Henry Scott and Miguel Duran | Milbank
An extract from The Projects and Construction Review, 12th Edition
Introduction
The project finance market in the United States benefits from a well-developed legal framework and sophisticated financial markets. The US legal system is generally viewed as clearly codified, stable and efficient, as well as one that is enforced in a regular and open manner.2 Contractual agreements between parties are recognised by law with few exceptions related to public policy concerns. The project finance sector has strong access to both the public and the private financial markets and is in some limited areas even supported – directly or indirectly – by government policies.
This combination of a strong legal framework and financial markets has facilitated the development of a robust project finance sector in the United States. Project finance is premised on the ability of the parties to contractually allocate risks among themselves and to enforce those contractual obligations in a reliable manner. A successful project finance regime is also dependent on commercial laws that allow developers to protect themselves through special purpose entities that benefit from non-recourse financing and that, similarly, allow lenders and investors to obtain security in the project assets and to enforce their claims against the project. Likewise, a sophisticated private financial market has the flexibility to allow the developer and the financing providers to create complex financing structures and to tailor those structures to the specific needs of a particular project.
This chapter discusses various transactional structures available to projects and the legal documentation frequently used to implement them. It reviews the various risks associated with project finance transactions and how parties allocate these risks. It also examines how the US legal framework supports the ability of lenders and investors to protect their interests, including obtaining, perfecting and enforcing security interests in a manner that permits lenders to enforce their rights in the event that a project encounters financial problems.
This chapter also considers how the legal framework is influenced and affected by social and environmental considerations. The role of a complex legal framework and sophisticated private financing providers and the public sector is also addressed, followed by a summary of the impact of taxes on investment, which may be of particular interest to foreign lenders and investors. The framework for how dispute resolution is processed in the United States is discussed in the final section.
The year in review
The nature and complexion of project finance in the United States has been shifting, mostly as a result of the expiry of certain government incentives, regulatory changes relating to power plant emissions, declining prices of distributed generation technologies, including battery storage, and lower natural gas prices as a result of increased domestic production.
More recently, the sector has been shaped by:
- uncertainty about the potential enactment of additional tax incentives for the renewable energy sector that the Biden administration is attempting to implement as part of its Build Back Better framework;3
- US trade policy and government actions with regard to certain imported solar modules and cells (including the imposition and recent extension of tariffs on imported solar cells,4 the modification of regulations governing the enforcement and compliance with anti-dumping and countervailing duty laws5 and the inquiries initiated by the Department of Commerce regarding potential violations of anti-dumping and countervailing duty orders on solar cells imported from China,6 which could result in the application (even retroactive) of substantial duties, although the concerns have been alleviated by an emergency declaration by President Biden that provides a 24-month period of relief against new anti-dumping or countervailing duties7);
- increased focus on environmental, social and governance issues;
- increases in interest rates;
- increases in commodity prices intensified by Russia’s invasion of Ukraine; and
- supply chain issues (exacerbated by persistent effects of the covid-19 pandemic).
Moreover, in mid-February 2021, the Texas power system experienced near total collapse as a consequence of Winter Storm Uri, a ‘black swan’ weather event for which the Texas power grid was neither designed nor prepared. The event caused widespread financial consequences, including litigation and bankruptcies involving tens of billions of dollars, many related to hedging instruments with fixed-quantity obligations and unmitigated exposure to extreme market prices. In addition to calls for increased weatherisation of infrastructure assets, the event exposed the consequences of an energy-only market with low reserve margins.
