Overreading into Underwriting

If you’ve ever secured a mortgage, signed up for an insurance plan, or—anyone could be reading this—taken your company public on the New York Stock Exchange, then you’ve needed something called underwriting. Taking on debt to finance a home is risky, to say nothing of raising funding for a company. You know this, and so does your bank, which hires teams of people called underwriters to assess just how risky your particular venture is. They comb through all your finances, and then they judge you. That assessment is how banks put a price on you and your creditworthiness; underwriting is how debt markets are made.

This applies to energy as much as to anything else. The renewable energy developers who need to secure debt before they can build a utility-scale system need a bank to underwrite their risks, and, after doing so, structure the developer’s debt so it has the financing it needs to build its project. Project finance underwriting is as complicated as it is essential to the building of new assets—and that’s precisely why the public sector requires underwriting and deal structuring capacity of its own. Not only are private sector underwriters sometimes under-equipped to structure clean energy investments at the scale that comprehensive national decarbonization requires, but recent volatility in the municipal bond and tax equity markets is deepening risk aversion among private underwriters when it is least useful. Investments in socially important infrastructure would benefit from less exposure to the discipline of a fragile private underwriting system. 

Our first post in this three-part series, below, focuses on what underwriting is and how underwriters structure transactions. It’s essential that policymakers and decarbonization advocates understand how this essential node in our financial system works. The second part will address the challenges of underwriting tax equity and municipal bond transactions, not just due to their financial complexity but due to the absence of liquid secondary debt markets for those asset classes. And the final part hones in on the importance of building public-sector underwriting capacity—particularly given how risky investments in decarbonization are today.

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Part 1: Underwriting and Structuring

Underwriting requires a lot of work from banks. Not only does a commercial bank doing underwriting, called the underwriting bank, need to be able to perform adequate financial modeling—cash flow analysis, revenue projections, debt service projections, etc.—for its clients, but it also needs dedicated sectoral expertise to evaluate if the project is technically feasible. The information that experienced teams gain by repeatedly engaging in underwriting across a sector is perhaps the most crucial advantage that an underwriting bank can offer developers when supporting new projects. Underwriters are constantly building close working relationships with the firms whose projects they’re assessing, evaluating them against their peers and competitors. By virtue of close and repeated interaction, underwriters learn the ins and outs of an industry and project developers get consistent access to financing. What project developers need is debt and, at the end of an underwriting process, their underwriting bank will judge how risky lending to them is going to be. Thus, underwriting is critical to building an ecosystem of information and capital that can foster and direct an industry’s development. 

Chances are, these project underwriting teams are also structuring the project’s debt. Whether it’s through syndicating a loan or preparing a bond issuance for the project developer, debt underwriters’ other job involves marketing developers’ risk-assessed debts: shopping it around to other investors who may co-finance projects’ loans. Underwriting is at the heart of a bank’s role as a market-maker which makes previously hard-to-price, hard-to-trade assets—in other words, illiquid assets—marketable and tradable. 

At this stage, the terminology around underwriting changes slightly. When firms coordinate both underwriting and debt sales, underwriters are sometimes called “book runners”. As book runners, they can bring other banks into the process to aid with processing payments to and from developers (the account bank) or to ensure that lenders are insured (the insurance bank). Since underwriting is expensive, there's little incentive to duplicate underwriting expertise on a per-project basis, so, in larger deals involving multiple banks, smaller banks interested in holding a project’s debt will usually rely on larger banks with better-experienced underwriters. The lead underwriting team’s sector-specific knowledge allows them to organize the process of structuring debt. 

Once the complex process of underwriting and structuring is complete—it may take months—a developer can issue their debt or take out a loan to finance their capital expenditure. The underwriting bank will be either the issuer of the loan or the first buyer of the debt, and will immediately resell it onto the project’s other bond investors and loan participants (see Figure 1).

Figure 1. A simplified depiction of how an underwriting bank conducts debt finance from interested secondary market investors to the project developer’s SPV, taking a spread as their commission.

