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Selling wind farm assets is about yield not costs

Selling wind farm assets is about yield not costs. From a banker's perspective, the traditional approach to wind plant valuation -- installation cost plus a profit margin -- is never going to find acceptance in the new world, where investors drive the market. In a special debate article, author James Sproule, head of research at Augusta & Co merchant bank, takes a look at the issue.

From a banker's perspective, the traditional approach to wind plant valuation -- installation cost plus a profit margin -- is never going to find acceptance in the new world, where investors drive the market

Veterans of the wind energy industry are used to being told that everything is changing. That renewables are facing a brave new world. That life in wind energy is never going to be the same again. In most walks of life such hyperbole is seldom justified, but for wind energy we all recognise a ring of truth. The arrival of serious amounts of cash and even more serious investors is the latest development in an industry where we have all come to see rapid change as, more or less, the normal course of events.

It was less than five years ago in much of Europe that wind farm development more often than not meant a farmer and a developer getting together and, with the financial backing from the development arm of a turbine manufacturer, they built a wind farm. Matters have very definitely moved on and everyone in the industry is aware that this model is well and truly dead, but what has driven this change, and what are some of the implications?

As recently as 1997 over 55% of all wind farms used 300 kW turbines. These machines did not generate much electricity, but nor did they cost very much. It took until 2003 for more than 30% of European wind energy to be generated in wind stations of over 10 MW in total size and by that point, 2 MW turbines were on the market. Today, European wind transactions are often over 200 MW.

This means that not only has the capital cost grown well beyond the means of even the richest farmer or developer, the deals are now of growing interest to professional investors. With larger and more expensive deals now the rule rather than the exception, the turbine manufacturers have become understandably less keen on providing finance. This is not just because the industry has grown well beyond the point where the turbine manufacturers could supply any significant amount of the capital the industry now requires. Even those manufacturers who are well capitalised, such as the wind unit of General Electric, are only going to finance projects where they see an opportunity to push the industry into new fields. It is not their job to provide general capital for an industry where mainstream investors are clamouring to put their money to use.

A new world

What in many ways helped to usher in this new world -- where investors drive the market -- was the sale in 2004 of the wind power assets owned by Innogy, a major British power company owned by Germany's RWE. Innogy had developed wind power assets using its own internal capital. But Innogy's job is to generate and distribute electricity, not to hold assets. Augusta and Co advised the private equity buyers that became the new owners, but the contract guaranteed that Innogy continued to receive all of the power, as well as any green certificates. It quickly became apparent that this could be an advantageous deal for all concerned.

As the financial advisor, Augusta and Co was keenly aware of the degree of education that all the financiers involved with the deal had to go through. Until this time, the normal way to determine the value of a wind farm had been to look at all of the costs involved. From land leases, to interconnect fees and the costs of the turbines; on top of this was added a profit margin and voila: the cost of the wind farm.

We can see the cost plus thinking still prevailing today -- the most common comparator between wind farms remains the cost per installed megawatt. But this "cost plus" approach is simply never going to be acceptable to financial investors. What they want to know, perfectly rightly, is the sort of cash this asset is going to yield and what are the risks to that cash flow.

It is return on invested funds or the yield that matters, in other words, the amount of electricity that can be generated by a given wind farm at what price. If a developer has managed to negotiate rights to a particularly windy hillside, where capacity utilisation is 35%, the result is a very valuable asset and a significant profit to the developer.

Alternatively, if a wind farm only sees a capacity utilisation of 15%, its value is going to be determined not by what it cost to erect, but by how much power it produces. If the value determined by power production does not cover costs of building the plant, well, then the developer and whoever else took the risk of making the investment, has lost money. It is useless to expect investors to pick up the tab for a wind farm that never should have been built in the first place.

The numbers

What does all of this look like when translated into numbers? When wind energy was a long way from being an economic form of electricity generation, what mattered was the cost of the equipment. The driving number in wind farms was the average European cost per installed megawatt, something around EUR 1.5 million/MW.

