Picking up speed

all the consents required to construct the project be in place before financing;

a significant wind measurement campaign on the wind farm site, typically for at least one year;

simple construction contract structures – ie, an EPC (engineer-procure-construct) wrap, ensuring all construction risk could be simply placed on one EPC contractor (typically the turbine supplier);

turbine warranties extending for a significant period, typically five years;

long-term power purchase agreements (PPAs) to remove energy price risk over the debt period; and

relatively high debt service cover ratios to cover any remaining uncertainty and risk, traditionally based on the P90 revenue stream (ie, the annual output value which there is a 90% chance of exceeding on average).

However, over the past few years there have been a number of significant changes in the wind energy markets, which have driven a number of trends in wind farm financing.

At the most general level, the increased focus on climate change and security of energy supply has seen a significant increase in public and political support for renewable energy. This has led to increased confidence in the support mechanisms put in place, whether these are via tax credits, fixed tariffs or green certificates.

Against this general background, the rate of wind farm construction has accelerated rapidly and this trend is set to continue. In 2000, approximately 4GW of wind farms were installed globally. Last year, 20GW of capacity was installed, equating to approximately $42 billion of investment. Current predictions for 2010 are sitting at around 40GW of installed capacity.

Impressive as these headline numbers are, this does not mean that the wind energy market is trouble-free. Its rapid expansion has resulted in severe constraints in the turbine supply market, with installation of new projects often delayed by waiting times of approximately two years. This shortage of turbines is also being reflected in their increasing cost. While suppliers are working to increase their manufacturing capacities, they in turn are constrained by the availability of key components such as gearboxes and bearings, so it seems likely that supply constraints will continue for some time to come.

Problems associated with obtaining planning consent continue to be a significant issue in some countries. In the UK, for example, only 62% of planning applications were approved in 2007. There is a general feeling in the UK that government policy to support the development of renewable energy projects is not reflected in the local planning system, and it is often hard to predict whether a project will successfully negotiate the planning hurdle.

Many markets also suffer from a lack of suitable grid infrastructure, which can lead to severe delays in constructing and connecting otherwise viable wind farm projects. Scotland is a good example, with a north-south highvoltage line required to reinforce the grid system. The permitting and construction of this line is significantly delayed, leaving an estimated 8GW of potential wind farms sitting in a connection queue, with connection dates out as far as 2016.

Lastly, the support mechanisms in place vary significantly from country to country and each present their own risks in terms of reliable revenue forecasting. The US support mechanism is based on a production tax credit (PTC), and this mechanism is currently renewed (or not) every two or three years, meaning that there is always a risk that the construction of a project will be delayed and may therefore not qualify for PTCs. This has resulted in a wind industry that goes hot and cold, depending on where it is in the PTC cycle.

In the UK, the support mechanism is through Renewable Obligation Certificates (ROCs). The value of this support is dependent on the amount of capacity installed against annual targets, so that the value of ROCs will decrease the closer the UK gets to meeting its targets. ROC values are currently high, but there is uncertainty about how they will hold up in the future. In addition, the ROC mechanism is guaranteed to 2027, with support mechanism uncertainty beyond this date. Although this is beyond most current debt terms, it is beginning to become an issue, particularly for offshore projects with later commissioning dates and longer debt terms.

Future uncertainty on support mechanisms such as the ROC and the PTC is also a key issue when valuing large portfolios of wind projects, much of which may still be in early stages of development. Some of these projects may not be built for some time, and therefore their value is very sensitive to future changes to support mechanisms.

All of the issues above have put a higher value on projects that are operational, and many utilities, operators and investors have been looking to expand their wind assets by acquiring wind farm portfolios. These portfolios may be entirely operational or may contain a spread of projects that are operational, in construction and in development.

