The window of opportunity created by the extension of wind's production tax credit (PTC) in the US to the end of the year is fuelling a frenzy of wind farm construction. But perhaps even more significantly, this latest boom in the American market is attracting new players looking for a piece of the action on both the equity and debt side of the financing equation. "You are going to see, I believe, a significant expansion of the tax equity market and another deepening of the debt market," says Jeffrey Chester of law firm Kaye Scholer LLP.
The US wind industry has made great strides in attracting new sources of capital since 1999, says Chester, when FPL Energy, which still owns about 40% of the country's installed wind capacity, was essentially the only equity player in the market and Europe's Fortis Bank dominated the debt side. "We see the markets expanding on every front." Chester made his comments to a full house of delegates at Infocast's recent Wind Power Finance and Investment conference in San Diego, California.
New avenues to equity
The $0.019/kWh PTC, which is worth about one-third of the capital cost of a typical project, is the main driver of US wind power development. The challenge has been to find equity investors with enough tax appetite to use it. Until now, a handful of key companies in the energy sector, like FPL, have dominated the market, but the situation is beginning to change. There is a growing interest in wind among so-called passive investors looking for tax shelters, many of which were active in the affordable housing and leasing markets until yields for those investments started to drop.
"There aren't any other investments in the marketplace for our investors to put their money in and get the kinds of deals they are getting on wind transactions," says Maura Schoenfeld, president of Meridian Clean Fuels, an affiliate of one of the leading brokers of tax motivated equity investments in the US.
Another emerging source of tax motivated equity is the utility sector, an avenue that was cut off when the move to competitive electricity markets in many US jurisdictions forced a large number of utilities out of the generation business. "Utilities are being allowed now to go back and own generation and they are doing it with more of a green hue. They are also willing to let you to develop and operate wind projects," says James Walker, CEO of Enxco, a wind power project developer based in California. "It is a whole new and very important part of the market opening up."
US wind developers are also increasingly looking north of the border to Canadian income funds as a source of cheaper capital for their projects. The funds raise money in Canadian capital markets and pool it for investment. Because they pay little US income tax on their earnings and are not subject to tax in Canada, says Keith Martin of law firm Chadbourne and Parke LLP, they can afford to pay at least 27% more than competing bidders for businesses in which they invest. The problem is that with no US tax base, they cannot make use of the PTC. They could, however, find a niche as cash investors alongside equity investors with a tax appetite, says Martin.
For independent wind power developers too small to utilise the PTC, the growing access to alternative -- and quite diverse -- sources of equity capital is positive. "The supply and demand of money in this industry has worked very much in our favour in the last 18 months or so," says Jan Paulin, CEO of Padoma Wind Power. "What that has led to, basically, is that return requirements have gone down. We are now seeing, on a regular basis, the availability of equity in the single digits on a non-leveraged, after-tax basis, which is significantly good news for the industry as a whole."
While few of the equity players represented on the conference panels at the San Diego event were willing to pinpoint the yields they expect from their wind investments, all agreed the increased competition as more equity providers crowd into the market means their returns are trending down. "Some CFOs at wind companies report that people are throwing money at them for the first time in their lives," says Chadbourne and Parke's Martin.
The returns acceptable today for equity investors are influenced by a variety of factors. "It really does depend on the risk, the offtake, what kind of contract you have, what stage is the development at, who the developer is. All of those pieces play into it," says Schoenfeld. But generally today, wind projects financed entirely by equity -- so called "unlevered" financing with no debt element -- provide returns to investors in the low 9% range, says Martin. This is down from two or three years ago when the industry was a "buyer's market" for equity and yields were greater than 10%. But in December, he adds, Schoenfeld's company, Meridian, closed a wind deal returning just over 8% and a recent deal, the details of which have not been made public, slipped below the 8% mark. And Schoenfeld expects yields to go even lower. "We don't know what the floor will be," she says.
As the returns drop, it should lead to cheaper wind power. Panellists, however, cautioned that developers should not look to force equity returns down too far, too fast. "For us, we invest in broad range things and at some point the relative value forces you into other markets," says the Prudential Capital Group's Ric Abel. "I think that right now it is pretty important to encourage the depth of the market."
Still, says Paulin, developers continue to investigate ways to get to even lower equity returns. "There are some structures, at least conceptually, that are being thought about which effectively aim at converting investment in a wind project into a riskless coupon, by using hedging and insurance remedies to take away the risk," he explains. "I don't know, as I'm sitting here today, whether we will see one or more of those types of deals done in 2005. I think there is a chance," he says. "From our perspective, navigating through these various options and choosing the right combination of equity package can make a huge difference in terms of how much money, at the end of a day, a developer can pocket."
The fees for developers are actually rising, something PPM Energy CFO Merrick Kerr is prepared to accept. "As I look at the market, the thing that distinguishes it is the people who have the good sites. The site that has the good capacity factor and the transmission is where the value is going to be. The value is not in the person that has some money and a tax appetite. That is not a unique skill."
The new types of deal structure in the marketplace are also a reflection of the increasing diversity of equity players. While that gives developers options beyond simply selling their development rights or projects to major players on the energy markets, like FPL, Shell or PPM Energy, it carries its own set of challenges.
