Title: Monetizing Opportunities in Energy Storage in a Post-IRA World
Speakers: John Leonti and Vaughn Morrison
Vaughn Morrison (00:07):
So as the energy storage market has emerged in the US, we’ve seen a relatively greater emphasis on merchant revenues as compared to contracted offtake. Can you talk a little bit about why that’s been historically and how that’s evolving?
John Leonti (00:21):
Sure. You know, it’s funny. The renewables business is largely built on long-term contracted assets. So for solar and wind, for years we first started out with 20-year PPAs and then we got into this period where they got shorter and it was 15-year PPAs. And so lenders, financial institutions, banks, tax equity investors all started to have to get comfortable with less contracted revenue. And that story is continuing through those assets as well. We’ve done hedge deals where something less than 100% is hedged. They have lots of merchant exposure on the backend and frankly, even during the time that the tax equity or lender’s in the deal. And so this idea of merchant revenue has been around, but now we’re seeing on the battery side where day one, we just have full 100% merchant assets. And there’s a lot that goes into that.
One, the battery is just not a generation tool, right? It can charge and discharge power. And so the sponsors want the flexibility to run those assets however they can optimize it. Whether it’s a sort of a capacity play in like a PJM, an RA play in Cal ISO, or just run it merchant in ERCOT so that you can have energy arbitrage as well as provide ancillary services. So the battery just has a lot more flexibility that sponsors are looking to really take on. And I would love to hear from you about just the different off-take arrangements that you’re seeing out there, in particular the tolling agreement.
Vaughn Morrison (02:00):
Well, the tolling agreement — so that’s kind of the most conventional off-take arrangement for energy storage. Under that structure, the off-taker has authority to charge and discharge the battery and run it as they see fit within certain operating parameters, in exchange for a monthly tolling payment, typically often with some adjusters based on project performance. And that is the most easily understandable, I think, form of contracted offtake for energy storage. From there, it gets more complex. You can add to that the resource adequacy contracts in Cal ISO, which provide for a routine, largely fixed payment. And then there’s all kinds of financially settled products. There’s hedges, there’s EBITDA guarantee products out there backed by insurers. So we’re seeing a lot of creativity emerge in that market.
John Leonti (03:02):
Are you seeing different sectors of the country focus on different agreements? So like tolling agreements in one state versus a hedge play in another state?
Vaughn Morrison (03:13):
Tolling agreements are primarily found in bilateral markets with utility off-takers. There are some true physically settled tolls in organized markets, but those are more the exception than the rule. Hedge products are more common in organized markets where there’s greater liquidity and more revenue streams to play with.
John Leonti (03:34):
It is interesting how there has certainly been financings of fully merchant battery projects, at least on the debt side. But now with the passage of the Inflation Reduction Act, batteries are now eligible for investment tax credits. And that leads to bringing in tax equity investors into the space who historically have required assets to be contracted in order for them to finance it. So it’s interesting with tolling agreements, hedges, and other new products that are coming out there, how prevalent will these products be in order for a third-party tax equity investor to come in? And then on top of that, with the transferability market that I think you and I fully expect to develop in the near term, how amenable will that be to battery operators so that they can actually continue to run these plants on a merchant basis?
Vaughn Morrison (04:31):
I think the answer to that is yes and yes. As tax equity comes into the market, there will be a greater emphasis on contracted revenues. Those investors just have a different risk profile for merchant revenues than debt lenders. So for projects where tax equity makes sense as your form of ITC monetization, which will be a lot of projects, I think you’ll still see an expectation for more contracted revenues and those products will become more popular as a result. For projects where contracting that offtake would have a major negative impact on the revenue profile, I think that’ll push some developers towards a monetization strategy that involves ITC transfer and allows them to rely on a little bit greater risk appetite from the debt markets as compared to tax equity.
John Leonti (05:29):
It really is an interesting balancing act that sponsors are gonna have to play with storage assets. Yes, they are eligible for the ITC, but do I do a transfer credit deal or do I do an investment tax credit deal with a traditional third party tax equity investor? On the one hand, if I do a traditional third party tax equity deal, I can monetize depreciation plus the tax benefits and get a basis step up. If I do a transfer deal, potentially I can step up the basis, but I’m probably leaving the depreciation on the table and it’s like a monetize it myself. And then you take, well, if I enter into an off-take contract, whether it’s a toll or a hedge or otherwise, what is that doing to my economics? So there’s gonna be a lot to unpack there for sponsors.
Vaughn Morrison (06:16):
It’s a lot, and the basis step up is a big deal. We’ve spent a lot of time with sponsor clients trying to help them develop strategies to step up the ITC basis without the benefit of a tax equity investor. And there are good strategies for it, but it’s not perfect. It’s not easy. And as you said, that still leaves the depreciation on the table. Well, thanks for joining me for the conversation today, John. Really interesting as always.
John Leonti (06:39):
Vaughn, it’s great sitting down with you today. As always, thank you.
Vaughn Morrison (06:42):
Likewise, John. Thanks a lot.
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