Power surge in the high stakes world of battery project finance | Commercial Awareness Compass #66

Hello and welcome to the commercial awareness compass, your weekly guide to thinking like commercial lawyer. Each episode we explore a key issue shaping the legal and business landscape, helping you to build the clarity and confidence to discuss it by breaking it down to three levels, beginner, intermediate and advanced. This week we're exploring how Project Finance works in the UK battery energy storage system and how lawyers help lenders and sponsors. I'm Sam, a law conversion student and future trainee solicitor. I'm joined today by James from Watson Folly Williams. James would you like to introduce yourself and tell us a bit about what you do? Yeah, absolutely. Absolutely. Thank you very much Sam. Thank you very much to the podcast for having me on. So yeah, I'm James Valentine. I sit in the energy team at Watson Folly Williams and my specialism really is renewable energy projects. I work on quite a wide variety of transactions to be honest. So project financings and M&A transactions and then more widely in the project, what's described as the project development space, so supporting with renewable energy projects in the contracts that support building those projects, so construction contracting, operating those projects, so operational contracting, and then selling the power from those projects, so off-take contracting. So it's quite a broad, broad ambit of what I do, but the very clear specialism is renewable energy projects. That's my world and in the renewable energy space batteries, batteries have been hot for the last few years. So it's a large part of the work on my desk at the moment, even today, but I'm very pleased to be on and look forward to chatting to you about this. Yeah, hopefully the batteries aren't too hot. I've heard that's caused some issues with them occasionally. So yeah, just to get started, I'm very glad to be joined by someone who's such an expert. I'm really hoping to pick your brain on this, but just to get us started, what is project finance in the broadest sense and how does it differ from the usual things that people have heard of like borrowing or going to a lender in a typical way? Yeah, it's a very good question. Very good question. I think if you take a step back, the core premise of project financing is that the focus of the lenders, so the people who are lending is taking the renewable energy space, which is obviously where I work, but this can apply in other sectors, but taking in the renewable energy space, the core focus of the lenders will be on the renewable energy project and its ability to generate revenues, because that is how they will get their debt that they lend to that project repaid. That's kind of taking a step back in terms of structuring these project finance things. The way it's done is that a company is established which essentially is a representative of that project. So we'll focus on renewable energy projects. And batteries is the focus, isn't it? Let's say you've got a battery project, you will have a project company that is the project company for whose key goal is to deliver that project. And what lenders when they lend money to that project company, what they're getting protected for in relation to the debt they're giving is their protection is limited to what that company that represents the asset that holds, which really is just the asset and all the contracts around that. And their protection is the comfort that they know these assets make money over the long term. And so there'll be a long term revenue contract that they can look to and say, look, our debt will be repaid over the tenor of the debt, whatever that may be, by reference to that revenue stream, then we're protected by the assets of the project. And going back to your original question, the difference there then from another type of financing is they're not looking to the balance sheet of what are described as the sponsors or the investors into that project company. We're not looking to get security from the balance sheet of those investors. You've just got the project the project company and the renewable energy project. And then you've got the revenues that that project itself will make. Does that make sense? Yeah, so just to sort of clarify for myself here, when you say the project company, is that a specific company, let's say company A wants to build a battery site somehow? Is it company A who's doing that or are they using a special company within company A? And is that what you mean by the project company? What I mean is very good questions, very good question. What I mean by the company is that that project, special purpose vehicle, the entity that houses that project above that that project company will need to be the investors and that might be one big entity, BP or someone, it might be them 100% as the investor in the project. Or you often see kind of joint venture arrangements with multiple different investors with share holdings in this project company being the company that holds the asset. Okay, so it's almost like I think the term that I've heard a few times is like a shelf company almost that they use as then so product finance is that then specifically looking at funding these individual SPVs to then do the project and then the asset that the SPV holds is that sort of what they use to make sure the loans are repaid and that's where they get their profit from rather