There is both an opportunity and challenges of using Municipal Corporation for the acceleration of rooftop solar. Therefore, if municipalities are to play a role in the necessary acceleration of rooftop solar in India, they will need to look for new sources of finance and business models to spur the required development. This will also require building partnerships with local solar developers and other stakeholders in the domestic and even international financial markets.
There are two business models to deploy rooftop solar in India.
- The first one is the CAPEX model in which the consumer fully owns, finances and consumes the energy generated by the PV system. Consumers in the CAPEX model are fully responsible for all capital expenditures, and bear all risks of operations, management, and maintenance. The CAPEX model accounts for approximately 84% of currently existing rooftop solar systems in India and is mainly driven by commercial and industrial operators.
- The second model is the OPEX model or the third party financing model in which a renewable energy service company (RESCO) provides all the necessary capital and is responsible for installing, operating, and maintaining the rooftop solar system in exchange for a fixed tariff Power Purchasing Agreement (PPA) with a customer, or multiple customers. This model is also referred as third-party financing model.
As CAPEX model is a self-funding model for the rooftop solar projects as far as the end consumer is concerned, it does not require much financing support from external entities. On the other hand, the third party financing model requires significant debt investment from the capital market. Hence, the municipal corporation can collaborate with the rooftop solar developers to facilitate the access of the debt capital from the capital markets under the OPEX model route.
A research article published by the Climate Policy Initiative (CPI) proposes the OPEX model as one of the promising solutions to address several barriers to scaling rooftop solar. According to studies conducted by CPI, the third party financing model is expected to dominate the rooftop solar market, given its benefits for consumers of no upfront and installation cost and the operation and management services being carried out by local developers. Globally, the third-party financing model has been a significant driver of growth in the rooftop solar sector. However, the third party financing model has not picked up in India at the rates expected due to the lack of availability of debt capital at competitive cost, which affects the ability for companies advancing this business model to scale.
Thus, to achieve further scale for the OPEX model for rooftop solar in India, alternative methods of financing should be considered.
Overview of Solar Municipal Bond Model:
The CPI study propose an alternate approach where municipal corporations can play the role of finance aggregators for rooftop solar projects deployed under the OPEX route. The proposed model called Solar Municipal Bond (SMB) model advocates a bottom-up approach to facilitate financing for rooftop solar projects and complements the existing government efforts to achieve the 40 GW national targets. The SMB model suggests using municipal financing for rooftop solar projects. It is based on a public-private-partnership (PPP) investment approach for rooftop solar projects at city level where municipalities would issue bonds and then transfer the proceeds to private solar rooftop developers through special purpose vehicles (SPVs).
This model differs slightly from a conventional design-build- finance-operate (DBFO) model. In a typical DBFO investment model, all activities from design to operation are taken care by a private developer. In the proposed model, however, CPI recommendes that municipalities should raise debt capital to finance rooftop solar development. The transaction structure is similar to the Morris County model successfully used in the USA for financing the rooftop solar but limited to the public places only. The proposed SMB model advocates its implementation beyond public buildings.
Rationale For Municipal Bonds For Rooftop Solar Projects:
Before discussing the transaction structure of the solar municipal bond model in more detail, let us take in to account the rationale of using municipal bonds as financing mechanism for the rooftop solar:
Build-in Incentives for Municipalities under Solar City Program
Municipalities have target-based responsibilities to increase renewable energy deployment under the Solar City Program, so they have a built-in incentive to increase rooftop solar in their jurisdiction. However, the targets set under the program are quite moderate and municipal corporations can be given additional responsibilities to increase these targets as per their true potential.
Municipalities are in a better position to raise capital by issuing bonds
The main advantage for the proposed public-debt based financing for rooftop solar under the OPEX model is that compared to private developers; municipal governments are in a better position to raise capital by issuing bonds. The key reason behind this is that Municipal Corporations have relatively larger balance sheets as compared to that of a rooftop solar developer, which provides the feasible financial strength and capital base to raise bonds from the capital markets.
High credit worthiness:
One important reason why municipalities are in a better position to raise debt-based finance than project developers is their credit ratings relative to that of rooftop solar project developers. More than half of the rated municipalities – 94 in total- are investment grade (i.e. BBB- or above); whereas almost all rooftop developers are below investment grade. A high credit worthiness is essential for successful listing of a bond as it not only helps in reducing the cost of debt servicing but also attracts long-term institutional investors.
Easier access to public guarantees:
Being government-backed entities, municipal corporations can leverage upon the strength of the state or central government to secure guarantees on bonds. This helps in raising the credit rating of the bonds. For private project developers, it is quite difficult to access such guarantees from the government institutions.
Security for investors:
In addition to the project revenues which are used to service the bond payments, municipal corporations have various other streams of revenues such as property taxes, service taxes etc. which can provide security for investors in case project revenues are not sufficient to service the bond payments. Private solar developers rarely have revenues other than that from solar energy generation.
