Islandsbanki: Financing geothermal projects in challenging times

Financing geothermal projects in challenging times Islandsbanki Geothermal Research June 2009

Introduction

U.S. Geothermal Investment Needs by Development Stage

As the financial sector collapsed world wide last fall, the environment for financing renewable energy projects changed. The availability of tax equity has mostly vanished, and financing geothermal projects has become extremely difficult. There is now hope that with the new stimulus legislation in the U.S. the investment climate for projects will improve. All signs now show that this is indeed the case. And this is very much needed. For current projects, financing of around USD 21 billion is needed to provide the U.S. with much-needed renewable energy base-load capacity.

6,000

In million USD and for current projects only

USD4.7bn

5,000

USD3.8bn

USD3.7bn

4,000

348

2,368

3,000 2,000

USD1.9bn 348

1,000

982

0

USD5.4bn

328 285 2009-10

3,823

2,736

3,823 2,338

664 2010-11 Exploration

2011-12 Pre-Feasbility

1,802

1,565 2012-13 Feasibility

USD1.8bn

2013-14

2014-15

Design & Construction

Source: GEA Industry Update of March 2009, ThinkGeoEnergy Research

General situation & financial markets The current market conditions continue to be difficult. While recent results of the big banks in the U.S. offer hope that things will not turn worse, there is still a lack in financing for renewable energy projects.

Big banks that traditionally financed or invested in renewable energy projects benefited from the tax credits they gained from investing in those projects.

Now many of those big banks either have gone under or have been kept afloat by bailout programs both in the U.S. and internationally.

The sector saw some highly publicized venture investments last year, e.g. into EGS-related companies, but generally it has stagnated in 2008 and such events are most likely to be even fewer in 2009. Private equity investments currently favor cash-generating assets, which makes it difficult for projects in development to get financing. It simply is cheaper to buy operating assets than develop those. On the project finance side, most of the big players in this market are now reluctant, as they have seen some extremely difficult times, and are now applying their resources very selectively, which doesn t make it easier for geothermal developers. Tax equity has as mentioned above pretty much dried up.

The provisions of the U.S. stimulus package are trying to tackle this by providing new incentives and widening the scope of financial investment possibilities to spur geothermal development. With details on the Department of Energy research and development allocation from the stimulus package announced recently, the industry is now waiting anxiously for details regarding the other elements of the U.S. stimulus package. Various U.S. renewable energy industry associations in a letter to President Obama, have warned that bureaucratic delays could sink large-scale projects (and urge him to) to intercede so that already-authorized loans are made available quickly.

Oil price increases have in the past spurred geothermal development, while decreases have had a negative impact. So current low price levels have been a concern, but are not expected to last. Oil prices are expected to increase slightly until 2010, and the IEA estimates oil prices of USD 200/barrel by 2013. The positive impact is that more oil companies and supply firms in the oil sector are more seriously looking into geothermal energy, with some players already investing in geothermal development, e.g. in Asia.

Key issues Decrease in oil prices can be seen as temporary and with no large implication for geothermal development efforts.

Current financial situation serious: the tax equity market has dried up, limited availability of debt financing and limited investor interest in earlystage projects, with a slightly better situation for close-to-operation projects.

Stimulus legislation very positive: extension of production tax credits (PTC), availability of investment tax credit (ITC), and possibility of cash grants up to 30% of development cost.

N e w c a p i t a l s t r u c t u re s a re a v a i l a b l e w i t h different models for investors, who can now benefit despite not having a taxable income.

Production tax credits still more valuable option for geothermal developers despite possibilities for ITC and cash grants, but cash grants could help lower financing cost for developers.

Loan guarantees are likely to decrease the cost o f f i n a n c i n g a n d s t i m u l a te m u c h - n e e d e d availability of funds.

General concern for time limitations of ITC, cash grants and loan guarantees, which will be challenging for the majority of geothermal projects today.

D e p a r t m e n t o f E n e rg y, Re s e a rc h a n d Development allocations: with the allocations towards various critical areas for geothermal technology development, this par t of the stimulus package will have a very positive impact on the industry, for current projects and future development.

