Up until late last year, purchase prices for wind farm assets were still holding strong and wind energy companies were raising record amounts of money on the public markets, with several initial public offerings making headline-grabbing news. Asset valuations, which for the past two years year had attracted adjectives like "astronomical" and "unsustainable," were still rocketing as strategic utility investors, in particular, showed themselves willing to pay high prices for a slice of the action, both in Europe and the United States. Private equity business was buoyant as ever more money chased relatively limited opportunities, with high-street asset management funds and other new sources of capital joining in.
But that was all before the reverberations of the credit crunch resulting from the financial turmoil of the sub-prime lending crisis in the United States finally reached the wind sector. A string of companies, large and small, decided to play safe for the time being and put their planned initial public offerings on hold. Meantime, at least some customers for wind project development assets decided to bide their time in the expectation that prices may come down.
The big question being asked now is whether wind project prices will stay at recent levels when trade picks up again, or whether a price correction is on the way.
According to seasoned wind sector investors, it is high time for more rational wind project prices and a market that encourages more sensible returns on investments. While the technology risks are unchanged, investors say they are buying projects from developers at terms which barely make them a profit. On the other side of the fence, project developers are hoping prices will stay where they are, or keep going up.
Among financial advisors, there is no consensus on what will happen next. For every argument that points to a future for the wind sector of rising prices and plentiful supplies of cheap equity in a relatively low risk business, there is another one in support of a market-wide price correction, with project prices coming down and returns on equity investment going up.
Most observers agree that it will be harder to obtain project financing, where loans are secured by future cash flows rather than by assets, in the current conditions. In a capital intensive industry such as wind, the sudden credit freeze and the increased cost of money, together with prices rising generally across the board, is making it more difficult for developers. More marginal projects will suffer first. Shell's recent pull-out from the huge London Array offshore development in Britain is a graphic illustration of the point (page 54).
As Jérôme Guillet of Dexia, a European bank specialising in public and project finance, said at April's European Wind Energy Conference, the crisis is having an "impact on pricing as funding costs increase for banks and banks become more prudent." They are now a lot more choosy about who they lend to and demand higher returns and more flexible terms. For project portfolio financing they are also more selective about who their syndication partners are; and the trend is to create larger syndication groups with many lead arrangers to spread the risk.
For single wind farms and smaller deals, securing project finance is still fairly easy, since the bank can keep the assets on its books if necessary, says David Jones, CEO of Allianz Specialised Investments. "At this level it is a well-defined, understood and well-practised and rehearsed piece of financing -- everyone understands it," he says. But he sees problems for developers trying to arrange syndicated financing for larger portfolios worth several million or billion euros: "Third-party debt is competing with utilities which are more prepared to and can afford to pay a strategic premium," Jones notes.
The flip side of tighter financing, however, is a more rigorous appraisal of projects and more emphasis on due diligence and sound financial modelling by investors. "There has been a flight to quality," says Nick Gardiner of Fortis Bank, who believes wind is still a strong growth asset. Andrew Perkins of financial advisors Ernst & Young agrees. While conditions for sellers of projects will become slightly less favourable, he argues, "There is very strong investor appetite for renewables assets, and not many opportunities out there for asset-backed investments, which are good in this sort of market."
Investor appetite is wetted by the same fundamental mechanisms as before the credit crunch, with asset valuations fuelled by regulatory regimes and support mechanisms and a rapid rise in fossil fuel prices, making renewables ever more competitive. The big utilities are also still out there and have an imperative to invest in wind as they seek to meet renewables targets and mitigate their carbon emissions. They are still eager to build their strategic investments in the sector, and will remain willing to pay for it, Perkins believes, even for a single project or a stake in a portfolio.
"Utilities are increasingly making very public statements about their commitment to the sector and the positions they intend to take in renewables," adds Andrew Donovan, of corporate finance advisory firm Lexicon Partners, citing E.ON and Enel, German and Italian utilities which are both stepping up their wind power holdings. "It is all about improving the visibility of their renewables investments and strategies in their wider portfolios," he says.
The major driver of value is and will continue to be the cost of equity, Perkins asserts. "As you reduce the cost of equity, the value gained in a project is enormous, making things like re-powering and refinancing much more attractive and this has a leveraging affect on overall value," he says, with reference to both project and portfolio financing. The outlook for project developers with assets to sell is "very sunny" believes Perkins, at least onshore, though the more risky offshore market is less certain.
He also notes that, from a buyer's point of view, "the perception of risks and costs is still relatively low compared to the benefits of owning assets," which partly explains why companies such as global wind fund manager Babcock and Brown Wind Partners are beginning to monetise their asset portfolios (Windpower Monthly, April 2008).
As investors shy away from more marginal projects, the ability to value assets, and particularly development assets, will become increasingly important. Key in this is how likely it is that the project, or projects, will get built. This depends to a large extent on the management team behind it and the experience the team possesses. Mortimer Menzel of Augusta, a merchant bank, quotes evidence indicating that the value of a project with a development team is double that of selling the assets on their own (graph).