Renewable energy projects continue to remain a significant component of the market. In 2021, approximately 42 per cent of the total value of project finance transactions in the country was invested in the renewable energy sector.8 For example, 12,747MW of wind energy projects, 12,364MW of solar energy projects and 2,599MW of battery storage projects were installed in 2021.9 At the end of 2021, there was approximately 42GW of wind capacity (42 per cent of which is offshore wind), approximately 66GW of solar capacity and approximately 12GW of battery storage capacity in near-term development.10 Additionally, approximately 1.49GW of hydroelectric generating capacity and 52GW of pumped storage hydropower capacity were already in the development pipeline at the end of 2019.11
Throughout 2021, much of the project financing activity in the United States involved energy projects that were able to qualify for a production tax credit (PTC)12 or investment tax credit (ITC)13 by meeting certain requirements. The PTC programme is available for certain eligible facilities for which construction began before 1 January 2022 (with a progressive phase-out reduction for wind facilities if construction begins after 31 December 2016) and the ITC programme is available for qualified solar facilities for which construction began before 1 January 2024.
Current Internal Revenue Service (IRS) guidance provides for certain safe harbour provisions with respect to the beginning of construction requirement, requiring the performance of certain specified actions (based on either physical work or the incurrence of costs) prior to the applicable qualification deadline and placement in service of the facility within four years of the qualification deadline. To address the unforeseen interruptions experienced by developers because of the covid-19 pandemic, in May 2020 and June 2021 the IRS modified its prior guidance and extended the four-year safe harbour requirement by two additional years for projects for which construction began in the calendar years 2016 through 2019, and by one additional year for projects for which construction began in 2020.14
Additionally, developers of clean energy projects employing new or innovative technology that was not in general use were able in 2021 to request loan guarantees pursuant to Section 1703 of the Department of Energy’s loan guarantee programme,15 including US$8.5 billion of loans for advanced fossil energy projects that avoid, reduce or sequester greenhouse gases,16 US$8.5 billion of loans for renewable or efficient energy technologies17 and approximately US$10.9 billion of loans for nuclear energy technologies.18
In December 2016, the Department of Energy announced a conditional commitment to guarantee up to US$2 billion of loans to construct a methanol production facility employing carbon capture technology in Lake Charles, Louisiana, which would represent the first loan guarantee made under those solicitation programmes.19 In February 2018, Congress enacted the Bipartisan Budget Act of 2018,20 which substantially increased the value of the Section 45Q tax credit available for carbon capture, utilisation and storage projects, and significantly expanded the universe of companies that would be eligible for this federal subsidy (which was originally made available in 2008) by increasing the eligible uses, decreasing the carbon capture threshold and eliminating the prior programme’s limitation to the first 75 million tons of carbon captures.
The Section 45Q tax credit will be available for eligible projects placed in service after 9 February 2018 and for which construction began prior to 1 January 2026 and can be claimed over a 12-year period.21 In February 2020 and July 2021, the IRS issued guidance with respect to the determination of the beginning of construction for purposes of the Section 45Q tax credit22 and the allocation of the Section 45Q tax credit by partnerships,23 the definition of carbon capture equipment, and requirements regarding ownership and placement-in-service,24 which is expected to increase the development of carbon capture and sequestration projects.
Propelled by extended federal incentives, advances in green technology that decrease investment costs, state incentives and regulatory policies implementing renewable energy portfolio standards (RPS) on utilities, and the positioning of renewable energy as a key component for strategic energy independence for the nation, the development of renewable projects is expected to continue moving forward. As at September 2020, 30 states, the District of Columbia and three US territories have enacted RPS programmes, and eight additional states and one US territory now have voluntary goals for generation of renewable energy.25
For example, California’s RPS programme, one of the most ambitious in the United States, requires that utilities derive 44 of their energy from renewable sources by the end of 2024, 52 per cent by the end of 2027 and 60 per cent by the end of 2030 (with the ultimate goal of obtaining 100 per cent of the retail sales of electricity to end-use customers and the electricity to serve all state agencies from renewable energy resources and zero-carbon resources by the end of 2045).26 While all three of the largest California utilities have enough renewable energy capacity under contract to meet the 2024 threshold, the generation forecasts that those utilities prepared in 2021 (risk adjusted to account for a certain degree of project failure) show that, in the aggregate, there will be a deficit beginning in 2028.27
Other states, such as New Mexico and Washington, have similar 100 per cent carbon-free goals in the next few decades, and Hawaii has gone further by requiring 100 per cent renewable energy generation by 2045.28 As a result, there is a need for additional renewable energy generation in California and the rest of the United States. As the existing fleets of wind generation projects developed before 2000 approach the end of their useful lives, it is also expected that repowering investment will significantly increase during the next decade.
