Geothermal energy risk management

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Thursday, 1 December 2011

The current industry and political landscape has opened opportunities for cleaner energy options, while investors and government regulators endeavor to provide the essential infrastructure, services and legal framework to develop and deploy new energy technologies. Before considering some of the key risks, which have an impact on renewable energy projects and the general approach to proper assessment, it is useful to identify barriers that are preventing the uptake of RE projects.  Foremost of these are barriers, which relate to the low level of awareness, understanding and attention, afforded to the complex array of policy, regulatory, technical financing and organizational factors affecting RE projects. Geothermal project financing is not the typical boilerplate scheme with pro forma agreements utilized in other resource project development.

Geothermal Developer Profile

Investors are either large and traditional energy service companies that have the ability to finance RE investments in technology or projects funded on a non-recourse finance basis, or smaller but entrepreneurial geothermal developers seeking investors for technology R&D and/or project finance.  For these entrepreneurial geothermal development firms, there are different business models and balance sheet sensitivities to consider.

While financial institutions carefully evaluate developer qualification and track record, being a major and well-known developer is not required because financiers recognizes investment opportunities having considerable experience in developing energy projects by providing equity.  However, new geothermal developers are required to demonstrate their competency by selecting experienced and well-respected consultants, and specifying and using equipment with proven track record.

Most if not all capital prior to the geothermal project’s proven feasibility is done through equity and not debt.  Financing of exploration and confirmation drilling usually comes from company equity or risk capital provided by investors.  Generally, investment is sourced from seed capital, venture capital, or equity financing for a geothermal developer.  Due to the high risk involved with geothermal exploration, banks do not provide funding through loans until the later stages in the development process.

Risk Identification

During the critical resource identification phase, the developer aims to obtain as much information as possible about potential resources while investor costs are low providing the developer with a stronger foundation for decisions on actual exploration and project development.  Information and knowledge increase resource certainty and reduce risk, which allows better access to capital. For this reason, the government can help mitigate risks by establishing a well-documented geothermal database that is readily available to potential investors. The government must also develop a standard classification system that addresses the probability of risk based on a standard set of geothermal resource criteria and attributes.

Key indicators of success from geothermal exploration wells are high temperatures and permeability combined with production of a high-enthalpy fluid that is not acidic and does not produce scaling over and above that is normally expected for geothermal fluids.

The highest risks for the implementation of geothermal energy projects are resource availability risks.  Risk management challenge is magnified in the context of geothermal development due to the extremely high risk of loss during the identification, exploration, and delineation drilling phases of project development where the probability of drilling a dry hole is high. Other identified risks can be further categorized into: operational risks (failures in planning, etc.), economic risks (increasing operating costs, etc.) and political risks (licenses, etc.).  Risks that cannot be realistically avoided can increase the cost of capital or raise the required rate of return.

In Europe and North America, the insurance industry has been providing many of the traditional risk management products for the petroleum industry to geothermal, such as property damage, business interruption, machinery breakdown and construction.

Contract Structure

Geothermal project financing is initially dependent on a “bankable” reservoir report, which is based on the complete and thorough documentation of the exploration and drilling data as independently evaluated by a disinterested third-party’s technical analysis and recommendation report.  Engineering, Procurement, and Construction (“EPC”) contracts typically pass all geothermal plant facility design, development and construction risks from the developer who acquires a “bankable” turnkey energy project, to the contractor who is paid a premium for the assumption of the risks.  In an EPC contract, the contractor agrees to deliver the keys to a commissioned geothermal energy plant to the developer for an agreed price, on a fixed schedule with performance guarantees and liquidated damages for the failure of acceptance tests and timely commissioning.

Project finance is also highly dependent on the Power Purchase Agreement (“PPA”) executed between the developer and purchasing end user, typically an electrical utility. The PPA provides for the sale of capacity and energy at an agreed price, price structure, and specified time period. In addition, the financial institution will include a careful analysis of the interconnection studies and transmission agreements.  From the risk perspective however, it is preferable that economics and demand for power drive projects rather than contract provisions.  Also, contracts negotiated with either side being at a disadvantage, is a cause of concern for lenders.

Conclusion

Needless to say, streamlining the permit process by government regulators will have an impact on geothermal development, as shorter project periods would reduce uncertainty for policy and market dynamics when modeling economic returns.

Geothermal projects are characterized by significant upfront capital investment for exploration, well drilling, and the installation of plant and equipment. But once the geothermal projects are placed in commercial operation the fuel source is secure for the tens of years of expected lifetime with a steady revenue stream.

It is good to note that traditional insurance products are now becoming more available to the RE industry while new financial risk management instruments are evolving.  Nevertheless, there is a need for customization of coverage and linked products that provide a total solution for the risks inherent in geothermal development.  While geothermal energy will continue to face obstacles to gain investment market acceptance and application, there is room for optimism as the use of this energy source is only beginning.

Fernando “Ronnie” Peñarroyo is the Managing Partner of Puno and Peñarroyo Law Offices (www.punopenalaw.com). He specializes in Energy and Resources Law, Project Finance and Business Development.

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