Carbon Market Evolving Deal Structures: The Rise of Carbon Project Finance
Deal structures in the carbon markets are changing. Kita’s team is seeing a marked rise in Carbon Project Finance deals, characterised by pay-on-delivery offtakes coupled with financial institution lending structures enabling financing against future carbon credit cash flows. As the carbon insurance specialist, Kita has a front row seat on the evolution taking place. In this article, we summarise carbon project finance deal structures, including how insurance can help mitigate risks which have been holding back deals and thus help unlock investment.
The Kita team has seen many carbon project deal structures since launching in 2021 – simple pre-payments; streaming deals; equity investments; portfolio assets etc. While we still see a wide range of deals, over the last six months one deal structure in particular is flooding our Underwriting inbox…
This is the Carbon Project Finance deal, which has the potential to channel financing into well-governed and risk-managed projects, and safeguard delivery of carbon credits to companies seeking to retire them.
Project finance deals can be complex, with multiple stakeholders and long-term timeframes for the repayment of investment. Identification and allocation of risk is an important component to getting these deals over the line, and insurance can be core to this.
In this article we cover:
What is project finance?
What risk management is required?
What are specific considerations for carbon project finance?
How is carbon insurance incorporated into these deal structures and why?
The path forward
Please don’t hesitate to get in touch with the Kita team to discuss further how our specialist carbon insurance products can help unlock carbon project finance transactions.
What is project finance?
Project finance is a way to provide long-term financing for projects, where the financing is based on the projected future cash flows of the project rather than the balance sheet of the project developer. For example, a carbon project typically expects to deliver future carbon credits over many years, and if a value for these credits can be pre-agreed with a buyer (e.g. via a fixed price offtake), there is now a forecasted cash flow that financing can potentially be secured against.
Project finance deals generally involve non-recourse or limited-recourse financial structures such as Special Purpose Vehicles (SPV), that (i) shield the project developer from the risk that failure of an individual project will impact other projects or cause a failure of the company as a whole; and (ii) ensures the revenue from the project goes to repaying its investors/lenders rather than being allocated to business activities outside of the specific project in question.
What risk management is required?
Given the long-term nature of a project finance deal; the specific focus on repayment via future project cash flows; and the various stakeholders involved, identification and allocation of risk is essential. Considerations tend to include the following:
Security package: often investors/lenders will seek for their financing to be secured by project assets and potentially have step-in rights if the project is underperforming.
First loss structures: via the SPV, it can be common for there to be senior and junior tranches of capital, via which certain parties take a ‘first loss.’ This means the senior parties (generally the debt financing parties) take priority in any return of capital ahead of junior parties (often equity holders), thus potentially reducing any loss.
Risk identification and transfer: insurance is a standard part of project finance deals, helping manage factors such as country, performance and counterparty risk considerations.
What are specific considerations for carbon project finance?
Carbon project finance is not reinventing the wheel, although there are some carbon-specific considerations to keep in mind:
Pay on Delivery Offtake: Carbon project finance deals require the project developer to have an offtake (usually a pay-on-delivery offtake from an end user of carbon credits). This provides certainty of both future demand and price, which is required for investors and lenders to quantify future cash flows, upon which the project finance is dependent. These offtakes are increasingly placing responsibility on the developers to safeguard against project failure and under/non-delivery of credits – such as securing a letter of credit, putting aside money to cover future losses, and imposing contractual penalties if milestones are not met. While these types of contractual safeguards are not uncommon in project finance deal structures, the challenge in the carbon markets is that project developers who are inexperienced/small/located in a developing country might struggle to satisfy offtaker requirements.
Upfront financing: To deliver against a pay-on-delivery offtake, the developer must have upfront financing. As noted above, financiers, particularly banks providing debt financing, are more likely to finance a project when an offtake is in place. However, financing entities are still wary of various carbon-specific risks such as those noted below:
Carbon model and performance: how accurate are the future delivery calculations as a means of assessing future cash flow? Should haircuts be considered? Has the developer over- or under-estimated any risks, such as supply chain resilience or tree mortality/machinery performance?
Non-creditworthy counterparties: how can risks related to project developers with small balance sheets and limited track record be mitigated?
Long-term return profiles: return profiles of carbon projects can be longer than normal expectations and require nuanced deal structuring to manage this risk.
High-risk countries: how might changes in Host Country approaches to the carbon markets impact this project over time, and what protection is in place to manage this exposure?
Internal requirements: internal signoffs require carbon investments to be safeguarded as in other asset classes, which may require significant internal education.
