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United States

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A new reality is spreading through the United States' wind market in the wake of the financial crisis. Inflated project valuations and ever riskier investments have come to an abrupt halt, to be replaced by a healthier approach. Barack Obama's stimulus package is providing stopgap stability, but needed next is legislation to wean the industry off its reliance on tax credits and propel it into the adult ranks of the power generation business

Tough economic times are prompting a return to fundamentals in the financing and acquisition of wind energy projects in the United States after several heady years of blockbuster buyouts, easy credit and greater risk taking. "There is a flight to quality," sums up David Boyce of Wind Capital Group, a wind project developer in the US Midwest. "Banks only have so much capital to put out the door and as they stack up every deal they are looking at, they might as well put it out the door for relatively lower risk projects. That is going to benefit some developers out there and probably going to hurt some. It is really going to shape how people assemble projects going forward."

For banks providing loans in the US wind sector, lower risk means soundly structured projects. First, they must have long-term power purchase agreements (PPAs) with credit-worthy companies. Equally essential, projects must have experienced developers using turbines with proven operating records. Some of the innovations of recent years, such as loans to cover down payments on turbines or to back projects without PPAs using financial hedges to protect against price volatility in competitive power markets, have been shelved. "I think a lot of the creativity has been taken out," says Peter Duprey of Acciona Energy North America. He and Boyce were among a full house of delegates at Infocast's recent Wind Power Finance and Investment conference in San Diego, California.

There are still about 20 banks active in the sector, but in addition to the more stringent requirements they have for lending money, there are more restrictions on what they are able to offer to projects that do qualify for a loan. Banks are reluctant to hold debt on projects for long periods, leaving developers with shorter terms and more refinancing risk. "In a capital constrained world, one of our goals is to turn our capital over as quickly as we can," explains James King of Bayern LB, one of a group of German banks specialised in wind project financing after cutting their teeth in the sector on the well matured home market.

Cautious and smaller

Competition for that limited capital within the banks themselves has also become tighter. For the European banks that have traditionally dominated the wind project loans business in the US, that means shifting focus back to their home markets. "I think European banks are increasingly under pressure to stay closer to home or to find some kind of European content in deals," says Chip Carstensen from Nord LB, another German bank.

It also means focusing more on smaller transactions. Portfolio deals, where several projects are bundled into one financial package to spread the risk and lower transaction costs, are now too big for banks to handle. The days of one or two lead arrangers underwriting deals are also gone, says Gisela Kroess of Germany's Hypervereinsbank, more commonly known in the US as HVB. The trend now is towards getting groups of banks together to each take a smaller bite, she says, with the appetite of most lying somewhere in the $25-75 million range. Stuart Murray of Citigroup, a financial services company based in New York, agrees that smaller is the new reality. "Deals that are more than $200-250 million really start to test the capacity of the bank market," he notes.

It is an environment that is going to favour players with deep pockets, a situation expected to drive further consolidation in the industry. Companies and projects in the market today are finding it a challenge to achieve the right price structure to attract financing. Gone are the days when European utilities, buoyed by easy credit and a strong euro, were prepared to swoop in and pay a hefty premium for development companies and their pipelines of projects just to gain a foothold in US market. But expectations of what projects are worth have been slower to adjust. "There is still a significant spread between what a buyer wants and a seller wants. We see that spread converging over time, hopefully, as we get into more activity. This is going to be a year where you see real change in the market," says Alex Alvarado of Credit Suisse.

Gregg Elesh of Marathon Capital is running an auction for a group of wind assets, most of which have power purchase contracts. The sale is being widely attended, he said, which suggests "there is still significant capital" in the hands of companies either looking to enter the wind sector, or to expand their holdings.

About 75% of the companies participating in the bidding are based in the US, a change from the past few years when the majority were more likely to be European. Utilities are among the investors starting to show more interest, he says. "There is a common sense part of it that says if there is some price depression in the marketplace and the exuberance of the last couple of years is off, it makes things more attractive," Elesh says. "I think they continue to be concerned about potential legislation and issues with carbon and they are having to take a harder look."

Private equity firms, which are mostly interested in project development rather than ownership, and infrastructure funds, which are looking to add operating assets or projects that are under construction to their portfolios, are also testing the waters. "There have been a lot of private equity shops and infrastructure funds very interested in renewables, specifically wind, for a long period of time and yet have felt the valuations and return expectations did not meet the hurdles that they needed," says Perry Offutt of Morgan Stanley. "While we haven't seen a transaction in print yet, we're starting to see a situation where it seems like there are starting to be some good opportunities for them."

Focus on Quality

But like in the bank market, the focus on quality is key. Tristan Grimbert of Enxco, a California-based developer and an affiliate of France's EDF Energies Nouvelles, told delegates that most of the development projects he has looked at are not worth considering. "We were in a speculative industry where there was a lot of hype and a lot of bad money being thrown at bad projects," he says. "There is a little bit of coming down to reality."

Joseph Slamm of Hudson Clean Energy Partners, a private equity firm investing in renewable energy, expects part of that new reality will be less focus on project pipelines when valuing companies. "The next generation of companies who are going to buy couldn't care less about brag-a-watts," he says. "You are not going to be evaluated on the size of your pipeline. You are going to be evaluated on the size of your earnings and the ability of those earnings to keep on growing. So it is a lot of getting back to basics. We are getting back to committing on turbines and committing on financing when you really have a project -- and that's a good thing."

