Don Quixote meets Wall Street
Let me tell you more about what has kept me so busy at work in the past couple of months.
I am not sure how familiar most of you are with investment banking and structured finance, so I'll try to make it as clear as possible; I apologise for those of you for whom all this is well known.
What I have worked on has been the financing of the acquisition of 6 wind farms in Spain, for a total amount of EUR 195 M. (That's the financed portion, the total value of the transaction was approx. EUR 235 M, the rest, about EUR 40 M, being brought by my client). For that kind of money, you buy, in that case, 158 MW of capacity, generating about 350 GWh per year.
For comparison purposes, a typical gas-fired power plant which has the same initial investment cost (EUR 200 M) has a generating capacity of 400 MW and produces about 3500 GWh annually. You need to buy the gas afterwards (which costs 1-2 Eurocents/kWh), so the economics are not so different on a per kWh basis (power typically costs 3-4 cents/kWh for gas plants and 4-6 cents/kWh for wind power plants)
An individual family typically consumes 10 MWh (i.e. 0.01 GWh annually) so my wind farms can service around 35,000 households.
What I do is project finance. Project finance, also known as limited-recourse or non-recourse finance, consists in financing very specific assets or projects, with the repayment coming ONLY from the cash-flow generated by that project or asset, without any claims (with some very specific exceptions) on the companies (our clients) that develop these projects.
Investors like project finance because it provides off-balance sheet financing (they do not borrow the money themselves and thus do not carry the debt, it is the project company that does) and it improves their return on equity (they need less capital to develop the project). The downside is that it is costly to set up and they have to deal with very assertive banks that in a very real sense own the asset until the debt is paid off.
Banks finance a good chunk the project (between 30 and 90%) and generally have first priority rights to revenues generated by the project once it is built (the exact order between debt repayment, operating costs and taxes is usually a topic for lively negotiations...). Banks want to be sure that the project is properly build and then operated, so the investors have to make specific commitments in that respect, and all their plans, designs, and actual work are supervised by independent experts on behalf of the banks. There is a huge amount of contractual and legal work, as the responsibilities and rights of each party must be defined in all possible circumstances (cost overruns, delays, accidents, insufficient performance, etc...). Banks also take a lot of care to make sure that the projects are environmentally and socially sound, but this is not really an issue for wind farms.
The biggest risks banks take in the wind sector are performance risk and regulatory risk, as well as the risk of availability of wind.
Performance risk is the risk that the turbines do not function properly or are not repared quickly enough when something happens, or the electrical lines are not available, or any other technical problem occurs that prevents the electricity from being produced or sold. To prevent such problems, we make sure that contracts are in place for the long term operation and maintenance of all necessary pieces of equipment, and that the people or companies that are responsible for these tasks are able to do them and have an incentive to perform properly (i.e. they are paid enough to do their work, they are penalised if they don't and their reputation is at stake if something goes wrong). This means that (i) we set the terms of what we want to see in the contracts (with the help of technical experts), (ii) we check that our client has signed contracts that fulfill our requirements and (iii) we have the right to step in and take over the project if this is not done. Additionnally, we get the independent experts to go through the project sites and technical data to confirm check that all works properly, that all likely needs and scenarios are covered for, etc... and these experts are responsible towards us for that advice (i.e. if they tell us something patently false about out turbines, we can sue them). We also make sure that the project is properly insured - and again, we define what must be insured and check that it is done and is in place.
In this case, our client was buying the wind farms from the constructor, and he had an incentive to check that everything had been built properly, and that everything would be operated well, so there actually was little conflict of interest between him and us on all the above. The difference is that the investor is closer to the assets than we are and can sometimes be satisfied with less stringent criteria than we do, and the fight is to get formalised things that would likely be done, but in a more haphazard way; sometimes, the fight is with the constructor (who wants to limit its obligations and liabilities), and our client is stuck in the middle between our requirements and what the constructor is willing to give him.
All problems are solved on a case by case basis; clients worry about different things, have different kinds of expertise, access to capital, etc, and the solutions found for two similar financings can be surprisingly different.
Regulatory risk reflects the fact that wind power still relies on some component of subsidy in its revenues, and such subsidies are set by political decisions which can theoretically be reverted. If the subsidy is eliminated in the future, the project could have insufficient revenue to pay off its debt. This is a significant risk as wind power projects are typically financed over 10-15 years, which leaves a lot of time for politicians to interfere...
This is a risk that banks take in full, which means that we have to be convinced either that (i) the subsidy will stay in place for that long or (ii) that the project can withstand its elimination at some point in the future.
