UK: Biomass and CHP Financing

Last Updated: 20 April 2008
Article by Michelle T. Davies

Biomass in the UK has seen a huge surge in the past 12 months. This has been largely due to the doubling of ROC's (Renewable Obligation Certificates) for qualifying biomass projects. It is also driven by the appetite of the utilities and independent developers for a more diversified portfolio of renewable generating assets and the need for waste generators e.g. local authorities in respect of waste wood, and retailers in respect of food waste, to deal with their waste more effectively. The Green agenda is driving this particular part of the sector as is the increasing cost of landfill and the psychological shift in thinking of waste as a cost to a resource.

The types of project tend to fall into two categories. Large scale projects, that is 40 - 50MW plus, and project portfolios where much smaller projects in the 1 to 5 MW range are housed under umbrella equity and debt arrangements often located on or close to the sites of the fuel supplier. The common factor is that these projects are all CHP for ROC purposes.

The smaller schemes are being promoted actively at a local and national political level because they can be housed on the site of the fuel provider and avoid what some regard as the greatest inefficiency of renewable electricity from biomass generation - loss of heat. The push towards these types of projects is also being driven through guidance and regulations applicable to development of buildings and local authority actions.

Also prevalent is a more diverse fuel base and technology use. There are a number of gasification / pyrolosis projects being developed principally under the umbrella portfolio structure. These tend to be smaller projects because of the need to ensure consistency of feedstock and the avoidance of technology concerns driven largely by consistency of fuel supply. Notwithstanding the maturity of anaerobic digestion plants on the continent, there are still very few as a proportion of all biomass plants in the UK. This is expected to change dramatically and may represent the biggest difference in the composition of the technology mix between now and in 2 years time.

Feedstocks now regularly range from virgin wood, energy crops, agricultural residues, straw, food waste and animal waste and industrial waste and co products. The providers of feedstock are also becoming more sophisticated requiring improved deals but largely in return for more bankable contracts. The UK has certainly come a long way in a short period of time.

The appetite for equity and bank debt is probably at its highest but developers need to proceed from the outset with a degree of caution in structuring any biomass project.

The key concerns for developers and investors, however, are as they have always been - technology and security of fuel supply. Many technology concerns have been overcome but do still exist with the newer technologies, particularly where there is a lack of financial covenant behind the technology supply. This is principally why those gasification projects which are debt financed for example are rarely in excess of 5MW. Many projects secure fuel supply but not on terms which are bankable. In simple terms, a bankable fuel supply is one of sufficient duration to cover the debt repayment commitment from a secure and financially credible source. There are many fuel supply arrangements being negotiated at the moment with overseas providers which are unlikely to meet a bank's criteria for credit worthiness. Alternative fuel supply arrangements may also need to be brought into the structure to enable the plant to run off more than one fuel source type and so provide funders with greater comfort on the achievement of availability targets. A common trend is for developers seeking financing to take ownership or a degree of control over fuel supply often in other jurisdictions. This trend originated with biofuels but has spread into the larger biomass projects where certainty of feedstock is the key concern. Common overseas jurisdictions for this purpose include North America, Asia and Eastern Europe.

Sustainability is also an issue in financing as many finance providers will have a concern regarding future legislation in this respect and the impact of its involvement in a project which does not tick the sustainability box. Sustainability for these purposes includes not only the source and nature of the feed stock (palm oil being a good example) but also the environmental cost of shipping and haulage generally. Sustainability is also a key factor for private equity. Sustainability increasingly means the moral and social cost of developing renewable energy and in particular the impact on food supply and price. There is very little movement of private equity funds at the moment in e.g. biofuels because of the sustainability debate where the chief concern is the consequence of increased food prices for those in poorer nations.

Sustainability concerns are not going to be helped by the publication of two recent studies which have shown that changes in land use to produce crop-based biofuels can actually result in more greenhouse-gas emissions than burning fossil fuels. The studies, both published in Science (8 February), estimate the impact of converting forests and grasslands into cropland for the production of biofuels. The studies conclude that the resulting carbon emissions, released through decomposition or burning of biomass, create a carbon debt' that takes decades or even centuries to be paid back through biofuel usage.

This finding goes some way to undermining previous claims that substituting fossil fuels with biofuels should reduce or even offset greenhouse-gas emissions because biofuels sequester carbon while they grow.

Consequently, projects that utilise fuels which do not infringe on agricultural or forest land (save for energy crops of short rotation growth) such as waste wood and food, animal and industrial waste are more likely to be attractive to funders.

The problem with these sources of fuel, however, is a logistical one in terms of coordinating what are often numerous supplies of smaller amounts from smaller suppliers. The more challenging the logistics, the greater the concern for both debt and equity providers.

Other options typically attractive for smaller developments will be the provision of grants. There are several schemes that offer grants to help encourage the efficient use of biomass for energy production, for example, the Bio-energy Capital Grants Scheme and now Defra's Bio-energy Capital grants Scheme for smaller scale biomass boilers (launched on 9 April 2008). However, the application time will need to be calculated into the project timescale. In addition, some funders have concerns about the proportion of grant funding in a project. Grant providers are more alive now to the risks of providing funds to special purpose vehicles and often require some form of parent company protection. This is required to back up any claw back rights the grant provider may secure. Claw back will often apply if the project is not developed in circumstances where it is proved to be technically and/or financially viable. Funders will be looking to isolate their liability in this respect which requires the principal developer to be prepared to take this risk.

Enhanced capital allowances for certain CHP installations will also be available as will interest free loans such as those made available by the Carbon Trust to eligible SME's (Small and Medium Sized Enterprises).

What is interesting is the development of more merchant positions on the off take arrangements and fuel supply. Some transactions in this sector are enjoying the ability to take advantage of a favourable market with lenders in some cases abandoning the requirement for fully contracted PPA's (Power Purchase Agreements) and fuel supply arrangements.

Before the credit crunch and the current market conditions, there was a move to a smaller equity component on financing structures. In the new financial environment, the debt/equity mix is back to what it arguably sensibly was 12 months ago in the 70/30 to 80/20 region. Fuel supply risk will take the equity component higher. This is likely to continue in the near future. The good news is that there is still a good degree of private equity available in the market to finance the requisite proportion of these transactions. In addition, some specialist banks are prepared to offer mezzanine finance for biomass CHP projects. This can be helpful for the small to mid size developers with limited access to equity or for the larger developers developing multiple projects.

If the current market conditions prevail as predicted, this could impact on the flow of equity and the UK may begin to see other finance structures emerging but for now the more traditional format looks likely to continue.

In conclusion, the UK biomass market is growing with financial structures developing to accommodate the increased confidence in fuel supply security, the technologies used and offtake prices. The newer technologies are likely to continue to develop with a continued growth in portfolio structures and larger projects.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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