Last year, we acted as technical adviser in the acquisition of 33% of the Zephyr/Beaufort portfolio developed by Npower renewables. The investment in this 391MW portfolio of fully operational UK sites was made by Infracapital, and valued the portfolio at around £440 million (then around $880 million), giving a value of approximately £1.1 million per MW. This value is very much in line with 2007 estimates of wind farm development and construction costs and so may seem low for an operational portfolio. However, the portfolio includes a number of sites constructed in the early- to mid-1990s using small turbines which would now be considered obsolete. In these cases, much of the value is in the potential for repowering the sites – a difficult judgement in today’s volatile planning regime.

More recently, we advised Scottish and Southern Energy (SSE) in its 2008 purchase of Irish developer Airtricity. This £1.1 billion deal added 372MW of operational sites to SSE’s portfolio, plus a further 9000MW pipeline in Scotland, Ireland, Portugal and China. This acquisition was of huge strategic importance to SSE, allowing it a shortcut to operational sites and also to a pipeline of wind turbines through the framework agreements already put in place by Airtricity.

Offshore wind farms, like early onshore projects, were originally the preserve of utilities able to fund off-balance sheet. Despite a more reliable wind regime offshore, the higher capital costs and unfamiliar risks associated with construction and operation of offshore assets meant that for some time offshore was not ‘bankable’.

The situation changed in October 2006 when Dexia, Rabobank and BNP Paribas closed the €189 million (then $238 million) financing of the 120MW Q7 project off the Dutch coast – the world’s first project-financed offshore project. SgurrEnergy took a technical due diligence role in this deal, and has provided similar support in the financing of the Thornton Bank, Thanet and Ormonde offshore wind farms.

Q7 was originally expected to be a relatively simple entry into offshore wind project finance, with a single EPC contract provided by turbine-maker Vestas. However, this initial contract structure failed and the project was constructed under two contracts, with Vestas and marine contractor Van Oord. The banks also agreed to share the construction risks, with contingencies for construction delay shared equally by the developer and the banks.

Subsequent offshore projects are now being financed based on similar models, with the next step likely to be the financing of offshore portfolios and development pipelines.

From a financing point of view, the changing market has led to a rapid evolution of strategies. The constraints in turbine supply and the maturation of wind farm financing has meant that there are now more organisations looking to back wind farm projects than there are projects, and the financing market has therefore become more competitive. This has given more power to the turbine suppliers and wind farm developers, and resulted in lenders accepting more risk in their financing structures. For example:

In some cases, lenders are providing finance to projects or portfolios where not all the consents are in place, but a turbine supply contract has been agreed. This may initially seem risky, but is based on the sound premise that the turbine supply agreement is a valuable asset. Should the project itself fail to reach construction, then the turbines can be sold on to recoup the debt.

Lenders have become more comfortable with financing projects that are constructed on a multi-contract basis, driven by the turbine shortage, as turbine suppliers are concentrating on producing turbines and are less inclined to take the risk associated with taking on the balance of plant work associated with wind farm projects.

Lenders are having to accept shorter warranties in turbine contracts, with two years now typical. Again, this is driven by the high demand for turbines giving the upper hand to turbine suppliers.

Developers are increasingly turning to smaller, less experienced turbine manufacturers to meet their development goals. While the expansion of the turbine market can only be a good thing in the longer term, in the short term, equity and debt providers are having to quantify the increased technical risks associated with less well-proven technologies.

Developers are increasingly pushing lenders towards financing projects without a long-term PPA. From a developer’s perspective, long term PPAs are becoming less attractive as they are losing out on the upside of increasing electricity prices. They would rather take their chances on a buoyant market with the prospect of significantly increasing their profitability. The lenders, of course, have little interest in the upside, but are being driven towards accepting this higher risk approach.

More creative financing structures are being applied, including the use of mezzanine financing to allow higher debt ratios and the profiling of debt repayment to minimise the risk of ‘merchant tails’ (revenue risk beyond the end of PPAs). Hedging – of fluctuations in the electricity price, or of the wind resource itself – is also being incorporated into some financing structures to offset risks.

Lenders are keen to look at financing portfolios of wind farm projects, to benefit from economies of scale and risk diversification, preferably in different wind regimes and with different turbine technologies. If a portfolio is situated across different countries then all the better – this spreads risk across different legislations and wind support mechanisms as well.