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United States

Facing a market of new realities

The rising price of wind power, the shortage of turbines, the entry of far stronger financial players, and the oil and gas sector's growing interest in the wind business were all strong themes at a recent workshop in Texas. With power purchase agreements often elusive and complex in such aturbulent market, the long dormant option for "merchant" sales of wind power without a contract looks as if may be about to come into its own

Higher costs for wind power in the US may have been largely offset by a parallel run up in fossil fuel prices, but a series of new market realities are significantly impacting the business. While increased demand for wind power, a renewed production tax credit (PTC) and the rise of renewable energy credit (REC) markets have put the US industry on track for at least two more years of unprecedented growth, the path is not all smooth.

"We are experiencing a shortage of turbines and we are experiencing for the first time in the history of this industry significant increases in the cost of wind energy for a whole variety of reasons, not just turbine costs," said Randy Swisher, executive director of the American Wind Energy Association (AWEA). "The only reason we are in as good a shape as we are, the compensating factor, is that the cost of energy in general is higher so we are able to continue to compete in the market. But it is troublesome," he added. Swisher was speaking at AWEA's recent Wind Project Finance and Investment Workshop held in Houston, Texas.

Turbine prices, workshop delegates heard, have increased as much as 45% over the past two years. That hike, combined with increases for things like transportation and construction, have pushed the price tag for a typical 100 MW wind farm from about $100 million a few years ago to $170-180 million today, said Jan Paulin of Padoma Wind Power, a California-based project developer. And where producers were signing contracts for as little as $0.025/kWh in 2004, they now need around $0.05/kWh in good wind regimes, and even more elsewhere.

That could have an impact on wind's place as the most favoured technology for meeting state renewable energy standards, a key driver in the industry's growth. "The more expensive wind is getting, the more opportunities there are for geothermal and biomass in particular," warned Ed Feo, a partner in the law firm Milbank, Tweed, Hadley & McCloy LLP and the workshop's program chair.

While most speakers did not begrudge manufacturers increasing their prices to ensure an adequate rate of return, some openly questioned whether the hikes have gone too far. "The pendulum has probably swung too far the other way, but it is not the end of the world that Vestas reports positive earnings," said Michael Skelly of Houston's Horizon Wind Energy.

Getting the turbines

A continuing challenge for the industry is the ability of developers to get their hands on wind turbines, whatever they cost. "I would say that what is interesting about the market is that it has evolved from where everyone was so focused on how low can the yields go to where people are now more than focused on do you have the turbines and do you have the project that justifies putting the turbines in," said Hunter Armistead of Babcock & Brown, an Australian company that got into the US wind business four years ago. "That has forced a concentration of the market in the players that have the financial wherewithal to order turbines. But it has also made us very keen on finding people who are good at developing good projects," he adds.

Manufacturers that were willing to take reservation payments for wind turbines are now demanding full down payments that that are typically 20% of the total bill. Making that kind of financial commitment when a project is still in the development phase, said Paulin, is a huge risk.

Not making it, however, means turbines may not be available when the project is ready to go. Babcock & Brown, says Armistead, is trying to secure turbines for 2008 at the same time its working to complete 700 MW worth of installations before the PTC is set to expire at the end of 2007. "I can show you my book of exposure for all of the turbines I have ordered over the next two years. It's daunting," he told delegates.

Lack of clarity

Complicating the picture is a lack of clarity of just what is available and what is not. "It is very difficult today to come to grips with what the status is," said Paulin. "But I think what we are seeing happening right now is that some of the projects people thought would materialise in the 2006 and 2007 timeframe are running into various obstacles. We are hearing that the turbines are there and we are seeing people offering turbines second hand. I think if there is a project that is ready to go to construction, I think there might be turbines available. I don't know. It is a very murky area."

The shortages are having an impact on other aspects of the business as well. Getting the right technology for a project is more difficult. "These days one would be happy just to buy a turbine. But there is a very significant amount of value associated with getting the right turbine on a given site," said Paulin. Negotiating with turbine makers for modifications to make the equipment more effective in a particular location is part of the process. "This is something that is easier done when turbine manufacturers are hungry than when they sell out years in advance," he said.

Less stringent

At a time when utilities are demanding increasingly onerous performance guarantees in their purchase contracts, said Paulin, manufacturers are finding buyers willing to take less stringent warranties covering things like turbine availability. "We have seen a dilution of the terms that manufacturers are prepared to agree to these days because the market is such that some parties have committed to buy turbines without necessarily having a whole lot of experience," he said.

Married to utility performance guarantees are demands on developers for some sort of bond, letter of credit or deposit that can amount to many millions of dollars. "We have seen demands all the way up to $20 million on a 150 MW project. They can usually be negotiated down to something more reasonable, but I think it is likely you will see on a 150 MW project something in the $6-10 million range," said Paulin.

The need for a strong balance sheet to deal with some of these costs, particularly to secure turbine supply, is placing a burden on smaller players. "I think there is a lot of disjointedness in the industry right now. There is a lot of stress that is particularly acute to independent developers," said John Calaway of Superior Renewable Energy, a Houston-based wind power developer. "It is really unfortunate, because in the end if you don't have a healthy independent development community it is going to be very difficult for everyone later on."

