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‘Innovative financing’ is a phrase used broadly. Often cited as a critical tool a host of stakeholders in the clean energy transition - developers, utilities, corporates, financial institutions, and governments/contracting authorities – are to pursue. Mentions of innovative finance include an expansive range of financial techniques – some tried and true, others less common – with the extent of innovation often in the eye of the beholder.
Successful financing of a project is one where the incentives of all stakeholders coalesce in generating both services and returns that must last 10, 20, or even 30+ years. Most projects do not require adaptations from template agreements (e.g. PPAs) as past innovations have become leading practice.
Innovative financings occur when standard approaches are unable to address (i) alignment in stakeholder’s incentives through template financial and contractual terms, and (ii) when the inclusion of non-standard approaches have cascading impacts on the interests of consortium’s stakeholders.
For an example solar project, consider the case where construction contractors, equipment suppliers, O&M contractors, and even offtakers (e.g. utilities, corporates) hold equity as project sponsors. These active investors can create a positive impact by promoting, developing, and managing the project towards mutual financial benefit. On the other hand, while financial institutions often recognize the benefits of aligned sponsors, additional due diligence needs to be conducted to make sure arms-length agreements are struck to ensure pricing and terms are in line with the market. A financial institution might celebrate sponsors sharing in the risk of the project through their equity contributions, but simultaneously not take kindly to cash leaving the project through excessively priced supply contracts prior to debt service. A balance must be struck.
Ultimately the goal of innovative financing should be the design of a deal structure to deepen capital pools and de-risk investments through careful consideration of (i) any atypical financial structuring and contractual terms, and (ii) balance of how stakeholders are impacted across the agreements.
With this framing, we would like to consider the approach that Plug Power has utilized to structure its deals to supply Wal-Mart, Amazon, and other large corporate retailers with hydrogen hardware, services, and fuel. Our hope is the discussion will shed light on how infrastructure in more nascent areas of hard to decarbonize sectors could utilize deep partnerships through innovative financing approaches to the benefit of all parties.
Let’s make a deal.
The structure is straightforward. Plug Power’s customer agrees to purchases over several years, in Wal-Mart’s case structured as a power purchase agreement (PPA). As Plug Power’s customers make purchases on time and in the amount specified, customers are granted the option to purchase equity – called a warrant – for Plug Power’s stock.
Some differences do exist between the deals struck by Wal-Mart and Amazon. Wal-Mart structured a PPA enabled by a sale-leaseback to finance the equipment, while Amazon agreed to pay cash at the time of purchase.
In the sale-leaseback, Plug Power sells their hydrogen fuel cell systems and infrastructure to a financial institution, in this case Wells Fargo, to generate the funds to deliver the equipment. In exchange, Plug Power leases the equipment they sold from the financial institutions. To meet the new lease obligations, Plug Power delivers the leased hydrogen fuel cell systems and infrastructure to Wal-Mart through a PPA structure. Wal-Mart then makes payments to Plug Power, who issues warrants for Wal-Mart to purchase stock – see below.
Precisely how does this structure impact the strategic alignment of incentives between Wal-Mart and Plug Power? The company designed the warrants to help customers “capture a portion of the new value [their customers] help create.” In theory, allocating the potential for this new value to customers creates an innovative incentive to drive long term, predictable demand for Plug Power’s products and services. The partnership helps mitigate a fundamental concern for most clean energy firms requiring production volume to increase cost competitiveness – predictable demand.
Among the key risks in project financing, the certainty of demand/offtake – be it fuel, electricity, water, or any other capital-intensive product – is among the chief concerns of any financier. Variance in the top line has a dramatic impact on any project finance model, but especially for one like Plug Power where the projection of lowered costs with increased scale is crucial for long term viability of their business. Warrants create a mutualistic incentive for customers to agree to long term purchase arrangements, maintain planned purchases, or increase demand against contracted amounts.
The warrants have no cash outflow when the deal is struck, and in fact provide small positive impacts on Plug Power’s cash when exercised. It is no surprise that the structure was utilized in a nascent area of hard to decarbonize sectors where technology, the company, and to some extent business models have relatively low free cash flow.
Why not offer discounted services and products to strategic customers? One consideration would be that a discount would erode margins in the short term. More interestingly, a discount does not inspire customer loyalty the same way sharing in the upside of the business writ large might. As we will see in the next section, this logic is tested when Amazon executed their warrants.
When should warrants – more generally equity positions in the supplier by the customer – be considered when financing the deployment of clean energy infrastructure? Aligning equity incentives with some measurement of the “new value [the customer] helps create” makes for a start. Taking Wal-Mart as a case example:
High credit quality with very low credit risk by all major rating agencies. Wal-Mart provided a customer guarantee for the majority of its transactions with Plug Power, further reducing demand risk.