While still in its early stages, the US offshore wind energy sector recently experienced noteworthy developments. In May 2021, the US Bureau of Ocean Energy Management, the US Army Corps of Engineers and the National Oceanic and Atmospheric Administration’s National Marine Fisheries Service issued their joint record of decision29 with regard to Vineyard Wind LLC’s 800MW offshore wind project. Vineyard Wind achieved financial close (raising US$2.3 billion of senior debt) in September 2021,30 and construction commenced in November 2021.31 While there are currently only two operational offshore wind projects in the United States,32 as at May 2022 several additional states already have offshore wind projects under development.33
Proposed regulations aimed at limiting greenhouse gas emissions from existing fossil fuel-fired electric generating units in part by setting state-specific goals for reducing emissions from the power sector have been the subject of multiple legal challenges in recent years, and the final outcome is still uncertain. The initial rules released by the US Environmental Protection Agency (EPA) in August 2015 (the clean power plan) were repealed and replaced with the affordable clean energy rule on 6 September 2019.34
On 19 January 2021, the US Court of Appeals for the DC Circuit vacated the ‘ repeal and replace’ rule35 but, at the request of the federal government, granted a stay with respect to the vacatur of the repeal of the clean power plan to ensure that the clean power plan would not go into effect while the EPA was promulgating a new rule governing power plants’ greenhouse-gas emissions.36 While no regulations are currently in effect, certain aspects of the decision by the US Court of Appeals for the DC Circuit are currently being challenged before the US Supreme Court, which heard oral arguments on 28 February 2022 and is expected to rule on the merits by June 2022.
Going forward, most renewable energy projects will increasingly rely upon commercial banks and capital markets to satisfy capital demands. For larger projects, mixed bank–private placement transactions with two or more tranches of funds may provide a preferred financing structure.
In the past couple of years, the market has seen an increase in the amount of available capital for project financings combined with a reduction in the number of projects seeking funding, as a result of which financiers have been driven to offer almost unprecedented conditions (including a significant downward trend in pricing for capital) to remain competitive. This environment has allowed sponsors to refinance existing facilities with inexpensive long-term capital sources and has fostered an increased interest in the acquisition of operating assets.
New financing tools have also become increasingly important for renewable energy projects, particularly in the field of structured finance. For instance, approximately US$3.7 billion was raised in 2021 as part of the securitisation of thousands of residential and commercial solar energy contracts.37 As other solar developers increase their portfolios, they may choose to follow this lead to secure financing.
Outside the renewable energy space, the retirement of coal and nuclear facilities generated renewed interest by sponsors in the development of new gas-fired power plants. Since 2016, natural gas-fired generation in the United States has surpassed coal generation every year, and the gap keeps increasing.38 Natural gas-fired electric generation is expected to grow to a forecast level equivalent to over 34 per cent of the total generation by 2050, while coal-fired electric generation is expected to decrease to approximately 9 per cent of total generation by 2050.39
The introduction of new capacity markets may further spur investment in gas-fired projects, which have been challenged by lower wholesale electricity prices in some markets, such as Texas. Additionally, project developers have devoted more attention on gasification facilities, which convert feedstock into a synthetic gas that is used as fuel or is further converted into a variety of products, including hydrogen, methanol, carbon monoxide and carbon dioxide. These projects have commonly used fossil materials, such as coal and petroleum coke, as feedstock, although there are several gas-to-liquid projects in development, and there is an intensified interest in the use of biodegradable materials, including municipal solid waste and forestry, lumber mill and crop wastes.
