Decarbonisation Technology - August 2024 Issue

complexity can be better understood by a chart (see Figure 1 ) that maps out the intricate web of relationships needed to execute a standard project financing transaction. A project finance transaction typically starts with the developer setting up a special purpose vehicle (SPV). This SPV then executes agreements with various stakeholders, including the engineering, procurement, and construction (EPC) contractor, a product offtake agreement with the product purchasers, a feedstock agreement, and so on, to distribute various project risks. A successful project finance transaction tries to balance the risks and rewards while aligning incentives for all participants. In addition to large commercial banks, a project can also raise project finance debt through taxable or tax-exempt bonds, export credit agencies (ECAs), multilateral agencies, private placement debt, and other sources of funds. Furthermore, debt providers also require a project to raise equity, which can come from energy companies, strategic investors, investment funds, operators, off-takers, and even host governments. Different funding sources are essentially different ‘capital pools’ with different risk appetites and eligibility requirements. Large projects often raise money from a wide spectrum of financial institutions and stakeholders to achieve financial close. Project financing in the energy transition Even though there is significant momentum and a lot of talk about achieving net zero, only a handful of commercial-scale energy transition projects have been built to date. In order to build many more of these large facilities and achieve meaningful impact, stakeholders will need to unlock project financing for these unproven technologies. However, this requires innovative contracting structures and supportive regulation and policy to mitigate key project risks. Completion and performance risk One of the main risks facing energy transition projects is related to completion and performance. Constructing first-of-a-kind (FOAK) facilities might bring about unforeseen technical and engineering challenges, unanticipated stress on equipment and material supply chains, increased labour costs due

to uncertainty and greater complexity than planned, and unexpected delays during startup, all of which can drive up costs and put the project’s financial viability at risk. Additionally, rolling out a first commercial facility for a new technology presents significantly different and more complex performance risks than testing in the lab or the field, as the technology might be inefficient, generate inadequate production, or simply fail at larger scales. In an ideal scenario for a project financed transaction, the EPC contractor offers a fixed price lump sum turn-key (LSTK) structure for a project (see Figure 2 ). Under an LSTK structure, the EPC contractor shoulders a significant amount of risk by guaranteeing a project’s cost, schedule, and performance. These guarantees reassure banks, prospective equity investors, and the operating company. LSTK EPC contracts, however, are rare for projects involving unproven FOAK technology or FOAK integrations of technology since many of these risks cannot be effectively managed by the EPC contractor. For example, if a technology fails to meet the contractual guarantees, EPC contractors’ recourse against technology providers is typically capped at the value of the provider’s supply or licence agreement. This amount is often a fraction of what is required by lenders and thus EPC contractors cannot provide a full LSTK wrap without taking significant risk on the technology. At the other end of the spectrum, a cost- reimbursable (Cost-Re) structure is a contractual approach where the owner typically takes a significantly larger share of the completion and performance risks. Under this commercial structure, the EPC contractor is reimbursed based on actual costs incurred during the project, with the owner being responsible for most cost overruns. Cost-Re contracts can provide flexibility to handle the uncertainties inherent in complex FOAK projects but require a much higher level of owner involvement, oversight, and financial support compared to LSTK EPC contracts. This increased exposure to cost overrun risk, as well as the potential heightened exposure to performance and schedule risk, makes Cost-Re less attractive or even unacceptable to lenders and investors, reducing the project’s bankability. The challenge is in finding a balance between