It is standard practice for renewable energy companies to utilise simple financial models to price and structure their projects.

These simple models are often used to size any non-recourse financing required to support the project in question, and therefore are developed to adhere to the constraints and covenants that are required as part of the financing.

Naturally, renewable energy developers seek to maximise investor returns on their projects. Gearing up with relatively cheap long-term debt is a great way to boost returns on equity investments. Developers usually look to borrow the maximum amount of debt that the project cashflows will support.

Bespoke, accurate and detailed financial modelling can be used to maximise debt size whilst ensuring lender covenants are met, and therefore can help maximise equity returns in renewable projects.

Uncertain revenue projections

Unlike public-private partnership (P3) projects, where project revenues are consistent and reliable, there is a greater level of uncertainty of revenues for renewable energy projects. Though power purchase agreements fix the price at which energy will be sold, energy production varies naturally over the project life.

Though energy production cannot be known for sure, detailed forecasts are available. These forecasts are presented at different probability levels to show the variation as well as the expected production.

The most common production level used by equity investors is P50. The P50 level is the median level of production, so it gives a good indication as to what the equity investors can expect as a return on average.

Lender requirements

Lenders are more interested in seeing how the project fares in the worst-case scenarios, and often use P75, P90 and P99 levels. The actual production is expected to be higher than the levels given 75%, 90% and 99% of the time, respectively. Lenders, therefore, gain comfort in projects that can demonstrate that they perform well even under these conservatively predicted production levels and often have minimum Debt Service Cover Ratio (DSCR) targets for several of these production levels.

In simple financial models, debt repayments are often sized to be constant each period or sized to an annuity. For lenders’ comfort, sensitivities can be run on the production to ensure that output DSCRs do not fall below the targets for each level. However, project cashflow is often not constant between debt service periods for renewable projects. Revenue seasonality, varying maintenance costs, or decreasing volumes because of degradation of the asset lead to spiky, non-flat DSCRs, with the debt facility size reduced until the DSCR criteria are met in all periods. Often this leads to DSCRs well in excess of the requirements in many periods resulting in suboptimum returns for equity investors.

Comparison to P3 projects

By comparison, P3 projects’ revenue is usually received through monthly availability payments with performance deductions passed through to the service provider. As a result, lenders to these projects are generally comfortable with higher gearing and lower coverage ratios than when lending to riskier renewable projects.

As part of the financial submission process for P3 projects, financial models are tightly optimised to obtain the lowest possible bid price whilst still meeting equity returns and all lender covenants. It results in the maximum debt possible to be drawn and flat ratios sized to meet the minimum requirements set out by the lenders. This is done by sculpting the periodic debt repayments to a target ratio; usually, the minimum ratio required. There is little “excess fat” in these deals; otherwise, parties risk being too expensive and rejected by procuring authorities.

Lessons for renewable projects

Sculpting debt repayments to target ratios enables the highest gearing possible for projects, which results in the highest returns for equity investors. As renewable projects require ratio covenants to be met at a variety of production levels, accurate sculpting needs a detailed financial model. Whilst lenders’ requirements can be met with a sub-optimised model meeting their covenants, equity investors have a chance to earn higher returns with a detailed sculpted solution.

In any given period, debt service should be maximised such that DSCR covenants are met for all production periods. Therefore, at least one production level DSCR should be equal to its lender required minimum in any given period to optimise the total debt service paid and, thus maximise the amount of debt the project can support. This results in the highest possible equity returns for a given project.

At Operis, the approach we use for debt sizing on renewables transactions is generally more complex than those detailing comparable projects and encourages greater stakeholders scrutiny. We find it extremely well received because it represents a significant tangible benefit to developers and equity investors.

Operis has honed its financial modelling techniques over three decades and has provided model development services over various industries and geographies. We would be delighted to discuss in more detail what we can offer for model development and how it can help optimise your renewable project to ensure you are getting the highest projected returns possible.

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Meet Mark Mark Southall
Mark Southall
Associate Director - Model Audit & Financial Modelling


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