driving DOWN the cost of capital
The first wind industry step into the bond market for project financing, taken by American project developer FPL Energy last summer, was a "landmark deal" that will help broaden the investor base and lower financing costs. But companies looking to duplicate FPL's successful bond issue -- a $380 million private offering of 20-year senior secured bonds -- will face challenges getting to an investment grade rating, Mike Davies, managing director of Freestream Capital Partners, told delegates at the Global Windpower 2004 conference in Chicago in March.
FPL's bond issue (Windpower Monthly, November 2003) was rated investment grade by credit rating agencies Moody's and Standard & Poor's (S&P). The bonds financed seven largely completed projects spread across the US. "The involvement of the rating agencies in that transaction I think was key," said Davies.
"They have taken their first somewhat tentative steps. As they get experience with the performance of the portfolio, they'll get more comfortable. In time, I think we'll see the rating agencies and their independent assessment of the risks being an absolutely key driver of the financing sources for the industry."
There are some significant risk factors that come into play when rating agencies look at wind power deals, said Terry Pratt, S&P's director of energy and project finance. "Everyone who calls wants to know what an investment grade project looks like. Well, we've only seen one of them, but I can give you a sense of the challenges to the sector in getting to investment grade ratings."
Technology, arrangements for offtaking the power, the credit worthiness of the counterparty and wind supply risk are all part of S&P's project analysis. FPL's portfolio, which included projects in six states with 12 different offtakers and utilising five different turbine types, scored well on all counts. The agency's analysis also set some "pretty harsh" financial thresholds the company was able to meet. FPL took all construction risk off the table and put it on the corporate balance sheet, eliminating agency concerns over an issue that could be "a big problem" for wind in getting to investment grade, said Pratt.
"We don't know a lot of the supplier contractor credit qualities: we don't know if they can fund their operations; we don't know if they can pay liquidated damages and we don't know if they are going to be around to meet their warranty obligations in the future. This is one thing we will have to get more clarity on going forward," he told delegates.
Operations and maintenance (O&M) risk is an area rating agencies focus heavily on, and one where FPL, as the world's largest operator of wind power projects, stood out. "If you have a single asset that is going to pay some debt service, it better operate as planned and meet its contractual obligations. I can't think of any investment grade project that we've ever had that doesn't have a very, very strong O&M program." FPL's deal also set aside a $15 million O&M reserve to manage type-failures of turbines and a $1 million major maintenance reserve.
Whether other companies in the wind industry can achieve investment grade ratings remains to be seen, but Emeke Ngwube of Credit Suisse First Boston is convinced they are out there and they will find success. "I am optimistic because there was a lot of demand for the FPL bonds and investors really liked the structure of the deal," he said.
The key will be to put together a portfolio of assets diverse enough to balance the risks. "Looking at the matrix of diversification in FPL's portfolio, that is something that got people comfortable with putting 20-year money into a sector they had no familiarity with 12 months ago."
With markets opening up for the big players, the challenges accessing financing for smaller transactions is an area "the wind industry needs to get more involved in," said GE Wind Energy's Pete Duprey. There is a "huge opportunity" to move to more standardised contracts, which will help lower transaction costs by removing expensive "due diligence" requirements -- the need for independent financial and technical assessment of every detail of every project.
Standardised contracts could also open up an opportunity to aggregate small projects into portfolios, allowing them to tap into sources of debt financing that would otherwise be unavailable. "We need to get developers to think in more standardised methods so their deals can get funnelled into a capital markets conduit and they can all benefit from the lower cost of capital that an FPL can tap into," he said.
A more global flow of capital would also help lower financing costs, said Duprey. Tax-oriented support programs like the US production tax credit (PTC) require equity players who can actually used the credit, discouraging investment by companies operating outside the US. "If we want to lower the cost of capital around the globe, we need to start moving away from these tax-oriented schemes and more to cash-flow oriented schemes so that more players can come in and participate. It would simplify things. It would allow a more global flow of capital around the world," he said. "Investors can also get more diversity in their portfolio and that, too, will lower the risk and lower the cost of capital."
While the industry needs to attract institutional investors, said Duprey, it also needs to understand their risk tolerance will be a lot lower than those whose business is energy. Long term service agreements can help shift some of the technology risk onto manufacturers, who are better equipped to manage it. Insurance products and derivatives are also evolving to help transfer risks, like wind supply and ensure a more stable cash flow, said Michael Corbally of XL Weather and Energy.
The key, said Davies, is understanding what the risks are and who is best placed to take them. "It is a matter of best identifying and best apportioning, and best pricing that risk to drive down the cost of capital."
One risk area where financiers are adopting a wait-and-see attitude is in offshore wind development. "I'm not aware of any offshore project that hasn't been financed off an investor's balance sheet," said Duprey. "I think everyone is waiting to see how the projects that are in the water now are going to perform in terms of service issues. I think the industry is certainly learning with respect to the whole movement offshore and the financing markets are watching it very closely. I think eventually the financing markets will be comfortable with the risk."