Background: I’m exploring an idea called Evergrow, and wrote up a list of 30 questions relating to the idea. I’m now going through and answering each of these questions. I recently came up with a new way of thinking about the idea, which I’m publishing here. I’ll likely refer to the ideas in this post in future questions.
My original post about Evergrow proposed the creation of a single entity, likely a C Corporation, to develop, finance, and own reforestation projects in perpetuity. This means investors in the company would need to assume a bundle of risks across the lifecycle of each Evergrow project, including:
- Origination risk, the risk that we may not be able to find and acquire sites for new projects.
- Financing risk, the risk that we may not be able to finance the acquisition and development of new projects.
- Project risk, the risk that a project fails due to operational reasons (e.g., planted trees fall victim to fire or disease; offsets fail to materialize due to issues with certification, etc).
- Offtake risk, the risk that there is no market for the offsets and/or timber from a project in the future.
- Price risk, the risk that the price for offsets and/or timber is lower than expected at the time of sale vs at the time of development.
These risks change over time. For example, for a given project, origination and financing risk go to zero once the land and financing transactions are complete. Similarly, project risk for a project declines significantly after the first years of the project’s life, during which time tree survivability rates become clearer, up-front costs are paid for, and offset certification visibility increases. These risks also interact with each other. For example, a bank is likely to charge a higher interest rate to finance a project that sells its offsets on the spot market, taking both offtake and price risk.
Different investors have different risk appetites, liquidity needs, and return expectations. By unbundling Evergrow’s risks into separate entities, each with separate roles in the value chain, we can better align stakeholder expectations and create more value for all. Taking a page from the renewable energy project finance playbook, I think we can break Evergrow into 3 separate companies:
- A development company, or “Devco“, which finds land, acquires it, and develops it;
- A holding company, or “Holdco“, which acquires fully developed projects from the Devco and owns them for the long term; and
- An offtaker, or “Offco“, which promises to buy substantially all of the offsets generated by each new project at a pre-agreed price.
The Devco takes all the origination and financing risk for each project, as well as the project risk for the first few years. The Holdco takes only project risk over the remaining life of each project, which should be minimal. Completing the trio, by promising to buy all generated offsets at a pre-agreed price, the Offco removes offtake and price risk for both the Devco and Holdco, transferring it instead to its shareholders.
I think the Devco is best structured as a traditional investment fund with a 10-year life. This is because the Devco is taking equity risk in each project, so its investors should be willing and sophisticated enough to accept that risk plus illiquidity in exchange for potentially higher returns over time. There’s also no guarantee that we will be able to continually find good projects to develop. By structuring the Devco as a fund with a definitive end-date, if we find this to be true, we can simply choose to not raise a successor Devco fund, which feels much less painful than shutting an operating company down even if intellectually somewhat similar.
The Holdco takes the least risk. This is because Devco will have (mostly) de-risked each project prior to selling it to Holdco, and the Offco solves for offtake and price risk. The Holdco simply collects a check from the Offco each quarter, pays out its (hopefully minimal) maintenance expenses for its forestry assets, and sends shareholders a dividend check for the remainder. As a result, I think the Holdco is best structured as a C Corp and taken public as early as possible. Being public gives the Holdco access to cheap capital, which can be used to finance additional acquisitions from the Devco once each project reaches completion. This is not unlike how Devco/Yieldcos work in renewable energy, except that unlike an energy yieldco, the Evergrow Holdco doesn’t require additional projects to grow, because the underlying assets themselves (i.e., the trees) are growing.
The Offco needs to be an investment-grade entity, ideally AA or even AAA, with sufficient capacity to buy substantially all of the offsets generated by each project. In the renewable energy world, the traditional offtakers are utility companies who sign 20-30 year Power Purchase Agreements (“PPAs”) with power plant developers prior to the start of construction. A developer can then take this PPA to a bank to obtain debt financing for development costs. Having a creditworthy offtaker with a long-term contract at a specified price makes it possible for the bank to underwrite the project, and it’s almost impossible to get a renewable energy project financed without one.
To my knowledge, no offtaker of this type exists for carbon offsets, so we need to create one ourselves. How? I can think of two ways. One option is to aggregate existing CCO buyers – i.e., companies that are under the CA cap-and-trade mandate – into a single buying pool, similar to how Level10 aggregates smaller PPA buyers in the energy market. Members of the pool would pre-commit to buying a certain number of CCOs from Offco each year at a pre-determined price over a 20-30 year horizon. So long as the pool was properly collateralized and covered its positions, it should get a good credit rating.
Another (and cooler!) option is to use structured finance. For its credit rating, Offco could enter into a sleeving transaction with an investment-grade company, in which the investment-grade company “fronts” each offtake agreement for Offco and passes through the obligations (less a fee) to Offco on the backend. Then, for capacity, we find one or more counterparties who want to bet on the price of CCOs (e.g., a hedge fund). Offco enters into a long-term (say 30-year) collar on the price of CCOs with this counterparty, whereby Offco can put CCOs to them at a small discount to the ARB floor price on CCAs, and they can call CCOs from Offco at a slight premium to the ARB floor price. If the limit on the collar is, say, $100M/year, Offco now has $100M/year of CCO buying power, and makes money on any deal where it buys CCOs for cheaper than the call price in the collar. In energy, I’m told PPAs are often done at a 10-15% discount to the spot price on energy, meaning the Offco could make a substantial vig on each project. And because the ARB floor price increases by 5% plus inflation each year, the counterparty here is taking less risk than it may seem at first, as the assets being put to them have a baked-in price floor that should in theory always go up (unless there’s a major dislocation between CCA and CCO prices in the future, which itself is a position a hedge fund could take or hedge depending on their view).
Finally, tying the Devco, Holdco, and Offco together is the Evergrow Management Company (“Mco”, pronounced “em-co”). The Mco is the General Partner of the Devco, a controlling shareholder in the Holdco, and the sponsor of the Offco. This ensures collaboration between the three companies, retention and sharing of IP and data, and centralized leadership while still segmenting goals, risks, and investors into separate buckets.
Over time, I can see us wanting to open up the Holdco and Offco to projects developed by third-parties. This is good for both the planet (more reforestation projects!) as well as Evergrow, which benefits from good projects in the Holdco and Offco regardless of their source. I also believe that as the market matures, more developers will enter the market, and the Holdco and Offco are more long-term valuable and defensible than the Devco. Thinking long-term, it makes sense to consider ways to entrench Offco and Holdco as the default offtaker and holding company for reforestation projects globally. It feels like in years zero to N, most value creation happens at the Devco level, but beyond year N, most value creation happens at the Offco and Holdco level.
Thanks to Richard Matsui of kWh Analytics for helping me think through the above.