than the big say BP. Yeah, I think you've broadly summarized it correctly. There are complexities in the project finance world. I should clarify because one point you made there is it one asset that's being project financed or is it a few different assets. The answer is you can have portfolio financings which involve a suite of assets and you look to the revenue stream of all of all of those assets or you can just have one asset. Both of those are project finance structures that we do see but yes, I think you've summarized it correctly. Thank you. Yeah, it seems very complex and quite a broad topic to sort of try and get into quite a nice sound by it. But on that when you talk about the lenders typically who will be those parties will it be if let's say a company wanted to do something where they wanted to finance a project would they go to one bank one lender or will there be multiple lenders who are working on this together? How does that sort of work? Good question. Good question. You can go you can go to one or two lenders if you've got a relationship and it's perhaps a small debt package but on substantial large scale projects with big debt packages you'll often go you'll often see a very very large number of lenders being approached and then quite a large club of lenders ending up in the financing mix. Okay, so there can be sort of a broad range of people working on it together. And so I guess if there are sort there could be either fewer or more but if there are these various parties as lawyers how do you sort of look towards things like regulatory certainty because especially in things like energy and renewables you always see the government policies changing on these where one government wants one thing and the next incoming government wants another thing or even within the same government cycle you have different policies. How do you sort of balance that regulatory challenge and what do these typically look like during a project? Yeah, yeah I'd say our world, the world of energy projects, renewable energy projects, it's a world I find personally very interesting partially because because it is ultimately also a political world we inhabit. I did history at university and the geopolitical aspects of being involved in energy deals is exciting and interesting and to your question absolutely if you're a lender lending on the premise of let's say a 15 year debt tenor to a to a to a battery project you need a fair amount of comfort that the UK isn't just going to suddenly reevaluate its entire regulatory framework and, you know, to take an extreme example which is certainly not applicable to the UK but might be applicable to certain emerging jurisdictions, just suddenly take your permit away and say you can't keep building. Regulatory certainty is very, very important and an important part of how governments frame their approach to energy is, you know, it will impact how how how lenders look at different markets. What I'm thinking in my head at the moment is Donald Trump pulling out the will under, pulling out the rug under off your wind projects in the US by executive order. That's kind of exactly what you don't want to see as a long term lender. And so looking for regulatory certainty and a strong level of consistency within government policy is absolutely at the heart of delivering, of being able to deliver substantial project financing. So do you find that working internationally especially does that ever do those sort of regulatory concerns ever lead to projects maybe falling through or not finding funding if they are in countries that may not be as politically stable? The short answer to that is yes. Yes. I would say that there needs to be a strong level of comfort that the regulatory environment won't be changed and if it is that lenders have relevant protections. Don't want to go into too much detail because I probably can't disclose the types of projects this involves without getting into a bit of a hot bed. Of course, no, no discussion, but yes, it is very important. And looking to the UK, I think on a positive note, the UK is the type of jurisdiction that is seen as reliable and stable. The types of changes that create nervousness in the UK to take an example at the moment, the grid connection structure, the ability of projects to confirm the time frames for their grid connection is being re-evaluated by government and different projects are being ascribed different grid connection dates subject to certain criteria and parameters. It's called the gate to process. That's quite an important issue that lenders will look to and want comforts around. But the fact is because people have a lot of confidence in the UK regulatory stability deals are still getting done and being structured around the fact that there is this process ongoing, but people are confident that provided you are hitting the relevant criteria, there's a very high likelihood of execution and so you can progress with these finance things and these processes. Brilliant, thank you. You very expertly steered away from the political there. So thank you for that. I do think Trump, but I think that's what we're talking about. Yeah, just one reference should be OK. And now as we move into the intermediate, I think maybe we can look a bit more about how the sort of risk of the financing works. And so one thing is we were talking just before we came on air about the revenue stack of projects. Could you explain a little bit about what a revenue