Financial muscle for flexible business

The wind industry's bankruptcies of the past all too clearly demonstrated the dangers of weak financial foundations. Development of the project

finance model has helped build strong projects, but not necessarily strong companies. What much of the wind industry currently lacks is the

financial muscle to carry it into the next phase of the sector's evolution. Building that muscle is the next big challenge. It has also just got easier

The financial markets are opening up to the wind sector like never before. Whether a wind company is in search of equity or debt to get a project off the ground, of more capital for company expansion, or desirous of a strong new owner, the industry track record of the past few months has been good. Commercial investors, banks and big corporations have shown themselves willing to oblige, either by entering the sector or increasing their interests in it.

Just as well, too. The wind sector is becoming increasingly weak at the knees for lack of money. Current and future growth is being constrained not so much by the absence of finance for individual wind projects, but by the inadequate finances of the wind companies themselves. Right across the sector, from turbine suppliers to component makers to project developers, owners and wind farm service providers, a disturbingly large percentage of the companies do not have sufficient funds -- capital -- to carry out their businesses, let alone grow them. It is not that the companies all face impending bankruptcy -- an outcome of under-capitalisation in the extreme -- but current and future business is being jeopardised.

Judging whether a company is adequately capitalised comes down to three questions. First, if it hits a major downturn or business issue, such as a series failure or the need to inject further money into a wind farm to keep it solvent, does the wind turbine manufacturer or project developer have enough money to deal with the problem and continue in business? Companies which cannot deal with harsh, but realistic, economic downturns are not properly capitalised. They are far more vulnerable than they may realise and need to act decisively to rectify the situation.

Second, ignoring future growth prospects, does a company have enough money to invest in and take advantage of opportunities to make its existing business more efficient and profitable? Companies unable to take advantage of cost savings due to lack of capital are not competitive, or on their way to not being competitive, and therefore have uncertain futures.

Third, do customers, suppliers, project counterparties, and industry commentators perceive the company as having enough money to carry out its business? This is absolutely critical. Perception is not always the same as reality, but the two do tend to converge over time. Companies that are perceived to be adequately capitalised have a real competitive advantage.

A number of wind companies do meet the capitalisation test, certainly the utilities and the large multinationals such as GE Energy. Many more do not. In large part this is a function of the historical development of the wind sector: dispersed, entrepreneurial and independent. It is also a function of the changing nature of the sector: larger, more expensive projects both onshore and offshore dramatically increase capital requirements. But the weak state of much of the sector's finances is also due, perhaps ironically, to the one of its key drivers of success, the "project finance" vehicle.

A curious culprit

Project finance has its origins in wildcat oil and gas, when sponsors had little to show prospective financiers except a promising hole in the ground. It has evolved greatly since then, but the focus -- individual project strength -- has remained constant. Project financing has allowed sponsors of wind or other energy projects to raise extraordinarily high amounts of debt secured only by the project's equipment, contracts and other assets.

Wind power has proven to be particularly well suited for project financing, with its often long term power purchase contracts and the solid regulatory regimes that have existed some of the time in some of the markets. The ten-year tax credits in the United States and Europe's government mandated purchase prices, or mandates for minimum purchases of green energy, have provided the basis for secure flows of income. So have similar market frameworks in countries as disparate as Canada, Japan, India and Australia.

Indeed, with some notable exceptions, the wind sector has been built using project finance. A project finance approach is second nature across the sector and it deserves no small amount of credit for enabling the rapid growth and financing of the industry. It has been the bedrock on which the sector has been built.

There comes a point, however, when a relentless project-level focus to finance can lead to myopia. So much energy and effort is put into thinking along project finance lines and making project finance deals work, that there is a strong tendency to lose sight of the bigger picture -- the state of the financial affairs of the companies involved in each deal.

