Abstract
The Government of India had set a target of 40 GW of rooftop solar power installation by 2022. However, the progress on rooftop installation is lagging far behind, reaching only 7.9 GW as of June 2022. Lack of availability of capital—both debt and equity and high cost of capital are the key reasons for this uninspiring growth of the rooftop solar sector. Multilateral Development Banks (MDBs) such as the World Bank and Asian Development Bank have provided a credit line of USD 625 million to the rooftop solar sector through commercial banks to address the high cost of financing and limited capital availability. However, these lines of credit are far lower than the capital requirements of the sector. The article will show that securitization with an appropriate credit guarantee structure can help Indian rooftop solar developers access the capital market and reduce the cost of debt through expansion of the investor base, reduction in liquidity discount, and bankruptcy risk mitigation. This will allow the sector to better leverage public and MDBs’ capital to attract the much-needed commercial long-term debt capital at appropriate terms of credit to India’s rooftop solar sector.
Introduction
The Government of India had set an ambitious target of 40 GW (Gigawatt) of rooftop solar power installation by March 2022. However, the progress on rooftop installation is lagging far behind reaching only 7.9 GW as of June 2022. 1 The lack of availability of capital, both debt and equity, and the high cost of capital are the key reasons for this sluggish growth of the rooftop solar sector. Even though rooftop solar installations make economic sense for commercial and industrial users, a lack of confidence in the credit quality of rooftop solar projects has attributed to limited performance records and small-size deals.
Multilateral Development Banks (MDBs) such as the World Bank and Asian Development Bank have provided a credit line of USD 625 million to the rooftop solar sector through commercial banks such as the State Bank of India and Punjab National Bank, respectively. However, this line of credit is far lower than the capital requirements of the sector. In this article, I aim to illustrate how these lines of credit from MDBs can be leveraged effectively to attract more commercial capital to the sector through securitization by adding credit enhancement to the transaction structure.
Securitization helps the borrower in reducing the cost of capital compared to conventional financing through expansion of the investor base, diversification of risk, reduction in liquidity discount, and bankruptcy risk mitigation (Buchanan, 2013). It also helps the lender to deleverage its balance sheet and frees up its equity capital to lend more. Since 2013, solar developers in the United States have started using the securitization route to raise capital based on future solar leases/Power Purchase Agreements (PPA)/loan payments. This model has proved as one of the successful renewable energy finance innovations, which has helped the sector to diversify its financers base.
A similar stimulus is also warranted in India if it is to achieve India’s rooftop solar expansion ambition. Commercial loans to small rooftop solar developers in India can be pooled together and refinanced through securitization by issuing asset-backed securities to institutional investors. These securities are backed by loans provided to rooftop solar developers. Refinancing of these loans will free up MDBs’ line of credit which can then be reused to finance other rooftop solar projects. I propose the use of a portion of the MDBs credit line in creating a guarantee fund to provide a partial credit guarantee (PCG) to improve the credit rating of securitized bonds. This is particularly essential to attract large institutional investors mainly investing in highly rated securities. Public credit guarantee schemes have been used extensively used by Governments and MDBs to increase access to credit for unserved segments (Gozzi & Schmulker, 2016).
The article shows a path to how securitization with a credit guarantee structure can help Indian rooftop solar developers access the capital market, and better leverage public and multilateral banks’ capital to attract much-needed commercial long-term capital to India’s rooftop solar sector.
Literature Review and Current Practices
Securitization pools illiquid assets and transfers them into highly liquid and tradable securities in the capital market. These are then sold to institutional investors like pension and insurance funds wherein the investors’ return is drawn from the cash flows of the underlying assets. Apart from helping borrowers in reducing the cost of capital compared to conventional financing through the expansion of the investor base, it serves as an important tool for deleveraging banks’ balance sheets and frees up capital to lend more (Ito & Park, 2013). However, securitization was blamed for the 2008 credit crisis when all the risks are passed on to the investors, and loan originators and financial intermediaries have no incentives to choose good quality assets and/or perform their fiduciary responsibilities. However, a robust transaction structure where the interests of all stakeholders are aligned properly can mitigate these risks associated with securitization.