Consolidation

The situation is helping to drive consolidation in the US industry, a trend already marked by the high profile 2005 purchases of Seawest Windpower by power industry giant AES Corporation and of Zihlka Renewable Energy by US investment banking firm Goldman Sachs. Just last month, Spain's Iberdrola added to the tally with the announcement of a merger agreement that will see it acquire Pennsylvania developer Community Energy Inc.

"I think you will see a continuation of consolidation. I think it is going to happen," said Calaway. "I think you will see eight to ten major players that are going to dominate the business in the foreseeable future. So people like us, who are certainly not in the category of major players, there is a good shot we will have the fate of a Zilkha."

Lining up on the buyer side, said Mike Stengle of investment banking firm Capital Alliance Corporation, are large US utilities who want to increase their internal rates of return by owning instead of purchasing wind, large international utilities and developers who want to establish a strong presence in the US, and private equity firms with energy portfolios. "A lot of large balance sheets are lining up with developers who have a very strong project pipeline and PPAs in place," said Stengle, referring to power purchase agreements (PPAs). "Certainly we think that through the end of 2007 the trend will continue. Then it becomes slightly less attractive after we move closer to the expiration of a non-renewed PTC."

Even with the face of the US industry changing, Eric Bakker from BP Alternative Energy North America believes there will continue to be room for smaller players. "If we want to grow our portfolio aggressively to the size the company wants it to be in five to ten years time, we do need people who understand the local situation," he said. "But it will be a niche."

Oil and gas

BP's presence at the workshop was notable. Several speakers said they expected to see a growing involvement by oil and gas companies in wind, driven by the need to reduce emissions and to fill the gap as energy demand increases and hydrocarbon production diminishes.

BP, says Bakker, expects to build its first US wind farm in 2007 and increase its overall installed wind power capacity from 30 MW today to 450 MW by 2008. Its wind investments are part of a plan to spend $8 billion over the next ten years to become one of the world's leading low-carbon power producers.

Climate change is a big driver, says Bakker, as is BP's belief that hydrocarbons will increasingly be reserved for uses in areas like the production of plastics, not power. "Burning them doesn't seem to be the most efficient way of using them."

Shrinking prospects

Superior's Calaway told delegates he left the oil and gas exploration business for wind after coming to the conclusion that opportunities in the US petroleum sector were shrinking. "I can tell you for sure that after 20 years and shooting 10,000 miles of 3D seismic data from south Texas all the way to the Florida panhandle, there are not a lot of good prospects left."

Making a transition to renewables is a logical move for petroleum producers, said Calaway, and one he expects to see accelerate. Horizon's Skelly agreed. "In the future we would expect to see more competition, at least competition from our perspective, from the oil and gas sector. They have huge tax appetites, and getting bigger by the day, and access to lots of capital. These are companies that think about the world over decades -- and they thoroughly know the energy industry."

Natural gas was trading on the New York Mercantile Exchange for more than $8 per million cubic feet on the workshop's opening day, enough, said Calaway, to push the energy cost component alone for gas-fired generation to over $50/MWh. The result is not only more cost-competitive wind power, but also a growing interest in developing merchant wind projects (projects without a power sales contract) to take advantage of market prices that are higher than producers can get through long term PPAs.

Merchant wind power

Other factors are also driving the move towards merchant, delegates heard. In some markets, long term PPAs are not available. Where they are, developers often face onerous PPA performance standards and penalties, complex REC banking provisions and the poor credit risk of some utility off-takers. PPA prices may also not reflect the value of the RECs that are generated, cutting off a potential revenue stream for producers.

"Wind merchant financing is something that up until very recently has been frowned upon both by equity and by the banks," said Padoma's Paulin. "But people tend to forget when we talk about wind that there is really a significant amount of certainty in what you are going to get, even in a merchant situation, because your return, for a large part, consists of PTCs."

Closing the risks

The tax credits, combined with the tax benefits provided by accelerated depreciation, probably provide 60% of a project's return, said Paulin. "It is really only a 40% risk as opposed to a gas plant or some other traditional power plant, where it is 100%. So I think we will see merchant and I think we will see hedging products offered by banks to try to close some of those risks."

In fact, said Feo, deals are in the works right now that use financial instruments to compensate for a lack of a PPA. "What we have been seeing is that the financial community is accepting the risks associated with merchant facilities that have a hedge in place."

Whether banks are prepared to follow the lead of Manulife Financial, a Canadian insurance company involved in wind financings on both sides of the international border, remains to be seen. Manulife recently closed a deal providing C$42.5 million in non-recourse debt financing to the Kettles Hills wind project, a merchant facility currently under construction in the province of Alberta.

"When I say merchant, in this case it is truly exposed. There is no hedging in place," said William Sutherland, the company's vice-president of project finance. "From a lender's perspective, we've got proven technology with very low cash operating costs relative to the generation technologies at the margin, particularly for gas, less so for coal." The breakeven price for wind, which includes operating costs and debt service, is also low relative to forecast spot market prices, he said. In the US, PTC cash flows lower it even more.

Most US banks that lent into the merchant gas power industry in the late 1990s remember it as a source of loss, said Thomas Emmons of HSH Nordbank, and that experience still dominates. "I think that may fade as the wind market evolves and the expectation of higher power prices in the US solidifies," he said.

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