The landfill gas (LFG) business has experienced a flurry of activity in recent months. In late October, the senate finance committee approved a $245 billion tax bill that, if passed, would extend the tax credit for LFG projects by one year. As developers race to meet potential deadlines for new projects, attention is focused on financing alternatives.
One increasingly popular choice, project financing, is an alternative to more traditional corporate lending or equity financing. Recently, three landfill gas projects implemented project financing or elements of it to obtain capital.
Hardly a new concept, project financing spreads risk out over a long period of time. It provides the borrower with a long-term, contractual flow of cash which can be highly leveraged on either a stand-alone or a non-recourse basis. Fortunately, this type of financing complements the typical development of a LFG project, where developers seek a long-term gas market. Also, project financing minimizes the need for expensive equity, because it provides long-term (8-10 years) capital without forcing the parent development company to pledge corporate assets.
This method is fairly flexible in terms of gas usage. Direct sale of medium- or high-Btu gas, electric generation, compressed gas and leachate evaporation are all acceptable if the sale occurs under a long-term, take-if-provided contract from a creditworthy buyer.
Generally, the construction/technology risk of a LFG project relates to the processing plant. This risk can be mitigated by selecting an experienced, creditworthy, third party construction contractor and developing a well-defined contract.
However, project financing cannot resolve all the risks involved in a LFG project. In fact, the largest risk - availability of methane gas - usually becomes a lender's main focus. Generally, the lender will hire outside consultants to offer an opinion on the availability of gas reserves. Unfortunately, the consultant and borrower rarely agree. A lender may want 50 percent more gas forecasted than actually required to amortize the debt. Therefore, it is best to begin with a margin of safety in gas reserves in the project pro forma model.
A lender also may be concerned with transaction size and environmental liability. Since contract review and structuring require time, most lenders have a minimum return required in absolute dollars earned. The minimum return is measured both as an internal rate of return on the loan amount and the absolute dollars generated by the loan from the closing fees, spread income and any additional fees and/or kickers. In some cases this return requirement is hard to meet on a small landfill gas project. This is especially true when the transaction term is short.
Environmental liability also is a major concern for lenders. No amount of return on a single transaction can compensate for being dragged into a potential lawsuit. However, by consulting an attorney while structuring leases and contracts, the environmental liability can be placed with the generator and not the project. Certainly, the interests of the borrower and lender must be aligned on this issue.
Only one of many alternatives for landfill gas projects, project finance can bring significant benefits to both the developer and lender.