Location is also critical. More value tends to accrue to sites in Europe where EU targets put pressure on governments to provide greater support in terms of planning, grids, regulatory regimes and so forth. Investors are also attributing "very real value" to the potential for re-powering existing sites ten-to-fifteen years down the line, reckons Donovan. This will become more important in future, partly because of consenting issues but also as good sites are harder to come by.
There is also evidence of investors who want to secure higher rates of return accepting more development risk by investing at an earlier stage. Donovan says that for the moment utilities are generally better than financial investors at valuing development pipelines. For a project which is effectively consented, with land and connection and turbine contracts in place, utilities have been willing to pay 20-30% of the value of a fully operating project, he says. For projects further down the line, utilities "take a probability view of whether they will get built."
The financial sector, however, is moving up the learning curve, Donovan feels. The Canadian Pension Fund's $200 million (EUR 129 million) investment in Noble Environmental Power, an American wind project developer in Connecticut is "the first tangible evidence that pension funds are becoming comfortable with equity investment in development portfolios," he says. Noble also announced an initial public offering last month (page 41)
Project development is a "lumpy" business, with sporadic and often unpredictable cash flows, making it difficult to manage on a sustainable basis. Some developers struggling under the increasing cost of capital are being forced to sell either single projects or whole portfolios. This allows better capitalised companies to jump in. For this and many other reasons, mergers and acquisitions (M&A) are growing by leaps and bounds.
According to research by New Energy Finance, a London-based information provider, corporate M&A activity in the clean energy sector surged in the first quarter of 2008 to $7.7 billion (EUR 4.98 billion), compared to $3.5 billion (EUR 2.26 billion) the previous year. Much of this was generated by a number of large deals, such as British utility Scottish and Southern Energy's (SSE) acquisition of Irish wind developer and independent power producer Airtricity. "No doubt the impact of the credit squeeze meant that some companies became targets of corporate acquirers rather than private equity investors or the public markets," the report notes.
The trend is likely to continue, according to global advisory firm KPMG, which has just completed a survey on merger and acquisition activity in the renewables sector. A high 68% of respondents believe M&A activity will carry on growing in the next three years. The main reason for this is the long lead times for getting projects built. This leaves M&A as the "fastest way to expand rapidly," the report says. KPMG expects M&A activity to contribute almost as much revenue growth in the sector as organic investment.
Cash rich utilities
The cash-rich utilities are likely to remain dominant buyers of assets in the present market, continuing a trend that saw French wind developer La Compagnie du Vent go to global energy giant Suez; Horizon Wind Energy of the US to Portuguese utility Energias de Portugal and Airtricity to SSE, among many others. Owning generation rather than buying output not only allows the utilities to have greater control and take a long-term view, but to make more efficient use of capital.
Donovan notes a recent shift towards joint-venture co-investment where low-cost pension funds, infrastructure funds and the like sit alongside large utilities, with advantages for both sides. "The utility achieves more efficient capital allocation, while still controlling offtake operations, while the fund benefits from the chance of establishing a relationship with a big strategic player, plus access to a rich-nation pipeline other than through a competitive auction process," he explains. In fact, he sees signs of "bid fatigue." Auctions are wearing on a company's resources and can resemble a "turkey shoot." Some bidders are also concerned that the industry is now at the high point of the procurement cycle, that turbine and other costs have perhaps reached the top and, if they wait, prices will begin to fall.
Which way are prices going? For the moment, Donovan believes there is still more capital than investment opportunities in the sector. If so, that is reason to expect prices to remain reasonably buoyant. The majority of executives polled in the KPMG survey also believe that buying pressure will continue to push valuations up, while half feel there is "a real risk of a bubble" in the renewable energy sector. It looks like purchasers are still willing to pay significant premiums.
Valuations are difficult to call since the market is driven by worries over climate change and security of supply, not just questions of financial return. In a world "where supply, demand and potential growth depends as much on government policy as technological innovation or traditional market structures, ... these might explain current valuations better than irrational exuberance," comments KPMG.
Not everyone agrees. Vittorio Perona, of investment bank Dresdner Kleinwort Wasserstein, believes the value per megawatt for M&A acquisitions may decrease in 2008 as the number of buyers willing to pay a "strategic premium" falls. "This justified high prices, which may not be repeated," Perona says. If so, a correction of asset prices in 2008 can be expected.
Menzel agrees, at least for onshore projects, saying that investors may as well put their money in the bank if returns on wind farm investments fall below 7%. He expects offshore prices to continue up, however, "because of the scarcity of offer" and their appeal as utility-sized projects. Augusta's James Knight also feels that "price momentum is abating," with the "smarter money willing to wait to get the right returns."
Nevertheless, Knight argues that wind is still a sellers' market and project developers have not seen the end of the good times. While the credit crunch has led to a price correction, he believes it will not be too dramatic. There is still plenty of demand for energy and oil prices continue to rise, while stable subsidy regimes ensure continued returns for investors, despite uncertainties in Spain and, yet again, the US.
The crisis might even drive investors to the relative safe-haven of the wind sector. As Guillet explains, the financial crisis was caused by a lack of risk analysis, whereas the risks in the wind industry are well understood, as are the revenue streams. But perhaps Gardiner provides the best summing up of the long term impact of the credit crunch: "No one knows. We are living day to day. Are we over it nor not?"