Portfolio standards, power purchase agreements Most of the utilities won't be able to reach the targets set by state-based portfolio standards. The pressure for utilities is estimated to continue and keep pricing for PPAs for geothermal power projects roughly at where it is today.. But most of the projects are not far enough in their development to clearly impact portfolio targets of the utilities. Therefore, developers need to prove both financial and development capabilities, as well as a favorable time plan for the construction and start of operation of a geothermal power facility.

Federal portfolio standards, which are currently discussed, could also have a positive impact should they be introduced.

Structure of geothermal financing Financing for geothermal project development has always depended strongly on equity investments, mostly because of the risk structure and time frame of geothermal project development.

The resource element and the “drilling risk” also demands investors that understand the challenges in the development process. Traditionally, debt financing was only available when the developer was able to prove the resource through successful drilling results. Mezzanine/bridge financing structures then had been made available through Glitnir, which had built its business strongly on a specialization in geothermal energy, industry experience, and knowledge. This kind of financing will most likely

not be available for some time, so drilling will most likely have to be covered by equity provided by the developer, a private equity player, or through public markets. In other countries, governmental drilling risk insurance models have had a large impact on getting investors to provide financing at that stage.

Construction/ project financing is then the earliest stage for debt financing and the entry of tax equity player.

Start-up

Venture Capital

Exploration / Pre-Feasibility

Feasibility

Detailed Design & Construction

Mezz./Bridge Debt, Const.

Financing

Project Financing

Drilling Equity

Project Equity

Development Equity

Start of Operation

Tax Equity

Source: Islandsbanki/ ThinkGeoEnergy

Tax considerations (PTC, ITC, and the new cash grants) In the last few years, the largest part of project finance for geothermal projects has been provided by "tax equity investors," which were typically large investment banks and insurance companies. In those very specialized financing structures, federal support for renewable power technologies was capitalized. As a result of the financial crisis, the number of active tax equity investors has declined dramatically.

Grants will be available for property placed in service in 2009 or 2010, and for geothermal if construction begins in 2009 or 2010, the grant can be claimed for property placed in service before 2014 and in some instances until 2017. Companies that are eligible for the ITC are eligible for the Cash Grant program by the U.S. Treasury. Guidance and application material will be available in July 2009.

Net Capacity Factor (%)

Net Value of ITC for Geothermal (7.5% Nominal Discount Rate)

70.0 72.5 75.0 77.5 80.0 82.5 85.0 87.5 90.0 92.5 95.0

3.0 -14.9% -16.0% -17.1% -18.3% -19.4% -20.6% -21.7% -22.9% -24.0% -25.2% -26.3%

3.3 -11.9% -13.0% -14.0% -18.3% -16.1% -17.1% -18.2% -19.2% -20.3% -21.3% -22.3%

3.6 -9.5% -10.5% -11.4% -15.1% -13.3% -14.3% -15.2% -16.2% -17.1% -18.1% -19.0%

Total Installed Project Cost (million $/MW) 3.9 4.2 4.5 4.8 -7.5% -5.7% -4.2% -2.8% -8.3% -6.5% -4.9% -3.5% -9.2% -7.3% -5.7% -4.3% -12.4% -10.1% -8.1% -6.5% -11.0% -9.0% -7.2% -5.7% -11.9% -9.8% -8.0% -6.4% -12.7% -10.6% -8.7% -7.1% -13.6% -11.4% -9.5% -7.8% -14.5% -12.2% -10.3% -8.6% -15.4% -13.1% -11.0% -9.3% -16.3% -13.9% -11.8% -10.0%

Negative values mean that the PTC provides more value

As a result, the U.S. stimulus legislation was designed to make federal incentives for renewable power technologies more useful.

The provisions in the act include an extension of the production tax credits (PTC), with the possibility to elect an investment tax credit (ITC) instead. ITC-eligible projects can also receive a cash grant of equivalent value.

The extension of the PTCs, particularly for geothermal, is positive, and the possibility of utilizing investment tax credits and even a cash grant are destined to help the industry. The rules for investment tax credits (ITC) are very stringent and the basis for any utilization of the cash grant program to be put in place. The rules for the cash grant are currently being worked on by the U.S. Treasury.

The new system makes financing structures more complicated, and while it will reduce the need for tax investors, who are currently rather scarce anyway, it will not eliminate them.

