A New Reality

FROM THE DECEMBER ISSUE: Off-take agreements lose their financial appeal under a new provision taking effect at the end of next year.
By Lynn Knox | November 15, 2017

Off-take agreements have been commonplace for proposed energy projects for years. An energy user, or off-taker, kept the off-take agreements off its balance sheet, allowing it to keep its ratios intact on financial statements, which helped maintain its corporate bond ratings and borrowing capacity. That meant the company expensed out 100 percent of its energy or product purchases.

After Enron’s 2011 bankruptcy on the heels of years of accounting deception, the Financial Accounting Standards Board began its work changing the required accounting procedures for all contracts, including off-take agreements and leases. FASB adopted its Topic 842 on Feb. 25, 2016, which takes effect on Dec. 15, 2018, and is retroactive to Feb. 25, 2016. All off-take agreements with a duration of more than 12 months are to be reported in accordance with FASB Topic 842. That includes ethanol agreements.

The provision requires that off-take agreements entered into before the construction of an energy project now be reported on a purchaser’s balance sheet as both a right-of-use asset and an offsetting liability, both calculated at the present value of all purchases. That has a negative impact on liabilities, as well as on the return on assets, as the company’s net income does not change but its assets increase.

For years, off-balance-sheet off-take agreements were preferred by companies over capital leases with $1 buyout. But with the adoption of FASB Topic 842, capital leases (now referred to as finance leases by FASB) are far superior.

To avoid the negative fallout of this change, Credit Lease Investments LLC offers what it calls a Lease-Operations & Maintenance Agreement. In the agreement, 100 percent of project costs are provided, in exchange for an initial annual lease payment, generally calculated at 3 to 3.5 percent. After the 2.25 percent annual lease payment escalations, the implicit rate (the interest rate to amortize the principal to zero by the end of the lease term) is generally 4.3 to 4.75 percent, which still is less than the costs of financing and raising equity under an off-take agreement.

The lease structure has three tiers:
Tier 1: Developer-operator provides purchaser with the first amounts of energy/product up to the required lease payments at no charge to the purchaser.

Tier 2: The purchaser guarantees energy/product purchases in the amount of the project’s operational expenses and developer-operator’s minimum profit.

Tier 3: Developer-operator has the right to sell the balance of energy/product produced to other purchasers at a specific price stated in the Lease-O&M Agreement, wherein the purchaser can also purchase the balance of energy at the same price, if unsold to other energy/product users.

The developer/operator has complete control over the design, implementation and operations of the project. The result of this Lease-O&M structure is that the unguaranteed energy purchases should be considered off-balance-sheet for the purchaser, subject to approval of its auditors.

Under this lease, benefits to energy projects with a useful life greater than the finance lease term include:
1. Only interest paid plus the amortization of the right-of-use asset are expensed.

2. When the company buys out the finance lease at the end of the lease term for $1, the company receives a new asset, without liability, improving tangible net worth, or net assets for nonprofit companies.

Other benefits under this lease structure, even for those energy projects with the same useful life as the finance lease term, include:
1. Lower financing costs, which result in purchaser paying less for energy or product.

2. Purchaser guarantees only the amount of the lease payments, project’s operational expenses and developer-operator’s minimum profit.

3. After the purchaser buys out the finance lease for $1 at the end of the lease term, its payments for energy/product significantly reduces under the option periods in the agreement.

With new programs such as this one in place to accommodate FASB’s Topic 842, most companies will not find off-take agreements for proposed projects financially attractive.

Author: Lynn Knox
President, Commercial Property Lenders Inc.