As demand for renewable energy grows as part of the global energy transition, we have seen an increased interest in finding alternative ways of structuring renewable energy projects. In this blog post we consider some partnering and alliance structures that could potentially be used to balance risk and reward on renewable energy projects.
A shifting balance of risk
Most renewable energy projects span several years. They involve multiple contracts and an array of contractors and suppliers. Historically, most projects in the renewable sector were structured on a multi-contract model where the owner held responsibility for the interface between each contract / part of the works. While more recent, large-scale renewables projects tend to be procured on an EPC or turnkey basis, they still comprise several different work packages with the owner retaining the interface risk among the packages.
The recent boom in renewable energy projects, combined with stakeholders’ increased confidence in the long-term performance of renewable technologies, has broadened the market of experienced contractors and suppliers. The risks typically involved in these projects have become more certain, and costs more predictable, putting owners in a better position to either (a) push project risk down to contractors and suppliers; or (b) use past experience in delivering projects successfully to manage interfaces between contractors and avoid unnecessary markups in the supply chain.
This competitive market puts pressure on contractors to deliver work at increasingly tight costs. Enduring disruption to cash flows and supply chains – driven primarily by the rising cost of raw materials and currency fluctuations – have further made the commercial viability of projects a pressing factor. A key concern is how to prevent costs-related pressures from jeopardising successful delivery, damaging relationships between owners, contractors, and suppliers, and increasing the risk of disputes.
Partnering and alliancing structures may help balance the risk of these issues and are gaining traction in the industry. These structures offer contractors a stake in the project’s overall success, beyond their own scope of work, which can incentivise collaboration, innovative solutions, and reductions in overall cost, while reducing the risk of dispute. Although models vary, the key distinction between partnerships and alliancing structures lies in the distribution of risk and reward. In partnerships, parties generally agree to cooperate in working towards specific objectives and goals, but typically retain a degree of independence, meaning certain partners may reap rewards at the expense of others. In alliancing models, members typically place their profit margin and reward structure “at risk”, meaning the entire alliance benefits together, or not at all.
There are a range of possible partnering and alliance structures, and in a continuously developing field, there is vast scope to customise such structures according to required outcomes and asset types. We consider two examples below:
Project 13 is an “enterprise” model initiative for delivering major infrastructure projects, developed by the UK’s Institution of Civil Engineers. A set of general principles, rather than a prescriptive model, Project 13 emphasises integration and collaboration between owners, advisers and suppliers, aiming to circumvent the common hurdles of major projects, such as delayed delivery, inflated cost and quality issues. (For those wondering, the name simply comes from it being the ICE Infrastructure Client Group’s 13th project.)
One of the pillars of Project 13 is having a “Capable Owner”, who will not only own and operate the asset, but will establish the enterprise, define customer outcomes and set the project up for long-term asset performance, a critical element in renewable energy projects. Partners in the enterprise (for example, advisers and suppliers) are rewarded based on value added to the overall outcome, rather than to their individual scopes.
Perhaps most significantly for the current market, the Project 13 approach stresses that suppliers should be engaged early on in developing solutions to any technical, cost, efficiency, or supply-related hurdles. Supply chain disruption is a particular concern in renewable energy projects, due to factors such as the limited availability of raw materials, fewer well-established manufacturers and newer technologies. Projects which incentivise contractors to bring with them trusted supply chains, or which give key suppliers a stake in the project’s success, may therefore be more attractive to investors, as there is greater incentive for completion to occur on schedule.
Sweat equity generally refers to a person or company’s unpaid contribution toward a business venture. In a major projects context, sweat equity may refer to the contribution of design services, construction work, or technology development in return for an equity stake in the project, or deferred payment for the contribution.
Although a “sweat equity” approach has to date more typically been seen in other sectors (such as real estate), or smaller projects, the overall shift towards alliance-based contract structures could mean this model is on the horizon for renewable energy projects too.
There are two main structures for this style of contracting:
- Equity participation, whereby a special purpose vehicle (SPV) is set up to undertake the project, and contractors will become equity participants in this SPV; and
- Deferred payment, whereby contractors forgo interim payment in return for a premium rate of interest pending final payment when the project is commercialised.
A single project could also combine both structures to allow a flexible approach for different partners. In projects involving novel technology, for example, it may be more appropriate for research institutions to participate via deferred payment, and consultants or project managers to become equity participants.
These structures could deliver the same incentivisation, and alignment of partners with overall outcomes, offered by other alliancing models. However, specific considerations may hinder the use of a sweat equity approach, particularly in a renewables context. For example:
- Contractors may be unwilling, without payment, to continue providing services, and/or keeping resource available over extended periods where the project is delayed by other participants. Consideration should be given upfront to contractual mechanisms to deal with this risk such as, for example, additional payment rights tailored to address such circumstances;
- Where new technology is used (a common feature of both renewable and sweat equity projects), contractors may not have enough knowledge of, or trust in, the commercial capacity of the asset to put themselves at risk based on the promise of a return through their equity share;
- Uncertain commercial return is also a consideration where the project’s financials will rely on government support, for example subsidies or guaranteed strike prices paid to electricity generators to top up wholesale market prices;
- In government-facing projects, the pool of equity participants may be restricted by the need to meet government or regulatory requirements; and
- There may be an increased risk of internal conflict or tension, for example, where certain participants consider that their contribution should convert into a higher equity share. Equity shares should therefore be valued up front before each contribution commences.
Sweat equity, Project 13, and partnering structures more generally, will not be appropriate for every renewable energy project, but the principles behind these models could offer a valuable approach to balancing risk and reward in a changing renewable energy landscape.