Being the developer’s debt finance conduit allows the underwriter to do a little bit of arbitrage; this is how they get paid. By charging a slightly higher interest rate to the developer relative to the interest rate that they offer all other participating lenders or bond investors, they can claim the difference, or the spread, between the two (as shown in Figure 1).¹

The economics of underwriting are based on the ability of the lead bank to set a price that other market participants accept as reasonable given the borrower’s risk, available secondary markets for the resulting loans, and the sectoral context. To be sure, it may fail to do this: it’s possible that project finance bond issues remain undersubscribed—as in, not enough investors are interested in buying the project bonds that the underwriting bank offers up for sale.² In this situation, underwriting banks have to hold the unsold bonds themselves, depriving them of the chance to earn a spread on reselling the developer’s debt at a discounted interest rate.³ For this reason, underwriters need to be conscious of when they sell debt on the market. Nobody wants to sell into an unfriendly investment environment. Project underwriters therefore benefit from markets with dealers who buy, sell and warehouse financial assets for investors. Dealers’ activities can create deep reserves of liquidity for instruments meeting specified standards or targeting particular kinds of capital investments.

Part 2: Project finance—in this economy?

Underwriting becomes more complex to execute, and therefore more risky, when markets lack deep, elastic, liquid secondary trading markets, usually backed by dealers of last resort who will buy assets, at a discount, no questions asked. The lack of a dealer of last resort characterizes a variety of lending markets, including the tax equity market for the IRA’s tax credits, investment-grade debt for energy projects, and various forms of mezzanine (more flexible, higher-risk) financing. The debt products in those markets bear significant liquidity risk, on top of the risks of investing in nascent technologies with their attendant non-financial risks. 

Project preparation in this environment requires increasingly intricate financial structuring—and renewable energy projects are extremely complex. Developers can access tax credits, but, because their projects usually don’t have tax liabilities large enough to make use of the full credit amount, they look to commercial banks to provide them with an equity injection in exchange for their tax credit being transferred to the commercial bank.

Tax equity financing, as it’s known, requires a specialized form of underwriting: tax credits carry their own unique risks, being contingent on the project both being completed and accessing as many credits as estimated by the developer at the time of the tax equity transaction. The tax equity piece of clean energy project financing has become even more complicated to assess the risk of, particularly thanks to new labor and other due diligence requirements in the IRA, prompting more participants to seek tax insurance options. Some market participants are encouraging peers to prioritize the costs of tax credit insurance over the value of the tax credits themselves. (See Figure 2 below for a stylized depiction of this process.)

The difficulty of underwriting tax credit finance means that only four large commercial banks even really participate in tax equity transactions for renewable energy projects, underscoring how dependent the clean energy transition currently is on a few tax equity-experienced underwriting shops. Those banks’ large tax liabilities are a large part of what makes underwriting tax equity transactions worthwhile. Market experts have not found a way to consistently standardize transactions across energy resource types and developers’ heterogeneous capital stacks. And investors rightly perceive this shallow and complex market as fragile. And there are more challenges: potential changes in tax equity risk management rules could, in the very near future, dissuade commercial banks from entering and structuring tax equity deals entirely.

Figure 2. Underwriting tax equity transactions requires underwriters to engage not just with a nascent market for energy project debt, but with risk-averse tax equity investors and tax equity insurance providers.

Municipal bond markets—another key potential financing source for financing public renewable energy development, not to mention other social investments of all kinds—are facing similar difficulties. Citi Group recently announced they would no longer underwrite and structure municipal bond issuances, depriving cities and local governments nationwide of a commercial bank partner whose deep expertise in (a) understanding their debt needs, (b) structuring muni bond issuances, and (c) selling them to interested investors allowed them to access longer-term debt financing for crucial social investments and capital spending. As with tax equity transactions, comparatively few banks underwrite municipal bonds—they are often complex both in financial structure and in expertise required to evaluate local governments’ current and future economic health, and credit rating agencies already constrain which municipalities’ bonds are considered “safe” investments. Citi’s exit means there is one fewer backstop in the market for muni debt, a worrying outcome for a deeply necessary but historically volatile asset class. (See Figure 3 below for a stylized depiction of this process.)

Figure 3. Municipal bond issuances usually see underwriters and participating secondary market lenders making financing decisions with regard to risk evaluations from credit rating agencies.

