Out-Law Analysis | 15 May 2020 | 11:39 am | 8 min. read
The review is necessary because of the impact the ongoing public health crisis is having on energy consumption, energy infrastructure and assets and their owners. The pandemic is likely to be impacting the cost of construction and build timeframes, and ultimately the commercial model of the underlying projects.
Borrowers risk defaulting on their loan if they do not get lenders' consent to increase construction expenditure, or fail to notify them of the impact of Covid-19 on their project.
As is the case with all project financed assets, the construction period is typically the most risky time for both lenders and sponsors. This is because capital expenditure in relation to the underlying asset is at its highest and there is no revenue or power being generated. Lenders and sponsors alike have strong commercial incentives to ensure construction is carried out and completed efficiently and timeously to provide the revenue stream to allow repayment of the financing and a return on equity.
Many contractors and employers have shut down their construction sites during lockdown. In addition, as the effects of Covid-19 are felt across the globe, many manufacturers of essential infrastructure components, such as wind turbines and solar panels, either remain closed or have only recently recommenced works. This has potential long term implications for the supply chain and could lead to delays and additional costs. The solvency of providers in the supply chain remains an ongoing concern too during this continued period of uncertainty and both borrowers and lenders should be considering whether they are over exposed to any one supply chain provider or group.
As a result, projects currently in the construction phase will likely feel an impact on both construction timetable and budget, although where the time and cost risk will fall in that regard will depend on the terms of the contracts in place.
The availability of any financial relief to borrowers under their contracts or under construction insurance policies for any liability they incur under their construction contracts will depend on the underlying terms of those contracts or policies and may not, or only in part, recompense the borrower. In any event, any insurance proceeds received may be required to be applied in mandatory prepayment of the loan – whilst this would de-risk the loan for the lenders, it will not assist with the completion of construction of the project.
In addition, any extension of time to the construction timetable under the construction contract will not automatically pass down into the loan agreement given that both the construction timetable and budget will, for the purposes of the loan agreement, have been approved by the lenders at the outset and written in to the terms of the loan agreement. This means that borrowers may need to seek lender consent to the approval of increased expenditure beyond that budgeted for as a result of the complications caused by Covid-19, which may be required to be funded from sponsor equity. Lender approval may also be needed for any revised construction budget and any extended longstop date for completion of construction. Lenders will also likely seek assurances that increased expenditure and delays will not negatively impact the long term financial position of the project over the life of the loan, particularly if a forecast funding shortfall is envisaged.
Of particular concern to the lenders, and the borrowers, is the availability of cash to fund the construction of the project. Any Covid-19 related delay, increased expenditure or forecast funding shortfall could result in a default or event of default under the loan agreement. This would give the lenders the right to refuse any request by a borrower to utilise a loan and put further pressure on the borrower to formulate a solution to these issues. Given the current uncertainty, this will be challenging and may increase the likelihood that further equity will be required to be injected into the borrower/project by the sponsors to meet ongoing construction expenditure.
Demand for electricity has decreased during the lockdown, with many businesses closed. This has led to National Grid stating that it may be required to issue orders to temporarily shut down certain operational energy infrastructure to ensure that there is not an oversupply of electricity in the system and a resultant overloading of the electricity grid. Any borrower impacted by the temporary constraint of its project would need to consider carefully the effect a shut down would have on its revenue stream.
Whilst a borrower will likely receive compensation from National Grid for constraints placed on their generation of electricity, the level of compensation will vary from case to case and depend on the price of such borrower's "constraint bid" made to National Grid as part of its grid connection process. National Grid is incentivised to constrain those borrowers with the lowest bid price first – those being the cheapest to constrain.
Compensation received for constraint may not align with the contractually anticipated revenue stream, and delays in receiving compensation could significantly impact a borrower's liquidity. If a borrower has not properly assessed the impact of any constraint on its revenue stream this could put a significant strain on a borrower's ability to repay its loans when due which, in turn, could lead to an event of default for non-payment.
Moreover, any constraint in excess of an agreed threshold period set out in the loan agreement may, in itself, be an event of default.
