The most fundamental element of disruptive business models is financing. the article explores creating, adopting and adapting proven models for new industries.

1. Transformation
Cleantech: enabling the business
response to climate change
Global cleantech insights and trends report 2008-09

2. 20
When we think of emerging technology, we think of disruptive
technology that can be deployed more cheaply, faster and with
less complexity than what it’s replacing.
That is true unless you’re talking about renewable power
generation. As with other emerging technologies, there is still
a technology risk. Venture capitalists make consistent bets in
the tens of millions of dollars that pricing on thin film solar will
continue to decline as efficiency increases or that power from
waves or tides can be a consistent alternative to coal-based power.
Dams, power plants and other large-scale conventional projects
are built with access to billions of dollars in project finance capital
from insurance companies and the public markets. This is where
any similarities end.
Venture capital will sponsor inexperienced management teams
with unproven technologies but not to the point of excessive
concentrated risk in a single project. Project investors finance
billions in conventional power generation worldwide with
currency, legal and expropriation risk. But they will not finance
early-stage technology companies with performance and scaling
risk as well as the lack of experience of prior investors. As clean
technologies continue to come to market and the developers of
these technologies transition from innovators to operators, the
commercial financing gap will remain daunting. In this article, we
examine the drivers of the US market and the basics of project
finance, as well as some of the asset structuring required for
renewable power finance.
International trends
According to the United Nations Environment Programme’s Global
Trends in Sustainable Energy Investment 2008, nearly US$150 billion
in new money flowed into the clean energy sector in 2007 — a 60%
increase over 2006 investment levels. The report goes on to state
that investment levels are on track to reach US$450 billion a year
by 2012 and US$600 billion a year in 2020.
The majority of the new money (57%) went into asset financing
or the actual build-out of renewable power generation as opposed
to research and development (R&D) or manufacturing scale-up.
Wind power accounted for 43% of all new investment in 2007,
which is understandable given the maturity of the technology.
Solar experienced a change in investor sentiment in 2007 versus
2006, as large-scale deployment via asset financing increased
from 6% of total new investment in 2006 to 21% in 2007. Solar
continues to post very strong investment growth year-over-year,
averaging 254% since 2004.
Europe led the way in 2007 by attracting the bulk of financing as
attractive government subsidies continued to support the build-
out of renewable power generation projects. European asset
finance totaled US$49.5 billion (78% was new build-out), taking
62% of asset finance worldwide.
The US is not too far behind, however, with 28 states implementing
renewable portfolio standards (RPS) and another four with
voluntary RPS; California increasing its RPS to 33%; and 10 states
in the Northeast launching the Regional Greenhouse Gas Initiative
(RGGI), according to the Pew Center on Global Climate Change.
RGGI, the first cap-and-trade program in the US, will auction 100%
of the allowances and use the proceeds to incentivize renewable
power and energy efficiency. Ernst & Young’s quarterly ranking
of US states and their relative attractiveness to a renewable
power generator, United States Renewable Energy Attractiveness
Indices, indicates that on a prospective basis, the US has more
favorable fundamentals than other countries when scoring across
all renewables (wind, solar, biomass). With European subsidies
declining as renewable power production approaches national
capacity caps, expect the investment focus to shift to the United
How cleantech can close
the financing gap
by Tony Maull, Mid-Atlantic Cleantech Leader, Ernst & Young, and
Michael Bernier, Tax Credit Investment Advisory Services, Ernst & Young
Key points
The UN expects worldwide investment levels in the clean•
energy sector to increase from US$150 billion annually
to US$450 billion by 2012.
Ernst & Young’s• Renewable Energy Attractiveness
Indices identifies the US as having the most attractive
investment environment among all countries.
Twenty-eight US states currently have a renewable•
portfolio standard.
Unproven technology requires creative structures to get•
financed — quality cash flow is key to success.
FIN 46(R) makes the identification of the primary•
beneficiary and the consolidation of assets and liabilities
very complex — legal ownership is not the answer.

