How to Secure LFG Project Financing

Herbert C. Muther

Financing a landfill gas (LFG) use project never has been easy. So how can you maximize your chances to secure financing for your project on favorable terms? The key is to understand how the lender evaluates your project and its risks. By doing so, you can better understand and anticipate the lender's requirements and take a proactive approach early in the project's planning stages.

LFG projects are highly specialized and are served by a relatively small number of developers. Yet several parties are involved in a typical transaction, and detailed knowledge is required of two distinct industries: LFG production from municipal solid waste (MSW), and energy and power generation.

Add to this the project construction-associated risks, LFG production, operation and maintenance, end-user credit and wellfield management, and it is easy to see why institutional lenders have not flocked to lend money to these projects. The reality is that most financiers are not willing to take the time to understand the business and learn how to lessen the risks of these projects.

The Lender's Perspective The first key point that developers must understand is the risk/reward scenario the debt lender considers. If a LFG project is successful, the project's developer and equity partner will realize a certain rate of return. As the project becomes more financially successful, the developer and equity partner will realize a greater return - an upside potential with their investment.

The debt lender, on the other hand, only realizes a fixed return through the repayment of principal and interest, and has no similar upside potential. Given this limited earning potential, the lender must do everything possible to protect its fixed rate of return. This primarily is accomplished through the careful analysis and lessening of potential project risks.

The amount and type of risk the lender assumes largely hinges on the type of loan issued to the borrower. For example, if a capital lease is used to finance equipment for a LFG-to-energy project (i.e. internal combustion engines or turbines), the lease payments are secured or backstopped by the borrower, in this case the developer. Regardless of the performance of the project, the developer must make the required payment to the lender.

Therefore, the primary risk to the lender in this type of transaction is the borrower's creditworthiness. Assuming the credit of the borrower is strong, the lender is almost certain to have the debt service repaid.

The preferred financing structure for LFG projects is a Non-Recourse Project Finance Loan in which the debt repayment is linked directly to the revenue of the project.

If the project does not generate sufficient revenues to repay the debt service (principal and interest) on a non-recourse loan, the lender cannot require the borrower to make up the difference.

In non-recourse project financing, the debt repayment depends completely on the project's financial success. So unlike a lease, the lender in a non-recourse situation assumes credit risk, as well as project performance risk. Therefore, the lender must structure the loan to minimize the chances of project failure, which would likely cause a loan default.

Risk Evaluation What are the risks the lender must evaluate when analyzing a LFG project loan?

The specific risks vary depending on the project type. For example, a project that uses LFG to drive a gas turbine to create electricity that is sold to a utility would be considerably different from one where LFG is used to evaporate landfill leachate. While the extent of risks may be project dependent, some of the different types of risks are: construction, technology application, LFG production, credit, underlying contract issues, regulatory requirements, tax credit availability and developer capability.

Construction Risk If the lender provides construction funding to the developer, it must have confidence that the developer has the skills and experience to build the project on schedule and within budget. The lender makes assumptions about the project's financial viability based on a total development cost. The amount the project exceeds the anticipated construction cost will, at the very least, reduce the lender's anticipated debt service coverage ratio (DSCR) and potentially risk the debtor's ability to pay the increased debt.

Therefore, expect the lender to scrutinize your construction plan carefully. Lenders will require a detailed plan including a construction schedule, and a list of subcontractors to be used. Lenders require a healthy contingency amount built into the budget for unforeseen costs, and most lenders will require the borrower to secure a payment and performance bond which names the lender as the payee in the event of non-performance. Lenders also will evaluate the financial strength of any subcontractors that will have a significant role in project development.

Finally, the lender probably will use an independent engineer to review the construction plan and monitor construction. The independent engineer will help evaluate the project's technical risk for the lender. (The cost of the independent engineer usually is capitalized as part of the overall project financing.)

Technology Application Risk Lenders, like project developers, have become specialized. Some financiers focus exclusively in certain markets such as tax-exempt municipal and government loans, while others specialize by technology type or equipment.

Even with experience in the industry, project lenders have varying levels of risk tolerance with projects involving new technology. The developer should assume that the lender only will finance projects involving proven technology. This would include demonstrating similar project applications the developer has initiated over the past five years.