5.1 -1.6% -2.3% -3.0% -5.0% -4.3% -5.0% -5.7% -6.4% -7.0% -7.7% -8.4%

5.4 -0.6% -1.2% -1.9% -2.5% -3.1% -3.8% -4.4% -5.1% -5.7% -6.3% -7.0%

5.7 0.3% 0.0% -0.9% -1.5% -2.1% -2.7% -3.3% -3.9% -4.5% -5.1% -5.7%

6.0 1.2% 0.6% 0.0% -0.1% -1.1% -1.7% -2.3% -2.8% -3.4% -4.0% -4.5%

Source: NREL March 2009

Generally, the possibility of getting a cash grant, which is nontaxable, permits investors to monetize credits, even though those investors do not have sufficient taxable income. This should widen the scope for possible investors. Furthermore, it allows for different financing structures for the project than found in the limited traditional PTC focused set-up, where it was necessary for the tax investor to have sufficient tax appetite.

The new rules in effect allow for structures that reduce the developer's financing costs since 30% of the purchase price would be captured in the form of the cash grant, in a structure where the developer sells the project to a tax equity investor and leases it back.

The diagram on next page shows the structure which allows for two scenarios, either the traditional sale-leaseback, or the possibility for the developer retaining the cash grant and the depreciation in the special purpose vehicle.

Power Purchaser

Power Sale

Developer

Project Sale Leaseback

Special Purpose Vehicle Source: Reed Smith LLP

Investors can therefore benefit from the new rules, even though they might not have a taxable income. The depreciation can be separated from the credit, allocating the depreciation to a party with a tax appetite and the credit part of the financing to a party with no tax appetite. This widens the scope of financial structuring with the possibility to choose a lease structure, something that wasn't possible before in a PTC scenario. It allows parties to pass the cash grant to the lessee, so the geothermal project could be sold to a party having the ability to utilize depreciation, either for current income or the ability to use carry backs. The cash grant could then be retained as benefit by the investor, or be passed to the developer, now lessee.

Projects may still have to monetize their depreciation benefits, but a 30% cash grant instead of having to monetize investment tax or production tax credits provides developers with substantial certainty about their capital structure. The cash grant might have limitations for the geothermal sector as it applies only for plants placed in service in 2009 or 2010, or later if construction begun before 2011. As referred to on page 1, the majority of geothermal power projects in the U.S. will not reach the construction stage in this time frame and thereby be excluded of claiming the cash grant as it is currently put down.

Overall, it seems like that the PTC/ITC structure favors lower capacity projects, such as wind and solar, but the decrease in financing cost for the developer as such, given the lack of tax equity appetite, is still very positive for geothermal development.

Loan guarantees What cash grants should do for the disruption in the tax equity markets, the new loan guaranty program should do for the debt markets. The legislation provides for a new Department of Energy loan guarantee program available to renewable energy and transmission projects, supporting loans up to 80 percent of project costs.

The expansion of the existing loan guarantee program to cover commercial (rather than just innovative non-commercial ) projects incentivizes debt financing of projects. The program

appropriates USD 6 billion to reduce or eliminate the cost of providing the guarantee; this amount could support USD 60-100 billion in new loans, depending on the risk profiles of the underlying projects. The program also is expected to lower interest rates on loans supported by these guarantees.

But similar limitations as for cash grants apply. In order to be e l i g i b l e fo r t h o s e g u a ra n te e s , p ro j e c t s m u s t co m m e n ce construction by September 30, 2011, a very short time frame for the majority of projects currently under development in the U.S.

DOE research & development Just recently announced by President Obama in Nevada, the Department of Energy (DOE) is going to administer the program set forth for the stimulus program for the developing the use of geothermal energy, which represents funding of USD 350 million.

There were earlier concerns about a too strong focus on EGS technology, but the now announced crucial areas draw a more positive and balanced picture: geothermal demonstration projects, enhanced geothermal systems research and development, innovative exploration techniques, and a National Geothermal Data Resource Assessment and Classification System.

This shows that DOE is aware of the need for a balanced support for technology development across the various utilization forms of geothermal energy and resources. The program covers the advancement of much talked about utilization from oil and natural gas, as well as geo-pressured and lower temperature geothermal resources. This will increase the scope of geothermal development beyond the Western states in the U.S. EGS will receive support for research and development to demonstrate the technology's readiness in the near term .

Funding for exploration technologies is also much needed, as drilling still represents the main obstacle because of the risk element and the corresponding lack of private sector money, so the strong support for this element of geothermal project development is very positive and will help increase investor interest at this development stage.