Offtake clauses: offtakes safeguard deals, but today's offtakes can have significant 'out' clauses that mean an offtaker might be able to pull out of the contract even in instances where the project is operating as expected. Likewise, in a market where demand is constrained, it is possible that securing a large offtake can push developers to pursue production targets, leaving little room for delay/failure.
Special Purpose Vehicle: Like project finance deals in other sectors, a Project SPV is a standard part of these transactions, to ringfence the project costs and liabilities into a separate vehicle. For carbon projects, a SPV can also be a useful tool for developers headquartered in a country where specialist carbon insurance is difficult to access. By setting up a SPV in a country where insurance availability is higher, project developers might navigate around this challenge.
How is carbon insurance incorporated into these deal structures and why?
On carbon project finance deals, Kita is seeing market participants utilise specialist carbon insurance as a condition precedent to deal closing because this insurance is designed to help address some of the risks noted above.
Subject to the specifics of each project, the insurance can cover multiple parties in the same deal. For example, developers can use insurance to meet offtake requirements and/or mitigate their contractual liabilities in a more cost-effective way than holding them on balance sheet; and financiers using insurance to smooth internal signoffs and ensure risk-mitigated returns, where a fixed premium replaces or reduces the risk, scope and/or extent of loss.
Examples of the types of insurance applicable at each level are:
Non-Payment Insurance: Non-Payment Insurance (NPI) is a time-tested form of insurance utilised across other asset classes as a way for lenders to manage the risk that their financing is not repaid and thus unlock their ability to finance otherwise high-risk transactions.
Lenders: when banks or investors expect repayment of their financing based on future cash flows, Non-Payment Insurance is a scalable solution to manage their risks (in a way that can enable capital relief for banks). NPI is a comprehensive insurance policy protecting against the risk financing is not repaid. When applied to carbon deals, this could include: non-delivery of carbon credits to the offtaker; non-payment by offtaker upon delivery; potentially other causes of non-repayment of the financing to the lender.
Non-Delivery Insurance: Non-Delivery Insurance (“NDI”) can provide comprehensive protection against under or non-delivery of future carbon credits. For a carbon project finance deal, if the credits are not delivered, there is no future cash-flow and there will be a loss. This policy is geared therefore to protect against the instance in which a carbon project fails to deliver the expected carbon credits. It can be applied to both Developers and Investors:
Developers: supply-side NDI can protect developers against the risk of being unable to deliver carbon credits against contractual obligations for reasons outside of their control. In a market where liabilities are increasingly placed on developers, Kita’s insurance can help reduce risk on balance sheet and meet stakeholders’ risk management expectations to get deals over the line. Insurance has the potential to replace a letter of credit and/or protect the provider of a letter of credit, which can improve access for project developers.
Investors: demand-side NDI can protect against the risk that investment does not result in the expected number of carbon credits within the timeframe expected. This leads to a loss of upfront capital as well as potentially additional onwards liabilities, for example against offtake contract obligations. This is a comprehensive insurance wrap covering up to 100% of investment value via a flexible “Carbon Credit Claims Price” mechanism.
Political Risk Insurance: Political Risk Insurance (PRI) is utilised in deals where the offtaker/financier is not comfortable with the host country. This insurance is taken out by the developer or investor most commonly, and can protect against expropriation, export license cancellation, forced abandonment, discriminatory tax and war/terror/civil unrest type events leading to losses of future carbon credit deliveries/future revenue streams.
The path forward.
There are many positives to recent developments in carbon project finance structuring – namely scalable upfront financing for high-quality projects, and deal structures appealing to institutional investors and lenders, such as pension funds and banks. Offtakers, likewise, are protected from project underperformance, particularly when they contract directly from a trusted intermediary who can manage risks on their behalf (such as their existing banking partner financing the deal).
The financing parties are generally able to access insurance and have in-house insurance buying teams to support them. We expect that the prevalence of carbon project finance deals obtaining insurance to protect lenders will rise markedly – most likely via Non-Payment Insurance or Demand-side Non-Delivery Insurance.
This is because developers take on liabilities, via their balance sheet, that they are not best-placed to cover themselves. This can damage the stability of the deal as a whole and make it harder for developers to deliver a carbon project over time. Non-Delivery Insurance and/or Political Risk Insurance for developers is an excellent tool to help protect both developers, when their project is damaged for reasons outside of their control, and offtakers and financiers, who are then one step removed from the underperformance risk once insurance is in place.
As the carbon markets scale, this insurance will likely become increasingly standardised, making it easier to analyse and secure. As the longest-standing specialist carbon insurers, Kita has the expertise required to cover a wide range of project types within a carbon project finance structure. We can even settle insurance claims in cash or replacement carbon credits, enabling flexibility for our clients. If you wish to find out more, please get in touch with our specialist team.