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Paying for Wind: Financing Wind Energy Projects in the U.S.After explosive growth from 2000 to 2003, wind power is drawing increased interest from U.S. investors. Innovative strategies to finance wind energy projects are beginning to attract large financial institutions such as banks and insurance companies. Elisa Wood reports on the world of renewables financing, U.S.-style. 11/15/2004 James Duffy’s topic could only be described as arcane. The attorney from Boston-based Nixon Peabody LLP had come to the Global Windpower 2004 Conference in Chicago on 29 March to talk about syndicating tax credits. Would he get much of an audience? Before Duffy had finished his presentation, not only were the room’s 250 seats all taken, but an extra 100 people were elbowing each other for standing room. Gone are the days in the U.S. when renewable energy conference planners scheduled project financing sessions for the unpopular, late-afternoon slots. The topic now draws strong attention because it is less a matter of what financing is needed for renewables, and more about what financing is being undertaken, according to Michael T. Eckhart, president of the American Council on Renewable Energy (ACORE). “Part of the transition to commercial business is mainstream financing,” says Eckhart, “which is now beginning to occur. It’s still dependent on positive and stable public policy, as is the case in every energy industry. But within that envelope, bankable deals are being done, more each day.” Growing interest among investors has inspired Eckhart to bring the topic to their turf—Wall Street. ACORE and its partner, Euromoney Energy Events, plan to hold New York’s first renewable energy finance forum on 23–24 June 2004 to match financiers with developers. Deep Pockets and Trusted Manufacturers The investment climate for green energy projects, moribund for so long in the U.S., appears to be improving. Why the turnaround? Explosive growth in wind development is a major factor. U.S. wind capacity has expanded at an average annual rate of twenty-eight percent over the last five years. Now, the U.S. is second only to Germany in terms of the amount of energy it produces from wind, according to the American Wind Energy Association (AWEA), while wind energy was the fastest growing sector of the electric power industry from 2000 to 2003, according to Standard and Poor’s (S&P). This volume of development has made financial institutions more familiar with clean energy technology. “The newer the technology, the more difficult it is to get the lending community behind it. They like to work with proven technologies,” says Gregg Elesh, a founder and chief investment officer of Marathon Capital, an Illinois-based company that provides financial services for the power industry. Marathon served as advisor to Ormat Nevada in its financing and US$214 million purchase of 120 MW of geothermal assets in California from subsidiaries of Covanta Energy Corp. late last year. Marathon also assisted Ormat with its $190 million bond issue in February 2004. One way of raising funds for commercially untried technologies is through venture capital, a route that proved successful for Evergreen Solar, a photovoltaic panel manufacturer. Another event catching investor attention is the emergence of deep pocket players (see Table 1), such as FPL Energy. As the largest wind developer in the U.S., with 2700 MW of wind capacity across fourteen states, FPL’s large balance sheet and access to capital markets has enhanced the industry’s financial credibility. Last year, it became the first U.S. wind company to be assigned a public bond rating by S&P’s Ratings Services. FPL Energy sold a $380 million bond offering for the FPL Energy American Wind LLC, comprising seven wind projects totalling 697 MW in six states. S&P assigned a BBB-rating to the senior secured debt associated with the project, while Moody’s Investors Service assigned a Ba2 rating. An S&P BBB-rating indicates an adequate ability to meet financial commitments. For’Moody’s, a Ba2 rating denotes mid-range elements of speculative credit risk.
Investors are also looking more kindly on the wind market now that GE Energy has entered the scene. GE became a major player in wind turbine manufacturing after it purchased Enron Wind in 2002 (see Table 2). Last year, the Atlanta-based company supplied wind turbines for projects totalling 873 MW, over half the capacity installed in the U.S. during 2003.
