Project Financing and Energy Storage: Risks and Revenue

March 08, 2023

The United States and global energy storage markets have experienced rapid growth that is expected to continue. An estimated 387 gigawatts (GW) (or 1,143 gigawatt hours (GWh)) of new energy storage capacity is expected to be added globally from 2022 to 2030, which would result in the size of global energy storage capacity increasing by 15 times compared to the end of 2021.[1] The rapid growth in the energy storage market is similarly driving demand for project financing.

The general principles of project finance that apply to the financing of solar and wind projects also apply to energy storage projects. Since the majority of solar projects currently under construction include a storage system, lenders in the project finance markets are willing to finance the construction and cashflows of an energy storage project. However, there are certain additional considerations in structuring a project finance transaction for an energy storage project.

Technology Risks

Lithium-ion batteries remain the most widespread technology used in energy storage systems, but energy storage systems also use hydrogen, compressed air, and other battery technologies. Project finance lenders view all of these newer technologies as having increased risk due to a lack of historical data. As a result, a primary focus for lenders in their due diligence of an energy storage project will be on technology risks.

Much of the lenders’ diligence on technology risks will be covered by the report from the independent engineer. The independent engineer will examine the project’s ability to satisfy the commissioning testing requirements and minimum performance requirements under the applicable offtake agreements. In addition, for energy storage projects using lithium-ion batteries, lenders will expect a robust review from the independent engineer on capacity degradation and safety issues tied to overheating. Project companies can mitigate degradation concerns by securing a performance guarantee, equipment warranties, and/or an operations and maintenance agreement to ensure that equipment will be replaced or otherwise maintained at a minimum capacity.

In particular, performance guarantees and equipment warranties mitigate technology risks by shifting these risks away from the project company and to the technology vendors. Performance guarantees and equipment warranties provide assurances to the lenders that the applicable equipment will perform at the levels set forth in the lenders’ financial models.

Lenders will also assess the value of any performance guarantees and equipment warranties based on a couple factors. First, any performance guarantees and equipment warranties should be assigned to the project company on or prior to the operation of the project so that the project company is able to directly enforce these performance guarantees and equipment warranties. Second, any performance guarantees and equipment warranties should be given by creditworthy counterparties. Given the ever-changing landscape of energy storage technologies, some of the equipment providers and service providers are new entrants and may not have strong financials. If an equipment provider or service provider has a weaker balance sheet, this weakness can be offset by securing letters of credit from the provider or a guaranty from a parent entity with a significant balance sheet.

Construction Risks

It is fairly common to see multiple equipment supply, construction, and installation contracts rather than one turnkey engineering, procurement, and construction (EPC) contract for energy storage projects. Lenders tend to prefer fixed-price turnkey EPC contracts so that there is a single contractor, which shifts some of the construction risk from the project company to the EPC contractor.

An energy storage project with a split EPC structure will require additional diligence by the lenders to address any additional risk exposure. In particular, given the volatility in the battery markets in recent years in terms of supply and cost, which volatility is expected to continue in the near future, lenders will undertake additional diligence of a battery storage project to ensure that there are sufficient reserves for potential cost increases and adequate cushion to address delays.

Operating Risks

As a general matter, lenders will conduct diligence to understand the energy storage project’s operating limitations and operation and maintenance (O&M) costs. Lenders will look for an O&M agreement for the project with an experienced operator that will ensure that the project will be operated within the project’s operating limitations. To the extent that there are project degradation issues or other anticipated major maintenance costs such as the augmentation of battery systems, lenders may require the project company to establish O&M reserves to ensure sufficient funds will be on hand to cover these maintenance costs.

In addition, lenders will look for confirmation that the project company has sufficient rights to the system’s software and any other intellectual property rights, which is critical to the daily operations of the energy storage. More specifically, the project company will need to show that the system’s software can be accessed by the project company if the operator is replaced or by the lenders if the lenders have exercised remedies and taken title to the project. This can be evidenced with transferable software licenses or technology escrow agreements.

Revenue Streams

As in all project finance transactions, project companies must show that the project can support a steady and reliable stream of cashflows. Traditionally, for solar and wind projects, this has been accomplished with a long-term offtake agreement, which can cover payments for delivered energy, capacity, or ancillary services, or a combination of the foregoing. These projects will have long-term predictable revenue streams. In addition, lenders may be willing to finance merchant cashflows, but with less leverage and subject to detailed market studies and cash sweeps.

These trends for solar and wind projects also apply to energy storage projects. Energy storage projects with contracted cashflows can employ several different revenue structures, including (1) offtake agreements for standalone storage projects, which typically provide either capacity-only payments or payments for capacity plus variable O&M costs; (2) offtake agreements for renewables-plus-storage projects, which typically provide payments for delivered energy or energy plus capacity; and (3) build-transfer agreements, which typically provide payment for title to the energy storage project upon substantial completion and operation of the project (or after mechanical completion and prior to the project being placed in service for tax purposes if tax credits are involved).

Similar to solar projects and wind projects, lenders may be willing to finance merchant cashflows for energy storage projects subject to less leverage and cash sweeps. For energy storage projects with merchant cashflows (whether in whole or in part), lenders will focus on understanding the markets, running the model sensitivities, and preparing for all reasonably foreseeable scenarios that would affect cashflows. In particular, the available revenue streams for merchant cashflows in the United States differ significantly based on the location of the energy storage projects and the applicable market forecasts.

Developers may seek a portfolio financing as an alternative to a single-project financing. Portfolio financings can mitigate the risks associated with any single project since the lenders will not be wholly dependent on a single project. However, portfolio financings can also be challenging from a diligence and structuring point of view.

Underwriting Tax Equity Investments

Renewable energy projects in the United States (particularly wind and solar) are eligible for tax benefits, including the investment tax credit and the production tax credit. These tax credits have been financed in the nonrecourse project finance markets, often using construction bridge debt that is fully repaid once the tax equity investment is made after the project is placed in service (as defined by the IRS).

Historically, in the energy storage space, tax credits have been available only for energy storage systems that are paired with renewable energy generation projects. However, with the passage of the Inflation Reduction Act of 2022, tax credits are now available for standalone energy storage systems, and thus lenders may be willing to provide bridge capital that is underwritten based on the receipt of proceeds from an anticipated tax equity investment, similar to renewable energy projects. See New Tax Credits and Monetization Opportunities for Energy Storage Have the Chance to Revolutionize the Industry for more on this topic.

While lenders may need to undertake additional diligence before financing an energy storage project, the project finance market for energy storage has grown, and is expected to continue to grow, alongside the rapid expansion of the energy storage market.

Read our full report, Energy Storage: A Global Opportunity and Regulatory Roadmap for 2023 >>