Rooftop project developers are usually small in size to attract financing on a one-off basis along with lacking collaterals. Securitization can thus help them in reducing the cost of capital compared to conventional financing. Long-term PPA along with low and predictable operating expenses, and low recurring capital expenditure generates predictable cash flows from solar projects including rooftop solar projects. This asset characteristic makes the rooftop solar sector an ideal asset for securitization. Solar developers in the United States (US) have started using the securitization route to raise capital since 2017 based on future solar leases/PPAs/loan payments.
Credit enhancements are a form of protection given to investors to cover losses on securitized assets in adverse conditions (Standard & Poor, 2008), thereby reducing the risk of securitized bonds. A credit guarantee is usually structured to cover up to 100 percent of each debt service payment, up to a certain cumulative guarantee amount. A credit guarantee-backed security allows borrowers to diversify their funding sources. By structuring a credit guarantee wherein both lenders and investors are comfortable providing longer-term credit, it enables obtaining longer-term funding that may have not been available previously.
Securitization with credit enhancement can therefore contribute to capital market development by overcoming the problems of the small size and low credit quality. While, a credit enhancement can be in the form of a credit tranche, over-collateralization, excess spread, guarantee, and so on. In this article, I am proposing to create a credit guarantee fund.
The overarching question related to the success of public credit guarantee is whether it provides financial additionality by increasing the availability of credit and/or improves borrowing terms (e.g., longer tenor, lower rates, and so forth) (Gozzi & Schmulker, 2016). Another aspect is whether it leads to economic additionality, that is the resultant increase in access to finance leads to improved performance of the supported firms (e.g., higher employment, growth innovation, and so on). Several studies (Cowan, Drexler, & Yanez, 2015; Cowling, 2010; Wilcox & Yasuda, 2008) have found supporting evidence for financial additionality for Chile’s FOGAPE SME lending program, Small Firms Loan Guarantee in the United Kingdom and Special Credit Guarantee Program in Japan, respectively. An OECD (2017) study, evaluating performance and cost-effectiveness of publicly supported credit guarantee programs for SMEs in 23 OECD and European Union also provided evidence for financial additionality.
One key example of credit enhancement in solar space is the Property Assessed Clean Energy (PACE) bonds where the state, municipality, or state/local agency issues bonds and uses the proceeds to help residential, commercial, or industrial property owners finance energy-efficient upgrades or renewable energy installations to their properties through payments of additional property taxes. These bonds are credit enhanced primarily through a security of the property tax and the excess spread (the difference between incoming and outgoing interest rates) incorporated in the structure rather than over-collateralization. Starting back in California, the United States in 2014, the PACE market has reached over $4.7 billion in funded projects (EuroPace). PACE-like programs are under development in Canada, Australia, South Africa, and Europe with potential funding from the European Commission.
Proposed Mechanism
MDBs provide concessional and long-term credit line to banks for commercial and industrial purposes to accelerate financing in the rooftop solar sector (Figure 1). Bank disburses loans to developer meeting minimum eligibility criteria; credit rating and grading of developers (RESCO—Renewable Energy Servicing Company) are the two key criteria of loan sanction. I propose a minimum credit rating of the developer to be “BBB”—meeting the investment grade—the rating of the developer significantly affects the rating of securitized loans.
The bank creates a financing Special Purpose Vehicle (SPV) for securitization and appoints a trustee to monitor the assets of the financing SPV. The bank transfers the loan to the financing SPV and thereafter the SPV issues asset-backed securities to institutional investors. The target investors are institutional investors such as domestic insurance and pension funds, and mutual funds in India. However, these institutional investors seldom invest in a bond with a credit rating less than “AA.”
MDBs’ capital will be used to capitalize a Credit Guarantee Fund Trust, set up by the bank, appointing a trust manager. The trust will provide a PCG to asset-backed securities and collect credit guarantee fees. An appropriate credit enhancement can improve the rating of the securitized bond to “AA,” attracting institutional investors to invest. The mechanism of the proposed structure is provided in Figure 1.