GE’s strong entry into the market makes investors feel more comfortable about signing on the dotted line because they know GE is a solid U.S. company that will stand behind its warranty. Investors have shied away from some wind projects in the past because they were concerned about manufacturer credibility, according to Brian Daly, Managing Director, Energy & Infrastructure, Trust Company of the West (TCW), a Los Angeles investment firm. Daly comments: “We now have a major equipment player who can bring first-tier manufacturing expertise and capabilities along with significant warranty improvements. Those of us on the finance side are all much more comfortable that there is someone who can stand behind the investment with a strong credit rating.” Policy Snakes and Ladders According to industry analysts, U.S. government policy on renewable energy investment is two-edged, providing both help and hindrance For example, Brian Daly favours the renewable energy portfolio standards (RPS) instituted in several states. RPS rules require that utilities and competitive retail suppliers provide a portion of their power from renewables. As a result, project owners are able to drive better contracts with utilities. Since the utility must secure the power to meet the RPS mandate, it is unlikely to put up barriers to the project’s success. This was a common problem for independent fossil fuel developers in the U.S. during the 1990s as they tried to negotiate power purchase contracts with utilities which saw them as competition. However, Daly believes that another prominent government programme, the federal production tax credit (PTC), may do the industry more harm than good in the long run by “distorting the focus of the industry.” Rather than negotiating solid contracts with utilities that provide the necessary return, developers rely on the PTC to make the project cost-effective. And too often, says Daly, much of the benefit of the tax credit accrues to the manufacturer which adjusts the price of equipment based on the existence of the credit: “The industry has internalized the credit in all of its economic calculations. It needs to go back and adjust its fundamentals.” Others commentators point out that while the PTC may have flaws, it does provide the extra financial boost wind power requires as a fledgling industry. “Like any new technology, it takes time to get to the point where you have the volume large enough to allow economies of scale to be reached. In the U.S., it is still a small market,” observes Michelle L. Vensel, financial consultant with Protean Advisors, who has been retained by AWEA to educate investors about wind. Gregg Elesh of Marathon Capital adds: “Developers and investors can deal with either extreme. Tax credit and no tax credit. It’s when you don’t know what is going to happen that it is a problem. The uncertainty stalls the development of projects.” For better or worse, the 1.8 cents/kWh PTC is at the heart of many U.S. wind investments. This year, for the third time in the PTC’s history, Congress has let it expire. Industry observers say Congress is likely to restore the credit—but until then, investors are wary and new wind development has slowed to a crawl after a near-record 2003. The U.S. reliance on the PTC tends to restrict the pool of equity investors to those with a tax appetite. Financial opportunities are broader outside the U.S., where investment agreements are less tax-driven, according to Steve Taber, chair of the Princeton Energy Group. Based in Sausalito, California, but with an international reach, Princeton Energy developed 15 MW of wind in Greece with Enron Wind in the 1990s. This year, the company expects to bring 67.4 MW of wind power on-line in the first phase of a 400 MW project in La Ventosa, Oaxaca, Mexico. The Mexico project is financed by a consortium of international banks and Princeton’s strategic partner, SIIF Energies, the renewable energy development arm of ElectricitÉ de France. Princeton is also developing 41 MW of wind power in Turkey, and has been selected by Carson City, Nevada, to bring renewable projects to the area to spur economic development. Innovative Investment Strategies Whatever its flaws, the PTC has given rise to innovative strategies to finance renewable energy projects. These strategies are beginning to attract large financial institutions, such as banks and insurance companies that can benefit from the 10-year tax credit. Speaking at Global Windpower 2004 in March, James Duffy explained how the PTC can be used in tax syndication. Typically, developers cannot take full advantage of the PTC because they do not have enough tax liability. Instead they end up selling their entire project to a major buyer with a tax appetite. It is difficult to determine the monetary value of the tax credit, so the developer may unwittingly sell the project below market, according to Duffy. His syndication strategy gives developers an opportunity to retain ownership and management control of the wind power facility. Rather than selling the entire project, the developer finds a partner in need of the tax credit who buys into the project. Federal tax law allows more than one owner of a wind power plant. The owners share the PTC benefits in proportion to their ownership interest in the plant’s gross sales. To make this strategy work, the developer typically forms a limited liability company or limited partnership. The tax-interested investor buys into the project by assuming ownership of a large share of the gross sales—say ninety-nine percent—and is then able to accrue ninety-nine percent of the PTC benefit. The down side for the developer is that it receives only a small portion of project cash flow. On the other hand, it is able to collect reasonable