Recently, I explained why Obama winning re-election is not necessarily an automatic savior for the wind power industry. Basically, an extension of the Production Tax Credit (PTC) is not a given (although I give it better than even odds), and the current extension being pushed by the American Wind Energy Association would act as little more than a band aid.
While an extension of the tax credits is vital to a robust wind industry in the U.S., developers must start to consider strategic options for financing projects in a world without the PTC. Even with financing innovations, successfully putting together wind deals will be very difficult, and without these financing strategies there will be a period of time where virtually no wind projects will be financed or built in the U.S. (Read More: 5 Reasons Why Good Energy Projects Don’t Get Financed)
Many projects simply won’t meet the fundamental hurdle of profitability without the PTC, especially in a market where natural gas fired electricity is so cheap. So what can the wind industry depend on, and what strategies can they employ in the event that the PTC expires?
The cost to use money is at historic lows. This low cost of capital means that for very good projects even a narrow spread between the cost of producing electricity and the price to sell electricity may create enough return to attract an investor.
Additionally, the PTC is not the only support available to help improve the economics for a wind project. There are still some valuable state and local incentives for wind, typically renewable electricity attributes such as renewable energy certificates created under a renewable portfolio standard. Accelerated federal tax depreciation can add significant value. There are markets with growing electricity demand. Additionally, looking forward through 2013 and beyond an expected correction in natural gas prices will increase the cost of electric generation from natural gas.
The key to a successful deal structure will be a developer or investor’s ability to extract the full value from each of these supporting factors, while finding new ways to structure deals that result in the lowest possible cost for project capital. There are a number of approaches that can help make even a small return adequate to interest investors.
Each of the following five approaches — diversified portfolio, enhanced risk management tools, tax efficient deal structure, the use of low cost bond capital and adequate scale — can be used to reduce the cost of capital and open alternative financing options. These tools won’t cure deficiencies in basic project economics, but they may offer solutions for making a marginal project into a profitable and finance-able project.
Broaden the Portfolio
While there may be cheap capital available in the market, that money is only finding its way to extremely low risk projects. One location, one electricity buyer (other than the federal government), and one technology is not going to provide enough diversity to limit risk for an investor that will only receive relatively low returns. Mixing technologies at a single site is not an ideal approach to planning, but if an investment can be spread over multiple projects supported by multiple off-takers that may help spread the risk across enough good projects so that the threat of an underperforming turbine or even an underperforming project won’t undermine an investor’s expected returns.
Another option to build a broader portfolio, albeit with a potentially complex deal structure, would be to wrap financing for a new project into the refinancing for an operating group of projects.
Squeeze Out Project and Performance Risk
The less risk a project is perceived to have, the greater the number of interested investors. As with any market, greater supply (more investors) should lead to lower prices, and in this case a lower cost of capital. Traditional insurance products, and even more advanced products such as engineering procurement and construction (or EPC) ‘wraps’ have been common tools in risk management for wind projects. Less common are more comprehensive risk management products, such as a series of contracts, hedges or insurance that effectively reduces operational, technical and market risk to zero, can change the perception of a project. When matched with an electricity buying utility with highly rated credit this approach to risk management can change what would be viewed as a ‘risky wind project’ into something that ‘looks like a utility bond with higher returns’. By achieving this level of risk reduction, new low-risk investors like certain infrastructure funds may become potential investors.
Return of the Leasing Company
Without the PTC, realizing full value for accelerated depreciation becomes even more crucial to making the basic deal economics work. The cash value of depreciation varies, but is generally calculated at more than 20% of the capital cost of a project. A 20% effective reduction in cost, while far less than the more than 50% reduction when both accelerated depreciation and the PTC are available, is still an important value driver for a project. Unfortunately, many of the deal structures that have been regularly used to turn tax benefits into project financing cash (e.g., flip structures, inverted leases) are specific to deals that include clean energy tax credits and don’t work to monetize only tax depreciation benefits.
Despite those limitations, some leasing-based solutions may still offer some opportunity to convert value for tax benefits into project financing capital. Leasing companies, owned by taxpayers with adequate taxable income to absorb the tax losses created in the early years of a project, if carefully designed, may be used to exchange the cash equivalent of the accelerated depreciation benefits for project funding. The leasing company is not a new deal structure, rather the return of an old tool that if used properly can unlock some of the value of accelerated depreciation.
Find a Bonding Authority
Bonds can be issued by a municipality, utility district, development agency or even a Native American tribe. The cost of borrowing is tied to the risk profile of the issuing authority, rather than the project or the developer. Moreover, some of these organizations have clean energy or sustainability mandates. In some settings this might require a wind developer to join with a development to build a combined economic development where a wind farm is associated with some other development or redevelopment activity and the combined activities meet the broad economic development targets and mandates for the bonding authority.
The complexity of tax efficient planning has meant that wind project transaction costs have historically been relatively high. New approaches to financing wind projects, especially creative new approaches, will offset any reduction in deal complexity created by less convoluted tax equity financing because new deal structures will require new planning and review. As a result, finding ways to scale and reduce the per-unit transaction costs will remain extremely important. This is not necessarily achieved by building a bigger wind farm. Consistent terms, documentation and approach for a large portfolio of smaller projects can achieve similar (though not identical) benefits of scale.
The stability of a long-term extension of the PTC, even structured with a year by year phase-out, or with the amount of the credit indexed to natural gas prices would be far more valuable to the wind industry than any of these tools (though many of these concepts could be used with the PTC). However, even in a world without the PTC, there are wind projects, and as natural gas prices increase, an increasing number of projects, that can be financed and built with well-planned deal structures. (Read More: Does Obama’s Re-Election Save the Wind Power Industry?)