It makes sense that banks would be reflexively hesitant to underwrite deals involving fragile asset classes and complex financial covenants—particularly as higher interest rates and supply chain delays make the pace of investment more volatile. 

But, where clean energy investment is concerned, this lack of reliable, scalable underwriting has implications for policy design. Fewer underwriters and bespoke transactions keep energy finance borrowing rates higher than they should be, even if we take as given the role of the Fed or the “real-side” uncertainties of energy lending, such as clogged grid interconnection queues nationwide. The smaller pool of existing market participants remain skittish, and their actual capacity to assess lending into the energy sector isn’t expanding nearly fast enough to meet the financing needs of large amounts of required new generation, electrification, load growth, transmission, building decarbonization, and other capacity. 

Our view is that that policymakers should consider endowing green banks with greater underwriting capacities of their own. A publicly supported underwriting system to complement the current hodgepodge system will be more resilient and better equipped to catalyze the large volume of lending necessary to achieve national decarbonization priorities.

Part 3: Building Public Underwriting Capacity

The IRA has catalyzed a variety of public lenders, from the federal Loan Programs Office to the state-level green banks, which are thinking through creative ways to plug the financial gaps that hinder clean energy project development. Many of these programs are designed to induce private lenders to co-participate in deals as debt purchasers on secondary markets by having public entities subsidize their returns.  It’s genuinely promising that so much liquidity can now flow toward clean energy development. However, the very idea of public risk-taking relies on estimates of project creditworthiness and investor risk appetite. Therefore, it requires some form of underwriting. 

If the Inflation Reduction Act calls upon public, private, and nonprofit developers to get more creative with financing—especially since the law encourages developers to blend all kinds of federal, state, local, and private financing sources—it therefore requires them to get smarter about underwriting. Recognizing this, experts at the Climate Policy Initiative are now also advocating for the development of shared underwriting criteria among recipients of Greenhouse Gas Reduction Fund financing, who will on-lend to individual project developers. 

Our view is that the public sector can lead this process by example: invest in underwriting capacity to harness the public sector’s higher risk tolerance such that state and federal instrumentalities can lend more cheaply than private market participants can to energy projects—whether that be through providing construction, bridge, or other kinds of conventionally risky short-term debt. Even if public lending instrumentalities cannot themselves act as dealers of last resort to fully backstop secondary markets, they can increase secondary market liquidity by engaging in some buying and selling of the debts that have financed developers’ capital expenditures. They can also mitigate developers’ reliance on expensive private markets by seeding and growing revolving funds that facilitate greater public ownership in and operation of energy markets. By virtue of their wider understanding of available legal and financial tools, public officials can prepare, underwrite, and structure energy and housing transactions more quickly and more creatively than their small private and nonprofit counterparts could. 

As we have learned from public housing agencies in our work to push for better social housing finance models, private investors are prone to give up when they can’t underwrite something that involves financial structures more complex than conventional equity and debt.⁴ Beyond complexity, private underwriters may also falter in the face of real investment barriers: why underwrite an energy project that may never be interconnected to the grid, or a project with no secondary market buyers for its debt? Our housing finance work suggests that catalyzing investment into crucial sectors starts with empowering public officials to think more creatively about financial and regulatory structures than private investors can, lest good projects stay on the shelf. The more the public sector participates, the more its participation alters risk assessments of private co-investors or even developers working without public support—to say nothing of the positive effects that increasing public activity in strategic sectors has on upstream and downstream sectors, critical market infrastructure, and the standards and offerings of private market participants.

This is why CPE has stressed in our recent discussions with various green banks and public financing authorities that underwriting capacity is something that they must build urgently. In particular, public institutions should be capable of assessing the risk of, structuring the capital stacks of, and securing participating investments in ambitious decarbonization projects. To that end, green banks need to stack their underwriting bench with sector-specific technology and engineering experts—there’s no way to evaluate risk, or even to know what projects are worth lending to, without building these competencies in-house. This is what private underwriting banks and credit rating agencies already do; it’s also what the Department of Energy has already built at its National Labs through its networks of scientists and technical experts.

Figure 4. Here is how we imagine a public underwriter working within a state green bank to structure and finance deals for all kinds of developers and municipalities, similar to their private counterparts. But, to do so, and to best access and integrate federal financing supports, they must be endowed with adequate expertise.