A return to fundamentals when it comes to project performance is also needed to help attract new investors, agrees John Eber of JP Morgan Capital. JP Morgan has 52 wind energy projects in its portfolio, 45 of which have been operating for more than a year. But their overall production output is 10-11% below expectations, he says. "It is a challenge, I think, for the industry to get these numbers better," he told delegates in San Diego. "It is hurting the business. It is keeping people out of the industry who might otherwise get in because they are not comfortable with the numbers."

Getting more investors into the industry, especially those with tax burdens large enough to make use of the federal tax credit for wind power production in the US, was a clear priority for participants in the conference debates. For wind farm investors, the production tax credit (PTC) is worth $0.021 in tax rebates for every kilowatt hour generated, making it the major driver of the US wind development market. Most project developers do not have a big enough tax liability to use the PTC, so must sell their wind farms on completion to equity investors seeking to reduce their tax bills.

But the bottom fell out of this so-called tax-equity market in the fall as the global financial crisis took hold, leaving only a handful of equity players still standing. The amount of tax equity committed last year was about $2.5 billion, half that invested the year before. "This is probably the biggest issue facing the industry right now, that is to get this market going or come up with a substitute," according to Jeffrey Chester of law firm Kaye Scholer LLP.

The recently passed US economic stimulus package was an attempt to give the market a shove in the right direction (Windpower Monthly, March 2009). It extended the PTC to the end of 2012 to give potential new players some long-term visibility and comfort. It also offers developers the option of taking an investment tax credit (ITC), which allows them to deduct 30% of the capital cost of the wind farm in the year the project came into service, instead of the PTC, which is paid out on the actual energy produced over the first ten years of a project's life. Developers can take a cash grant equivalent to the ITC for projects that start construction this year or next, but the new form of tax credit also allows a new way for tax-motivated investors to get involved in the industry. Essentially, the ITC rules allow developers to sell projects to companies that will take the tax benefits -- and then lease the facilities back to the developer. At the end of the term, the developer can have the option of buying the project back.

"To the extent we are able to crack the very difficult nut of figuring out how to do leases for wind, there is potentially a small but meaningful group of investors who could be interested," says Jack Cargas of Bank of America Leasing.

For Eber, the stimulus package provides clarity for companies interested in entering the sector. "There are new players looking at getting into the market. Most of them have been sitting on the sidelines waiting to see what Congress is going to do before spending a lot of time and energy learning the business."

End of the PTC era

At the same time, though, there seems to be a growing consensus that continuing to rely on the tax code to drive investment in wind is not going to be enough to keep the industry growing at the rate it has been and at the rate it needs to in the future. "It is no secret that this industry at this scale is ever going to be able to survive on tax equity alone. It served its purpose. It did really well. And we have got to get off it. We have to move on," admonishes Slamm.

Meeting the industry's growth potential is going to require huge infusions of capital. "Governments can't do that. Private capital formation needs to do that," says Slamm. "We need to create a sustainable system that can attract all capital from all walks of life." That capital also needs to be "a hell of a lot cheaper" than the money that now comes in the form of tax equity, he adds. "There is basically a ten per cent spread in project finance costs between this country and the rest of the world. That is not sustainable. That has got to change."

Slamm started Hudson Capital after a stint at Goldman Sachs, which got into the wind business in 2005 with the purchase of Houston's Horizon Wind Energy. "When we invested in Horizon, we realised that wind energy in the US was a tax product and that's how we viewed it," he says. "Now it is an energy business and it needs to have a platform of rules that allow it to grow like an energy business."

Eric Markell, chief financial officer at Puget Sound Energy, a regulated utility operating in the Pacific Northwest, agrees. "It seems to me that this industry, which has grown so quickly, really is facing some very important structural changes. It would be my observation that the financial system that has been built in this industry so far will not carry it very much further," he says. "The grant and tax stuff that is part of the stimulus package is probably a band-aid on a corpse in a lot of ways."

What is needed, says Slamm, is national legislation requiring utilities to supply a minimum percentage of electricity from renewable sources, with a market-based system allowing utilities with plenty of renewables generation at their disposal to virtually sell the green attributes to utilities unable to meet the law. That market, facilitated by what in the wind industry jargon is known as a renewables portfolio standard (RPS), should operate across all jurisdictions in the US, argues Slamm.

A permanent market

The industry has been pushing for such national legislation for years, but has never been closer politically to seeing it happen. President Barack Obama favours a target of 25% renewables by 2025 and proposals are also starting to surface in both the House of Representatives and the Senate with variations on that theme. "I think under this administration and this Congress we are going to get there. So I'm very bullish about it," Slamm says.

It is a sentiment shared by a lot of players in the wind sector, including companies active in supplying tax equity. Tax credits such as the PTC are meant to be a temporary support measure to help new industries gain a footing, says JP Morgan's Eber. "Our firm has been financing deals for tax subsidies for 35 years. We just sort of move from one to the other as the government decides to implement them and take them out," he explains.

"The RPS is likely to come soon and when it does its purpose will be to wean the industry off tax equity and get it on an equal footing with most of the other traditional power industries." How soon is tough to predict in today's volatile economy, participants at the Infocast conference noted. "I don't know about the next year. I think it is tough to do this kind of policy change in the middle of a recession, but I'd be cautiously optimistic in the next two years, especially if the economy starts picking up. It just needs to happen," says Eric Blank from the US division of Iberdrola, a Spanish utility that owns more wind power capacity globally than any other company.

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