SGIP PAP25 Surety Structure

XBRL Extension for Construction, Energy and Transportation  

Background
The Investment Tax Credit (ITC) extension to 2020 will favorably impact the financial viability of renewable energy solar projects, but the costs associated with providing financial guarantees in support of interconnection to the Smart Grid, along with related Power Purchase Agreements, Decommissioning and similar requirements, continue to be a barrier as the costs associated can undermine financial viability. 

Traditionally bank issued letters of credit have been the instrument of choice given their “On Demand” liquidity, but surety bonds are better suited to manage defaults, and while the “On Default” criteria has often been seen as a negative, the ability of the surety to effectively manage defaults not only makes it a preferred option, but also significantly less capital intensive and therefore makes solar more bankable.

The Surety industry provides financial guarantee products issued by insurance companies, regulated by the Department of Insurance in each state, and follow regulatory statutes with established legal precedence for how claims are administered. 

Although issued by insurance companies surety is not an insurance product, which is generally described as “risk transfer”, but a credit product similar to a co-signer where the ability to retain the risk of the contractual obligations is quantified by the surety during underwriting, and assumed by the surety in the event of a default with the obligation “to cure the default” as prescribed in the underlying contract.

The surety bond guarantees the contractual obligations of the entity that is principally obligated to perform, and required to provide a financial guarantee, referred to as the “Principal”.  The entity the principal is obligated to under the contract is referred to as the “obligee”, and the co-signer that stands behind the obligations of the principal is the surety.

The unique nature of surety is that as “co-signer” the obligations of the surety are no more than the obligations of the principal, the rights and remedies afforded the principal under the contract are the same rights and remedies for the surety, and the sureties assumption of the contract is only to the extent the principal was obligated and limited to curing the default.

Surety bonds are not stand alone instruments, they are tied to and incorporate an underlying contract such as interconnection, decommissioning and power purchase agreements.  The default and cure provisions in the underlying contract, including notice provisions and timelines, for the principal are the same for the surety.

The “on default” and “curing the default” characteristics make the risk of financial loss to the surety substantially less than a bank letter of credit, where to obligation to pay is “on demand”, without the benefit of cure provisions within the underlying contract. 

The ability to defend against an unwarranted demand, along with the ability to cure the default, results in better pricing, terms and conditions from a surety that are significantly less costly than letters of credit from a bank.

Better pricing, terms and conditions related to securing financial grantee instruments reduce project costs, and with effective default risk mitigation along with predicable claim handling can make renewable energy projects more bankable while providing the highest level of financial protection.

Surety Effectiveness in Managing Defaults

An analogy for how surety works that is helpful for understanding benefits that surety bonds offer public agencies is when a contract to build or maintain a construction project is in default.  While utilities are not public agencies, they are regulated to a certain extent as if they were.

First thing is the procurement in public works is a drawn out process, with bid solicitations, notifications, pre-bid advertising and a bid award process that follows rigid protocols and procedures.  If the public agency accepted a LOC to protect against default, the default would be the public agencies to administer, under regulatory oversight and procedures, including the defaulted contract re-letting process which could require the same time consuming procurement process be repeated. 

Holding funds of a defaulted entity under a letter of credit also exposures the public agency to account for the funds on behalf of creditors, and to return any funds in excess of the loss.

With a surety bond the surety would administer curing the default, and with legal rights to the underlying contract the surety has the ability to facilitate the most cost effective way to bring in a new contractor.   In spite of it being a public works project there is no procurement process to deal with, and regulatory oversight would be minimal if at all. 

The surety would resolve any subcontractor and/or vendor payment issues on the defaulted contract.

The public agency, or the publicly regulated utility, could simply look to the surety to cure the default, and to restore the forward progress of the contract.

The surety legal structure is designed around efficient default management.

Structure for Surety Products Tailored for the Smart Grid
The same basic premise, where the surety assumes the underlying contract and “steps in the shoes” of the defaulted principal, and subcontractors and other payment bond claimants, would apply to Smart Grid related contracts.  Not only would the surety have the right to assume the underlying contract, but as outlined above, seek to cure the default by bringing in a replacement entity to take over the underlying contract at no loss, cost or expense to the obligee, and hopefully no loss to the surety.

If assumption of the underlying contract is not feasible or desired, the surety, at its option, can cure the default by simply paying the financial damages as defined in the underlying contract, and let the underlying contract expire.

The surety rights and remedies for assumption of the underlying contract with utilities is consistent with the surety rights and remedies on public works contracts.

Historical Responsiveness of Surety to Default
The lack of responsiveness by the surety to a default is often cited as a concern.  As noted above the obligations of the surety are tied to that of its principal, so before any surety can respond the obligation has to be verified.  That time and distraction can be detrimental to a project, but it can also be avoided with better communication between stakeholders while the problem is escalating and prior to default.

SGIP PAP25 is working with various data reporting standards, such as XBRL/FIBO and IECRE 61724, to improve communication and provide early warning data analytics that will prompt default mitigation measures and identify obligations so that a timely response from the surety can be achieved.

Unintended Consequences of a Letter of Credit 
One of the most valuable assets a solar developer has on any project is the guaranteed revenue from a PPA, which could be compromised if external pressures, like a bankruptcy of a parent or holding company, triggers a project level default and the utility draws down on the letter of credit and exposes the project to bank foreclosure action.


