New discipline in the grown up world

Until recently the term "project financing" had only been tossed around in the wind business in the more competitive markets of the United States and Britain where cheap money is not available. But as mainland Europe frees its markets from government care, companies specialising in project finance are beginning to sense money in the wind. What is their view of the business and are they needed in such thriving wind markets as Denmark and Germany?

There is a feeling abroad that the world of wind power is about to make the transition from the agricultural era to the Information Age in one very short step. Agricultural age wind power took the "wind farm" concept very seriously. In many ways, turbines in Europe were simply another form of agricultural machinery. Many of them were built on farms in Denmark and Germany, owned by farmers, and financed like tractors. Small scale projects enabled this paradigm to persist over the years. Supporting these "onesy and twosy" projects were generous utility purchase programs-not unlike agricultural support programs-providing as much as ten cents a kilowatt hour to producers. This fertiliser resulted in the luxuriant growth we see today-and was even spread by newcomers to the business such as Spain. In 1999, of a total world capacity of some 13,400 megawatts, fully 70%, is found in Europe.

In America, the formative years of the wind business were quite different. Wind power was a battlefront in Jimmy Carter's "moral equivalent of war" crusade for energy self-sufficiency of the late seventies. Weapons deployed were the Public Utilities Regulatory Policy Act (PURPA) and a variety of state initiatives, particularly in California. Shock troops were tax lawyers. The most prominent of the generals were the brass at Kenetech, both in public relations (remember the KVS-33 perched high over the Capitol?) and deal complexity. Unfortunately, when the KVS turbine didn't work, neither did the Kenetech deals. The resulting chaos burned the ability of the wind power industry to attract financing for a generation.

The American wind business moved forward not as farmers, but as independent power (IP) entrepreneurs. The IP business has been a seedbed for project finance since its inception in the early eighties. The basic economic tenet of this industry is the development of an asset base with an enterprise value in the hundreds of millions without putting down any of one's own money. IP entrepreneurs are the kings of non-recourse leverage (meaning they avoid a lot of risk), borrowing huge sums of money against long-term off-take agreements with creditworthy entities such as utilities. This fundamental economic lynchpin has given rise to the myriad IP structures including limited partnerships, ring-fencing, senior notes, junior debt, and so on.

Non-recourse lenders, as the term implies, have no recourse to the project sponsor. They must solely rely on the cash flows of the project to repay the loan. This is the essence of project financing. These lenders, which include banks and insurance companies, receive super-normal yields relative to corporate borrowing. But in order to manage project risks they must develop expertise in a variety of disciplines so they can assess the individual project risks accurately (the due diligence process), and structure the deal so as to reduce their risks to a minimum.

Better returns

Project finance allows project sponsors to undertake more and/or larger projects than they might otherwise contemplate-both because they might not take on so much risk or the financial market might not let them. In addition, by increasing the ratio of debt to equity-the leverage-project financing can substantially increase the internal rate of return. This is the return to the investor expressed as an annual average over the life of a given project. Put another way, the more that can be borrowed the less that is needed from investors and the better the yearly payments to those investors who have stumped up the money needed to get the project underway.

The gamble with greater leverage is that if the overall profitability of the project as a whole increases, the returns to the investors increase even more. And while banks might be satisfied with an 8% return, investors are looking for 15% or more from the start. This whole philosophy of increasing the debt to equity ratio is one of the secrets of high growth companies such as Enron Corp to generate high returns in a utility sector.

Originally, the key to the IP sector was the power purchase agreement (PPA) which spells out the terms and conditions for power purchase between the utility and the independent generator. Early agreements, often known in the United States as Standard Offer Contracts, set out the utilities' so-called avoided cost of power-the costs they avoid by buying wind instead of power from another source-which was fixed for a period of time, often a decade, with guaranteed escalation as well as defining interconnection, basic operating protocols and so on.

In effect, the IP entrepreneur needed only to produce power to be paid what, even then, were astonishingly high prices for power from renewable or cogeneration plants, the so-called Qualifying Facilities. As time passed regulators moved to correct the one-sided nature of the contracts allowing utilities to negotiate lower prices and increase the assumption of market risks by the entrepreneur.

fundamental change

By the late nineties the move to deregulation was in full swing, particularly in the English-speaking world and the Nordic countries. Other European countries have followed suit and the European Commission has become an enthusiastic advocate of deregulated power markets.

Deregulation has fundamentally changed the project finance environment. In the US it initially provided the wind energy industry with a new spate of long-term, highly financable PPAs, such as the large contracts in the Midwest and Texas. These were often the result of "stranded debt" deals whereby in exchange for relief from the mountains of nuclear debt piled up during the 1970s and 1980s, utilities would agreed to buy additional renewable resources. But this cannot be regarded as anything more than a temporary reprieve. As the market continues to evolve the long-term PPA is more and more becoming a thing of the past. Renewables projects will increasingly involve some element of merchant risk, forcing developers and financiers to rely on market forecasts of future prices, rather than fixed off-take agreements such as in Germany. One sign of the times is the length of the queue for the services of reputable market forecasters such as Henwood Associates, which now stretches around the block.

The indications are that wind power, like other forms of power-is moving into that most entrepreneurial place-the free market. Long-term, above market contracts will be increasingly difficult to come by, forcing wind energy developers to compete in the same markets as other forms of energy. Luckily for the wind industry, the economics of power production are changing radically.