3. 21Transformation Cleantech: enabling the business response to climate change
States to fulfill the RPS and access the state-level incentives.
The reduction in subsidies for wind and solar explains part of the
accelerated growth in asset financing in Europe in 2006 and 2007
as producers rushed to lock up attractive power rates. The caveat
to near-term US renewable power generation is the question of
whether the federal production tax credit for wind, solar and
geothermal will be extended. It is anticipated that the extension
will be passed by both houses in November after the 2008
general election.
Project finance
According to the data provider New Energy Finance, financings
of renewable energy generating assets grew by 61% in 2007 to
US$108 billion from US$67.3 billion in 2006.1
US$84.5 billion
went toward building new capacity while the remainder was
allocated to refinancing and acquisitions. The allocation remained
evenly split between on-balance sheet and off-balance sheet in
2007. Most of the balance sheet financings were completed in
China while the off-balance sheet financings were concentrated in
the United States and Spain.
Project finance methods
Multiple structures can be utilized to complete an asset financing.
They can be levered or all equity; equity can be paid up front or
on a scheduled basis (PayGo). The conditions will change, as will
the required rate of return, based upon the risk in the technology
and the predictability of the cash flow. Sources of cash and tax
benefits will typically come from project revenue, renewable
energy certificates, tax benefits from accelerated depreciation,
federal tax credits (investment or production tax credits) and
state incentives.
While the considerations for different kinds of renewable
projects, whether wind, biomass or solar, are not entirely
the same, the following contract terms capture many of the
commonly required items:
Participation agreement•
Identifies all parties to the transaction−
Funding−
Cash flow−
Purchasing, leasing, securing or mortgaging assets−
Tax indemnification−
1 Global Trends in Sustainable Energy Investment 2008, United Nations Environment
Programme, 2008.
2001
US$4.6b
(17/103)
India
China
Other OECD
EU Europe
United States
US$5.1b
(38/130)
US$9.3.b
(44/197)
US$12.4b
(77/267)
US$27.5b
(281/502)
US$50.3b
(330/547)
US$84.5b
(544/906)
US$4.5b
(17/103)
US$5.1b
(38/130)
US$9.3.b
(44/197)
US$12.4b
(77/267)
US$27.5b
(281/502)
US$50.3b
(330/547)
US$84.5b
(544/906)
2002 2003 2004 2005 2006 2007
2001 2002 2003 2004 2005 2006 2007
Lease/vendor financing
Bond
Project finance
Balance sheet/syndicated equity
Figure 1 : asset finance new investment by region
Figure 2 : asset finance new investment by type of security
Note: this figure represents investment for new-build clean energy projects. Numbers
in brackets refer to disclosed/total deals
Source: United Nations Environment Programme,
Global Trends in Sustainable Energy Investment 2008
Note: this figure represents investment for new-build clean energy projects. Numbers
in brackets refer to disclosed/total deals
Source: United Nations Environment Programme,
Global Trends in Sustainable Energy Investment 2008

4. 22
Lease agreement (if lease structure is used)•
Lessee, lessor, owner trustee or equity participants−
Term−
Renewal options−
Fair market value purchase options−
Facility lease agreement for fixed assets•
Easement and access rights to property−
Partnership agreement (if partnership flip used)•
Cash flow−
Taxable income or loss−
Tax credits−
Preferred returns−
Residual allocations−
Power purchase agreement or energy services agreement•
Sale of power−
Construction contracts•
Construction loan agreement−
Project finance case study:
solar photovoltaic rooftop installation
structured as an unleveraged partnership flip
The following case provides a practical example of how the
various elements of renewable projects come together in the US,
highlighting the important considerations and benefits.
In this case, the sponsor enters into an agreement with a host
where the host will lease its roof space to the sponsor. The
sponsor and the host will enter into a power purchase agreement
(PPA) whereby the sponsor will sell the electricity generated by
solar equipment installed on the host’s roof for a fixed price for a
period of time. Typically, the fixed price will inflate at a rate of 2%
or 3% over the life of the agreement.
Once installation of the solar equipment is complete, but prior to
its being put in service, the equipment will be sold to a partnership
consisting of the sponsor and the tax equity investor. The equity
contribution of each party is negotiated. The contribution on
the part of the sponsor can be nominal but is typically 1% to 5%.
The ability of the tax equity investor to buy more deeply into
the project is a function of the terms of the PPA and the credit-
worthiness of the power purchaser. The partnership will be
responsible for the future sale of the electricity and equipment
maintenance. The partnership will receive all of the revenues
associated with the project including tax credits, state incentives
and renewable energy certificates. The amount of capital
contributed to the partnership by the tax equity investor is the net
present value of the tax benefits and liabilities, and the free cash
flow expected to be allocated to the tax equity investor until the
allocation flip.
The tax benefits and free cash flow of the partnership will be
allocated between the two parties with 99% of all benefits
going to the tax equity investor and 1% going to the sponsor
until the tax equity investor receives a predetermined return
(currently 8% after tax). Once the required return is met, the
allocations automatically flip so the sponsor typically receives 95%
(negotiated) of all the benefits. The tax equity investor should
achieve its target internal rate of return within 15 years. After
the flip, the sponsor typically has the right to buy the tax equity
investor’s remaining interest at fair market value of the investor’s
expected cash flow.
The parties to this structure are as follows:
Sponsor• — the project developer, who typically plays other
roles within the transaction including PPA provider, panel
supplier and panel installer
Tax equity investor• — the entity that can readily utilize the
tax benefits generated by renewable energy facilities
Host• — the provider of the property where the solar installation
is sited; typically acts as the purchaser of the generated power
Renewable energy credit (REC) market• — the local utility
in the state with an RPS is typically the buyer of the credit
State and local government• — provide local incentives such
as California’s Solar Initiative (US$3 billion to promote the
installation of 3,000MW by 2016)