One of the key issues that a private rooftop solar developer faces in raising the debt capital is the small size of the projects, which increase transaction costs. Given municipalities’ relatively good proximity with the consumers, the municipal corporation can quickly facilitate rooftop solar project aggregation. If rooftop solar developers would like to access the debt capital through municipal bonds, multiple developers would have to aggregate their projects at city level which would ensure the aggregation of the projects and make the issuance of the bond more feasible. This process will also help to reduce the transaction costs of raising the debt capital.
Incentives for Municipal Corporations
Municipal bond issuance can expedite governance reforms. A municipal bond issue would mean not only a plethora of challenges but also offer the local body a number of opportunities. Most importantly, a successful bond issue warrants financial discipline and accountability of the issuer. Past experiences have proved that efficiency of project management systems, procedures to reduce time delays and cost overruns, and a healthy revenue system are essential for constant engagement with capital markets. A rooftop solar project in this respect could be a less risky project than alternative projects to be funded through bonds as the revenue streams of a rooftop solar project are largely assured due to PPAs and would prepare municipalities for larger issues in the future.
Transaction Structure of the Proposed Municipal Bond Model
The proposed solar municipal bond model for rooftop solar combines public debt-based finance with an existing OPEX model. Under this mechanism, a public entity would issue a bond at low cost- long tenor and transfers the bond proceed to a private developer. This model is quite similar to bond-PPA model called Morris County Model, named after Morris County in New Jersey, U.S., which developed the model to finance solar power installations on public facilities in 2011.
However, in the proposed bond model for India, CPI proposes going one step further from the U.S. based Morris county model. In Morris County model, the municipal corporations raise bonds to facilitate the financing of only those solar projects, which are installed for municipal corporation consumption. In the CPI model, the fund raised through a municipal bond would be used to finance as many rooftop solar projects as possible including residential, commercial, and industrial customers.
The model combines many of the benefits of self-ownership and third-party ownership from the perspective of local government as consumer. Like self-ownership, the model allows local government to leverage low-cost public debt. Like a third-party financing model, the proposed model enables the developer to benefit through savings passed on from tax incentives i.e. the accelerated depreciation benefit. In addition, the local government and the other consumers receive fixed electricity costs for a long-term contract and have no operating and maintenance responsibilities for the solar equipment.
Figure 1 shows the transaction structure of the municipal solar bond model that is based on public-debt and OPEX model of project deployment. A public entity, in this case a special purpose vehicle (SPV) which is 100% owned by a municipality, issues a revenue bond which would be ring fenced with the project cash flows. We refer to this SPV as Master SPV or the corporate municipal entity (CME).The bond can be raised by the municipal corporation directly as well. The main reason of raising the bond via SPV is to de-link the financial risk of the project from the municipal corporations’ financial books. However, we have assumed that the CME or the municipal corporation, whoever is raising the municipal bond, meets the required eligibility criteria laid by SEBI (SEBI 2015). The CME then issues a request for proposal (RFP) seeking solar developer(s) to build, operate and own solar rooftop projects or a portfolio of projects on municipal buildings and other consumer segments.
The CME floats the bond to finance/refinance the development cost of solar PV projects. The CME then enters into a capital lease agreement with the project SPVs owned by project developers. The project SPVs then sign a PPA with consumers to sell the electricity from PV systems.
Limitations of the Solar Municipal Bond Structure
Size of municipal bonds
As per the SEBI’s guidelines, a bond should have a minimum issuance size of INR 1 billion if the issuance is via public placement route. Municipal Corporations can also go for a private placement route to raise the bond as there is no such restrictions. However, if we want to optimize the transaction cost, the issuer should ideally raise at least INR 1 billion for private placement and INR 1.5 billion for public placement. Debt-based capital of this size would allow municipalities and solar rooftop developers to build rooftop solar systems of large-scale, and achieve low capital costs by pooling in individual small-scale projects.
The model is more suitable for non-residential consumers
The credit rating of the bond is one of the key criteria to ensure its successful subscription. In addition to the credit rating of the SPV, which depends partially on the rating of the respective municipality, the off-taker risk would be of utmost important. In the case of rooftop solar installed under the Opex route, enforcement of PPA contracts is a major concern for the project developers. This enforcement becomes relatively difficult when the off-taker is a residential consumer. On the other hand, off-taker risks of municipal, commercial, and industrial consumers are relatively lower. Also, most of the existing rooftop solar projects under OPEX models in India involve commercial and industrial customers. Hence, for initial success of the SMB model, it is recommended disbursing the capital from the bond proceeds for the projects in the non-residential consumer class. Hence, the solar municipal bond model will remain most suitable for non-residential customers because of low off-taker risk until a solution is found to reduce residential off-taker risk.