If the developer is seeking financing or development capital for a new technology application, it may be more suitable to approach equity investors or to seek research grants instead of debt financing from a lender.

The developer should expect the lender to use an independent engineer to evaluate and comment on the appropriateness of the technology being used for the intended application.

LFG Production Risk All LFG use projects depend on a predictable source of fuel. Almost all other project-related assumptions, including equipment sizing, project expenses and tax credit revenues, are based on the anticipated LFG volumes and methane content. Factors that can influence the volume and content of LFG include waste composition, compaction, moisture content, and the configuration and operation of the gas collection system.

In addition to the lender's independent engineer, the developer should commission its own study by a qualified engineering firm to validate the project's feasibility. These studies, together with historical LFG production data from existing flare stations, should be made available to the lender and/or the lender's independent engineer. This will expedite the project's evaluation.

A lender will look more favorably on a project involving an active landfill. In fact, some project financiers will not finance a project that is based on a closed landfill due to the risk of declining methane production.

Credit Risk With a conventional loan or lease transaction, the lender primarily is concerned with the borrower's ability to repay the debt on time throughout the loan's term. Because the loan repayment obligation is absolute and not based on project performance, the lender primarily is concerned with the borrower's creditworthiness or financial strength. In simple terms, the better the borrower's financial position, the better the lender's interest rate.

In non-recourse project financing, the credit evaluation is different. While the developer is the borrower, the debt repayment can only come from the project's cash flow. Because the loan is non-recourse, the lender cannot ask the borrower to make up a shortfall.

Hence, while important from the standpoint of its ability to build, own, operate and maintain the project, the developer's credit is not the primary basis for the credit evaluation. In fact, much more important to the lender is the end-user's or host's credit quality. Depending on the LFG project, the host customer could be a local utility that buys the electricity or gas, or an industrial end-user that is purchasing the processed LFG directly.

Basically, the lender must be confident the host customer will be in business and buying the project output throughout the loan's term. It is important to remember that the host customer is the primary source of project revenue and, therefore, debt repayment.

Much like a loan or lease transaction, the developer should expect an interest rate commensurate with the host's credit quality. Most institutional lenders will provide debt financing for hosts that are investment grade or better (BBB or better as rated by Standard and Poor's, New York.)

If the host customer is not rated by the major rating agencies, then the lender must obtain two to three years of audited financial statements from the host and perform an internal financial evaluation.

Underlying Contract Risk As in any business transaction, contract documents outline each party's rights, obligations, responsibilities and benefits. The terms and conditions in these underlying agreements are critical to understanding the business risks each party bears [See "Looking Critically at Risk," on right].

For a typical LFG use project, the business structure and contracts can be complex, especially if tax credits are involved. For example, a LFG-to-electricity project would at least include a gas rights agreement between the landfill owner and developer that specifies the terms and conditions under which the developer can extract the LFG.

The second major contract is the Power Purchase/Sale Agreement between the developer and electricity purchaser, usually a utility or power marketer. If Section 29 tax credits are involved, the agreement structure is more complex.

To qualify for the credit, the landfill gas must be sold to an "unrelated person," meaning that the gas collection system must be owned by a separate legal entity from the landfill gas buyer. The owner of the gas collection system cannot own more than 50 percent of the entity buying the gas, or vice versa.

Selling Tax Credits When a project developer cannot use the credits itself or within its own company, it is possible for such landfill gas producers to essentially "sell" the tax credits to third parties that can use them.

Although ownership of a landfill gas-to-electricity project may be structured in several ways, the most common structure is for the project developer to create two separate entities: a corporation or partnership that holds the electric-generating facility [GENCO] and a limited partnership that holds the gas collection system [GASCO].

The lender must analyze all of these contracts carefully to determine how the business and financial risks are allocated. Keep in mind that the lender is concerned with any event or condition that ultimately could cause the borrower to default on the loan.

The lender also must review the underlying agreements, recognizing that if the borrower defaults, the lender has the right to assume the responsibilities of the borrower under the existing contract agreements.

Thus, the lender must be comfortable with the rights and obligations contained in the agreements because it may find itself party to the agreements in a worse-case scenario.