The success of securitization hinges on the asset quality and design of credit guarantee mechanisms as they influence and send signals to potential participants in the securitization process. There are three conditions under which a credit Guarantee scheme works efficiently (Honohan, 2010), that is, the Guarantor has information advantage and enforcement power, the ability to spread and diversify risks, and regulatory advantage. I have proposed that the lending bank would provide a credit guarantee as they are better informed about the quality of loans and developers, as they originate the loans. Also, banks are offering credit guarantees on securitized bonds—ensuring their “skin in the game” which will give the right signal to investors on the quality of loan pools (Levitin, 2011). In this mechanism, credit enhancement is addressing two risks concerning bond investors: a capital buffer against known risk and a signal against asymmetric risk. In addition, the cost of credit would be lower if the same bank becomes a credit guarantor as it has already assessed the credit-worthiness of the borrower.
In India, IIFCL has a PCG product to improve the credit rating of fixed. However, the product has not seen success in the renewable energy sector yet; only two issuers have used this product. The opaque transaction structure and few incentives for borrowers to use this product did not help the product scale up (CPI, 2018). To address this issue, it will be important to support the instrument by organizing an awareness program among the institutional investors’ community.
Sizing the Credit Guarantee Fund
The adequate size of the credit guarantee fund is an essential component for this financial mechanism as it gives a right signal to the investors.
I have used the following elements in calculating the size of the credit guarantee fund: survival probability (P), expected size of the loan (S), recovery rate (R), discount rate (C), and time (N),
Survival Probability (P): The probability of survival is the chance that the debtor will not default on their payment obligation over a certain period. We have used the weighted average default rate to estimate the probability of survival. I have used the rating of the developer as a basis to assume the default rate of developers.
Expected Size of Loan (S): The size of the loan depends on the debt payment schedule and default rate. As we have used amortized debt payment structure, exposure at default decreases over the course of debt maturity.
S = P* Exposure at Default
Recovery Rate (R): The expected recovery of loan default. We have assumed no recovery of loan in case of default as there is no secondary market for rooftop solar PV systems in India.
Cost of Capital (C): Cost of capital of the guarantor.
Time (T): Time of default.
In this article, as an example, I have taken a case of ₹100 million of loans given to rooftop solar developers targeting commercial and industrial consumers. The key inputs and assumptions for the financial model are provided in Table 1.
Key Inputs and Assumptions for the Financial Model.
As the securitized bond is targeting pension and insurance funds, it is important that bond rating would be a minimum “AA rating.” The financial model shows that there is a need for ₹10.1 million for the Credit Guarantee Fund to support ₹100 million of bonds, which is approximately 10 percent of the total outstanding bond. This structure can also leverage by ~10 times the MDBs capital compared to using MDBs’ capital for direct lending—a more efficient way of using public capital. The results of the analysis are provided in Table 2.
Results Based on the Proposed Mechanism.
Conclusion
The rooftop solar project is characterized by predictable cash flow generation, which can be attractive to low-risk and low or medium return seeking institutional investors. This character makes rooftop solar project loans an ideal asset for securitization. Accessing the capital market through securitization could provide the much-needed long-term and low-cost debt financing to rooftop solar developers in India.
The addition of a PCG into the securitization transaction structure can further enhance the credibility of securities and consequently improve the rating of the securities. As the loan originator acts as a credit guarantor, it will address principal–agent issues, and send a positive signal to investors. This structure would use credit lines of MDBs more efficiently and effectively compared to simply lending to the sector. This framework could be a reference mechanism to develop an efficient mechanism to leverage public capital. This article only offers a first-hand analysis of the usage of a PCG structure based on a sample project. As the rooftop solar sectors and developers accumulate performance records, the pricing of securities including credit guarantee fees for this kind of transaction structure can be estimated more accurately.
Footnotes
Declaration of Conflicting Interests
The author declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.
Funding
The author received no financial support for the research, authorship, and/or publication of this article.