stack is and what lenders maybe look for in a revenue stack? So I'm thinking about how to frame this for your listeners who I appreciate probably spend less hours in the day than I do. Renewable energy projects. In the renewable energy market for say a solar or a wind project. Revenue stackers are constructs may make less sense because you may well have all of your capacity being taken by one contract. What's called a power purchase agreement. The world where revenue stacking is often used is the topic of this podcast, which is batteries. Because batteries have very complicated revenue streams that I won't I won't delve into how batteries make money. But the long and short of it is that on a battery project you tend to see that the revenue streams that the battery will make money from that get the lenders comfortable coming from a number of different avenues. And quite often we'll see particularly on very large batteries. A number of different contracts layered on top of one another to support the revenue stream of that battery. That's one point. Another point is within even within any one portion of the battery's ability to make money. The person who's making money from the battery will be doing so from a variety of different mechanisms. Things like things like ancillary services they're called capacity market payments. And so that's what the revenue stack in a battery context refers to. I think your question was what do lenders like to see? Lenders like to see contracted revenue. And by that I mean something as close as possible to what you get with a power purchase agreement in solar or wind. Power purchase agreement. And so that gives you a guaranteed this is how much we pay for this much capacity. So very easy to work out how much it's going to make every year. And for a battery as much as possible as you can get what's called a tolling arrangement, which is somebody agreeing to take hold of your battery and paying you X amount every year for access to that battery. That's what lenders like the most because it gives there lots of comfort that they'll definitely get paid. There are other contractual structures that I can describe in the battery world which to lesser extents achieve that certainty of revenue stream. But tolling agreements are similar to PPAs and they're the ones that lenders like to see the most. Yes there's almost like a big focus around security then and that's sort of towards idea of giving lenders more security and more of an idea of where their money will be coming from and that they will definitely get their money back. And to sort of stick with that deal of security what would you say are there sort of bigger broader commercial risks that lenders face when they are lending to maybe battery projects or other renewable projects? You ask big questions. I can make them narrow if you want. No it's good it's good it's good so the biggest risk if you don't if you'll forgive me I'll focus on batteries just to just just to give to narrow the question slightly and then we can maybe zoom out. In the battery world the the offtake so the revenue stream of the battery that will always be a very very important part of your discussion with lenders how they get comfortable with with the revenue certainty because it's unlikely you will get a hundred percent of your capacity being told a tolling agreement so therefore they need to get comfortable with with other parts of the revenue stream which may just be what's described as merchant. Merchant means selling on the market and so for a lender who love certainty they love certainty because they don't get upside they've just got their debt that they want to get repaid. The the the the the the the question of how much merchant risk they're willing to take versus guaranteed guaranteed flat flat revenue that will always be a big a big question. We haven't really touched yet on on how these projects are built and construction risk construction risk is always you typically see lenders coming into the structure prior to construction and so they will they will put their debt in and then the project will be built so they they they they focus a lot on the construction contract and the risk profile in them. In the battery world, the points that are particularly noticeable, I suppose at the moment, are around things like lithium pricing and tariffs. These are all quite interesting things I suppose for your listeners that I suppose everyone's aware of tariffs. Fewer people probably check the lithium price as much as I do. If you look, it's quite volatile at the moment, but the point there is the lenders, you want certainty of price on your construction arrangements. But for major battery suppliers, they struggle to have a fixed price for their battery without some level of protection if there are tariffs that apply or the lithium price suddenly, as it didn't December, doubles. And so they will embed protections in relation to tariffs and lithium, which then lenders need to get their heads around because, well, how does that affect their very conservative perception of they want a very clear fixed cost for the construction arrangements? The last point I would mention on the battery side, which I think is interesting. And I hope I'm not losing your audience by getting too technical. - No, this is what we want on the show, yeah. - But one aspect that I think is very, very interesting, and it crops up on every battery deal I've ever done, which is quite a few, quite a few