Debt Finance

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Overview

Capital structure pyramid

Debt financing comes in the form of loans and requires the repayment of both the principal sum borrowed and interest charged on that principal. Generally financial institutions will only provide debt finance to projects and project developers once the market is mature and therefore often need encouragement to enter the market. Debt finance can be provided to local finance institutions to allow them to on-lend to consumers, to project developers, or debt can be provided directly to a project developer. The debt must be repaid whatever the outcome of the project. 

International funds dedicated to development projects such as are provided by Multilateral Development Banks (MDBs) will often create loans with generous repayment terms, low interest rates and flexible time-frames, such loans are called "soft-loans".
Investment and commercial banks can lend money against the assets of the project. In the event of defaulting on the loan the bank can have no other claims other than the assets of the project. This type of financing is based on long-term commercial loan contracts. However, if the project becomes insolvent then the existing assests is sold to generate cash and debt (bank and other lenders) have precedent over equity. This is because, banks and other lenders provide money for a fixed return (margin) and have no claim on further "upside" (profits) while equity takes greater risks (as payments are received only after all debt claims have been met) and thus there is an assumption that equity investors also receive the additional "upside" (profits) if the project exceeds the expectation.

Senior Debt

Senior debt provided from public sources, takes its place among the first creditors to be repaid from a project. It is primarily used to reduce the costs of the project, by providing concessionary funds that may be blended with more expensive commercial funding, and to offer longer-term debt than may be available in local financial markets. Long-term loans from public sources can also help establish credibility among private financiers for longer-term lending to RE projects. A wide variety of debt amortization and repayment schedules can be used, allowing tailoring of debt service costs to project cash flows. For example, a bullet (one-off) repayment of the loan principal may be made at the end of the loan term, reducing debt service costs in the initial years of the project.

A distinction can be made between direct loans to project companies and the provision of credit lines extended through commercial financing in- stitutions (CFIs) or other intermediaries. Credit lines can create incentives for intermediaries to extend their own loans to RET projects along- side that funded from the credit line as well as allowing blending of commercial and conces- sionary loans to reduce overall costs. The choice of intermediaries is discussed in chapter.

Senior Debt
Uses	Advantages	Disadvantages
Reduces project costs. Provides long-term finance.	Obligation to repay creates incentives for project viability. Repayment of principal frees funds for further support to RET projects. Used as a means to increase CFI involve- ment in RET projects (through provision as credit lines).	Need for due diligence to verify ability of project to repay loan increases transaction costs. Leverage is limited and may crowd out potential private providers of debt.
Source: Adapted from The World Bank, 2013. Financing Renewable Energy - Options for Developing Financing Instruments Using Public Funds

Subordinated Debt / Mezzanine Finance

This type of lending sits between the top level of senior bank debt and the equity ownership of a project or company. Mezzanine loans take more risk than senior debt as because regular repayments of the mezzanine loan are made after those for senior debt, however, the risk is less than equity ownership in the company. Mezzanine loans are usually of shorter duration and more expensive for borrowers, but pays a greater return to the lender (mezzanine debt may be provided by a bank or other financial institution). A RE project can seek mezzanine finance if the amount of bank debt it can access is insufficient: the mezzanine loan may be a cheaper way of replacing some of the additional equity that would be needed in that situation, and therefore can improve the cost of overall finance (and thus the rate of return for owners).

Subordinated Debt / Mezzanine Finance
Uses	Advantages	Disadvantages
Provides intermediate funding between equity and senior debt, which helps reduce risks to senior lenders while not taking control away from project sponsors. By doing so, can extend the term and reduce costs of senior debt.	High level of leverage. Crowds in senior debt by allowing projects to meet acceptable risk criteria for lenders.	It is generally custom designed for each project, implying high transaction costs. Significant risk transferred to public financ- ing agencies, but with only limited ability to control these risks.
Source: Adapted from The World Bank, 2013. Financing Renewable Energy - Options for Developing Financing Instruments Using Public Funds

Further Information

• Debt Instruments
• Financing and Funding Portal on energypedia
• An Overview on Micro Hydro Debt Fund - Nepal
• Financial Instruments & Support for Renewable Energy