Feature

Crossing the "valley of death"


Paul Frankel

Part 1: could a new type of insurance help cutting edge renewable energy companies cross the valley of death?

Launching an early-stage technology from a pilot test to widespread deployment requires large amounts of capital. But generally, debt financiers are hesitant to invest in projects employing technologies at that stage because of risks that can't be quantified, and also because projects are too costly to be funded by venture capital alone.

These factors create what those in the industry call a valley of death for clean energy companies that need further funding i.e. they find themselves in a scenario where they have technology that has been successfully developed and demonstrated – but has not yet been built at commercial scale.

Insurance on the other hand can be used to both reduce the cost and increase the availability of financing for projects employing emerging clean energy technologies. Project financiers and developers use insurance to transfer and allocate risks, such as those related to property damage or bodily injury.

But developers of leading edge technologies have also expressed an interest in using insurance to transfer specific performance and technology risks. So, for example, if an insurance product were able to limit significantly the exposure of lenders and other financiers to technology risk, other, lower-cost types of financing would become available to project developers.

Theoretically, this could reduce total project costs in leading edge energy technology deployments by as much as 10-20 percent.

So could this be enough to take companies across the valley of death at a crucial stage of their development?

Market needs and historical precedent

The ability to obtain financing for the deployment of emerging technologies at commercial scale can make or break a company's fate, regardless of the technology's efficacy or potential environmental benefit.

Many promising emerging technologies remain in a stage perceived as higher risk, not because of a lack of commercial viability or market opportunity, but because of a lack of financing to prove it at scale. These technologies have gone through laboratory and pilot-stage testing, but are only just beginning to be deployed in commercial projects.

Some examples of currently emerging technologies that may face financing struggles include:

  • Innovations in windpower generation, like larger turbines or offshore locations that present new challenges and additional risks relative to the technology that is already widely deployed in operating wind farms;
  • Grid-scale energy storage, and batteries for electric vehicles;
  • Second-generation biofuels, such as cellulosic ethanol – that have limited or no commercial scale plants yet in operation; and
  • A range of new, lower-emission waste-to-energy technologies that are progressing from testing to commercial operations.

In general, emerging technologies like these are vulnerable to technology performance risk i.e. the risk that a project utilising the technology will not perform as expected.

This can manifest itself in various ways, including an inability to complete a project on time due to technical hurdles; initial production shortfalls; faster-than-expected degradation of production levels over time; and excessive operations and maintenance (O&M) costs.

Under (and non-) performance problems may be caused by one or more factors, ranging from a manufacturing defect in a key piece of equipment to substandard performance by the operator.

Insurance companies see clean energy as a growing market, and many seek to better address the market's specific needs and to differentiate themselves while doing so. But while the interest level from insurers is high, developing insurance products that cater to non-traditional exposures, such as technology performance risks, is challenging – especially for nascent technologies.

The necessary coverage could be characterised as efficacy insurance, a broad category that can be defined for such purposes as “any insurance that provides financial protection against the failure of a product or system to perform its intended function and to the degree expected”.

Other risk management examples, such as launch insurance for commercial satellites, offer precedents. In many cases, joint public-private approaches address risk exposures that are challenging for private insurers to manage on their own, such as terrorism and nuclear energy.

Governments participate in insurance markets for a variety of reasons, including filling a gap when private insurers leave a market, offering coverage at more affordable prices in the hope of advancing a policy objective, or responding to political pressure. In the past, insurance buyers have banded together to create new mutual insurers to increase the availability of coverage when dissatisfied with existing offerings.

As we will detail in the second installment of this series, a combination of an industry-funded captive or mutual insurer with Government support could align commercial and policy objectives.

Current clean energy insurance products

A handful of speciality insurance products currently aid clean energy developers, however, they do not address the risk transfer needs for first- and early commercial technologies. Among the most notable products available today are warranty insurance and performance/installation warranty insurance.

Warranty insurance is purchased by the solar photovoltaic (PV) industry to protect a manufacturer against the financial impact of warranty claims, which often arise from deficiencies in the manufacturing processes. Currently, many manufacturers offer a 25-year power output warranty on modules, and insurance can be structured to cover a portion, or the entire term of the manufacturer's warranty.

Because these products require insurers to assess the soundness of manufacturing processes and provide a financial safety net to a manufacturer, this willingness to assume the warranty risk may assure financiers of the viability of a supplier and its processes.

Warranty insurance can also be structured for developers and financiers when a project company is the direct beneficiary of the policy. Certain insurers also offer warranty coverage for components within a solar installation. The existence of warranty insurance products for established solar technologies suggests that similar coverage can be developed for other modular and individually-testable technologies – as they mature and accrue an operating track record.

