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Smart contracts will transform renewable energy financing

 

This post is the part of our new series called “Use Cases”, where we explore real, concrete and transformative applications of smart contract technology

In this article, we’ve examined renewable power generation – it’s exciting, growing rapidly, and critical to our planet’s future. But its also a specialized market that only a small number of investors can access directly and, when they do, it takes them decades to monetize the value that’s created in just the first couple of years of the project’s lifecycle. Smart contract technology has the ability to cut straight to the core of these structural challenges and provide this sector with a new set of possibilities.

We’re getting a bit tired of hearing about the conceptual benefits of smart contracts and distributed ledger technology (DLT). As exciting as they can be to the interested reader, abstract descriptions of market liquidity and operational efficiencies just don’t capture the imagination or the heart.

The unfortunate truth is that when it comes to boring people with bullet point lists, we’re probably more guilty than most.

To atone for our trespasses, we’re changing direction and starting another series of articles. Instead of reporting back on the results and insights from our market research (which we’re also continuing!), we’ll be analyzing real-world applications that have the potential to transform industries.

Long delays between creating and monetizing value in renewable power generation

We’ve broken down our post into three sections – an analysis of the sector’s challenges, a description of how smart contracts can be applied to them, and an example of a smart contract based wind-power project.

Structural challenges in renewable energy

Investments in renewable energy infrastructure (such as wind or solar) are typically considerable in size ($US hundreds of millions or billions), involve long capital amortization periods and the cost to participate (i.e. ‘ticket size’) is most often calibrated to institutional investors and/or banks able to deploy substantial resources to individual projects[1].

Simultaneously, renewable energy infrastructure is also viewed as a desirable investment class by many of the investor groups that have limited, indirect access to it. It is perceived as critical to the decarbonization of the global economy and well-positioned with regards to macrotrends in energy production, pricing and use. These potential investors include high net worth individuals and family offices seeking to create positive impact while also growing capital. Others include funds or asset managers seeking to profitably enhance their reported ESG impact – a regulatory mandate entering into effect for some and an increasingly important factor in the large majority of companies’ and asset managers’ public reporting[2].

But regardless of the sector’s broad appeal, non-institutional / non-bank investors have limited opportunities to engage. As reported by the Economist;

“Renewable energy… does not at the moment offer a wide range of choices to investors. Only three firms in the s&p 500 produce renewable energy, making up less than 1% of the index’s market capitalization. Even among private-equity and venture-capital firms only $11bn were invested in renewables in 2019”[3].

A number of factors combine to create this paucity of investor options.

Of the total $4.3T of 2030 forecast renewable energy assets (solar, wind and hydro), only a total of $1.6T are expected to be available to institutional investors due to high concentrations of government ownership[4]. Within these investible assets, only 3% are available via listed, pure-play vehicles and a further 26% available via listed portfolio companies. While these carry the advantages of being public companies, they carry with them management team related execution risk, not direct exposure to the underlying assets. Contrast this to sectors such as gold, oil or natural gas, which offer investors opportunities for direct exposure to underlying assets.

The remaining 71% of the 2030 investible projects ($1.14T) are expected to remain unlisted, private market assets[5]. This also limits non-bank / non-institutional investors to indirect investments via operating companies or specialized funds[6]. In addition to introducing a layer of execution risk as described above, indirect unlisted investments most often have the further challenges of low liquidity and infrequent reporting, limiting the use of portfolio management techniques by investors.

The widespread use of debt as a financing instrument creates a further barrier to entry for non-bank / non-institutional players. Steadily increasing over the last decade, project-financed European wind farms for example now source c85% of their total capital needs as debt[7]. As technology and the sector matures, the cost of capital has also been steadily decreasing to a 2018 average of c180 basis points over LIBOR[8] (for bank lending). In the case of green bond financed European renewable projects, the rates offered investors are often even lower[9]. These yield levels favour large scale capital allocations which are often driven by the terms of Power Purchasing Agreements (PPAs) and green investment mandates. These alternative drivers depress overall debt yields and limit attractiveness to smaller scale players seeking yield as the primary investment KPI.

However, between these market pillars a large opportunity exists. Due to its scale, the unlisted market for renewable energy infrastructure assets still provides an estimated 2030 equity tranche of $0.2T-$0.3T[10], against which the forecast $48B in listed pure-play vehicles provides a limited equivalent opportunity in the public markets.

