Debt and equity markets in the American wind power business continue to deepen in step with the industry's spectacular growth in the United States. For the financial advisors who earn their living putting ever-bigger wind deals together, these are boom times. "It has been an incredible market. We continue to see lots of action, lots of new entrants," says Jeffrey Chester of law firm Kaye Scholer. His words are echoed by Doug Carter of Invenergy LLC, one of the major wind farm developers in the US looking for finance for its projects. "There is just a big appetite. As long as you've got a good power purchase agreement or hedge structure and good credit driving the project, the markets are very aggressively trying to be competitive in bringing capital into projects," he says.
Not all is coming up roses in the finance garden, however, as discussions at the recent Infocast Wind Power Finance and Investment conference in San Diego revealed. Both the market players and their strategies are in flux in the wake of dropping returns, competing investments, tax credit uncertainty and turmoil in global credit markets.
With a $0.02/kWh federal production tax credit (PTC) driving US wind development, the challenge for project developers without large tax bills to offset is to use the PTC to find equity investors who have -- and who can use it to reduce their tax burden. In the past, developers had little choice but to sell their projects to major players like FPL Energy or Shell. Over the last few years, however, there has been a rise in so-called passive investors looking for tax shelters. In 2007, that market nearly doubled.
"We saw over $5 billion in tax equity committed last year in the market, which is up from about $3 billion the year before and about $600 million before that. So the growth is just phenomenal," John Eber of JP Morgan Capital Corporation told the conference. The huge appetite for tax-motivated equity is attracting new players, but the size of the required investment, especially in cases where developers combine multiple projects into portfolio offerings, can make it tough to gain a foothold.
The result, said Eber, is a growing interest in a secondary market where equity investors can buy into deals that have already been made. "We're attempting to do it at our institution just to bring in more investors," he explained. "It is easier for some investors to come in on a deal that has already closed. We've already funded it and it will be easier for them institutionally to prove that through and get it approved. At least that's the belief."
The challenge of getting more tax equity investors involved in the sector is complicated by the decreasing yields those investors can expect. "Equity returns in large portfolio deals where there is risk diversification in terms of turbine types and geography have dipped below 6% in some cases. Those are the largest deals," said Keith Martin, a project finance specialist with law firm Chadbourne and Parke. Returns can go higher, though, depending on the specifics of the deal. "Generally, I would say that returns in one-off deals are somewhere in the high sixes, maybe low sevens. But they can go as high as 9% depending on risk assessment," he added.
Returns too low
The situation is causing some retrenchment in the existing tax equity market. "There have been people who have dropped out just because the returns are so low," Martin explained. "You will often hear the equity complain that the returns have been driven so low in the larger deals that they are having trouble with their credit committees justifying putting more money in this sector given the competing investments that are possible."
Some of those competing investments are in other emerging renewable energy technologies. At JP Morgan, wind still rules. But the company is spending a fair amount of time looking at solar and geothermal projects, said Eber. "They're just coming on now. There are going to be a lot more solar and geothermal deals in the market this year and they are going to compete with the wind deals for the same tax equity," he said. "Last year we saw maybe a billion dollars worth of solar and geothermal deals in the market. This year we expect that to be closer to $3 billion. So that is huge growth. And that is not including any of these concentrating solar power deals that are being discussed that would soak up sizeable amounts of tax equity if they came into the market."
At GE Energy Financial Services (GEEFS), wind projects make up about 80% of its $4 billion renewable energy project portfolio. But interest in other technologies is growing, said the company's Timothy Howell. "We've recently done some big hydro deals and some photovoltaic deals and we're looking really hard at the concentrating solar power space and at geothermal."
There are also other alternative investments outside the energy sector that compete for tax equity capital. One of the biggest is the low-income housing sector, and the fallout from the subprime mortgage crisis is starting to send yields rising. Fannie Mae and Freddie Mac, quasi-government entities that are two of the largest purchasers of low-income housing tax credits, said in February they would reduce or stop buying tax credits because of their bad loan write offs. "That would push rates up in that market and perhaps attract some of this tax equity there," said Eber. "That market had gotten awfully cheap, partly because those two institutions were taking such a large part of the market."
The mortgage crisis has also diminished the tax capacity of some of the equity players in the wind market. Morgan Stanley, for example, was forced to write down billions in losses linked to subprime mortgages last year. "It does impact our ability to invest in tax-driven transactions. It just means we are going to be that much more cautious in terms of where we place our capital and a resource that was extremely large is not as large," says the investment bank's Jason Cavaliere.
But, for the most part, the subprime mess and the worldwide credit crunch it has sparked seem to have little impact on the wind industry, at least for now. "I suspect it has got to have an effect but we haven't seen too much yet. We've seen a few investors pull back who were not big investors to begin with. There other investors we've been talking to who were thinking about getting into the market who pulled back," said Eber. "It is more likely to be the slow down in the economy and the pick up of investment opportunities in other tax equity arenas that are going to have a bigger impact on the marketplace -- and that is going to play out over the next year."
Lenders not scared yet
On the debt side, the story is much the same, with lenders agreeing that wind project financings that need to get done in 2008 will get done despite the credit challenges in the market. "We hear stories about banks stepping away from wind, but there are very few. We also hear stories of banks coming into wind. So there is a flux going on in the supply and demand of capital on the lending side," said Michael Midden of Dexia Credit Local. "It is a little bit hard to really understand where it is going to come out. Generally I think there will be enough liquidity, just as there was last year, especially for well structured and well priced transactions."
GEEFS sees opportunity in that flux, said Howell, and is exploring the possibility of stepping in to fill gaps that could emerge if lenders opt out of the market. The company already invests about $4 billion a year in the energy industry on the debt side. "It has been broad-based, across fossil power plants and oil and gas infrastructure and reserves. There has not been a lot of lending by our institution in the renewables space, but they are certainly actively considering that right now."
William Marder of Fortis Capital, an early lender in the US market, believes the market remains strong. His company took a wind farm financing deal secured back in the summer to the syndication market over the Christmas holidays. The deal was of such a size that it required "a good number" of banks to come in. "It was a fairly aggressive transaction that we actually won in July, right before the whole market crisis occurred, so there were some question marks about how is the bank market as a whole going to react. I think the reaction was very positive. We were actually oversubscribed significantly," he said. "So I think it proves not only the attractiveness of the market, but the breadth and depth of the institutions that are involved."
More of a lender's market
Increased competition in the debt market has also helped mute the impact of the credit crunch on wind transactions, said Bruno Mejean of NORD/LB, a German bank active in the US market. But he sees a downside. "What we've found is the combination of new entrants -- the Spanish, the Portuguese and some American banks -- has really put a damper on the ability of banks to increase and pass on their liquidity costs in this particular market. That is not sustainable in my view, so I believe there will be a more gradual increase in the cost of funds that will have to be passed on to users."
Richardo Valeriano of Wachovia Securities agreed. "It is more of a lender's market this year. Given the turmoil we've had in the credit markets and the increased funding costs banks have had, you have to expect pricing for transactions to increase this year." One change that has already occurred is the introduction of "flex language" into deals, which allows lead banks to increase pricing or other elements of the transaction if they need to in order to sell them in the syndication markets.