Granular foundations

In the text book world of project finance, a critical success factor is to ensure that each of the participating companies is properly capitalised -- particularly with reference to the company responsible for engineering, procurement and construction, the EPC contractor, and above all its chosen wind turbine supplier. Capitalisation is not such an issue for owners and investors, who just need enough money to invest at financial close, and is even less of an issue for the developer. It will have cashed out and been paid by the time financial closure is reached. But the EPC contractor and the turbine supplier must stand in good credit throughout the construction, operation and the warranty period.

The text book world fails, however, to always take account of the real world. Myopia sets in when the creditworthiness of partners is looked at purely in relation to each separate project financing and not in relation to the wind business as a whole. If the same manufacturer has hundreds of other turbine warranties outstanding at the same time -- each with their own project financing attached -- and the series failure of a major component meant they all needed to be called upon at the same time, the credit picture for the specific projects may not look anywhere near as rosy.

Project financing has tended to promote a short term, granular evolution of wind sector's financial foundation, which has been fine for getting projects built but not for ensuring that strong companies get built.

What the majority of the sector's companies lack is the financial flexibility that comes with good capitalisation. Business flexibility is essential in the capital-intensive wind sector, where the costs are mainly up front: there are no fuel purchases to be made through the lifetime of a project. An example of the advantage of flexibility is currently being demonstrated by Indian wind turbine manufacturer Suzlon, which recently went to the financial markets for a major injection of cash, provided by two private equity firms (Windpower Monthly, October 2004). Suzlon built its first US wind farm with its own money. Almost complete, the project is only now being sold to investors and other financiers. With the ability to finance the project itself, Suzlon saved the time, expense, and effort that invariably would have come with convincing customers and banks to buy into the concept of participating in Suzlon's first US project. Capital can be a clear commercial enabler.

It is also an essential ingredient for offering competitive turbine warranties and EPC contract terms. Customers want both a strong EPC deal and a watertight warranty on equipment. To make sure they get what they want, their focus will be on the supplier's ability to stay in business for the term of the warranty. Suppliers who may have outstanding products at very good prices, but who are perceived as having a weaker financial status than a strong competitor like GE, are beginning to come under pressure to recapitalise or lose business. Companies with strong credit profiles, meantime, are finding their creditworthiness is winning them business. Increasingly, credit is a competitive advantage.

The financial inflexibility which results from inadequate capitalisation has a nasty habit of biting at the most inconvenient of times. The likelihood of getting caught in that particular vice has seldom been greater, at least according to some market analysts. They see wind sector companies as potentially being in a "perfect storm," with too many companies chasing too little business, each with too little capital, at a time when steel and other costs are rising but prices are not. In such a storm only companies which are large and financially strong enough to survive will do so without suffering.

Pumping iron

What the sector needs, from its turbine manufacturers, to its project owners, to its project developers, is fewer, stronger and better capitalised companies. "Fewer" companies does not mean "few" companies. A monopoly might be great news for the final survivor, but certainly not for the economic health of the final customer, the electricity consumer. Strong competition is in the public interest. Ten companies vying for a wind project contract, with eight of them too weak to be chosen, does not make for real competition.

The good news is that companies within the sector have already begun to respond. Within the last year turbine suppliers Vestas and NEG Micon have merged, creating the single largest company in the sector by market share. More importantly than just merging, Vestas also did a rights issue to help bolster the company's capital base -- and it refinanced and expanded its bank loans.

While the industrial rationale for merging Vestas and NEG Micon appears strong, it is the new capitalisation of Vestas that is the most compelling news, regardless of whether or not the merger happened. The new Vestas may be the largest wind company by market share, but if others should follow its example they should do so by shoring up their finances. Bonus has just announced that it will be the first to follow that lead through its proposed purchase by Siemens (page 27).

For the sector to evolve and growth to continue, there needs to be increased focus on the adequacy of capitalisation of the companies. The sources of capital, a key tool for addressing the corporate capitalisation issue, are all available (next article). What it now requires is for the sector (with a few notable exceptions) to face up to this reality and deal with it proactively, before the results of not doing so cause some decidedly weak knees to give way for lack of financial muscle.