fees for managing the facility. When the PTC expires after ten years, the partnership can reverse the arrangement, with the developer assuming a greater portion of the gross sales. Alternatively, the developer may opt to buy the investor out at market value. Arrangements similar to this are used in the U.S. by developers who build low-income housing or restore historic properties. However, this kind of tax arrangement is unlikely to be cost-effective for wind power projects valued at less than $2 million, unless the projects aggregate for PTC purposes to achieve greater scale. Generally, these are smaller projects, of roughly 4 MW or less, likely to be constructed for a school or similarly sized institution. Avoiding Costly Mistakes Sometimes it is not a sophisticated strategy that attracts investors, but more attention paid to the basics. “There is a perception among developers that they are not able to get financing. Many times they try to go to the financial markets too early and unprepared,” comments Thomas White, managing director of Marathon Capital. Some developers seek debt financing before the project has met its equity requirement. Others attempt to win financing with unproven technologies or with construction and engineering contractors that are not up to the task. According to AWEA’s Michelle Vensel, developers too often fail to hire experienced advisers, particularly for small projects. As a result, their business plans may underestimate project costs. The developer then negotiates a power purchase contract with the utility based on incorrect assumptions. “Hire someone to assist you. Spend a little bit of money. It is going to be worth it,” she advises, “There are too many people out there trying to do it on their own.” Vensel also sees new developers failing to use best industry practices when collecting wind data. She observes: “The better your wind data, the higher the return you will get.” But even if developers collect thorough wind data, they must still contend with nature’s whims. The wind may not blow to the degree expected, and this introduces an unwelcome degree of unpredictability into any business plan, which puts investors off. Mitigation products exist in the gas and power industries to offset risks associated with temperature changes that influence energy consumption. XL Weather & Energy, a subsidiary of XL Capital, is a key player in this field. It is now considering whether it can extend its product line to include the wind industry, in particular with respect to risk management products that would help wind farm operators manage their financial exposure if the wind fails to follow expected patterns. Michael Corbally, executive vice president of XL Weather and Energy, says it may be possible to structure transactions to provide the financial equivalent of “budgeted” wind conditions. Payments might be made based on actual versus desired wind speeds to offset budget shortfalls. This would give wind projects a more stable cash flow and provide investors with more secure returns or more certain payment on debt service. Specific business problems aside, global issues can influence a developer’s ability to win project financing. The Enron scandal, the power market collapse and the financial woes of major U.S. utilities have caused investors to proceed with caution on energy projects. However, Marathon’s MD, Thomas White, says that his company is not turning its back on renewable energy investment: “Lenders are smart. They understand that there are two different markets in the electric industry. There is the merchant market and the contract market. These renewable projects tend to be contract. The contract market has been here since the early 1980s and continues to provide reasonable returns.” Elesh adds: “Our viewpoint at Marathon is that it starts with a good project. Good projects get support from the lending community and get done. If it’s a good project that should get financed, it generally will get financed.” Public Funding and a Multistate Approach Private financing is not the only way to support renewable energy projects. State-level, public-funded initiatives have also been successfully introduced. One such is the Clean Energy States Alliance (CESA) which developed from the pioneering work of Lewis Milford. As director of energy programmes for the Conservation Law Foundation (CLF) during the 1990s, Milford struggled to persuade utilities to adopt renewable energy programmes. CLF finally made headway when a major New England utility agreed to a multistate programme. But if CLF did any celebrating, it was short-lived. State regulators voted against the programme because it would require a small tax increase. That incident caused CLF and Milford to veer in a new direction that would have a major impact on public funding for renewable energy in the U.S. “It convinced us that changing the system to allow for more market forces, and the introduction of more capital, was the only way to bring about clean energy innovation,” said Milford, now executive director of the Clean Energy States Alliance (CESA). “We realized there was no way we