Both state and federal governments heavily regulate the solid waste industry. Most recently, the New Source Performance Standards (NSPS) mandated new monitoring and emissions requirements that affect larger landfills. Financiers and borrowers need to be aware of the changing regulatory landscape. From a practical standpoint, the lender wants to be sure that it and the developer have no direct regulatory compliance requirements concerning the landfill's operation. The contract agreements should be clear as to which party is responsible for managing the wellfield. And even if the responsibility falls to the developer, it should not be obligated for regulatory compliance activities.

Tax Credit Availability Risk The availability of tax incentives commonly referred to as the Section 29 tax credit has made many projects more financially viable.

Tax credits for most projects are sold or monetized to an investor. This tax sale takes place on a year-to-year basis where a specific price is paid for each dollar of tax credit earned through LFG production. Most tax sale agreements state that the investor can reduce or eliminate the payment to the developer if there is a change in the tax law that reduces the value of the investor's tax credit.

For this reason, most investors will not lend against the revenue derived from tax credits like they would on the sale of processed LFG or electricity. They will look at the tax credit revenue as providing additional debt service coverage but not as primary project revenue.

Developers need a take or pay provision in their tax credit sales agreement similar to that required with the end user customer if they expect a financier to lend against this revenue stream as they would with revenues from the sale of the end product.

Developer Capability Risk The developer is not free from this risk evaluation procedure. The lender ultimately wants to know if the developer can fulfill all its obligations under the terms of the contract and meet or exceed projected revenues.

The lender will look into past projects to find out if they were completed on time and within budget, and if they met the projected operating results. It will also evaluate the developer's operations and maintenance performance.

Expect the lender to ask for both project-related and banking references. To determine the developer's financial position, the lender will check the developer's accounts payable history on current and/or past debt obligations.

Developers with a solid track record of previous performance and a sound financial position should not have trouble receiving funding for their projects.

The Bottom Line It is important to remember that most project risks can be lessened or greatly minimized by thoughtful contract development and conscientious project planning.

However, some risks are inherent to the LFG industry itself. Only lenders that understand the industry will be ready to provide debt financing, and then only to well-conceived projects. When planning a LFG use project, developers will benefit greatly if they consider the lender's perspective early in the development process.

* Medium Btu: Piping processed landfill gas to an industrial end-user to be used as a direct boiler fuel source.

* Electricity Generation: Using landfill gas to drive gas turbines or internal combustion engines, creating electricity that, in turn, is sold to the local utility or power marketer.

* High Btu: Creating a high Btu gas through the removal of carbon dioxide and other trace gases from landfill gas. The resultant high-Btu gas then is sold directly to an end-user or to a natural gas utility.

* Leachate Evaporation: Using landfill gas to combust the leachate produced at the resident landfill through leachate evaporation or a similar type of technology.

For several years, methane at the St. John's Landfill, Portland, Ore., went up in smoke in a flare system.

That energy no longer is wasted. Since March 1998, the nearby Ash Grove Cement Co. lime plant has used the methane gas to power three lime kilns.

In a $2 million project, a gas compressor station was built at the landfill and a 9,400-foot pipeline was installed to transport the gas to the plant, which produces lime used in steel mills, pulp and paper plants, and water treatment plants.

It took Metro, a Portland-based regional planning agency that runs the landfill, nearly 15 years to find a company that could use the methane for fuel. Ash Grove considered the proposal in 1985, says plant manager Gary Wright.

However, even though the methane gas cost about 11/48 the price of natural gas, those savings wouldn't offset the large capital investment required for the project, he says.

Then in 1996, Ash Grove formed a partnership, the Portland Landfill Gas Joint Venture Partners, with Cohasset, Mass.-based Palmer Capital Corp. Palmer Capital secured federal and state tax credits, and Metro agreed to sell the methane to Ash Grove for 25 cents per million British Thermal Units (Btu).

Wright says the tax reimbursements and lower utility costs provide "significant savings" for Ash Grove, which previously used a combination of natural gas and recycled oils to power its kilns.

The project also benefits Metro by helping offset the nearly $300,000 in yearly expenses at the landfill, which closed in 1991 after accepting more than 14 million tons of refuse over 50 years.