Currently, this equity is primarily limited to institutional-scale investors. Secondary transactions occur, but they are most often ‘lumpy’ deals involving large scale acquisitions of all or significant portions of the equity in operating projects. In addition to their large ticket sizes, executing these deals involves significant transactional friction for both buyer and seller[11]. These factors combine to hold syndicated equity investment in unlisted renewable energy infrastructure to non-relevant levels.

The opportunity for digitalized investment instruments

Distributed ledger technology’s primary novelty is its ability to create trust between unrelated parties in markets with no centralizing authority. DLT based fractionalization (tokenization) of the equity in a project-specific ‘special purpose vehicles’ (SPVs) can serve as the basic foundation for the creation of a sophisticated digital investment instrument that delivers considerable advantages to both the renewable energy production sector and to the substantial investor groups currently peeking in the windows.

Hunit’s approach to digitalizing private market investments is focussed on the use of digital investment agreements that are tethered to DLT-based tokens that represent ownership. These smart contracts have the ability to perform a sizable portion of the executorial tasks required for the day-to-day operations of the investment instrument. This includes automating functions such as:

  • Running the initial issuance and performing delivery vs. payment
  • Receiving incoming revenues from offtake partners and distributing it according to defined rules
  • Creating reporting based on external and internal data sources (weather services and wind turbine sensors for example)
  • Verifying the KYC and accreditation status of potential buyers of the investment instrument (underlying checks and investor accreditation performed by distribution partners and/or 3rd party service providers)
  • Managing shareholder matters such as governance voting, first rights of refusal, tag & drag provisions
  • Enabling secure and counterparty risk-free secondary trading in the decentralized global market that is native to Hunit’s underlying tokenization protocol (Stellar – an open source project benefiting from significant contributions from IBM)
  • Investment agreement covenant monitoring and breach resolution based on pre-planned remedies

DLT based investment instruments authored on Hunit’s platform allow the market-enabling advantages of digitalization while avoiding the need to perform and maintain a public listing. In fact, the business automation that they can provide serves to reduce day-to-day operational costs from current benchmarks, even while enabling the granular fractionalization of ownership that would be a challenge in today’s environment.

These technical capabilities provide the basis for the creation of a new vertical in the financial markets. Digitalized private market SPV equity can provide direct exposure to attractive asset class for a massively larger cross section of investors, unlock substantial pools of new capital for the industry and enable fluid secondary markets. In turn, these combined benefits can empower new investment models for the sector.

An example of the potential impact relates to the role of independent project developers. In general, this stakeholder group currently has problematic access to the substantial amounts of equity capital required to bring a project on-line. As a result, these groups focus on the development of the project package up until the so-called ‘final investment decision’ (FID), at which point a buyer is sought for the ready-to-execute project.

As the number of buyers with sufficient capital to fund the equity component of the buildout is limited to a handful of enterprise-scale power producers and specialists, the projects that independent developers assemble are structured around the needs and scale of this small group. As a result, projects that are smaller, more innovative or otherwise less well suited for a sale to an industry major are often left un-addressed.

By providing a scalable and repeatable channel to syndicated equity capital, these independent project developers have an alternative that increases the number of viable projects and gives them the opportunity to participate in the construction and operation of their projects. As more projects become viable, the potential exists to push market growth beyond the existing industry estimates (which are based on today’s development models).

Combined with a functioning secondary market for project equity, project developers that have extended their role later into the project lifecycle are still able to tap market liquidity when needed. Equity owners of existing operating sites also have the ability to digitalize their existing project equity and tap this market, eliminating the long-term capital lockups common to the industry today and releasing their capital for reuse in new project development. By allowing general market ownership to replace specialist ownership in de-risked projects, the resulting increased velocity of capital within the industry has the potential to fuel a virtuous cycle of accelerating sector growth.

Example instrument lifecycle:
from Final Investment Decision in a new wind farm under development

The following describes a hypothetical use of Hunit’s DLT-based smart contract platform for from the point of project FID. A simplified case follows below for a smart contract structure used to digitalize and create liquidity within an existing, de-risked wind farm.