Short-term solutions for refinancing projects through the municipal bond
It should be noted that the origination of initial debt would be through a conventional bank as bonds are not suitable when portfolios of projects have not reached to a certain scale, as is the current case in India for rooftop solar. Once the projects get stabilized and start generating regular revenues, the initial debt would be refinanced through the municipal bond. It is assumed that a bank would agree to originate the short-term loan because of: a) the larger size of the projects achieved through aggregation of all the projects at the municipal corporation level; b) the assurance from the municipal corporation that the initial short-term loan would be paid or refinanced through a Municipal bond within a year or two.
Another way to reach the required stability in project portfolios before the municipal bonds can be raised would be to create a warehouse line of credit. This warehouse would take care of the required aggregation of the creditworthy rooftop solar projects and also provide the initial line of credit over a period not exceeding 24 months. Once the required aggregation and the stability in terms of project cash flows is achieved, the refinancing of the warehouse line of credit would be done by issuing asset backed municipal bonds. The refinancing should reduce the loan costs and free up capital from the warehouse line of credit to finance additional projects.
Expected Benefits of Solar Municipal Bond
Reduced levelized cost of electricity from rooftop solar
The solar municipal bond structure is expected to offer better debt terms than commercial alternatives, which are passed on to electricity consumers. In this model, the project developers make capital lease payments that fully cover the bond service payments. These lease payments would be lower than the payments on commercial loan that a solar developer would otherwise have borrowed. The lower cost is expected due to the better credit rating of the municipalities, over-collateralization of the bond, and certain upfront payment towards the capital lease. The tenor of the lease is also expected to be longer compared to that of the commercial loan due to more flexibility available in a capital lease mechanism. Hence, the cost savings due to low-cost, long-term lease capital would enable the project developer to offer an attractive PPA price to its consumers.
Table 2 shows the expected impact of cost of financing using municipal bonds on the cost of rooftop solar power. As there are little empirical data about the yield curves of municipal bonds in India, it is difficult to estimate the probable costs of municipal solar bonds. Thus, here the cost of debt of the recent green bonds raised by Indian entities is used as a proxy to estimate the benefits of the proposed municipal bond.
A tax-free bond for a tenor of 12 years can reduce the solar power cost by 8.38%, and, if tenor can be increased to 15 years, the reduction would be more than 11.5%. This means that rooftop solar power would become cost competitive for residential consumers in the states of Delhi, Karnataka, Haryana, Punjab if these states opt for the municipal bond approach. The recent municipal bond (taxable) issued by Pune Municipal Corporation has a coupon rate of 7.59%. If a similar coupon rate is assumed for municipal rooftop solar bonds, then the reduction in the cost of solar power can be even greater than 11%.
Even if the bonds are issued as taxable instruments, the relatively better credit rating of the municipal corporations is expected to make their borrowings cheaper than that of the solar developer. For example, recently, Pune Municipal Corporation (PMC) raised a bond at a coupon rate of 7.51% and New Delhi Municipal Corporation (NDMC) announced its plan to raise a bond via non-convertible debenture (NCD) route and is expecting similar coupon rates. Both these municipal corporations are being rated AA+ by credit rating agencies and hence have a competitive cost of debt.
Issuance of municipal bonds enhance the capacity of local governments to access capital markets
Given that rooftop solar projects have become commercially feasible in India, raising municipal bonds for such projects is attractive for municipal governments interested in accessing capital markets for a broader range of projects, as well as for prospective investors in these bonds. This model will be a good proof-of-concept for municipalities to build their capacity for future bond and capital market-financed projects.
Mobilization of a varied class of investors into the rooftop solar sector
A study conducted by Climate Policy Initiative (CPI 2016c) showed that domestic investors including institutional investors, non-banking finance companies (NBFC) and development finance institutions have a total debt investment potential of USD 56 billion to be channeled to renewable energy in India.
Solar power generation projects provide a relatively stable stream of revenues for longer duration via PPAs. This will attract investors, especially institutional investors who prefer longer, stable and predictable returns on their investments. Hence, a significant amount of untapped investment can be unlocked for rooftop solar through the municipal bond route.
Municipal bonds issued in the past have been able to attract large domestic institutional investors (DIIs), such as provident funds, insurance companies, mutual funds, and commercial banks, irrespective of the projects for which the bonds were raised. Hence, investments from these DIIs can be mobilized into the rooftop solar segment via municipal bonds.
As they will be issued for clean energy projects, municipal bonds for rooftop solar will be green bonds that can attract additional classes of investors such as the dedicated green bond funds, private and public investors and multilateral organizations. India is already among the top ten largest green bond issuers in the world, with the majority of proceeds (76%) allocated to renewable energy projects. Hence, the proposed bond can be labelled as ‘green’ municipal bond to tap these additional classes of investors.