Cheaper finance Helps offset rising turbine costs
Financing costs in the wind power development industry are coming down as new equity and debt players look to carve out their place in the burgeoning clean power business. The trend is in sharp contrast to rising costs in almost every other aspect of wind energy development (previous story). For developers with quality projects, the money side of the equation is no longer an issue. "If you have a project and it makes sense to build it, it can be financed. I haven't seen better conditions in the last 20 years," says Niels Rydder of California's Oak Creek Energy Systems.
The reason for the greatly improved prospects for attracting equity and debt into the wind business boils down to the fundamental laws of supply and demand. "There is a lot of competition in our industry," notes Tristan Grimbert of Enxco, a project developer based in California and an affiliate of France's EDF Energies Nouvelles. Competition to put money into wind development is particularly keen in the critical area of "tax equity," in which investors looking to reduce their tax bills seek out investments that can earn them tax credits.
With a federal $0.019/kWh production tax credit (PTC) driving US wind development, project developers that lack a large enough tax bill to make use of the PTC welcome equity investors who can. In the past, the perceived risk of owning a wind plant kept investors at bay, leaving developers with little choice but to sell to major players like FPL Energy or Shell. The last few years, however, have seen a rise in so called passive investors looking for tax shelters. The issue was a major point of discussion at a recent Wind Power Finance and Investment conference in San Diego hosted by Infocast.
Conference chair Jeffrey Chester, who heads the wind practice at law firm Kaye Scholer LLP, told delegates there was a tremendous increase in the tax equity market last year. In 2006, tax equity provided $3.1 billion worth of financing to nearly 2900 MW worth of wind projects, up from 600 MW and about $1 billion the year before. In 2007, conference panellists agreed, the volume of tax equity transactions could reach $4 billion.
Open for foreigners
"We see not only the number of transactions increasing, the volume increasing, but we are continuing to attract new entrants in the market participating in these financings," said Chester. "What this has done is open up the market for independent developers and foreign owned developers to come in and build and own projects."
The first tax equity deals took place in 2003 and were pioneered by financial services giant JP Morgan, still the market leader, and Babcock & Brown, an international fund manager traded on the Australian stock exchange and one of the world's top five wind plant assets holders. In 2006, the list of lead investors in US wind power also included JP Morgan, GE Energy Financial Services, Morgan Stanley, Prudential Insurance, Lehman Brothers, Fortis and the Union Bank of California. But while more companies are coming into the market, said JP Morgan's John Eber, the total number of them is still quite small. "There are a number of other big institutions that would like to get in but they don't yet have the experience or knowledge base to be able to do it. But they will get in as the market continues to expand."
For some potential tax equity investors, said Rob Sternthal of Credit Suisse, it may get harder to carve out a niche. "I think what you are seeing is that smart developers are now combining four, five or six projects and you are seeing $500 million equity investments. Who can commit? A client just getting in on their first deal cannot commit to $500 million. So it takes a GE or a JP Morgan," he said. "There will be more equity playing in the re-syndication market, probably, than in the direct."
As the number of investors coming into the market grows, the increase in competition is driving returns down. While equity players represented on the conference panels emphasised that expected returns are dependent on the specific deal, they agreed that yields from their wind investments have dipped into the 6% range over the last year, down from double figures not so long ago. Equity return on deals that are leveraged with debt range up to 10% to help cover the risk that lenders could foreclose on the project. Portfolio diversification is also emerging as a factor in the type of returns investors find acceptable.
"A lot of the institutions we work with as partners are looking for more diversity," explained Eber. Too many wind projects are geographically close to one another or developed by the same group of companies, or both. "If there is a project out there that is in a geographic area that is different from what they are doing or uses different turbines or has different sponsors, they might be willing to be a little more aggressive on that project. Texas, for example, is a bit of a problem right now. I think about 35-40% of the market in 2007 could be Texas-based projects. A lot of investors that have gotten into wind in the last couple of years are doing a lot of Texas deals and many of them are looking for diversity."