General structure:

  • Ownership of a single site (ex. wind farm) is encapsulated in a SPV
  • SPV utilizes bank lending / green bonds as per industry norms
  • SPV equity is fractionalized and tethered to a natively digital investment agreement authored by the project originator’s legal counsel
    • SPV equity is exclusively reserved for accredited / sophisticated investors – no retail investor access is provided.
    • SPV equity includes ongoing royalty payments to equity holders based on operating results (for example)
  • SPV has direct contract relationships for:
    • Equity and debt placement via financial service providers (including bond holder agreements / terms)
    • Site construction with a specialized service provider
    • Audit / external verification provider
    • Power offtake PPA / grid interconnect
    • Business management services from project originator (or third party)
    • Physical site / equipment maintenance from specialized service provider
    • Site leasing from land owner
    • Purchasing / financing from power generation equipment (turbines, ancillary systems)
  • SPV is overseen by a board of directors, the starting composition of which is selected by the project originator

Project development / packaging:

  • Project originator sets-up above described SPV and associated contracted relationships
  • Project originator retains pre-financing project value (its ‘equity carry’) and potentially also contributes part of the equity capital on the same terms as the general market

Primary issuance:

  • Distribution partners (brokerages / investment banks) create vendor analysis and due diligence package based on project dynamics and SPV contracted relationships
  • Distribution partners allocate equity to accredited investors
  • Same or alternative distribution partners allocate debt (in either a conventional bond structure or using a separate digitalized instrument created on the Hunit platform)
  • Smart contract automates escrow, closing and DVP (substituting for normal ‘book running’ function)

During construction:

  • Smart contract unlocks milestone payments in accordance with terms agreed with construction provider and when milestone triggers have been certified by auditor
  • Modifications to construction agreement below specific thresholds (days over plan, cost increases as % of overall project) are at discretion of contracted provider of management services
  • Modifications of construction agreements above specific thresholds subject to smart contract run equity investor governance process

In operation:

  • Smart contract autonomously generates desired reporting based on API access to the wind farm’s IoT sensor data and external data sources. Due to the extraordinarily data rich operational environment, these reports offer the possibility of as much transparency as the project originator sees fit to specify. Data reporting can additionally have two levels of transparency, one for instrument owners and another for the general market.
  • Smart contract controlled bank facilities receive sales revenue from offtake partner and verifies that amounts are correct
  • Smart contract autonomously manages payments to
    • Debt coupons
    • Land leasing
    • Generation equipment provider
    • Service provider fees
    • Royalties to equity holders
    • Board remuneration
    • SPV cash reserve
  • In the event that business environment changes require modifications to operating agreements, bond holder agreements or smart contract rules, the smart contract runs a governance process to approve changes when they are above thresholds defined for discretionary action by the management service provider.
  • Smart contract executes on other general shareholder matters such as tag / drag in the event of a substantial buyout offer, first rights of refusal, periodic shareholder voting (board composition, etc.)
  • In the event of covenant breach (by service providers, offtake partner or SPV itself), pre-planned remedies are released by the smart contract.
    • Example: the SPV is unable to make royalty payments to equity holders due to a protracted period of challenging operating conditions, the smart contract issues subordinated, interest bearing promissory notes in their stead.

Secondary trading:

  • Equity tokens are available to buy / sell on the Stellar blockchain protocol’s native digital exchange offering global peer discovery
  • Potential buyers have access to original vendor due diligence materials and the general market reporting as made available by the smart contract since the primary issuance
  • Potential buyers must have been onboarded and KYC / accreditation status verified
  • Agreed transactions are first subject to equity shareholder controls such as first rights of refusal or tag along provisions (if specified in the smart contract investment agreement)
  • Transactions compliant with the above then complete
    • Smart contract clears sales proceeds if payment is completed ‘off chain’
    • Decentralized exchange clears sales proceeds if payment is made ‘on chain’ using an agreed form of tokenized currency

Example instrument lifecycle:
digitalizing project equity in an operating, de-risked wind farm

The following describes a hypothetical use of Hunit’s DLT-based smart contract platform for digitalizing SPV equity in an existing, de-risked wind farm.