Sizable – 42.4% of consolidated revenues for 2017 – and a long-standing customer since 2007.
Shared mission and values through renewable energy and emissions commitments in line with Plug Power’s product offerings
Unsurprisingly, Amazon shared many of these same traits: creditworthy, a key customer (29.4% of consolidated revenues), and strategic alignment in their commitments to sustainable operations over the long term.
Nothing is free, but some things don’t cost anything.
Partnerships are not without their costs. Over the last 5-year period of Wal-Mart and Amazon purchasing from Plug Power and subsequently receiving warrants, the stock price of Plug Power rose reaching a peak $73.18 over the period, representing a 35x increase over the price at closing on the announcement of the deal with Amazon. A great deal of “new value”.
While it is impossible to time the market, it would have been exceptionally difficult to NOT make a healthy return on these warrants at the cost of Plug Power shareholders. Assuming Amazon’s initial exercise price for the first ~35 million warrants, simple intrinsic values of a warrant are charted below over the period since the initial Amazon deal in April of 2017.
As a result of the issuance of warrants, Plug Power had to recognize reductions in revenue in 2020 reporting a provision for warrant charges of $420.0 million. To put that in perspective, the charge led to the reported revenue for Amazon for the entire 2020 year at a NEGATIVE $310.1 million. While this is a ‘paper’ charge, the real impact is to shareholders who become diluted by the new issuance of shares.
In fact, once the warrant’s intrinsic value became equivalent to the cost of acquiring a warrant – roughly every $11 of Amazon generated revenue for Plug Power to issue a warrant – the hydrogen hardware, services and fuel became effectively free for Amazon to purchase. Above that, Amazon would generate profits from creating revenue for Plug Power.
Do such exceptional returns on Amazon’s warrants reflect Plug Powers initial goal of allowing customers to “capture a portion of the new value [their customers] help create”? It should be noted that circumstances were quite exceptional. Most publicly traded firms do not see a 35x increase in value over 4 years. Additionally, judging ex-post does not account for the realities of all the risks in 2017 that could have left the warrants being worth less than the cost of accounting for them.
Doubling down.
What is the long-term viability of warrants issued to offtakers such as Wal-Mart and Amazon? In August of 2022 Plug Power and Amazon expanded their deal and increased the agreed spend by a factor of 3.5x to $2.1 billion over 7 years.
What is different today is that the warrants are worth far less per dollar of revenue. The $22.9841 strike price in the new deal is far above the ~$17 at the writing of this article, meaning exercising the options has no value - yet. While the option exists for prices to rise and exercise the warrants later, uncertainty has returned. The previous distorted incentive structure, to profit from simply making purchases from Plug Power, is no longer guaranteed. Future Amazon demand for electrolyzers, fuel cell solutions, and green hydrogen may be based more closely on the actual value created by Plug Power’s products.
While that value is getting a significant boost from public policy changes with the passing of the Inflation Reduction Act providing a $3/kg production tax credit to produce green hydrogen, it may not be enough. Plug Power’s cost of hydrogen has risen to $17.50/kg. The costs to supply fuel in its operations climbed 90.7% year-over-year in the company’s Q3FY22 reporting. While the company expects decreases in the cost of the molecule moving forward, the reality is those costs have gone the opposite direction since the agreement with Amazon.
It is difficult to quantify just how Plug Power’s innovative financing approach might change the calculus for its suppliers in such environments. Customers will once again need to think longer term – as Wal-Mart and Amazon had in 2017 – to consider whether shared success with Plug Power outweighs short term increases in operating costs. While the answer may still end up being a resounding ‘no’, the ability for the warrant structure to incite the question within their suppliers has and may continue to prove a powerful incentive.
Admittedly there is a long list of changes that could be made to these agreements to make them more favorable towards Plug Power’s customers. Would any create similar loyalty to Plug Power’s products like warrants? Probably not. Discounts create a race to the bottom with competitors. Longer terms might, but how would Plug Power negotiate such terms? More lenient termination clauses ease anxiety over commitments by allowing customers the ability to hedge suppliers, but this would ultimately increase demand uncertainty.
With an innovative inclusion of a non-standard term in structuring climate financing Plug Power have aligned the interests of their key stakeholders towards a long-term growth strategy. Was it costly? Certainly. But for early technology companies selling into a market where scale dictates the winner, early incentives for customers that align interests towards growth may be a key tool in remaining hard to decarbonize sectors.
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