But Eber believes returns are now stabilising. For passive tax equity, investments in wind have to be measured against the alternatives like the low income housing sector, where tax credit programs have fostered a $9 billion annual market. Returns there are moving back up into the 6% range. Wind power is riskier, he contended, and earnings on wind investments should reflect that.
"There should be a premium associated with taking the risk of these projects as compared to housing. We've been investing in housing for 15 years and have about $4 billion in the housing portfolio and I can't tell you that we have ever lost a penny," said Eber. "I can't say that about the energy project investments we have made. They are definitely riskier and some are going to end up having issues and for that you have got to get a premium. I think the housing market really sets the bar and prices in housing have been moving up over the last six months."
Risks of sex appeal
Some speakers at the Infocast conference expressed concern that the returns are not reflecting the real risks of being in the wind business. "Returns in wind have been pushed lower and lower and lower at a time when risk is not declining at all. In fact, risks seem to be going the other way," said Mike Storch of ENEL North America.
"There is way too much money chasing these opportunities. There is a lot of sex appeal associated with being associated with renewables. You have a ton of private equity chasing this business. You have the tax equity investor pushing returns down into the low sixes in terms of the money they will put up. I really believe there is not a very good understanding of the risks associated with the business. We have all done a marvellous job of convincing people that the risks are manageable, but I will be very interested to see, for example, twenty years from now how many of those turbines actually perform at the levels that were assumed for twenty years and only cost what was assumed in the financial projections."
The concern applies to the debt side of the market as well, said Padoma Wind's Jan Paulin, pointing to the example of declining warranty protection for turbines. "There is more debt chasing projects than there are projects being financed and therefore the terms of the financing have been relaxed to some extent prior to what is was previously. Five years ago you would never have been able to get non-recourse debt on projects with the kind of warranty terms that are now customary."
Proven technology favoured
Michael Midden of Dexia Credit Local said banks are more familiar with proven turbine technology. "That is resulted in relaxing, if you will, what is acceptable to the banks in getting deals closed. When you have brand new manufacturers or new models as opposed to the turbines that have been out in the market for a long time and have been proven, you are going to see a variety of terms and conditions in the market. So there is no one single answer."
The cost of debt has been decreasing over the past few years and in 2006 firmed up at the London Interbank Offered Rate, commonly known as LIBOR, a widely used benchmark in the banking industry for short term interest rates, plus 125 basis points. LIBOR is the interest rate charged by London banks when lending to one another to manage their balance sheets. "It speaks to the number of banks that are in the market," said Midden, referring to the price signal. "The number of banks could be anywhere up to thirty or forty for the right kind of transaction so it has made the cost of debt much cheaper."
Turbine supply loans
Debt providers are also moving into new areas of wind project financing, most notably in the provision of turbine supply loans to developers to help them meet the much earlier and much heftier down payments demanded by manufacturers. It is an area, said Thomas Emmons of HSH Nordbank, that is continuing to evolve.
"We have seen them so far for most of traditional manufacturers. But as new manufacturers become more active in the market, their technology will have to be accepted," he said. "We recently did a supply loan for Clipper turbines, which I believe was the first one and I am sure there will be others for Clipper and other manufacturers." Another potential innovation that would save on financing and closing costs, he said, are revolving turbine supply loans that can be replenished and available for the next series of project.
A market has also developed to loan a project developer its share of the equity in a deal, a process known as back leveraging. "There is definitely a limited number of banks willing to do back leverage, however, we see that number expanding," said Gisela Kroess of HypoVereinsbank (HVB), a German private bank.
There is more bank appetite to hold much longer debt on wind projects, sometimes even beyond the term of the power purchase agreement into what is know as the "merchant tail" period when energy is being sold directly into the market. Banks are also ready to look at projects without power purchase agreements (PPAs), as long as most of their output is covered by a hedge against price risk for a significant period. Essentially, a hedge provider pays if power prices drop below a floor value and takes any upside if rates rise above a set ceiling.