DOE Geothermal R&D Program Allocation

Innovative Exploration Techniques USD 100 million EGS Technology Research & Development USD 80 million

USD 30 million

National Geothermal Data System, Resource Assessment and Classification System

Geothermal Demonstration Projects USD 140 million

Source: Department of Energy, Geothermal R&D Allocation, May 2009

To round up the DOE allocations, characterization and assessment of geothermal resources across the country is given a strong support for creating a national geothermal data system.

The different program elements are well balanced and will have a very positive impact on current projects in development, but also on EGS technological development.

Conclusion The overall outlook for the geothermal sector is good, while it will remain challenging. The industry will see a new set of players coming from new and old angles, e.g. from the oil and mining sectors, but also more remotely related industries. The new stimulus legislation in the U.S. will have a positive impact and is seen by many as a lifeline to better days setting off some of the impact the global recession has on the industry.

The legislation's key elements are the much-needed certainty on production tax credits. But the most important elements are the ITC and cash grant elements, which make the application of new structures for financing of geothermal projects possible. The cash grants effectively decrease the financing cost for the developer, and investors can benefit from the new rules as well even though they might not have a taxable income. The loan guarantees will provide a stimulus to much-needed debt financing for construction and project financing and likely decrease financing cost as well.

There remains though a big obstacle and this are the time limitations for cash grants and loan guarantees. It will be challenging for the majority of projects to reach the construction stage by 2011, or even place plants in service this or next year.

The allocation of USD 350 million to DOE for research and development in geothermal energy is also a very positive step towards helping the industry. The recent announcement of the areas that will receive funding through this program also shows a balanced view within DOE. This will help to reach the short-term

potential, while also focusing on extending the reach of geothermal development through lower temperature technology and EGS.

Islandsbanki Islandsbanki builds its value proposition of the success of the Glitnir Global Geothermal Energy Team. The nature of geothermal projects demands a strong understanding of the underlying technical issues and risks. Islandsbanki has formed a team of experienced bankers who focus on the geothermal energy industry.

Unique basis for sustainable energy services Home market Iceland with more than 99% of electricity production from renewables (~8% in the United States).

Iceland, one of the leaders of geothermal energy utilization for electricity production & direct use.

Currently installed capacity (geothermal) in Iceland is 570 MWe. Strategic partners with leading positions in the sector.

Islandsbanki business origination Extensive geographical and industry research.

Industry player mapping & networks.

Advisory in the geothermal sector, across the whole value chain.

Islandsbanki Geothermal Team members are located in Reykjavík, Iceland.

Glitnir s selected customers & deals

Íslandsbanki s Sustainable Energy Team is based in Reykjavik, Iceland The team coordinates all energy activities of Íslandsbanki and is representing the bank and its activities globally. The team combines years of experience in the geothermal and sustainable energy sector, both financial and technical.

Árni Magnússon

Executive Director Sustainable Energy Corporate Banking

Hrefna Bachmann Manager Corporate Banking

Jóhannes Hauksson Business Manager Retail Banking

Ingi Rafnar Júlíusson Manager Corporate Finance

Hjörtur Thor Steindórsson Business Manager, Corporate Banking

Rósa Guðmundsdóttir Business Manager Corporate Banking

Már Másson Executive Director, Corporate Communication

Alexander Richter Consultant Think GeoEnergy

arni.magnusson@islandsbanki.is

hjortur.steindorsson@islandsbanki.is

hrefna.bachmann@islandsbanki.is

rosa.gudmundsdottir@islandsbanki.is

johannes.hauksson@islandsbanki.is

mar.masson@islandsbanki.is

ingi.juliusson@islandsbanki.is

alex@thinkgeoenergy.com

Íslandsbanki s Sustainable Energy Team Islandsbanki, Kirkjusandi, IS-155 Reykjavik, Iceland Tel: +354-440-4500 For more information: energy@islandsbanki.is www.islandsbanki.is/energy Islandsbanki cooperates with:

ThinkGeoEnergy is a news and service website focused on the geothermal power sector globally and is the key resource for industry news, deals, and development globally.

This document was written on behalf of Islandsbanki by: Alexander Richter, ThinkGeoEnergy alex@thinkgeoenergy.com

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