Wind power from large state-of-the-art turbines is now the cheapest form of energy in major markets including California and Texas. While barriers remain, such as 24-hour ahead pricing, which prevent full access for intermittent resources, the cost of wind-$0.025-0.035/kWh (net after incentives such as the Production Tax Credit)-is below gas generation. For project financiers, a key factor influencing our ability to deal with market risk is the all-in cost of a project relative to its peers in the market. For wind developers entering the world of shorter PPAs, this is good news now that wind is so cheap.

risk and the RPS

Another feature of the move to competition is the adoption by a number of US states and by the Clinton Administration (although not yet by Congress) of the idea of simply parcelling out a share of the market to renewables by mandating the sellers of power-now uncoupled from the generation sector-to have a small percentage of overall sales from green resources. This is the so-called Renewables Portfolio Standard (RPS).

Requiring a certain volume of renewables in any supply portfolio is likely to enhance financability of projects because of the protection the requirement provides from the adverse implications of an economic downturn. An RPS applicable to new renewable energy investment would act as a form of protection, giving confidence to funders that their investment would not be subject to unfair competition from legacy plants. With greater confidence the amount of capital increases and its cost to the renewable sector is reduced.

It is increasingly clear that the world is adopting the competitive market model despite the adjustment pains suffered by consumers during the implementation phase. As a friend who was an advisor said when his political boss wondered aloud whether it wouldn't actually be better to go back to the old system, "Minister, we've burned the fleet." In Europe, particularly in Germany, significant "soft" money funding sources give wind developers access to taxpayer subsidised or guaranteed low cost funding. This will help soften the blow, although in the long term-as the industry matures and grows-these funds will likely form a smaller part of the capital pool available for the industry.

The entrepreneur and the farmer

Unlike the wind farmers, the IP entrepreneurs live in a highly transactional culture. Contracts, not relationships, are ultimately what matters. A wind farmer might plant his turbines, trusting to the government sponsored power purchase rates. The IP entrepreneur would try to put together a masterwork of interlocking contractual terms-power purchase obligations, turnkey construction contracts, long term warranties, environmental indemnities-which would allocate risk to those equipped to take it and profits to those able to reap them. This makes project finance, after divorce, one of the most lawyer-intensive activities. Add lawyers to the other consultants, such as the independent engineer who certifies the estimates of the wind resource, and one has a team of several professionals necessary to bring the project to financial close-the point at which all documentation is complete and deal is funded.

The IP entrepreneur, probably to a much greater extent than the wind farmer, worries about transaction costs of all those lawyers, financial advisors, accountants and independent engineers. These costs, particularly if both the borrower and the financier are not dedicated to managing them, can add millions to the total cost of even relatively small projects. Most of the consultants operate on a "time-billing" basis, which means that the costs of due diligence and documentation are relatively constant for a big project as for a smaller one. When this is expressed as a percentage of project costs, it can be dire news for smaller projects. In our own case we have tried to deal with this problem by establishing the Small Power Funding Corporation, which has a mandate to minimise transaction costs, but for the consultants an hour is an hour whether it is spent at the behest of Acme Windies Inc or Megalopolis Corporation and, more importantly, a dollar is a dollar.

Positive discipline

A positive aspect of project finance-aside from raising the money-is the discipline it imposes on project development. Independent, third parties review the project in minute detail and financiers will force the resolution of issues which might be left to fester. Sometimes the deal will be restructured to enable financing. The process is often a pain in the neck, particularly for financiers, who had they been brought it at an earlier stage could have given advice that would have obviated the problem in the first place.

A competitive environment forces all of us to sharpen our pencils. The entry of new participants in the project finance market provides a stimulus to provide creative financial solutions to developers' problems. Compared with only a year ago, project finance structures in today's market already provide a greater level of risk sharing between developers and their lenders. Lenders increasingly have an ability to take market pricing risks and are willing to lend outside the framework of a PPA. Institutional lenders are providing much longer tenor (the time period over which a loan is amortised) on a fixed rate basis. Insurance company lenders have provided these fixed rate loans over 21 years, which is fully six years longer than traditional from the bank market. This has the impact of improving loan quality (that is to say, the debt service coverage ratios) from the lender's point of view, while significantly benefiting the project developer's internal rate of return compared to bank-sourced financing.

In search of billions

The new world of project finance must also address a fundamental challenge facing the wind industry, namely the lack of sufficient capital to meet the growing needs of the sector. Existing sources of debt capital are clearly inadequate to fund the 22% growth per annum (and more) the industry has achieved. Many projections show an increase of world industry capacity by 2004 or 2005 to some 33,000 MW, representing an investment of $25 billion. Where is all of this money going to come from? It will require a substantial broadening of the number of banks and institutions which participate in the industry. Yet at industry conferences in North America and Europe, such as the American Wind Energy Association's annual event, the presence of the financial sector is limited to few players.

In the US, banks and financial institutions have yet to expunge memories of Kenetech and this continues to hurt. Despite their reluctance to go back to a place with such bad memories-and memories are long in the private capital market-major US institutional investors are being attracted by the wind business. Much more interest will need to be found in the coming years, however, to ensure availability of capital to meet the sector's needs.

The transformation of society from the agricultural age during the industrial revolution did not only spawn change and innovation. It also gave rise the Luddites. While it is possible to be sympathetic to these people who wanted just to be left alone in a simpler time, the movement failed and their leader Ned Ludd found immortality as a synonym for mindless resistance to change. Similarly, we must recognise that the wind energy sector must move out of the agricultural era into the information age-a move that requires new expertise and new tools. In this world, project finance is a necessary tool, one that in the coming years will dominate the financing of projects both in North America and Europe.

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