"So far most of the transactions we have seen have had hedges for at least seven to ten years," said Bruno Mejean of NORD/LB, another German bank active in the US market. "But as we see the market moving to more merchant types of structures, that is where the Term B market and hedge funds and other non-traditional lenders will fill the gaps the banks are not willing or able to cover."
Rising project costs and low PPA pricing are driving US wind companies to look at taking more exposure to spot electricity prices in competitive wholesale markets like that of the Electric Reliability Council of Texas or PJM, a regional transmission organisation covering 13 northeast states and the District of Columbia. Selling output into the open market lets wind project owners tap into prices that are now starting to climb as supplies of green power tighten -- and retain potentially valuable renewable energy credits (REC). All of Edison Mission Energy's 14 wind power projects are covered by long term PPAs, said the company's Randolph Mann, but he expects it to take on its first merchant project in the near future. "I think that is something we would continue to find ways to do in the markets where we have liquidity and where we have REC values that make that attractive."
The interest in so-called merchant plants is also being fed by the trend towards signing longer term turbine supply framework agreements. "Before, developers would first go find the PPA and then go find the turbines. Now people have the turbines, they have the land, they have the permitting and now they have to go find an offtake," said Brian Falik of Credit Suisse. "That offtake may be significantly at a discount to what is available on the forward curve."
The question facing project planners is just how merchant to go. Eurus Energy America closed financing on a pure merchant plant in PJM last year, which has a set of electricity market rules relatively favourable to wind. Pure merchant means a project is fully exposed to market price with no hedges in place. "We are very, very happy to see the development of wholesale markets like PJM. We think it is a fantastic tool for us to help fight back against the utilities who have been offering extremely low prices and basically have a monopoly wherever you are," said Eurus' Mark Anderson.
And merchant risk
Many developers at the conference, however, seemed to think a pure merchant approach is too risky. It is an opinion shared, panellists agreed, by most lenders and equity providers, particularly those with a memory of the merchant power meltdown in the US a decade ago. But at least one lender is ready to commit. Manulife Financial, a Canadian insurance company, is providing debt financing to two pure merchant projects under construction in Canada, one selling to the Alberta Power Pool and the other, located in Prince Edward Island, wheeling power across the border into the New England Power Pool.
"From a lender's perspective, the technology is proven, it has a very, very low cash operating cost and very low breakeven pricing is required to cover cash operating costs and debt service," said Manulife's Bill Sutherland. In the US, PTC (production tax credit) cash flows lower the breakeven price even more.
The key difference between Canada and the US, he said, is getting tax equity comfortable with merchant risk. "We've had term sheets out and been prepared to move on a number of transactions over the last four years in US, and the real impediment there had been the lack of availability of that tax equity. In the Canadian market, tax equity is not an issue."
Credit Suisse's Sternthal expects that some of the private equity capital that is entering the business by investing in project developers will be more ready to bet on the market. "The question is will the tax equity or will the debt get there? It is in the realm of possibility," he said.
Although consolidation has already gobbled up many of the independent developers in the US market, many panellists expected the trend to continue with even larger transactions, a discussion that presaged Energías de Portugal's recent $2.2 billion purchase of Horizon Wind Energy from Goldman Sachs.
"There is very, very, very little opportunity to make venture type returns in this kind of market. About the only place is early stage development. In order to employ lots and lots of money you have got to be very efficient," said Ted Brandt of Marathon Capital. "So we think the private equity guys are going to be given over to the more efficient financial players, the financials will move over to the strategic players. I would predict you are going to see 14 or 15 well funded companies in this industry, and that won't last. Two or three years from now, you are going to see additional consolidation and you will very possibly be down to six, seven or eight major players."
It is also feasible that one of the "big gorillas" down the road may be a company that is not currently in the wind business, said Credit Suisse's Raymond Wood. John Calaway of Babcock & Brown agreed, pointing specifically to the oil and gas industry and the growing calls in the US for action on climate change. "It wouldn't be surprising at all considering the carbon companies need desperately to find solutions to their political problems in Washington and they have massive earnings coming on that are unprecedented," he said. "You can easily imagine someone like an Exxon jumping up and putting a couple billion dollars out to take a big position."