now, is the issue of degradation of the battery asset and something that's called overcycling. Essentially, you get delivered up your battery by your battery supplier. As you do with anything like a washing machine and they say, here's your warranty that you can call on if something goes wrong and we'll come, we can confirm that it definitely will work to this level of performance provided you don't do anything ludicrous with it. One of the things that they control amongst a number, but one of the things they control is how regularly you cycle your battery and you cycle your battery when you're using it and you're making money from it. - Is this a bit like when your iPhone says it will charge to say 80% rather than full, is that cycling where it's charging off with an emptying out? - Correct. - Correct. So, that's exactly right. So they will say you can only, our warranty will only work or we can only make it, if you're cycling at a maximum of say two cycles a day. But if you're the sponsor, you wanna make as much money as possible. You might think, well maybe there's a day where we can make a lot of money. So we'll cycle four times that day and that's fine 'cause we'll make loads of money. So we don't really mind that it might degrade the battery a little bit in the long run. It's like a mobile phone, exactly right. You've got a very important phone call. There's a job interview and you think it's worth running down my charge to take this call. Even though long term it means my battery life is less good. It's bad example 'cause it makes sense, but you take the point that the upside for the sponsor, the person who owns the battery, might be to occasionally overcycle beyond the warranty. If you are the very, very conservative lenders who don't get any, they don't get any upside so they don't get any extra money from you doing your four cycles a day, you absolutely do not want any of this overcycling happening. You want a nice steady battery that always, they will keep within the warranty and it will last for as long as it possibly can and we're all very sensible and good. And that will always be a big topic of discussion and has many funky solutions that we've seen. - Yeah, so just sticking with that point actually, as we move into the advanced, I wanted to ask a bit about how that works and for a lender. So if they've lent to a company and the company wants to overcycle, will they have say contractual arrangements to say you can't overcycle or there'll be consequences or will it typically be another way that they go about ensuring that the underlying assets that they're secured against aren't being misused? - Yeah, good question. Good question. The answer is it's hotline negotiated. It's hotline negotiated. So your question is, are they contractually, yes. The lenders will want something in there that says you cannot overcycle beyond your warranty. The question is kind of how aggressive is that protection and what remedies does it result in? And I won't go into the technical details of that but the long and short is there's a lender that they will want some level of comfort that it's not being overcycled. And if a, in general sponsors do accept that position because to be honest for them ultimately, they often are aligned that they want along a long-term battery and they don't want to invalidate their warranty, et cetera, et cetera. - Would you usually see like finds being a typical sort of remedy to that or is it something more complex? If it's too complex, don't worry about it that this is a general idea. - Yeah, so I mean, you can see an example of something you might see is called a cache sweep, which would mean if you overcycle and you get some profit, that profit has to be good, you don't get that profit, that goes to repaying your debt. So I suppose it's a bit like a fine, so the lenders are saying, look, if you're, if you're doing this to make money for yourself short-term, ha ha, no you don't, you have to pay out that. - Yeah, so you used to make a lot of sense, Camerashi as well from the lender's point of view because then they get their capital back faster which they can then use themselves. - Correct, and then it resizes it, yeah, the debt resizes. But yeah, that's an example. Another example is it becomes an event of default under the loan there. There are different ways to structure it. - Brilliant, thank you. I think we've got time for just one more question here. So you kind of touched on how constructions involved in it and I know we can't get too deep into it 'cause we don't have that much time. But in terms of the construction company, that will be generally a third party and how will the lenders and the sponsors interact with each other and the construction company, is it the lenders are sort of blind to the construction companies or will they seek assurances maybe as to the repressibility or the quality of the construction company? - Yeah, yeah. As touched on, as touched on, the construction arrangements are very, very important to the lender group in general. They will, they will, through me, often carefully diligence, carefully diligence, the construction package that's being delivered. So yes, they will absolutely have visibility on who it is doing the construction. I don't want to go into too much granularity, but just as an interesting point to note, in the renewable energy market in general, particularly in the, I'll say this is true, across Europe and Europe, you would very rare, it's