In fact, delegates heard, the complexity of deal structures under the PTC regime means that potential new equity participants may not have the experience and expertise. "Number one, they have to have a healthy appetite. Number two, they need to be able to synthesise and work with these very complex structures," says James Murphy of Invenergy LLC. "When you put all of these constraints together [the equity base] is much more limited than we would hope it would be."
Declan Flanagan, CEO of Ireland's Airtricity, which is hoping to break into the US market, agrees. "There are a lot of people out there who are interested in doing their first deal and that doesn't mean they wouldn't be of interest to us, they obviously would. But it just adds another layer of complexity to a lot of these projects."
The complicated nature of wind power deals is also increasing transaction costs, says Flanagan. "In Europe we've very much got our financing down to a cookie-cutter type of process and depressed the transaction costs and closing time frames down to a minimum. That is where we would want to get to in the US," he says. "These are very complex deals in the context of the wind industry internationally and very expensive to close."
A big part of the problem is what Enxco's Walker calls the "incredible artificiality of the constraints on who can be an investor," that the PTC brings. "I hope when we look at future policy, rather than hoping for a ten year extension when you've got a $500 billion budget deficit, just broadening the base of investors who can play in this market would be a huge benefit."
Yet few panellists or delegates in San Diego were ready to take the Exelon Power Team's Michael Freeman up on his suggestion that the PTC be eliminated. "Believe me, I don't want to pay $18/MWh more than I am already paying for the offtake, but to me it has become an albatross on the whole concept of renewable energy. I don't have any brilliant ideas on what to do without it, but I think that if we somehow started talking about a world without it, a lot of great ideas would crop up on how to handle that risk."
But Invenergy's Murphy says the PTC and its extension are key to his company's development program. "We are very encouraged by the status of renewable portfolio standards," he says, referring to legislation at state level mandating a minimum standard for the renewable energy content of electricity supply portfolios. "But right now we think this is still a business that is highly dependent on the PTC and we expect that to continue."
Other utility buyers agree. "Without the PTC, I'd have to change my answer on wind being economic," says Xcel Energy's Karen Hughes. She points out that because of the uncertainty of the PTC extension, Xcel issued a tender last year for new wind capacity, asking for bid prices with and without the PTC in place. "Wind was not cost-effective without the PTC," she says.
On the debt side of the financing equation, the trends are also moving in favour of wind energy developers. "It is becoming a very borrower-friendly market," Andrew Platt of BNP Paribas told Infocast delegates. "We are seeing spreads and pricing and other terms getting further driven into the ranges that make banks a little bit uncomfortable, which is great for most of you."
Banks, he explains, are flush with capital they are under pressure to utilise. They are also finding themselves competing with alternative sources of long term capital, says Platt, pointing to the $1.1 billion FPL Energy has raised through bond issues since it became the first wind developer to tap into that market in June 2003 (Windpower Monthly, November 2003).
The changing perception lenders have of the wind industry is also a factor in the easing of debt terms, Platt says. "There is a growing acceptance that wind is less of a niche and more of a mainstream type project." Michael Midden of Dexia Credit Local agrees. "I think people are getting a little more familiar with issues around wind farm financings and that has helped relax some of the pricing."
The broad financial crisis in the American power industry earlier this decade is still causing reverberations. The implosion suffered by US merchant power plant developers, who build projects to sell electricity on the open market rather than under contract, sent independent power producers -- and their banks -- scrambling to the security of long term power purchase agreements. In 2005, however, the pendulum could start to swing back, Chester told delegates. "One of the exciting things that is happening, I think, is talk of merchant wind plants."
Taking on the risk of building a wind plant without a contract for its output, however, requires a set of electricity market rules favourable to intermittent resources and good wind forecasting capability, as well as an integrated trading floor that can deal with merchant wind as part of a portfolio, said PPM Energy's Kerr.
"There is a lot to it," he told delegates. His company, however, has taken merchant exposure on its marketing of the output of the 300 MW Stateline Wind Power Project and has learned a lot. "I don't think it will be a surprise to anyone that PPM is probably not that far away from building the first wind farm which will be merchant on the day it goes live with PPM as the owner," he says.
Some financiers, however, are not convinced the banking community is ready for merchant wind. "The bank world did not have a good time with merchant gas projects and they knew from day to day pretty much the output they were getting," says David Perlman of Fieldstone Private Capital Group. "With a merchant wind project you not only have the volatility of power rates, but also the volatility of the output." On the other hand, suggests Steve Probyn, who heads Canada's Clean Power Income Fund, the fact that wind power carries no fuel price risk might actually make it a better platform for managing some degree of merchant risk. "You are probably going to get some cash volume out of that toy no matter what the power market conditions are because your operating costs are small relative to the price of power. Secondly, in a deregulated market, assuming a 25 year life of equipment, even if you had to reschedule some of the debt you would be able to ultimately recoup."
The Infocast conference, Windpower Finance and Investment, was the fourth in a series on financing issues, attracting 270 project developers, investors and buyers.