5. 23Transformation Cleantech: enabling the business response to climate change
US accounting and tax considerations
The Financial Accounting Standards Board (FASB) Interpretation
No. 46(R) (FIN 46(R)) addresses the consolidation of off-
balance sheet entities. Ernst & Young’s Financial Reporting
Developments booklet on FIN 46(R) identifies in detail the
application of its complex provisions. The FASB concluded that
guidance should be based on residual risks and rewards in certain
cases — measured by variability in returns — rather than legal
control and thus introduced the concept of the variable interest
entity (VIE). An entity is defined as a VIE when:
The total equity investment at risk is not sufficient to permit the1.
entity to finance its activities without additional subordinated
financial support provided by any parties, including equity
holders
As a group, the holders of the equity investment at risk lack2.
any one of the following three characteristics of a controlling
financial interest:
The direct or indirect ability through voting rights to makea.
a decision about the entity’s activities that has a significant
effect on the success of the entity
The obligation to absorb the expected losses of the entityb.
The right to receive the expected residual returns of the entityc.
The voting rights of some investors are not proportional to their3.
obligations to absorb the expected losses of the entity, their
rights to receive the expected residual returns of the entity or
both, and substantially all of the entity’s activities (for example,
providing financing or buying assets) either involve or are
conducted on behalf of an investor that has disproportionately
few voting rights
FIN 46(R) requires that the primary beneficiary of a VIE
consolidate the entity. It is possible that the purchaser of the
power under a fixed-price, long-term contract that exceeds 80%
of the useful life of the asset and does not own a share in the
project could be deemed to be the primary beneficiary. Under this
circumstance, the purchaser would consolidate the asset and its
related liability in its financial statements. Determining whether a
purchaser is a primary beneficiary is very complex and requires
review of the power purchase or the energy services agreement
and an understanding of the risks the entity was designed to
create and distribute.
If no party is found to be the primary beneficiary of a VIE, each
equity owner would recognize its share of the project company’s
earnings below the line as “equity investment in an unconsolidated
subsidiary.” When the share is below 20%, neither consolidation
nor the equity investment method may be required if certain
conditions are met. If the investor is a pass-through entity, the
owner’s equity investment is required to be below 3% to avoid the
equity method. Power purchasers must also evaluate whether
their purchase agreements constitute a lease pursuant to
Emerging Issues Task Force (EITF) Issue No. 01-08, Determining
Whether an Arrangement is a Lease.
As shown in the financing example, tax benefits from accelerated
depreciation, interest deductions, R&D, investment and
production credits and noncapitalized start-up expenses are
a significant contributor to the overall return of a project. The
consolidation issues that pertain to FIN 46(R) do not apply to
income tax accounting, but 80% control requires tax consolidation,
and in the case of foreign subsidiaries, 50% control may require
consolidation. Careful consideration has to be given to who owns
the asset and can utilize the tax benefits. The structures discussed
earlier are not for the exclusive use of venture capital-backed
companies that are years away from paying taxes. Even significant
global entities that have emerged from bankruptcy or are in a low-
tax situation should profit by bringing in a partner that can put the
tax advantages to greater benefit, thereby lowering the total cost
of the project.
Conclusion
There are multiple project structures that can be deployed and no
one structure is best for all situations. Issues related to cash flow,
revenue recognition, primary beneficiary status and risk have to
be considered in the proper context. Some market participants
believe the market has lost confidence in complex structures.
The questions of complexity and number of participants certainly
increase the difficulty of completing a transaction, but as long as
the ownership and risk are transparent and the cash flow is clearly
identified, the project has a good chance of getting financed.
We believe that the impetus of higher power rates, renewable
portfolio standards and cap-and-trade programs will spur more
renewable power generation projects and even greater financial
considerations as renewable power project cash flows are
securitized and more financial derivatives are created to mitigate
risk and attract new investors into the market.

6. Ernst & Young
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