Another speciality product developed for the clean energy industry is installation warranty insurance. Its coverage is tailored to technologies with a substantial installation track record, and for contractors with significant installation experience. It provides a financial backstop to contractors, and ensures project owners of revenue replacement or debt service payments until the system can be remedied or the coverage term expires. While it addresses risk associated with the quality of a contractor's workmanship, it may also cover component failures.

Neither warranty insurance nor installation warranty insurance are broadly available for emerging technologies, nor do they assure financiers' investment recovery in the event of uncured shortfalls in production. These gaps point to clear needs within insurance markets.

Insurance product extension for emerging clean energy technologies

The insurance industry is developing new products for clean energy technology customers, and the warranty insurance products offered today are attracting interest from manufacturers. However, potential buyers note several opportunities to improve existing offerings by evolving key features:

  • Comprehensive duration of coverage: Currently, some policies either limit the coverage term to a period shorter than the manufacturer's warranty or exclude any coverage related to warranty claims that occur in the initial years of the warranty term;
  • Strengthening protections for end customers in the event of manufacturer insolvency: Certain customers require the ability to make a claim against the insurance policy directly if the manufacturer is not able to honour its warranty obligation due to insolvency;
  • Extended scope of coverage: Most current policies cover only replacement or repair of the defect itself, or monetary compensation equal to the equipment cost, consistent with the manufacturer's warranty; in some circumstances, it would also be beneficial to include coverage for lost revenue and liquidated damages resulting from a defect, if not addressed by other insurance policies.

These extensions would provide valuable coverage and flexibility for component suppliers and project developers, but each may increase the cost of a policy and may not provide the coverage features necessary for the majority of customer scenarios.

Current warranty insurance pricing is perceived to be high already; this may reflect actual risk-appropriate pricing or the scarcity of pertinent underwriting data and warranty insurance market providers.

System performance insurance (SPI)

Insurance products that address total system performance risks, rather than isolating the performance of a single component, are currently limited in terms of eligible technologies and scope of coverage. Therefore, system performance insurance could be contemplated as an entirely new product rather than an extension of what is currently offered.

The market needs an enhancement of contractor performance guarantees, where not only system integration, but also revenue production is assured through an extended performance testing period.

Certain solar thermal systems may be a good example where SPI would be beneficial, especially since individual product warranties may not be adequate to provide sufficient assurances to project owners. The specifics of SPI policies would necessarily vary case-by-case, and in the second installment of this series, we propose a set of terms that would enable such a policy to improve access to lower-cost financing for early commercial technologies.

Costs and benefits of insurance for emerging technologies

Both component warranty and system performance insurance, if applied to first- and early-commercial technologies, would be novel and subject to uncertain and potentially large payouts. As a result, premiums will need to be high relative to policy limits and project size.

While such pricing levels would be challenging to absorb, the benefits of insurance are also significant, so such new insurance products may be attractive even at high price points.

The primary benefit of an SPI policy is the ability to access lower cost financing, estimated to reduce total project cost by as much as 10 to 20 percent. The benefits of lower cost financing are substantial: the potential to use debt in the capital structure from the start of construction, and the ability to secure tax equity participation early in the project – both of which would allow developers to raise capital in significant volume from a wide variety of providers.

These savings, net of the cost of insurance, would enable more competitive output pricing or higher returns to developers and equity investors, in either case allowing more projects to be economically viable. This would allow a greater number of the many promising energy technologies to reach commercial scale and potentially deploy more widely. Growth in the number of projects developed correlates positively to other positive macroeconomic and environmental impacts, such as job creation, tax revenue and GHG reduction.

Ultimately, the most cost-effective answer will vary project-to-project, and may or may not involve system performance insurance, but the significant financing cost savings potential that insurance promises suggests that such insurance could be a valuable part of some developments.

Delving into this topic further, the second installment of this series will present CalCEF's recommendations for expanding the capital base, together with product offerings within the clean energy insurance market.

Clean energy insurance demystified by CalCEF

In its latest white paper, the California Clean Energy Fund (CaLCEF), which creates financial products for the clean energy economy, proposes a new solution – system performance insurance – to help early stage technologies achieve mass adoption.

This article presents the first portion of the white paper, by outlining the market need, and explaining how current clean energy insurance offerings are limited. The second installment (out soon) will discuss CalCEF's recommended insurance mechanisms and public policy elements, and will map out steps for expanding the capital base and product offerings of the clean energy insurance market.

About: Paul Frankel is managing director of the California Clean Energy Fund (CalCEF). Before joining CalCEF in 2008, he was co-founder and managing partner of Ecosa Capital, providing expansion financing to growth stage companies in the clean energy, green building and sustainable agriculture markets.

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Comments

CHRISTOPHER MOORE said

14 March 2012
The industry has been crying out for such a range of products for years - anyone who comes up with an economically viable (bankable) product will have long queues out side their door, and much wailing and gnashing of teeth from the Venture Capitalist community, who will have to take a less avaricious approach in future....

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