Last year was a record-breaking year for the solar asset backed securitization (ABS) market. The market not only crossed the 1-billion mark but also registered the highest securitization value in a single year. Part of this success was a result of new players such as Mosaic, Sunnova Solar Energy, and Dividend Solar Finance coming on board.
Mosaic, though it was new to the securitization market, set the trend by closing two deals within the year. Its second securitization of $308 million was the highest securitization to date. It drew investors from both the United States and Europe, which indicates rising international recognition.
Securitization is defined as the process of combining financial assets into a pool and then selling portions of that combined pool on the secondary market to institutional investors, such as pension funds.
The resulting assets (such as mortgage-backed securities) generally require a credit rating from a rating agency assessing the risks.
By allowing the original investor in a project to sell the resulting asset on the secondary market, securitization increases initial lenders’ willingness to provide low-cost capital.
This is particularly true if the resulting securities receive a high credit rating because the asset will be worth more on the secondary market.
Why Should Financiers Use Solar Securitization?
Solar securitization offers prospects for a low-cost financing option for solar energy. This sector has been dependent on the ITC and other subsidies to finance its projects. These sources of financing nevertheless remain limited and insufficient given that there are few equity investors.
According to the National Renewable Energy Laboratory (NREL) report, “The Potential of Securitization in Solar PV Finance,” “Tax equity is a highly complex, illiquid, and thus high-cost source of financing.”
While other forms of financing such as master limited partnerships (MLPs) and real estate investment trusts (REITs) exist, they face a challenge; they require regulatory interventions to succeed.
An MLP is defined as a venture that is a publicly traded limited partnership. Profits are taxed only when investors receive the distributions. An REIT is defined as a company that owns, operates or finances income-producing real estate. It must meet certain guidelines.
Critiquing these options, Samantha Jacoby, associate attorney at Gibson Dunn, said in a comment on solar ABS market, “Solar-Backed Securities: Opportunities, Risks, and the Specter of the Subprime Mortgage Crisis,” that MLPs would require a tax code amendment qualifying renewables as MLPs, while REITs would require an IRS ruling classifying power purchases as “rents.”
Solar securitization thus can attract new classes of investors such as pension funds and other institutional investors without requiring new legislation.
In response to a question about the use of yieldcos, Frank O’Sullivan, director of research for the MIT Energy Initiative, said: “They are not suitable for distributed energy, which forms the core of solar securitization.”
Solar securitization also offers a broader base of capital than was originally possible, the NREL report said. This is made possible through tranching pieces of debt into segments with varying risks, maturities and rewards. This allows opportunities to exist for different investors with different risk appetites.
How Is the Market Developing?
Based on the Kroll Bond Rating Agency transaction reports, the total ABS market value for 2017 stood at 1.3 billion, which dwarfed the 2016 value of $321 million. As compared to the initial securitization of $54 million in 2013, 2017 showed immense growth for a market that has been considered rather slow.
In addition to the increased market value, there was also a marked difference in the collateral used to back the securitizations. As outlined in a MIT Energy Initiative Working Paper called “Solar Securitization: An Innovation in Renewable Energy Finance,” past securitizations were dominated by PPA leases. In 2017, however, most of the securitizations were backed using solar loans.
A PPA is defined as a contract in which an individual or business allows solar panels owned by a third party to be installed on their property and agrees to purchase the power at an agreed-upon rate over a fixed period of time.
While the investment tax credit (ITC) posed a huge challenge in the securitization process, companies are increasingly finding ways to navigate this dilemma.
The solar ITC is a 30-percent federal tax credit for the cost of solar systems installed on residential and commercial properties. The deal structure employed by tax equity remains complex. This makes it hard for solar developers to incorporate a securitization debt into the capital.
As of July 2016, three out of the four securitizations that involved tax equity used inverted leases, according to the MIT working paper. Only one used a partnership flip.
In tax equity investments, investment in solar development comes from a third-party private investor who uses federal tax benefits to offset taxes they would otherwise owe.
In such an arrangement, a third-party investor owns the solar panels and collects the tax benefits while leasing out the panels or selling the power through a solar PPA.
Partnership flips were defined well by a publication by the law firm Wilson, Sonsini, Goodrich and Rosati. “A partnership flip is the standard, go-to financial structure in the renewable market. The equity investor’s return is expected over a defined period - 10 years or less – and [consists] of cash and tax benefits. The developer’s/sponsor’s return [consists] mostly of cash and the renewable asset’s residual value. The sponsor recovers most of its invested funds relatively quickly and remains incentivized to operate and maintain the facility at as high a level as possible so that the equity investor’s interest will “flip” and it [can] realize a return on the residual interest in the asset as soon as possible.”
A webinar by Strafford explains how solar leases work. “The solar company assigns customer agreements and leases rooftop solar systems in tranches to a tax equity investor who collects the customer revenue and pays most of it to the solar company as rent. The solar company passes through the investment credit to the tax equity investor. It keeps the depreciation. The solar company takes the asset back at the end of the lease.”
Though investors preferred the partnership-flip model, the MIT working paper said that the inverted-lease model is more amendable to securitization than the partnership-flip model because it does not require back leverage or specific insurance.
What Challenges Remain?
O’Sullivan said the greatest concern for solar securitization is lack of a steady market. The current market seems sporadic, esoteric and small. This raises questions regarding its sustainability and efficiency in the future.
The NREL report and the MIT working paper highlight some hurdles that the solar ABS market faces.
These include lack of data or lack of sufficient data. Credit-rating agencies require historical performance data on up to 30 years of operations. However, most of these projects have less than 10 years of performance data available. Use of proxies and extrapolations of data adds risks to the process.
Changes in the regulations such as changes in utility prices, net metering, and electricity tariffs affect customer consumption patterns. This, in turn, impacts the cash flows from solar projects, thereby posing a greater risk to solar securitization.
Property-ownership transfers may also affect securitization. If the new owners do not have an interest in taking up the leases, solar providers may not be able to recover the costs of the assets. This may be aggravated by the existence of more efficient and far cheaper solar assets than the existing rooftop assets under the lease.
What Are the Future Prospects?
To accelerate growth in the ABS market, several actions will be required. The first is the pooling of financial resources. This will be beneficial in creating a large base of assets to conduct securitization while diversifying credit and geographic risks.
Pooling would also allow small and medium-scale solar developers to participate in the process. According to the MIT working paper, they account for about 40 to 50 percent of the existing residential solar.
The second action is contract standardization, which is necessary to overcome the cost of pooling resources. Standardization helps keep solar securitization and due diligence costs low by allowing for consistent project documentation, evaluation processes, and risk assessment.
Finally, there will be value in diversifying the securitization market beyond residential solar. Microgrids, community-shared solar, and solar plus storage may be viable options for securitization, O’Sullivan said.
The United States Department of Energy defines a microgrid as a set of connected electrical loads and power sources that has clearly defined electrical boundaries. It can be linked to a grid or operate on its own.
The commercial and industrial solar market, which has been less active on the securitization front, could also help in expanding the solar ABS market.