What are the sources of capital for mini-grid projects?

As the project moves from the prefeasibility stage to construction and operations, risk decreases and capital needs increase. During each stage of the project, developers need different types of funding. Even project developers who have secured grants may need to borrow money to complete a project.

The first phase in a project's life cycle is prefeasibility. Capital expenditures at this stage are fairly low, as activities are focused on study and analysis of the project. The prefeasibility phase asks whether the project is viable from an economic, technical, legal, resource and financial standpoint. At this stage, where the project's risk is the highest, funding typically comes from the project developers themselves, sometimes with funds or technical support from donor-funded programs, grants or angel investors.

If a project is deemed viable at the prefeasibility stage, the next stage is the feasibility study, which answers questions about how much the project will cost and the likely financial returns on the investment. The feasibility study includes a business plan, detailed system design and financial model outlining which portions of the project will be financed by equity, grants and debt. This stage of the project also addresses permitting and licensing, which can be time-consuming if the mini-grid project is among the first built in a country or region.

The feasibility study is crucial; mistakes in the business plan or financial model can lead to substantial cost overruns later or jeopardize the viability of the project.

Project developers often fund their own feasibility studies. Early-stage investors and government entities such as REAs may provide grants to cover a portion of the cost of feasibility studies, engineering studies and environmental impact assessments.

Once the feasibility study phase is complete, mini-grid project developers seek out either private or public financing sources to back the project. The overwhelming majority of capital needed in a mini-grid project is for construction, including purchase of any land, equipment and materials. Equally important is the cost of qualified personnel who can build and install the project correctly and test it properly.

Once funding is secured, project developers typically commission an engineering, procurement and construction (EPC) contractor to execute the work. EPC contractors specialize in quantifying materials needed such as cables, solar panels, wind turbines, thermal generator equipment, switch gears, transformers and steel or wood utility poles; procuring and transporting the required materials; and installing them correctly and in the right sequence.

The construction phase of mini-grid development is most prone to cost overruns and management challenges. Any unanticipated factors can change the project timeline and total cost. Poor communication, resettlement issues, adverse weather, local unrest or supply chain trouble are elements that can impact the mini-grid project cost.

Once a project has reached the point of commissioning, it enters the operations stage. At this point, the project is largely funded through its own cash flows (such as retail tariffs). Developers might seek funds to expand the mini-grid, but most sources of funding are in place. The developer begins to make scheduled loan repayments to banks and other lenders. Equity investors receive returns (in the form of dividends) when the project begins to earn a profit.

If the mini-grid sells electricity to the main grid, developers may want to design two-tiered tariffs (if permitted by the utility and local regulations). Two-tiered tariffs are an arrangement offered to small power producers (SPPs) whereby the payment for the first 8–10 years is higher than the subsequent tariff in the last 10–15 years. This arrangement can be useful to SPP developers, because the higher upfront project revenue stream better matches the project’s debt service requirements over time.

Equity investors decide whether to invest in a project or mini-grid company based on the business plan, management team’s track record, size of the market and the costs and risks and benefits of the project. Potential equity investors include private equity funds and impact investors with a mandate to achieve social and environmental benefits alongside financial returns. Multilateral development banks also design, finance and operate facilities that provide equity. Facilities designed to promote clean energy will often accept lower financial returns than a private investor would.

Some investors may find equity investment too risky but may still be interested in providing mezzanine finance. Mezzanine finance resides somewhere between debt and equity on the risk/return profile. It is generally debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in full and on time. Mezzanine finance lenders are paid before equity investors, but after debt funders.

Before they are willing to lend, commercial banks generally require that mini-grid project developers secure commitments from equity investors (or equity and mezzanine finance) equivalent to 30–40 percent of the project cost (with variations depending on the amount of risk perceived by banks). Considering their large capital cost, mini-grid projects often require loans that have long tenors and low interest rates. In many cases these are difficult to obtain due to the perception of risk associated with such projects. Development banks such as the World Bank have worked to offset risk for commercial lenders by providing line of credit to commercial banks, with funds earmarked for long-term renewable energy project loans.

Once project developers secure debt and equity from project investors, the project has reached financial close. Project close is defined as the execution of loan agreements between a developer and a bank or financial institution. Upon first disbursement of funds by investors, the project moves to into the construction stage.