We actually are pretty happy about item (i) these days, as the framework for wind power support benefits from very strong support in the countries we operate in, essentially Western Europe, the USA and Australia. The EU has the best support framework thanks to a specific directive on renewable power which has been put into law in most European countries, and there are no reasons to believe that this support will disappear, quite the contrary. Various mechanisms can be used to support wind power:
- a simple fixed tariff (usually set somewhere between retail and wholesale prices for electricity and paid for by the local electricity company to the wind farm) for a number of years;
- "green certificates" provided to renewable energy producers and which can be traded - and which have value because producers of "dirty" electricity are forced by law to purchase growing amounts of such certificates each year to compensate for the polluting nature of their production;
- investment subsidies (a one off amount paid at the onset of the project, or over a number of years) to compensate for higher initial investment costs.
In some cases (mostly with green certificates), this creates an additional uncertainty as these certificates are priced by an untested market and it is hard to predict how such a market will behave over the long run. In some cases, we ask our client to take all or a portion of that risk or to transfer it to someone else by signing long term power sales agreements (whereby they get to sell all of their production to the buyer at a guaranteed minimum price - such guarantee also has a price which means that they get less than the market price).
In the USA, the federal support framework is called "PTC" or production tax credit", which provides for a right to reduce taxes by 1.8c/kWh of electricity produced over 10 years (it enters in the third category above). This generates sufficient revenues in addition to the sale of electricity to make wind projects in the US profitable and financeable. The only problem is that the PTC were extinct in 2001, they only got renewed for 2 years and their renewal got stuck last year in the haggling over the infamous energy bill, which froze most projects for many months earlier this year. It has now been renewed but again, for 2 years only, which will lead to a glut of project before the new deadline at the end of 2005. These boom and bust cycles are not helpful to develop the industry, and many states are stepping in to provide more stable local incentives. Oddly enough, Texas has been the leader in recent years for wind power development...
We always have some margin of safety when we decide how much the project should pay us back each year (and thus how much it can borrow) to cover for the statistical wind risk (the fact that wind is highly predictable in the long run but highly volatile and uncertain in the short term, thus leading to strong comfort that the long term average will be close to predictions, but with an also strong likelihood that some seasons or even some years could see significantly lower production levels). Typically, we want revenues after all operating costs and taxes to be about 50% higher than what we actually need to repay the debt. This means that on any given period, revenues can be a third lower for any reason (whether lower wind, poor operating performance, or lower electricity prices) and we will still have enough money to repay debt.
The important thing in project finance is that if there is a problem, the banks have the right to be involved in their resolution and, if need be, to impose their terms or even to take over the project. In the worst cases, the investors are kicked out and the banks will then try to sell the project or to hire someone else to run it for them. Of course, banks are not utilities and do not have the competence in-house to run such projects, so they are not too keen to do so, but the threat to take the project form the investors (who then lose all of their investment) is a quite potent one to get them to behave in ways that maximise the chances to generate enough revenue for all. Of course, investors only ever get money out of the project if all goes well and banks are happy (on the other hand, if the project goes really well, all the extra revenue go to them and banks get paid the same as before - banks have a fixed, lowish, remuneration and thus want to take less risk; investors want a better remuneration and are ready to take on more risk).
The hardest part of any negotiation is the definitions of the triggers (called "events of default") which allow banks, in theory, to have the right to take the project from the investors. It is not a simple task, as banks want to be able to step in as soon as something fishy appears, but on the other hand, they do not want to get too closely involved in the running of a project and the inevitable hiccups that happen; it also makes sense to step in only if there is a real problem which the investors seems unable or unwilling to solve. Investors emphatically do not want the banks to have the right to stp in the project, but they know that it is the price to pay to get the leverage they want (in the wind sector, banks usually provide 70-80% of the investment amount upfront)
In our case, the main constraint was the very short time frame to conclude the transaction: the buyer absolutely wanted the money before the end of the year, which meant that all commercial contracts and all financial contracts had to be drafted, negotiated and signed in only a couple of months, all experts had to give their opinions on the project and on these same contracts at the same time, so it was many parallel tasks that fed off each other and had all to be pushed forward at the same speed by many different parties. The banks are, in a sense, the coordinator of all these tasks, as we have to be satisfied with the terms of all contracts before we sign and release the funds. We discuss terms with the client, wording with the experts, join efforts with the client to extract information from the seller and commitments from the future operator, and the lawyers slave away to formalise all this (our lead lawyer slept one hour in the 4 days prior to signing...). When the seller is Spanish, some of the documents are negotiated in that language, and with a client based in London but headquartered in Australia, with various instructions and conditions coming over (and discussed) at night, and it makes for lively days.
Anyway, the deal has been made public now, so I am not betraying any secrets here. Do not hesitate to aks for more specific questions on the whole thing if you are interested. I'll cross post this over at Le Speakeasy to keep the thread open longer.