The flare system now is being used at the landfill only when the plant's kilns are not in operation, which benefits the environment, Wright says. "We're reducing the amount of gas being burned," he says. "[Using] the gas for our kilns is good for the area's air quality."

Paul Ehinger, a civil engineer at Metro, also is pleased that the project saves energy and reduces air emissions. "As a government agency, we have an obvious concern for the environment," he says. "We're proud we got this project done."

However, there are drawbacks to using the landfill's methane for power.

The supply of methane occasionally drops to the point where the plant is forced to shut down its kilns, Wright says. A programmable logic controller at the compressor station, which was supplied by VR Systems Inc., Odessa, Texas, regulates methane flow rates at the landfill.

Methane also has about half the heat content of natural gas, so twice as much of the fuel is needed to power the kilns.

Environmental consultant Emcon, San Mateo, Calif., has been hired by the company to look into ways to boost methane circulation at the landfill. However, Ash Grove faces diminishing methane supplies even if Emcon remedies the current problems. The closed landfill will generate less methane each year, and there only will be enough methane to power the plant's kilns for about the next 10 years.

"I wish there was more methane," he says. "But we'll never get to the point where 100 percent of our fuel needs are met by the landfill gas."

The landfill supplies approximately 70 percent of the fuel needed to operate the kiln, with recycled oil contributing the rest.

The project has been honored by two organizations. In 1998, the Environmental Protection Agency (EPA), Washington, D.C., awarded the landfill gas partnership project Methane Outreach Program Project of the Year, and the city of Portland also gave it a Businesses for an Environmentally Sustainable Tomorrow (BEST) award in 1999.

A series of well-documented agreements that fairly and equitably allocate the business risks are critical to any LFG use project. Some of the critical issues include:

Commodity Price and Quantity Risk - Lenders want to be as certain as possible about the project revenue. To ensure a predictable cash flow, the developer should structure an off-take agreement that has firm purchase prices and quantity obligations for the commodity being sold, either processed LFG or electricity. The purchaser should be obligated to buy all of the product that the developer delivers. This usually is referred to as a take or pay obligation. The lender always will be conservative. In other words, if there is no obligation to take the output, the lender will assume the purchaser will not.

The same applies to the commodity's price. Lenders prefer prices that are locked in over the agreement's term. In many instances where processed LFG is being sold to an end-user, the purchase price is based on a percentage reduction over a fluctuating market-based index. While the developer may assume that the index will increase over time, the lender will be more conservative.

Termination Risk - If the commodity purchaser decides to terminate the contract before the end of its term, the loan would go into default. To avoid this, the financier will require a termination payout schedule in the event of early termination. The payout amount should cover the lender's remaining principal and interest, as well as any prepayment premium that may be required. The developer should only expect the lender to provide a loan amount equal to or less than the value of the termination amount.

Force Majeure Clauses - The lender will be sure that adequate and reciprocal Force Majeure (unforeseen circumstances) clauses are present in all contracts. The time to cure Force Majeure events should be reasonable for both parties.

Contract Term - All of the key project contracts should be for a period at least as long as the loan term. Most lenders prefer, and some will demand, that the Power Purchase Agreement and Gas Rights Agreement be approximately 25 percent longer than the loan term. This assures the lender that if there is an interruption during the contract period, such as an event of Force Majeure, the underlying contracts will not expire prior to the loan term. For example, if the developer wants a seven-year term loan, then the project agreements should be at least nine years long.

Purchasers and Sellers Obligations - The contracts should clearly state the obligations of both the commodity seller and purchaser. All of the following questions should be addressed:

* How much of the commodity (processed gas or electricity) is the seller obligated to provide per year?

* How much is the purchaser obligated to buy each year or month?

* What happens if either party does not provide or purchase the required amount for a given period? Is a credit given? Is it grounds for default?

* How will the commodity volume be measured?

* Who is responsible for maintaining the measuring device?

* If processed gas is being purchased, what are its quality measurements? (i.e. heating value, delivered pressure, sulfur content, etc.).

* If the project includes the sale of electricity, what are the availability requirements on the part of the developer?

* Is the rate paid for the electricity different for peak vs. off-peak hours?