atypical to only have one person delivering your construction package. You typically will have a few different contractors delivering it. So on a battery project, you'd have your battery supplier, but you'd also probably have, you know, somebody doing electricals at the site, somebody doing the civil works. So you have a few different contractors in the package that need to be managed by the project company. The next point of your question to them, they'll carefully diligence that package. There will be risks in it. They're always questions about kind of what's the bankable structure, what can lenders get comfortable with in the construction arrangement, in any arrangement? The answer is it depends and every project will be taken as a whole and in the round. But lenders will carefully diligence that construction package, which will include some risks always, but they will consider. And then provided they're comfortable with it, and the project financing is provided. There then will be controls during the construction phase, which means lenders have visibility on construction and particularly kind of the construction budget, for example, so ensuring that the capital expenditure for building the asset isn't ramping beyond what had been anticipated. And they will also, the lender group will also have something in place between. between your construction contractor and the project company and the lenders. There is a contract that exists there called a direct agreement, which is an important part of project financing. The direct agreement and the lenders will have that for the construction contractors, the operational contractors and the revenue contractors in a project finance. They will have this ability, essentially, to step in to that contractual relationship between the project company and the relevant contractor. So in the construction world, the lenders can step in to the construction contract. And that would happen if there was a risk, for example, that the construction contractor was thinking about terminating the arrangements because of something the project company had done. The lender group, very conservative, absolutely need this project to be built to get their debt repaid. So they say, no chance in terminating will step in will fix the thing you need to be fixed. And then you will not terminate. So that that I think answers your question as to kind of the line of sight lenders will have on the construction contracts. And I suppose the other point to make is that also applies to the operational contracts. And it will apply to the offtake contracts. Yeah, I think that's really interesting bringing that up. Because I think maybe it was a misconception, I'm not sure it was just me, but it's maybe one of those things that you don't see from the outside, but you always forget how much the lender actually does get involved. So I think in, I guess, personal finance, which is how most of us think about money and that sort of thing, you get a loan from the bank. They sort of leave you alone, say, just give us your repayment and we'll leave you alone. It's just not like that at all in project finance. Absolutely not like that. No. They are involved. They're involved and they want to know what's going on. A good way to see when I first started working the energy space and my supervisor asked me to prepare some analysis on what, what lenders would, what their views would be on certain amendments in a contract, which had been proposed by a construction contractor. And what he said, which I think is quite accurate, is the lenders basically have got all of the same interests as the project company. That they want this project to get built and they were, they're both driving exactly the same direction in terms of they need the project to get built and they need it to be successful. And so a good way to see a lender group on a big project financing is they're seeing everything through the lens of that they're very aligned with the sponsor that they're seeing everything through the lens of wanting to get the project bills and getting it making money. But with the very important caveat that they're much more conservative and they don't get upside. So they've got all the same interests in terms of it getting built, but at the end of the day, they care far less about how super profitable it is. They just want it to definitely get built and definitely make at least enough money to pay their debt. That's the world. That's the world they inhabit and they get nice and involved to ensure that that happens. Brilliant. Thank you. Yeah. That's a really good introduction to the sort of world of project finance. It's something that's clearly very deep and I know unfortunately I'm enough time to go into more depth. It's really interesting how much goes into each of these and like the fact you have to stop at each point. It doesn't make me think maybe we should come revisit this topic again because it seems as so much more detail we could go into. But unfortunately that does bring us to the end of the time for this week's commercial awareness compass. To honestly a big thank you again to you James for joining us and a thank you to everyone for listening. So remember being commercially aware isn't just about following the headlines. It's about understanding the questions they raise and how lawyers help to answer them. We'll see you next week to keep building your commercial awareness, but until then prepare without the panic. Thank you.