Fossil Fuel Financing 101
by Kelly Mitchell
June 23, 2017
Fossil fuel companies and banks use complicated financial instruments and structures to fund destructive projects like tar sands pipelines. Understanding these funding mechanisms is the first step toward holding banks and investors accountable for their role in fueling climate disruption. Don’t let acronyms and balance sheets intimidate you -- here’s a short introductory guide to fossil fuel finance.
The information on this page is not financial advice, investment advice, trading advice, or any other advice. It is intended for the purpose of presenting and describing general finance and funding practices.
How do companies raise money? – Debt & Equity
At the most simplistic level, companies raise money either by borrowing it (debt) or selling shares of ownership in the company and its future profits (equity). Debt financing includes bonds, loans, and lines of credit. Riskier companies have a higher cost of debt, meaning a higher interest rate, but all corporations can deduct the cost of debt on their taxes, making it a lower cost option. Transcanada is dependent on lines of credit from banks like JPMorgan Chase, for example. On the equity financing side, Kinder Morgan recently sold shares in its company to finance the Trans Mountain pipeline in British Columbia.
How are pipelines funded?
Pipeline projects are very expensive. Companies need to raise up to $10 billion USD to get started. As with many fossil fuel projects, pipelines have very high upfront costs, but once a pipeline is built and operating, it is currently predicted to be quite profitable and should theoretically generate revenues for its owners for decades to come. To reach the required level of fundraising, pipeline companies tend to leave no stones unturned.
Project Finance vs Corporate Finance
There are two broadly different types of debt that a company can ask a bank for: Project finance or corporate finance. Project finance is usually based on a ‘non-recourse’ structure, which means that the banks are paid back from the cashflows generated by the project itself, once it is up and running. Corporate finance is more like what you or I could get at a bank, if we had a business. The repayment of the loan usually has a repayment schedule and an interest rate on top.
Lines of credit
Lines of credit are one of the most common tools used by fossil fuel companies to finance operations and new projects. Anyone with credit card or home equity line of credit can understand the basic principle. An individual financial institution (e.g. bank) or a group of banks will provide a company with a revolving line of credit. The company can borrow up to the maximum amount stated, but it does not have to borrow all of the money at once. Often, the company only pays interest on the amount actually used, and the borrower, in this case the pipeline company, can spend, repay, and reuse the line of credit as desired until its maturity date.
Sometimes a loan or line of credit is too large or too risky to be handled by a single lender. In that case, multiple banks or institutional lenders will jointly underwrite the loan, meaning make the loan together as a group. In these instances, a single bank will usually take on the role of lead agent, providing specialized tasks such as risk assessment, underwriting, disbursement, or putting in more money than other actors. Lead agents often end up with a sweet deal, since they receive set payments for services — sometimes in the hundreds of millions of dollars — whether or not the borrower successfully repays the debt.
So Lead Agents are supposed to make sure the projects are good investments?
Since lead agents take on a degree of responsibility for the loan, they have taken on a fair bit of risk. So they are the first in line to do their ‘due diligence’ to make sure all the boxes are ticked. However, when it comes to pipeline projects, we sometimes find their risk assessments lacking, which some banks have admitted.
Banks are required to do number of risk assessments before they decide to fund any business to make sure they are getting a good deal. All leading banks have adopted global risk management frameworks for determining, assessing, and managing environmental and social risks (like the Equator Principles), which set the minimum standard for due diligence before decisions are made. Banks have adopted these criteria because often the environmental and social cost of projects will affect their bottom line.
The concept of corporate bond issuance should be familiar to anyone with a mortgage. A bond is similar to a loan with a fixed interest rate. A bondholder lends money to a corporation, which promises to pay back the full amount at a set maturity date. In exchange, bondholders will receive interest payments on a fixed schedule. For large corporate bond offerings, a bank or group of banks will often buy the available bonds and then resell them to interested investors, collecting fees for underwriting duties and other services.
So these loans have a date by which they have to be paid?
Well, it depends. Corporate finance can be a term loan or a revolving loan, which gives companies lines of credit on an ongoing basis. Generally, it would be easier for banks to end a revolving loan rather than a term loan, but it all depends on the contracts they have with the company.
Maturity date is simply the date at which a company must repay in full a line of credit, bond, or other debt instrument. This is that date looming 30 years in the distance when you sign your first mortgage paperwork. However, these dates often present interesting opportunities for banks and investors to flex their power.
Aren’t there heaps of loans for these companies?
Yes, we have dug up their banking relationships in the last few years and as you can see, the network of financial involvement between banks and pipeline companies is extensive. That’s why every bank is a battle, but to win the war, we need commitment from all financiers that they will not financially support these projects in any way.
Initial Public Offerings (IPOs)
In short, an IPO is when a company first makes equity shares available to the public, usually by listing on a stock exchange. This can mark the moment when a private company becomes publicly owned, but it can also be a tool used by fossil fuel companies to spin off packages of assets (e.g. mines, pipelines), raise money for specific projects, and shield parent companies from risks and liability.
Prior to launching an IPO, a company will work with a lead bank to create a prospectus (aka a giant document explaining the business to potential investors), outlining the opportunities and risks of the investment. The prospectus is filed with Securities Exchange Commission, which means that anyone in the public can read it. It is a good force for transparency that corporations are required to disclose information with SEC. (And hey you can go to the SEC’s website and look at the filings yourself!) If a company fails to disclose material risks in the prospectus, it may be forced to revise the document and/or face legal consequences. The company will also work with a bank to set goals for initial share price and amount of shares sold. Failure to hit those goals can cast a shadow over future investments.
Material Risks versus Reputational Risks:
We talk about the risk levels associated with some of these projects in multiple ways. Reputational risk means that the bank, by associating itself with the project through either lending money to the project, acting as a lead agent, or in any other way endorsing or supporting the project, could incur a certain amount of scrutiny from the public sector, from governments, and/or from other banks and financing institutions. Reputational risk is significant because banks depend on their good standing to secure future deals. They are constantly competing with one another for business. If a bank appears to have a bad track record on their environment or human rights policies, the amount of conflict associated with its projects, significant public blowback, lax processes on risk assessment, etc, the bank could lose future deals and opportunities
Material risk, on the other hand, is the potential for the bank or lenders to actually lose money on an investment or incur a cost that wasn’t necessarily part of the project’s plan. Banks could lose money on their investment in a number of ways. For example, the water protectors from Standing Rock were successful at drawing international attending to the problems and controversies around the Dakota Access Pipeline. In addition to the reputational risk incurred by the participating banks, by setting up semi-permanent blockades and encampments and delaying the construction of the pipeline, water protectors at Standing Rock also then represented material risk to the project since the delay was costing significant money. Another hypothetical example could be a massive lawsuit brought against a pipeline company for illegally sidestepping the necessary regulatory process, costing money in legal fees and time in proceedings, as well as delaying the project.