September 2006

The Guarantee Hump

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2006/10/27)
 

“Energy/Environment” has always been one of Washington’s great policy paradoxes. There either is an energy crisis, or maybe there isn’t. Yesterday there was; today, post-Gulf-potential-oil-find, there isn’t. Same with global warming. Yesterday, scientific doubts; today, melting iceberg spotted, crisis ahoy.

Last year, the energy crisis was perceived and EPACT was passed. It was, of course, a grab bag of provisions, designed mostly to elicit private response to the perceived crisis. Even then, the crisis was seen to have an environmental subtext; the need to reduce greenhouse gases while reducing the threat presented by energy shortfalls. Inevitably — as for so many other policy problems — technology was seen as the quick fix.

Which, in due time, has now led the Department of Energy to issue guidelines for Title XVII of EPACT, providing loan guarantees to facilitate the financing of these environmentally clean, productive, innovative, yet commercial energy technologies. The challenge: to boldly go where some men have gone a little bit of the way before; to deal with a group of problems which, while each is acknowledged to be important, have not been linked by a coherent legal framework in the United States rewarding to those who confront it; to guide America to build the perfect camel to get us over the current hump.

To which conundrum for DOE certain other policy guidelines inherent in the Federal loan guarantee process have been required to be added, notably: (i) to protect the public by reducing the risk of defaults, and (ii) to reduce the cost to the Government (whose resources have been depleted by fighting other wars) of paying for the review of applications for loan guarantees. Funding issues continue to hang over the program. Only a portion ($2 billion) of the authorized funds currently are available for loan guarantee purposes, and it remains to be seen whether Congress will insist on approving the funding of each project individually (which currently is the case under the proposed regulations). With all of the foregoing caveats, a look at a few key features (and quirks) of the proposed Federal loan guarantee program are in order.

• While Title XVII of EPACT seems to establish conjunctively both greenhouse gas reduction and new technology improvements as eligibility requirements, it appears that as long as a project falls within any of ten identified categories of technology, that project will be deemed to meet the statutory requirements. The eligible technology net is a broad one. It ranges from environmental control, to certain advanced uses of fossil energy, to nuclear, to energy efficiency, to “renewable energy systems.” Only initial dollar cut-off places distributed energy opportunities at some greater advantage in being the first projects to be guaranteed. It must be remembered, though, that these technologies may not be “demonstration projects.” Indeed, they must be “mature enough to assure dependable commercial operation,” and generate sufficient revenues to pay the debts which are incurred. They must, in short, be at a stage where the deal fundamentals of the demanding lender finds that a market can be met. They also must meet the Federal Government “scoring” standard which effectively translates into a requirement that the Government’s perceived risk premium, i.e., probability of repayment on the loan guarantee, is a fee which must come out of the developer’s pocket. This is the so-called “subsidy cost,” which a developer — not the Government — must pay.
   

• The loan guarantee will not overcome all of the challenges to project financing which a developer faces. The eligible amount of guaranteed project debt is 80% of project costs. It may be, at least it is the case in the first solicitation, that as little as 80% of that eligible 80% may be guaranteed. The project costs do not include the “subsidy cost” payable by the developer to obtain the loan guarantee. This is, therefore, another equity requirement.
   

• The possibility that there may be un-guaranteed debt can create a further issue. If Government foreclosure is necessitated by deficit, the Government’s lien extends to, and is superior to, all of the project’s property.  The balance of the loan in the project is thus not only non-guaranteed but junior in its security to that of the Federal Government. Everything non-Federal is emphatically junior debt.
   

• Whereas bundling equity sources while using other incentives is not precluded, DOE is very interested in project’s sponsor making a significant commitment and absorbing risk. Consequently and unfortunately, maximization of potential Federal benefits could be viewed unfavorably.
   

• The full onerousness of this provision is further enlarged by the fact that, under the guidelines, the guaranteed and unguaranteed portions of a project loan must be sold on a pro rata basis, i.e., The guaranteed portion may not be “stripped” and sold separately as an instrument fully guaranteed by the Federal Government.  The marketability of the guaranteed paper will be harmed (or conversely, the price that will have to be paid by a developer to market it will be increased).

Some environment/energy loan camels will go though the eye of the DOE Title XVII loan guarantee needle and (unless and until the law is changed) through the eye of the Congressional needle as well. Some improvements on the greenhouse gas and technological fronts are to be expected as a result of the program’s operation. It is probably to be expected that the scope of the loan guarantee program will be even further expanded as Congressional leaders vie to highlight their devotion to various energy technologies.  Loan guarantee programs have, in fact, proved to be major stimuli to a diverse range of activities deemed to be in the public interest — but much more so when they are standardized in nature and can develop stable markets.  That is the basic challenge faced here.

It raises the question whether a loan guarantee, not coupled with a Federal mandate or a Federal regulatory scheme, has the desired potential for impact. Can an energy/environment camel in crisis be solved by offering partial payment to individual camel drivers who will still face financial risk even if their plans are successful? We’ll find out whether DOE can get over that hump.

ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years.  In particular, he has analyzed and executed a wide variety and substantial value of project financings.  He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration.  He is a graduate of Brown University, Yale Law School and Harvard Business School.