General structure:

  • Ownership of a single site (ex. wind farm) is encapsulated in a SPV
  • SPV has used bank lending / green bonds as per industry norms
  • SPV equity is fractionalized and tethered to a natively digital investment agreement authored by the current project owner’s legal counsel
    • SPV equity is exclusively reserved for accredited / sophisticated investors – no retail investor access is provided.
    • SPV equity includes ongoing distributions to equity holders as per prior operating history (for example)
  • SPV has direct contract relationships for:
    • Equity placement via financial service providers
    • Audit / external verification provider
    • Existing power offtake PPA / grid interconnect
    • Business management services from existing project owner (or third party)
    • Physical site / equipment maintenance from specialized service provider (or existing project owner)
    • Existing site leasing agreement with land owner
    • Existing financing agreements for power generation capital equipment (turbines, ancillary systems)
  • SPV is overseen by a board of directors, the starting composition of which is selected by the prior project owner

Project development / packaging:

  • Current SPV owner restructures / novates above agreements into the SPV (if not already done)
  • Project originator determines the percentage of the SPV equity it wishes to offer to the market (a partial sale of equity may often make most sense for current SPV owners, who are then able to access market liquidity for a portion of their existing holdings while also creating digitalized efficiencies within its internal value capture from operating wind farm site)

Primary issuance:

  • Distribution partners (brokerages / investment banks) create vendor analysis and due diligence package based on project dynamics and SPV operating history
  • Distribution partners allocate equity to accredited investors
  • Smart contract automates escrow, closing and DVP (substituting for normal ‘book running’ function)

In operation:

  • Smart contract autonomously generates desired reporting based on API access to the wind farm’s IoT sensor data and external data sources. Due to the extraordinarily data rich operational environment, these reports offer the possibility of as much transparency as the project originator sees fit to specify. Data reporting can additionally have two levels of transparency, one for instrument owners and another for the general market.
  • Smart contract controlled bank facilities receive sales revenue from offtake partner and verifies that amounts are correct
  • Smart contract autonomously manages payments to
    • Debt coupons
    • Land leasing
    • Capital equipment financing partner
    • Service provider fees
    • Distributions to equity holders
    • Board remuneration
    • SPV cash reserve
  • In the event that business environment changes require modifications to operating agreements, bond holder agreements or smart contract rules, the smart contract runs a governance process to approve changes when they are above thresholds defined for discretionary action by the management service provider.
  • Smart contract executes on other general shareholder matters such as tag / drag in the event of a substantial buyout offer, first rights of refusal, periodic shareholder voting (board composition, etc.)
  • In the event of covenant breach (by service providers, offtake partner or SPV itself), pre-planned remedies are released by the smart contract.
    • Example: the SPV is unable to make agreed payments to equity holders due to a protracted period of challenging operating conditions, the smart contract issues subordinated, interest bearing promissory notes in their stead.

Secondary trading:

  • Equity tokens are available to buy / sell on the Stellar blockchain protocol’s native digital exchange offering global peer discovery
  • Potential buyers have access to original vendor due diligence materials and the general market reporting as made available by the smart contract since the primary issuance
  • Potential buyers must have been onboarded and KYC / accreditation status verified
  • Agreed transactions are first subject to equity shareholder controls such as first rights of refusal or tag along provisions (if specified in the smart contract investment agreement)
  • Transactions compliant with the above then complete
    • Smart contract clears sales proceeds if payment is completed ‘off chain’
    • Decentralized exchange clears sales proceeds if payment is made ‘on chain’ using an agreed form of tokenized currency

 

[1] McKinsey&Company; The Market for Unlisted Renewable Energy Infrastructure (Dec 2018). Available here (Accessed 29 June, 2020)

[2] ibid

[3] Economist; How much can financiers do about climate change? (June 20, 2020). Available here (Accessed: 30 June 2020)

[4] McKinsey&Company; The Market for Unlisted Renewable Energy Infrastructure (Dec 2018). Available here (Accessed 29 June, 2020)

[5] ibid

[6] ibid

[7] Wind Europe; Financing and Investment Trends (April 2019). Available here (accessed 28 June, 2020)

[8] ibid

[9] International Finance Corporation of the World Bank; Green Bond Pricing in the Primary Market H1 2018 (October 2018). Available here (accessed 29 June, 2020)

[10] Author’s estimate based on cited source materials

[11] Wind Europe; Financing and Investment Trends (April 2019). Available here (accessed 28 June, 2020)