But if the cost per megawatt installed determines value, yields will differ quite significantly depending on the wind resource and prevailing tariff regime. Such a situation would not be sustainable financially. Recent transactions have seen prices per installed megawatt vary widely from EUR 1.2 million to EUR 1.8 million (the sale price divided by megawatt installed). Where there is far less variance is in the cost per megawatt hour -- in other words, in the yield (sales price divided by MWh generated). From Sardinia to Scotland, sales of wind farms on a per MWh basis are remarkably similar. Prices per MWh have risen from EUR 480 to EUR 600 over the past few years, but this reflects the increasing attractiveness of wind as an investment much more than any volatility in any particular year's prices.

Mathematically all of this is backed up by the volatility of the cost per MW installed being almost double that of the cost per MWh. The point is, that while three years ago equity investors were demanding internal rates of return from wind investments of 16% or more, we are now seeing deals being bid at less than 10%. For what is in many ways a fixed income investment, these movements in yields (and thus prices) are considerable. In essence the discount rate that is used to arrive at the net present value has come way down.

Four predictions

So much for what has happened to date. Where is this all likely to lead? Four predictions seem fairly obvious.

First, energy security is going to be a growing concern. From the perspective of political policy makers, this means that incentive schemes whether feed in tariffs or energy diversification targets are unlikely to be reduced anytime soon. Spain has long stated that its interest in wind energy is at least in part driven by a desire to reduce dependency on imported oil.

But there is more to it than that. While there is every argument that investors are focused on yields, they are also always watching broader trends. Because it looks fairly certain that the response to oil insecurity is going to be a move towards wind energy, it looks likely to be only a matter of time before the security of wind supply trumps concerns over the fact that the wind does not blow all of the time.

Second, it does not take a clairvoyant to forecast that $60 barrel oil makes wind energy far more viable, and not just on a comparative cost base. It is certainly true that few forecasts see oil remaining at anything like present price levels, but equally no forecast sees oil returning to its former long term average of $25 per barrel. Economically the present oil crisis was set off by demand from Asia hitting a refining bottleneck. That bottleneck will be fixed in the not too distant future, but with global GDP growth set to hit 4.2% in 2006, keeping up with demand is going to remain a challenge.

Capital wealth

Third, the flood of money seeking to invest in wind power is only going to grow. This flood is not driven by oil insecurity, but because there is a growing pool of capital wealth across the developed world. First seen in the early 1990s in the United States, where baby boomers placed significant savings in retirement funds, a similar pattern of wealth accumulation is emerging in Europe. As Europeans have high savings rates, this flood of money is going to become ever more influential to asset markets, and the demand for assets with stable yields is an undoubted benefit to wind energy.

Finally, and less positively, given all of this, can prices for wind assets simply go up and up? Well, no. Yields on wind power assets have already occasionally dropped to below 8%, so there has to be a question as to how much further they can fall. Remember, government bonds (which financiers use as a proxy for a "risk free asset") yield 4.0% in the UK and 3.25% in Germany. Wind energy does entail some risk, even if that risk is solely due to wind variability. This risk means there has to be some sort of premium above government bonds before an investment in wind power makes sense. Equities are generally thought to carry a risk premium of 4% over government bonds; it does not seem unfair to rate wind energy somewhere in the same region. If prices for wind power assets rise to the point where yields fall to within 2-3% of government bond yields, it is likely that we are seeing a speculative bubble, rather than a new sustainable level of pricing for wind power assets.

Today's challenge

The flood of investment that is coming into the wind industry is most welcome, but it is also a new challenge to the industry. It is no longer difficult to find debt or equity investors who understand at least the basic risks involved with wind energy. The challenge today is to find investors who are willing to accept the lowest yield from wind assets. If these investors are to remain happy and continue to place more money in the market, they must be convinced that the industry understands their needs and demands.

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