If they do not invest in these capacities, public banks will not be able to lend to their full potential at their desired scale in their desired sectors. Green banks can build these capabilities by making themselve the lead underwriters on as many projects as feasible. But, because potential private co-investors might not at first trust nascent green banks as investment partners, green banks need to put up their own capital alongside their risk assessments: they could sweeten the deal by providing mezzanine/subordinate debt to project developers, lowering the green bank’s overall spread on the transaction while allowing private co-investors to claim greater returns. Given that public green banks can better tolerate lower expected cash flow from investments relative to profit-seeking private co-investors, this is not necessarily a substantial sacrifice. Indeed, temporarily surrendering spread to become the lead underwriter in more transactions is more than paid for by the result: green banks can structure energy projects in a standardized manner that co-investors will be more enthusiastic to engage with, deepening the overall market for debt securities in complex energy investments.⁵ Public underwriting has clear market-shaping and liquidity-enhancing functions that policymakers should not ignore.

Public banks aren’t the only possible players. The Environmental Protection Agency (EPA) is poised to disburse $14 billion in financing from the Greenhouse Gas Reduction Fund (GGRF) to capitalize between one to three nonprofit national green financing institutions under the National Clean Investment Fund (NCIF) program. NCIF recipients are charged with catalyzing private investment into distributed solar and storage, zero-emission transportation, and building decarbonization. (The Greenhouse Gas Reduction Fund has to leverage private capital—it’s written into the text of the IRA.) NCIF recipients will work with green banks and community development financial institutions (CDFIs) to create secondary markets for their loans to developers. The likely process by which they will do so works as follows: NCIF recipients will set standards for the origination of loans to projects in the above sectors, green banks and CDFIs issue loans to project developers following those standards, and NCIF recipients purchase and trade those loans alongside private co-investors. The creation of this secondary market should ideally spur greater loan issuance to developers as lenders gain confidence that they can offload their loans to secondary market purchasers as desired.

Getting the underwriting right is the key to the success of the NCIF program. Secondary markets for green bank and CDFI loans to developers are new and shallow, and potential private buyers will absolutely want their investments de-risked via NCIF-supported first loss protections. NCIF recipients have the opportunity to not just de-risk investment for its own sake, but to create the benchmarks for how underwriting happens in these markets. Dependable public and quasi-public underwriters can thus condition private entities to participate in these markets: as private co-investors begin treating these sectors as quotidian, rather than risky, they might even grow comfortable taking lower returns on their investments.

As nodal institutions in these markets, public underwriters can teach market participants not just to trust their developer counterparties, but to support public investment priorities. Thus empowered, green banks and NCIF recipients can become the much-needed backstop to developers who certainly won’t be adequately served by creaky private markets, quite literally underwriting a rapid buildout of what’s green and what’s good. 

Footnotes

1. This is the bond-market equivalent of an IPO (initial public offering) of a company’s shares on the stock market.

2.  Woe is the fate of Morgan Stanely, which served as the underwriter for Elon Musk’s takeover of Twitter and must now book $500 million in losses because they cannot find buyers who will purchase their Twitter-takeover bonds for anything but pennies on the dollar after Musk’s management of Twitter (now X) was immediately plagued with scandal.

3.  Loans and unsold bonds still earn interest, of course, but they take up regulatory space on the underwriting bank’s balance sheet that prevents them from rolling over other loans on their balance sheet as easily—and expose the bank to duration risk on the debt, which may see volatile swings in price.

4.  Don’t bank on them to try.

5. Underwriting banks operate best in asset classes with liquid secondary markets, like housing, where “dealers of last resort” like Freddie Mac and Fannie Mae create liquidity by committing to buying, aggregating, standardizing, and selling debt to private market participants at scale. Because underwriters in the housing market always know they have a federal backstop, their risk assessments become more forgiving as a result. The market for energy project debt lacks these features, and thus lacks liquidity. The policy implication that follows is this: governments should create similar backstop dealer institutions for energy project debt. Eliminating constraints in the financial ecosystem that underwriters sell debt into will convey greater investment into projects being underwritten.