would get major new investment in clean energy with a monopoly-regulated system.” As the U.S. electricity industry began to restructure in the mid-1990s, CLF saw an opening for renewable energy. Billions of dollars were on the table for recovery of utility stranded costs, investments the utilities said they would not be able to recoup in a competitive electric market without new ratepayer charges. CLF and other environmental groups agreed to back deregulation if legislators put aside a small amount of that money to cultivate commercial development of clean energy. Now, a dozen states have seventeen energy funds, totalling around $3.5 billion set aside for renewables. But Milford realized that “one state acting alone could not get the job done.” So, last year, he united the states into CESA, a nonprofit programme that fosters a multistate approach for promoting renewables development. While the federal U.S. Government generally finances research and development, CESA develops joint projects, pools funds, establishes best practice and shares information to avoid programme duplication. One of CESA’s goals is to encourage consumers to buy green energy. Five states in the group have funded research into why people responding to surveys say that they will pay more for renewable energy, but then fail to do so. In early April, CESA released the results of the research by New York advertising agency Gardner Nelson & Partners. The research aimed to gauge consumer sentiment and craft a message designed to make renewable energy desirable. The work produced some surprising results. What’s in a name? When Gardner Nelson asked 1000 Americans what terms best describe solar, wind and hydro electric power, many did not use the common industry terms “renewable” or “green.” Instead, survey participants preferred “natural” (32%) or “clean” (28%). “Alternative” and “renewable” energy received approval ratings of fifteen percent and twelve percent respectively, while the terms “green energy” and “green power” were supported by a mere four percent. Although “natural energy” was the most favoured term, Gardner Nelson recommended that states use “clean energy” in advertising, so that renewable energy is not confused with natural gas. To get an honest assessment of how people feel about energy, Gardner Nelson gathered groups of consumers and business and opinion leaders from various walks of life, economic strata and political persuasions and asked them to write an obituary for fossil fuels. The researchers told CESA that to find out how someone really feels about something, you must take it away from them. They asked the obituary writers to include cause of death, what it will be remembered for, who will take its place and who will miss it. “People were far less critical of fossil fuels than we might have imagined,” concluded the report. “It’s scary for them to imagine our world without them. While they recognize the problems of pollution, they see fossil fuel as a necessary evil because it can be relied on to power our world. If [they] went away, there would be a real sense of loss. Not a single respondent said fossil fuels died because they were bad, or because people figured out better energy solutions.” On the other hand, when the agency asked participants to draw pictures of a world powered by clean energy, they created scenes with makeshift contraptions that generally provided power on a small scale. The drawings led Gardner Nelson to conclude that Americans see clean energy as weak, unreliable and unable to supply large-scale power needs. The American public believes that renewable energy technology doesn’t really work, making it “more fantasy than reality,” according to the report. At the same time, the participants believed renewables are good for their health and the environment. But Gardner Nelson cautioned states against using environmental arguments to win clean energy converts. “The problem? It’s old news, and no longer very motivating. The environmental story is already well understood. It will take a new message to break through,” the report concludes. The good news, according to the report, was that every respondent could define clean energy and wanted it to work. Participants responded positively when they were presented with advertising images that made renewable energy seem “powerful, real and closer than you think.” “The most encouraging news—when equipped with facts they didn’t know before, people get excited,” the report states. “The facts give them the tools to become advocates.” The next step will be to use the research in multistate branding campaigns to spur green energy purchases. Genii Out of the Bottle In addition to the branding campaign, CESA has several other joint state projects underway. The group is looking at ways to inform project developers about financing, and educate the financial community about renewables. CESA is also seeking to aggregate state PV demand, explore incentives to create bankable long-term power purchase contracts and establish ways for foundations and socially responsible investors to partner with state funds as potential