Part 2 of the Energy Customer Investment-Grade Credit Support Blog Series

Ask around about the process of doing a virtual power purchase agreement (VPPA) in the U.S. right now and you are likely to hear the phrase “seller’s market.” Simply put, this means that the number of top-rated potential energy customers more than meets the number of available clean energy projects. Developers have their pick of offtakers and therefore tend to go with the gold standard: investment-grade offtakers. But what happens when the market shifts and developers run out of investment-grade options? 

Enter credit support: the key to engaging non-investment grade offtakers in the present and future-proofing the VPPA market. Credit support helps protect project financiers and developers against offtaker default risk. Non-investment grade offtakers looking to transact today are almost always asked to provide some form of credit support. Available enhancement mechanisms differ in how they address offtaker default risk, which can influence costs to the offtaker. 

Understanding the key credit enhancement mechanisms — Letters of Credit (LCs), surety bonds, credit insurance, and shadow ratings — can help you transact now and prepare you for future market shifts. 

• LCs: LCs are written agreements between a bank and a developer ensuring offtaker payment. While this is a common option in PPA negotiations for non-investment grade offtakers, they come with some drawbacks for offtakers. LCs typically require a hefty cash collateral and draw on a company’s line of credit, which needs to be preserved for core business functions. In addition, LCs are written to be immediately callable, meaning that issuing banks usually only have about 48 hours to pay a developer in the case of offtaker default. Considering these drawbacks, stakeholders are increasingly searching for alternatives. 
• Surety Bonds: Unlike LCs, PPA surety bonds are third-party agreements that pass the risk of offtaker default onto a new party: an investment-grade surety company. In this scenario, the offtaker pays a premium to the surety company who, in turn, is responsible for paying the developer in case of default. In case of default, the surety pays the developer the agreed-upon sum and then either looks to the offtaker for reimbursement or attempts to find a replacement offtaker. This allows the offtaker to secure credit support without drawing on its line of credit. While commercial project lenders have been hesitant to accept traditional surety bonds because they are not immediately callable, recent offtakers have found success by offering “on-demand surety bonds,” which are modified to closely mirror the callability of an LC.
• Credit Insurance: Credit insurance is a form of nonpayment insurance taken out by a developer against the risk of offtaker default. Here, the risk of default gets passed to an A-rated insurance company, instead of resting with the non-investment grade offtaker or developer. While the developer does pay a premium for the insurance, it can recuperate this expense through PPA pricing or even seek out more favorable terms from the project lender. This may end up being of no cost to the offtaker. And lastly, credit insurance lacks the “payment on demand” quality that is commonly seen in both LCs and modified surety bonds. All these qualities mean that credit insurance is often more affordable than other enhancement mechanisms and has the benefit of being an off-balance sheet solution. While the offtaker ideally should not be directly involved in the negotiation process between the developer and insurer, it can introduce credit insurance as an option. Those who have successfully used credit insurance in PPA negotiations have even gone as far as to seek out a preliminary quote from insurance agencies to include in their requests for proposals (RFPs). 
• Shadow Ratings: Finally, for companies that lack a public investment-grade rating simply because of the often-prohibitive cost of the public ratings process, there is the option to leverage shadow ratings. Receiving a public rating is a complex process requiring multiple years of audited financial statements along with a detailed review of company management and industry health. The cost of being publicly rated ranges from the hundreds of thousands to millions of dollars. This usually is not financially pragmatic for companies that are not using the rating for its primary purpose — to issue bonds. Luckily, the shadow ratings process is a more flexible one that is often significantly more affordable. Shadow ratings review similar information but are less comprehensive and lack many of the hefty fees of a public rating. Therefore, shadow ratings typically only cost in the tens of thousands of dollars if done by a credit-rating agency and can even be done at no cost to the offtaker if it is done in-house by a deal chain stakeholder.

LCs, surety bonds, and credit insurance are all financial products that place the burden of default risk onto a different investment-grade entity. Meanwhile, shadow ratings can reduce perceived risk overall. These solutions can be used individually, but experts have noted that packaging them together can yield maximum benefit. If your company is struggling with credit access and/or is interested in exploring any of these options, please reach out to disc-e@cebi.org.

This is Part 2 of CEBI’s Credit Support Blog Series. Stay tuned for an educational primer on this topic.

Authored by Chandni Sinha Das, CEBA