Another development in the energy sector involves an ongoing transformation in the identity of the power purchasers in the market. As electricity prices have been declining, it has become more difficult for developers to secure long-term offtake agreements with investment grade utilities, and businesses, universities and other non-traditional offtakers gradually have been taking their place.
In some states, communities have started forming community choice aggregations (CCAs) to source electricity. CCAs purchase electricity from a utility and sell it to their residents and businesses. While only 10 states have legislation governing CCAs,40 these entities have started to become more significant. Utilities, especially those in western states, face increasing difficulty in maintaining their credit standing, as they confront a declining customer base owing to the emergence of CCAs and distributed generation technologies, legacy pension liabilities, and the implications of climate change, including liability for utility-caused wildfires.
In addition, constrained state and local fiscal budgets, limited federal transportation funding, decreased tax revenue and the considerable need for new infrastructure assets and the refurbishment, repair and replacement of existing assets may hasten the further use of the public-private partnership (PPP) project finance structure (further described in Section IX). While most large infrastructure projects in the United States, at least since the introduction of the interstate system in the 1950s, have been completed using public funds rather than through the participation of private entities, a confluence of factors may be creating a fertile ground for the development of increased government and public acceptance of PPPs.
According to the latest report card by the American Society of Civil Engineers, the infrastructure of the United States has a C- grade point average,41 and an estimated investment of approximately US$5.6 trillion (in addition to the approximately US$7.3 trillion currently contemplated to be funded) will be required by 2040 to maintain a state of good repair.42 In November 2021, the US$1.2-trillion Infrastructure Investment and Jobs Act of 202143 was enacted, providing additional funding for infrastructure projects.
Given that existing legislation has been insufficient to satisfy the country’s needs for infrastructure funding, state and local governments started to turn to the private sector to fill the gap. Recent significant PPP projects include the up to US$4.9-billion Automated People Mover project and the US$2-billion consolidated rent-a-car facility at the Los Angeles International Airport (anticipated to become operational in 2023),44 the US$500-million consolidated rent-a-car facility and public parking garage facility at the Newark Liberty International Airport,45 the US$450-million Empire State Thruway project in New York,46 the US$1.8-billion Fargo–Moorhead flood diversion project,47 the approximately US$3.7-billion I-66 Outside the Beltway project in Virginia48 and the approximately US$5.7-billion Gordie Howe International Bridge connecting Detroit (United States) and Windsor (Canada).49 While in some jurisdictions developers will need to navigate uncharted legislative and regulatory waters, and may also have to overcome negative public perception regarding the private management of public infrastructure, the opportunities for growth may be unprecedented.
Outlook and conclusions
In the long term, project finance is expected to continue to be a popular vehicle to finance the necessary energy and infrastructure assets in the United States, particularly to replace the ageing fleet of coal-fired plants, nuclear plants and other public infrastructure, given the support of the strong legal framework and a strong, sophisticated private financing market (in addition to political support and other factors).
The US Energy Information Administration (EIA) estimates that energy consumption, across all sectors, will increase by 0.4 per cent per year between 2021 and 2050.89 While additions to power plant capacity are expected to slow from the construction boom years in the early 2000s, it is expected that there will be more long-term growth in certain sectors, such as projects from renewable sources and natural gas. For example, the EIA projects that electricity generation from renewable sources will grow so that its share of total US energy generation will increase from approximately 21 per cent in 2021 to approximately 44 per cent in 2050 in the reference case, or as high as 47 per cent based on a high oil price case.90
Additionally, projections from industry sources foresee that the United States may need close to US$5.6 trillion in additional funding to support its standard infrastructure needs in the coming years.91 With the enduring need for energy and infrastructure, the United States will look to project finance structures as one of the tools for satisfying this need.
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