Any actual or forecast reduction in revenue arising as a result of Covid-19 is likely to impact the ability of borrowers to meet their financial covenant ratios. Typically financial covenants are tested on calculation dates occurring at six monthly intervals, although some lenders may have scope to request an unscheduled testing if they reasonably believe that financial covenant ratios would not be met on such unscheduled testing date. Any failure to meet the financial covenant ratios will be a default or event of default, depending on the extent of the shortfall, and will lock up distributions.
Many loan agreements will contain an equity cure whereby, following an event of default arising as a result of breach of financial covenant ratios, additional equity or subordinated loans can be injected by the sponsors either for the purpose of repaying part of the loan or increasing project revenues in such amount as to ensure that the level of the financial covenant ratios will no longer result in an event of default. This allows borrowers to circumvent an event of default arising as a result of a breach of financial covenant ratios. However, as there is typically a restriction on distributions being made by a borrower for a certain period of time after an equity cure, this cure right cannot be used as a mechanism to recycle cash through the borrower to release distributions that were locked up due a breach of financial covenant ratio.
Regardless of the ability to equity cure, borrowers should be considering the impact of Covid-19 on their revenue stream and "stress test" the resulting ability of the project to continue to meet its financial covenant ratios.
In the event that there is a severe impact on revenue stream as a result of Covid-19, there will also be insolvency events of default available to the lenders.
Loan agreements will typically include a "material adverse change" (MAC) clause. These are generic catch all clauses which lenders can seek to rely on for the purpose of calling a default or event of default if an event occurs which has not been otherwise contemplated in the loan agreement.
Whether Covid-19 could result in the triggering of a MAC clause in a loan agreement will depend on the particular drafting of that clause and the impact that Covid-19 has had on the borrower. Whilst there is limited precedent on the interpretation of MAC clauses, what guidance we do have makes it clear that to be considered 'material', the adverse change must substantially affect the borrower's ability to perform the transaction in question.
Typically a MAC clause in the context of a project financing will focus on an event or circumstance, or series thereof, which has a material adverse effect on the business operations, financial condition or asset of the borrower, the validity and enforceability of the finance or project documents and the ability of the borrower to perform its material obligations under those documents. It is therefore not unforeseeable that Covid-19 could, for example, have a material adverse change on the business operations or financial condition of a borrower.
Given the subjective nature of MAC clauses, it is not surprising that lenders are typically hesitant in relying on them to call an event of default, particularly where it is possible for them to rely on other more objective triggers to do so.
Where a loan is not fully drawn, in the absence of any objective default, lenders may be more likely to use a MAC clause triggered by Covid-19 to prevent utilisations as opposed to declaring a MAC event of default. Lenders would need to give careful consideration to the specific drafting of the MAC clause and the impact Covid-19 has had on the borrower before triggering a MAC clause in this way.
Other defaults or events of default could also be triggered. Examples include: cessation or suspension of business; cross default/insolvency; abandonment and/or suspension of the energy infrastructure/asset; breach of a project contract by a contractual counterparty, and; misrepresentation.
The terms of the loan agreement would require to be considered in relation to determining whether any breach of these provisions would arise as a result of Covid-19.
Loan agreements will likely include obligations on the borrower to provide certain ongoing information to lenders relating to the progress of the project during construction, as well as in relation to performance of the project during operation and other material circumstances.
Borrowers should have a plan in place demonstrating how they and their project counterparties are complying with Covid-19 legislation and guidance. While complying, for example, with social distancing measures would likely not cause any issues for onshore assets since they will operate largely autonomously, this may be more difficult for offshore assets, and borrowers should give this some consideration.
In light of the pandemic, it is more likely that lenders will be seeking information in relation to both the ongoing impact of Covid-19 on a project and what "pandemic planning" measures a borrower has in place. Borrowers should therefore keep their lenders up to date with any impact the pandemic has on their projects in order that they can assist in analysing the risks. Ensuring that the information borrowers supply to their lenders, such as any updated construction or operating budget, compliance certificate or other financial information, considers the impact of Covid-19 will help facilitate effective and confident decision making by the lenders and allow them to feel fully informed when being requested to grant waivers or consents under the loan agreement.
A failure to provide information will potentially result in a breach by the borrower of its reporting requirements under the loan agreement, and this could lead to an event of default. It will also undermine the relationship of trust between the borrower and lender, making agreeing any pathway forward for the potential issues arising more difficult.