Assuming the energy being delivered meets the obligations of the PPA, therefore no loss to the utility, that draw down will need to be held in escrow making the utility a “custodian with a fiduciary responsibility”.

If the PPA default compromises the PPA itself, and the PPA is canceled as a result of the default, the impact on the valuation of the solar facility is significantly adverse, and will negatively impact any financial restructuring or sale.  Resulting in even more losses for the solar developer, its lenders and more unpredictability for the utility.

That is not a preferred position for the utility, the lender or the solar developer, and does not contribute to an orderly and cost effective management of the situation.

While the idea of being able to draw funds quickly has appeal, the ramification of the utility having to defend its holding of cash assets and having to actively engage in a protracted legal processes, all while the facility is meeting its PPA requirements and therefore no loss to utility, adds a level of inconvenience to the utility that far outweigh the benefit.

Instead of the utility being forced to engage in the legal proceedings associated with foreclosure, and contributing to the unpredictably due to deep discounting of project valuation, they could instead refer the problem to the surety to “cure the default”.

The distinction between a letter of credit and a surety bond is often defined as “On Demand” vs. “On Default”.  Another more important distinction is how defaults are managed, by “Foreclosure” or “Cure”.

The SGIP PAP25 and XBRL-CET surety structure and bond forms provide for how a default would be handled, and how a surety could mitigate the loss by having a mutually agreed process for curing a default, including the disposition of the PPA asset to a restructured entity, or replacement buyer.

If the project has a track record of performance, and operationally sound, then a surety structure can protect the PPA as a transferable asset, and make it so the default cure mitigated the loss and expedited the resolution without the usual encumbrance of the legal system and attorney costs.

The surety structure does not deny or dilute existing financial interests in the value of the PPA, but preserves the value for maximum loss mitigation for the project as a whole. 

The intended benefits of a surety bond are better than the unintended consequences of a letter of credit.

Basic Model of Surety Managed Default and Bank Foreclosure


Link to Model

The model is generic and simplified on purpose, because the focus is on the PPA contract preservation for the benefit of stakeholders, and for the surety to demonstrate how the PPA revenue is enough to cover O&M during the transition or restructuring, for no loss to the surety under the bonded PPA contract. 

The ability to demonstrate no loss to the surety is the basis for surety support.

We recognize there are a great number of variables and costs that are not reflected, but again the purpose is a generic overview of how a surety cure is better than a bank foreclosure.

We also acknowledge there are many factors that could alter the premise.

We also appreciate that the bank foreclosure process would involve many of the same processes as a surety, however surety has certain benefits, including legal structure and precedence, which can be instrumental to a successful outcome because of the protection it gives to the PPA and predictability it provides to many stakeholders, including the lenders and investors.

Benefits of Surety over Letters of Credit


Developers
- Reduced cost of capital for financial security instruments

- On existing projects a portion, if not all, of the collateral held by the banks to support LOC’s can be returned, and the ongoing debt burden for maintaining collateral would be reduced.


- Better protection against unwarranted draws, with the ability to defend and cure.

Investors
- While loss prevention may not be possible if a default was to occur, loss mitigation would be achievable through protection of the underlying contract, and a process that focuses on curing the risk of underlying contract default, instead of the more expensive and destructive foreclosure action from the underlying contract LOC being drawn on.

Lenders

- Lenders would not have a financial exposure for the amount of the LOC

An orderly management of financial restructuring of the asset debt, including the protection of the underlying contract, would preserve the overall asset value to support underwriting considerations.

Utilities
- In the event of a default and draw down on a letter of credit the utility would not have to hold and administer funds drawn from the LOC, and account to the creditors for funds not required to meet underlying contract obligations.

- Would not have a problem asset on their grid, with the associated unpredictability.


- Surety can act as a financial backstop to facilitate the restructuring or transfer of the asset to a financially sustainable structure, with the efficient management of underlying asset, the “bonded contract”, as a transferable asset.

- Managing and curing the default would be the obligation of the surety, not the utility.

Department of Energy / FERC / NIST
- Consistent with the objectives of the DOE funded Solar Bankability Data to create financial products and services that utilize data analytics to reduce risk and thereby reduce the amount of capital needed for development of renewable energy projects with better terms and conditions, and less collateral required.

- Provides “best practices” precedence for building the Smart Grid

- Validates assumptions regarding how surety can perform in a default situation that provides assurance to lenders and utilities for how defaults will be managed, and confidence in the predictability of the process

- Codifies the data sets and surety bond forms for building the Smart Grid as contemplated by SB-Data

SGIP PAP25 and XBRL-CET
- Brings focus to the proposed structure, engages the working groups to formalize the IECRE 61724 data set to enable data interoperability, along with analytics, and validates the surety structure as a qualified method for building the Smart Grid.

 

IECRE
- The effort will shift focus on the data set for 61724 from theoretical to actual, and produce a much more valuable product with a much higher engagement, adoption and implementation rate.

- Allows for the 61724 data set, or derivatives, to encompass all renewable energy, not just PV.

Surety Industry
- Addresses the main concern of a surety in providing new and innovative products; how will they work in a real world default situation.