Morningstar DBRS' Takeaways from the Evolution of Project Finance Event: Our Methodologies Keep Pace With Technologies

As part of its Takeaways series, Morningstar DBRS is publishing write-ups from the Evolution of Project Finance Lunch & Learn event that provided an overview of its evolving credit rating methodologies, "Global Methodology for Rating Project Finance" (the PF methodology) and "Global Methodology for Rating Essential Digital Infrastructure."

Biao Gong, Senior Vice President and Sector Lead, Project Finance at Morningstar DBRS, provided an overview of recent updates to wind and solar generation aspects of the PF methodology and the role of project finance in the ongoing energy transition.

PROJECT FINANCE METHODOLOGY ENHANCEMENTS
In December 2024, Morningstar DBRS published the PF methodology, consolidating the three standalone methodologies for rating project finance, wind power projects, and solar power projects into one. The wind and solar power methodologies were created more than a decade ago to meet the then-market demands and provided extensive technical details. But things have changed since then and, as bankers now have a deep understanding of the renewable power sectors, it was time to merge the methodologies into one, Gong explained. "We streamlined the methodology with enhanced transparency, deleted some of the more educational/ technical details that are no longer necessary, and added new guidance for merchant solar and wind projects," he said.

RATING MERCHANT RENEWABLES
Morningstar DBRS introduced guidance of debt service coverage ratios (DSCRs) and project loan coverage ratios (PLCRs) to rating merchant solar and wind projects in an extension of the approach to rating merchant hydro projects. "We believe these three renewables are in the same bucket in terms of their cash flow variability," Gong said. "Thermal power projects, however, are in a different bucket as they have much greater cash flow variability."

Revenue is a product of power price and volume, he noted, and renewable project volume is inherent to the resource risk. It can be predicted with a certain level of accuracy, but the same cannot be said for thermal projects because those are generally exposed to both volume and price risk. Often there is a positive correlation when both price and volume are down, meaning a less competitive thermal generator can not cover the fuel costs/variable costs to even generate any power.

Thus, to achieve a minimum investment-grade credit rating, the merchant renewable (hydro, wind, solar) project may need a DSCR in the range of 1.5 times (x) to 1.7x while the merchant thermal project, in theory, will need a DSCR three times that. The PLCR helps to quantify the refinance risk of merchant renewables. The concept of the PLCR is simple: during the refinancing period, the PLCR is roughly equal to a leveled hypothetical DSCR, based on a mortgage-style debt amortization schedule, assuming the balloon can be successfully refinanced during the remaining economic life of the assets. If there is significant balloon amount at the refinancing point, the current credit rating will likely be affected because of the weak PLCR.

MERCHANT HYDRO VS. MERCHANT SOLAR AND WIND
For Gong's team, notwithstanding that merchant renewables (i.e., hydro, solar, and wind) are considered less risky than merchant thermal, they can be subject to heightened curtailment and negative power price risks. For example, Europe has seen significant penetration of renewables, especially solar and wind, and last year saw a spike in negative power prices. With increasing negative prices, even merchant solar and wind generators will have to curtail their production. In addition, the low power prices often coincide with high production hours of these projects, which can lower the revenue even further. This is a consideration that lenders and analysts need to pay closer attention to when they look at merchant solar and wind projects.

Within the renewables bucket, a merchant hydro project has a distinct structural advantage over merchant solar and wind projects as it has an almost perpetual asset life and, should a hydro project experience prolonged low power prices, it has a longer time to recover¿an advantage from the lender's perspective. Hydro projects also have the significant advantage of storage capacity to regulate intraday waterflow to time with on-peak power prices.

Standalone solar and wind projects do not typically have capacity for power storage, but when rating merchant solar and wind projects, the Project Finance team takes additional credit considerations into account:
--Revenue projections for renewables are expected to be much more sophisticated and granular, sometimes counting down to hourly intervals.
-- Solar or wind projects paired with storage capacity have an advantage.
-- Structural enhancements, such as cash sweeps, more dynamic amortization to address volatile power prices, and enhanced liquidity reserves are typically expected to be in place.

UPDATE ON THE POWER SECTOR
"Power generation is still the bread and butter of our project finance universe," Gong said. Demand is up, power consumption is up, and the International Energy Agency has predicted 4% demand growth in 2025 driven by the continuing industrialization and economic growth of emerging markets, especially India and China; AI-driven data centres; and reshoring of manufacturing capacity in the U.S. "As a result, we foresee continuous supply growth in the coming year and beyond to support the demand growth," said Gong.

Natural gas-fired projects will continue to play an important role in energy transition, driven by dispatchability and operational reliability, while solar power generation will lead the growth of renewables globally. The story is a bit different in the U.S., where the new administration will likely favour developing thermal and nuclear projects while curtailing wind projects in particular. Canada is in better shape, with a robust procurement pipeline for future electricity supply and a relatively balanced supply mix.

Gong noted there is some general consensus about renewable energy development across the Canadian political spectrum, albeit with differences over the details, such as carbon tax. Looking at the procurement pipeline, Ontario has just increased its procurement target to 7,500 megawatts in its YE2024 announcement; Alberta has added the most renewables of all provinces in recent years; and BC, which has become the largest importer of electricity because of recent drought conditions, has made its first call in 15 years to add more renewables.

EMERGING TECHNOLOGIES NEED CREATIVE FINANCING
New technologies and financing alternatives will create new opportunities and challenges for project finance lenders. While battery energy storage systems are becoming a mainstream technology and can be rated under the PF methodology, emerging technologies such as green hydrogen, carbon capture, fusion, and small modular nuclear reactors are yet to be proven "bankable" for project finance lenders.

For financing renewable projects, the traditional physical power purchase agreement (PPA) is still the preferred approach. But sponsors are thinking about different ways to finance these projects and virtual/corporate PPAs are emerging. The virtual PPA is not simply a replacement for a physical PPA, rather it is essentially a financial hedging agreement, which presents its own challenges, including:
-- Basis risk, which, if the contract settles at different locations with different prices, introduces another layer of cash flow volatility;
-- Minimum volume commitments could be challenged by extreme weather events that curtail production, forcing power sellers to purchase from merchant markets at surge prices to fulfill their volume commitments under the contract, which can lead to significant financial losses; and
-- Complex contractual structures with caps, floors, and collars may benefit equity sponsors but are not necessarily good for lenders that want cash flow stability.

Written by Deirdre Maclean

NOTES:
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