New investors seek better safety nets

WORLDWIDE: Pension funds and other institutional investors have long been heralded as the saviours of all kinds of infrastructure investment, including renewables. When PensionDanmark and Dong last year jointly invested in two offshore projects, the structure of the deals offered a big clue as to what it will take to get a pension fund on board in the wind sector.

In the first of the two deals, where PensionDanmark bought half the equity in the operational 165.6MW Nysted offshore wind farm, Dong offered a fixed operating guarantee that PensionDanmark could draw on if production levels or the price of electricity fell below a certain level. A similar deal was made for the Greenfield 400MW Anholt wind farm.

Dong's guarantee offered a production and price floor on the project's revenues and gave PensionDanmark what it needs as an institutional investor: stable long-term cash flows. Unfortunately, most developers are not state-owned utilities like Dong with the cash reserves to offer such a guarantee - let alone the political clout to persuade a state-owned pension fund like PensionDanmark to invest with them in the first place.

Dealing with risk

As traditional long-term bank debt begins to dry up, developers need to source alternative forms of investment in their projects (see page 63). It is now widely accepted that new sources of capital are likely to come from more conservative investors such as pension funds.

Perhaps it was this recognition, along with banks' increasingly risk-averse lending practices, that led 43% of wind industry respondents to a survey conducted late last year by global reinsurer Swiss Re and The Economist magazine to say that weather-related volume risk was the biggest perceived risk in the industry.

This contrasts tellingly with what respondents said they thought were the actual biggest risks facing the industry, where weather-related volume scored lowest, at just 32%, behind financial, political, operational and market risks.

The difference between perception and reality makes it essential to offer comfort to investors and lenders over wind risk. The Swiss Re/Economist report predicted that an increasing number of industry players would begin looking to financial products such as weather derivatives to provide a solution.

While market take-up is minimal at the moment - just 1% of the survey's respondents said they had used derivatives to hedge wind risk - deals are being done, says Martin Malinow, chief executive of US-based hedge fund Galileo Weather Risk Management.

"The majority of our focus as a company has been on providing weather derivatives to traditional energy generators," he says. "However, in the last year we have seen much more interest from the wind sector."

This has been driven by the shifting investment landscape from banks to pension funds, adds Malinow. The increased interest in wind-risk hedging has been substantial enough for Galileo to launch a new weather derivative called Wind Lock (see previous page).

Why hedging helps

The potential to both guarantee against energy production falling below a certain level and to smooth out peaks and troughs of a wind farm's revenues is of course attractive to investors such as pension funds. However, it could also help a developer when project-financing with bank debt.

Galileo has been working with a developer who could only secure debt equal to 38% of the project cost and was required to hold a debt service reserve account (DSRA) to cover payments in periods when the wind failed to blow, says Malinow. However, it needed to free up cash to invest in other wind farms in its portfolio.

Through offering the developer its Wind Lock weather derivative solution that would pay out when the project's generating capacity fell below 24%, the bank was given greater comfort about the project's ability to service its debt. As a result, the bank relaxed its terms: the developer was able to increase the level of bank debt in the project to 43% and halve the amount of cash held in the DSRA.

Hedging wind risk also offers benefits to utilities, says Malinow. "We have a transaction in Australia concerning a large wind farm where the offtaker is counting that wind generation as part of generating stock," he says.

"The offtaker wants protection against the situation where they may have a really hot day (when electricity demand for air conditioning is high) but the wind stops blowing. Our product works so that every half hour, if demand is above a certain level and production is below P50, then we replace every megawatt lost at market price. At the moment this is a one-off transaction, one of a kind, but I think we are likely to see more of them. Our office in London is looking at how we can take a product like this to Europe."

Better resource assessment

Tom Murley, head of renewables at UK investment house HG Capital, is sceptical about derivatives and whether they are the ideal solution for the industry. In his view, the best way of providing greater certainty and comfort to investors is by improving the quality and quantity of data available on wind speeds.

"Are we, as an industry, accurately forecasting long-term averages on most sites?" asks Murley. "The answer is a resounding 'no'. What HG Capital are doing with the projects we invest is going back to see what errors were made in forecasting wind and trying to rectify them. Nothing less than one year of monitoring is acceptable - two to three years is preferable."

According to Murley, the current picture is far from satisfactory, with six-month monitoring still prevalent and some projects, especially in Germany, based on the wind speeds of nearby wind farms. HG Capital insists on measures including one meteorological (met) mast for every 20-30MWs, met masts that match hub heights, and supplemental Lidar (light detection and ranging) and Sodar (sound detection and ranging) data in complex terrain.

However, far from removing the need for risk hedging, improved data is actually likely to make products such as derivatives far more attractive, says Stephen Doherty, chief executive of UK weather data specialist Speedwell Weather.

"The weather market's origins were in temperature products and it is rather easier to find a good history of temperatures than for wind," says Doherty. "A lack of historical data can be a problem in terms of pricing financial products for the wind market, but I think things are improving in our business in terms of the dataset. There is so much wind capacity and we are seeing (derivatives) deals being done. It's still the thin end of the wedge."

COMPLEX INNOVATIONS - TACKLING WIND RISK THROUGH DERIVATIVES

The traditional power sector has been tackling weather risk with financial instruments known as derivatives for more than 20 years. Generators typically use them to protect themselves against temperatures that would adversely affect their revenues.

However, the practice of hedging wind risk with a financial instrument is far less common. This is largely due to the lack of historical data and the high variability of wind speeds across short distances. Because wind was less predictable than other weather events such as temperatures, financiers tended to offer relatively expensive wind-hedging products. Most developers deemed them an unnecessary layer of protection, especially if their projects were financed using conservative production estimates like P90 (the wind speed likely to blow 90% of the time). The tide seems to be gradually turning as financiers gain access to vastly improved wind data, which is making their products more price-competitive, while on the other side capital-constrained banks and conservative investors like pension funds look for more certainty in wind revenues.

One new derivative is Wind Lock, offered by US-based hedge fund Galileo Weather Risk Management. The generation level at which the developer has chosen to hedge its risk acts as a production floor. While paying the premium depresses revenues, this arrangement does have the advantage of narrowing the gap between the extremes of production. So not only are revenues guaranteed to never fall below a certain level, the gap between the peaks and troughs of the revenues has also shrunk, making them more predictable and attractive to investors.

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