldcos to private entities,39 some of the remaining yieldcos have shown improved health.40
Outside the renewable energy space, the retirement of coal and nuclear facilities generated renewed interest by sponsors in the development of new gas-fired power plants. Since 2016, natural gas-fired generation in the United States has surpassed coal generation every year and the gap keeps increasing.41 Natural gas-fired electric generation is expected to grow to a forecast level equal to over 36 per cent of the total generation by 2050 while coal-fired electric generation is expected to decrease to less than 14 per cent of total generation by 2050.42 The introduction of new capacity markets may further spur investment in gas-fired projects, which have been challenged by lower wholesale electricity prices in some markets, such as Texas. Additionally, project developers have devoted more attention on gasification facilities, which convert feedstock into a synthetic gas that is used as fuel or further converted into a variety of products, including hydrogen, methanol, carbon monoxide and carbon dioxide. These projects have commonly used fossil materials such as coal and petroleum coke as feedstock, although there are several gas-to-liquid projects in development and there is an intensified interest in the use of biodegradable materials, including municipal solid waste and forestry, lumber mill and crop wastes. The bankruptcy filings of Westinghouse Electric Company in March 2017 43 and FirstEnergy Solutions Corp in April 201844 may be a harbinger of further headwinds in the nuclear sector.45
Although still in its infancy from a technological and economic perspective, the nascent sector of electro-chemical energy storage (batteries that store electrical energy in the form of chemical energy) is beginning to attract the attention of a broad range of project finance participants.46 Reliable and cost-efficient battery energy storage systems have the potential to shake up the energy sector. Significantly, this type of storage system could become an ideal complement for intermittent resources such as wind and solar energy power plants and facilitate power grid balancing efforts. As a consequence, natural gas ‘peaker’ plants (those that are used when there is high demand for electricity) may become less significant and the electricity generation mix could be reshaped further.
Another development in the energy sector involves an ongoing transformation in the identity of the power purchasers in the market. As electricity prices have been declining, it has become more difficult for developers to secure long-term offtake agreements with investment grade utilities, and businesses, universities and other non-traditional offtakers gradually have been taking their place. Additionally, in some states, communities have started forming Community Choice Aggregations (CCAs) to source electricity.47 CCAs purchase electricity from a utility and sell it to their residents and businesses. While only eight states have legislation governing CCAs,48 these entities may become more significant in the near future. Utilities, especially those in western states, face increasing difficulty in maintaining their credit standing, as they confront a declining customer base due to the emergence of CCAs and distributed generation technologies, legacy pension liabilities, and the implications of climate change, including liability for utility-caused wildfires.
In addition, constrained state and local fiscal budgets, limited federal transportation funding, decreased tax revenue and the considerable need for new infrastructure assets and the refurbishment, repair and replacement of existing assets may hasten the further use of the public-private partnership (PPP) project finance structure (further described in Section IX). While most large infrastructure projects in the United States, at least since the introduction of the interstate system in the 1950s, have been completed using public funds rather than through the participation of private entities, a confluence of factors may be creating a fertile ground for the development of increased government and public acceptance of PPPs. According to the latest report card by the American Society of Civil Engineers, the infrastructure of the United States has a D+ grade point average49 and an estimated investment of approximately US$5.1 trillion (in addition to the approximately US$5.6 trillion currently contemplated to be funded) will be required by 2040 to maintain a state of good repair.50 The Trump administration’s infrastructure plan, published in February 2018, is intended to stimulate at least US$1.5 trillion in new infrastructure investment over the next 10 years 51 and 12 federal agencies agreed on a framework to expedite the environmental review and approval of infrastructure projects.52 Given that existing legislation has been insufficient to satisfy the country’s needs for infrastructure funding, state and local governments started to turn to the private sector to fill the gap. Recent significant PPP projects include the up to US$4.9 billion Automated People Mover project and US$2 billion Consolidated Rent-A-Car facility at the Los Angeles International Airport,53 the approximately US$3.7 billion I-66 Outside the Beltway project in Virginia,54 and the approximately US$5.7 billion Gordie Howe International Bridge connecting Detroit (United States) and Windsor (Canada).55 While in some jurisdictions developers will need to navigate uncharted legislative and regulatory waters, and may also have to overcome negative public perception regarding the private management of public infrastructure, the opportunities for growth may be unprecedented.
Outlook and conclusions
In the long term, project finance is expected to continue to be a popular vehicle to finance the necessary energy and infrastructure assets in the United States, particularly to replace the ageing fleet of coal-fired plants, nuclear plants and other public infrastructure, given the support of the strong legal framework and a strong, sophisticated private financing market (in addition to political support and other factors).
The US Energy Information Administration (EIA) estimates that energy consumption, across all sectors, will increase by 0.3 per cent per year between 2019 and 2050.95 While additions to power plant capacity are expected to slow from the construction boom years in the early 2000s, it is expected that there will be more long-term growth in certain sectors, such as projects from renewable sources and natural gas. For example, the EIA projects that electricity generation from renewable sources will grow so that its share of total US energy generation will increase from approximately 19 per cent in 2019 to approximately 38 per cent in 2050 in the reference case, or as high as 40 per cent based on a high oil price case.96 Additionally, projections from industry sources foresee that the United States may need close to US$5.1 trillion in additional funding to support its standard infrastructure needs in the coming years.97 With the enduring need for energy and infrastructure, the United States will look to project finance structures as one of the tools for satisfying this need.