investors. Representatives from the states meet every six months to advance ideas. “None of these conversations were taking place six years ago,” Milford says. “If you look back over the last five or six years, the level of activity around clean energy has been explosive. This is a direct result of restructuring. Even though restructuring has not played out the way we all thought, it did let the genii out of the bottle. It unleashed various market, policy and customer forces that were being held in check.” Nth Power Pioneers Venture Capital for Energy Nancy Floyd and Maurice Gunderson spent four and a half years meeting with 197 potential investors before they were able to raise any money for their fledgling venture capital firm, Nth Power. The business partners were breaking new ground in the mid-1990s by trying to convince investors that the time had come to put money into energy innovations. Floyd, who had worked in telecommunications during the dismantling of the monopolies, believed energy was about to see the same technology explosion. When investors finally listened, they listened well. At the end of 1996, Nth Power’s investment funds jumped from $0 to $65 million. And now, the San Francisco–based company has three funds totalling $250 million. More than fifty percent of the company’s efforts go into renewables or related control technologies. Investors include equipment manufacturers and electric and gas companies that seek high growth potential. Nth Power’s message began to resonate as investors realized that competition in the energy arena would lead to innovation. It continues to resonate today for different reasons. Floyd says that now investment is driven by radical changes in power needs as society increases its use of digital technologies, and seeks more reliable and secure energy delivery. According to the Electric Power Research Institute, twelve percent of power generated is now delivered to digital devices. Large venture capital firms, including those with general funds, are starting to eye energy investments. A recent Nth Power study shows that venture capital for energy reached $428 million in the U.S. during 2003, almost on a par with the $435 million raised during 2002. This is a good sign, according to Floyd, since overall U.S. venture investment dropped last year. Nevertheless, energy still remains a relatively minor player in the venture capital world, attracting 2.3 percent of the total $18.2 billion in venture investments made in the U.S. last year. Floyd says this level of investment is inadequate, considering that energy is one of the four largest industries in the world. Looking for the Next Evergreen One of Nth Power’s stars is Evergreen Solar, a developer, manufacturer and marketer of photovoltaic panels based in Marlboro, Massachusetts. The company, which went public in 2000, reported product revenues of $7.7 million last year, up from $5.3 million in 2002. Evergreen received $28.3 in private placement equity financing in 2003, quadrupling its manufacturing capability. Evergreen manufactures solar panels with proprietary crystalline silicon technology known as “string ribbon.” Invented by Emanuel Sachs, a professor at the Massachusetts Institute of Technology, string ribbon technology involves pulling high-temperature strings vertically through a shallow silicon melt and then allowing the silicon to freeze between the strings to form a ribbon of silicon. Evergreen says that string ribbon technology can yield more than twice as many solar cells per pound of silicon as conventional methods. The composition of the string is kept confidential by Evergreen. Nth Power filters more than five hundred proposals a year, looking for the next Evergreen. Only five to ten companies are selected. Usually, they are technologies that have advanced beyond the need for R&D and seed funding. Initially, Nth Power invests between $1 million and $5 million, with more money allotted over time. Why do so few applicants meet Nth Power’s standard? Many are rejected because their business plans focus on the effectiveness of the technology, rather than demonstrating a market for it. “They offer solutions looking for a problem to solve. A fundable plan identifies the problem first, then develops the solution,” says Floyd, “We want to see plans that are expressed in market terms rather than technology terms.” Another classic mistake is the claim that the business has no competition. “Everybody has competition,” observes Floyd. At the very least, the new business must change the customer’s usual consumption pattern, in itself a form of competition. A third problem, says Floyd, is that the business plan attempts to “raise money and then make the investor go away.” She explains: “We have no way to return profits to our investor unless the company goes public or is acquired. Some entrepreneurs want to keep the company private. It might be a nice business, but it doesn’t fit the venture capital model.” The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct. The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct. |
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