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As a general observation there is a pattern of evolution of the market’s players which is common across all renewable energy sectors. The companies who begin developing renewable energy projects tend to be smaller, entrepreneurial ventures. A number are pure developers, but at the beginning of almost all renewable energy sub-sectors, the pioneers are frequently technology-led manufacturers. Gradually, as the technologies become more established and there is more of a market pull, or demand, for these projects, the technology companies focus on manufacturing and a separate development market forms. At this stage the technology companies seek capital to expand and/or merge with other manufacturers. Developers tend to be specialist developers and the projects are small as the equipment is still small-scale per unit and the developers are cash constrained.

The next stage of evolution is the entrance of deeper pocketed developers. This is normally the introduction of financial investors, such as private equity or infrastructure

funds, either investing directly, where they buy into or inject capital into existing development companies, or indirectly, through a dedicated fund. This category of investor is return-driven and they want a short to medium term investment, which they can sell on to a long-term asset-holder. This long-term investor is typically a utility although pension funds have recently begun to invest significant amounts in the sector, either through long-term funds, but increasingly in their own right as primary asset purchasers.

The other category of deep-pocketed investor is the utility company. Utilities are not typically early-stage developers but prefer to acquire assets when the technologies and projects are proven and they can acquire large, meaningful portfolios. As a result, the utilities can be seen as aggregators of assets, who leave the development risk to the smaller, early stage, project developers.

Whilst the smaller project development companies and financial investors use considerable amounts of project finance debt, the utilities have not, historically, been so active. This is because project finance is no longer deemed to be ‘off-balance sheet’ for utilities, so it counts towards their total debt, and the high credit rating of utilities means that they can raise cheaper corporate debt through their normal treasury funding, than the project finance market. The scale of this is enormous – of the more than 4,000MW of onshore wind commissioned to date in the UK, only 18 per cent – less than 1,000MW – is project financed. The rest has been financed by utilities on their own balance sheets.

One can therefore conclude that the nature of the renewable energy market’s participants, from small developer to short term funds and ultimately highly creditworthy pension funds and utilities will influence the demand for, and structure of, project finance for the relevant participants’ projects.

Figure 13.1 renewable market evolution

regulation

As renewable energy is the new kid in the power generation playground, it suffers from being a relatively ‘new product’. Three problems that arise for any new product are: it is relatively expensive, it needs further development and it has to win market share. This means that there is little mass-market ‘pull’ for renewable energy projects in a liberated, unregulated market. As a result, governments need to give it a market ‘push’. This is the reason behind the plethora of regulatory change in most active renewable energy markets.

However, one corollary to this market push is that anyone trying to finance projects in the renewable energy sector has to live with a greater degree of political, regulatory and tariff price risk than most other infrastructure sectors. As new technologies come to the fore and existing technologies become better (and cheaper), so regulations need to be adapted, to encourage the use of these new technologies and to reduce the cost to the consumer of the maturing technologies. Consequently, the changing regulations creates a risk that will not go away for some time and is at the mercy of the ever-shifting winds of political change, bias, prejudice and government budgets. As we shall see, this has caused significant problems for the renewable energy market, particularly in recent years.

Technologies

The most prevalent renewable energy sector is that of wind.¹ Historically, it was certainly the first distinct, widespread, renewable energy technology, the poster child of the industry. However, the history also illustrates the problems of developing technologies:

there were a number of competing technologies, debates as to which was best, so it took a number of years before today’s typical wind turbine became entrenched as the market standard. This diversity of approach has the problem of hampering cost reductions and improvements in performance, as it takes longer to create supply chains, efficiencies of scale and enhancements of design when there is a lack of co-ordinated research and development and pooling of knowledge as competing designs are developed.

If this diversity and internal competition appears unique to the wind industry, it is unfortunately still a major issue for the wave and tidal sectors as well as the waste to energy sector – and a continuing issue in the wind industry as it develops vertical axis turbines, direct drive turbines and other innovations.

While this is a feature of the renewable energy market that can be argued is essential – innovation and improvement surely being a good thing for any industry – when taken with the above observations on market regulation and market pull, one can perhaps see the issues. In other words, if a new style of wind turbine is created, and a market has a fixed tariff for all onshore wind projects, unless this new turbine is immediately at a competitive level (which is unlikely), either it will not be competitive or the regulations will need to be amended to distinguish between this turbine and the more established turbines.

1 Some may argue that hydro power is older and more widespread, but I would argue against this as it has not developed as a widespread, distinct, industry but rather a part of utilities’ portfolios with limited geographic application.

For this reason, the evolution of renewable energy technologies will be prone to having long lead times as prototypes are developed, a ‘standard’ technology takes shape and the projects can then be developed with appropriate regulatory support. Nevertheless, project financiers are – rightly – extremely wary of technology risks, which will also hamper the evolution of the market as early-stage technologies struggle to attract bank debt and have to finance the first projects on an all-equity basis. This will, in turn, tend to dictate that the projects are very small to begin with, only growing in scale through a combination of improved technical efficiencies and a slow trickle of equity and debt financings.

This concludes my review of the broad history of the development of the renewable energy market and the consequences of it. Some might say the lessons of it as the patterns we have seen for the onshore wind, offshore wind and solar photovoltaic markets, look to be repeating themselves for other renewable energy sectors such as biomass, waste to energy, wave and tidal.

Let us now look at these sectors individually, from a banker’s perspective. Below I will set out the key features, risks and issues, and describe how a banker will view them, assess them, and structure a financing around them. As mentioned earlier, this will be a practical description of how such projects are being evaluated and financed, which may not be seen as the optimum way that these projects should be evaluated and financed!

While project developers will always have cause to disagree with a banker’s perspective, by and large the very successful track record of project financings means that lenders are doing something right. Let us remember that banks are typically very highly exposed to the projects (typically financing 75–85 per cent of a project’s cost), and only have a fixed rate of return. Equity has a much lower commitment and, if the project goes well, stands to make a much higher return.

wind

table 13.1 Wind

risk Level

Permitting 1

Technology ½

Construction ½

Operation ½

Fuel supply 1

Power sales ¼

Financing issues ½

InTrODuCTIOn

Wind is the most prevalent renewable energy source and has been developed longer than any other as a specific industry. That said, to many it is not necessarily the best renewable energy technology as it has certain inherent weaknesses, which we describe below. That

said, because there is now such a significant international wind energy industry, and it is currently the most economic renewable energy source, it will remain a major sub-sector for some time to come.

Some of the most important risks and issues to consider, from a project financing perspective, are the following:

PerMITTInG

Wind projects suffer from being highly visible, spread over a large area and therefore in areas that people consider to be unspoilt and of natural beauty. If they are closer to communities, then people near the turbines may complain of being too close and the visual impairment of this, noise from the blades turning and even snow and ice being thrown off the blades, if it is in a cold area. As a result, whilst there can be much popular support for the concept of wind projects, there can be strong local opposition to them.

One acronym for this effect is NIMBY-ism (Not In My Back Yard); although there are also those who oppose the projects in their totality, who can also be called BANANAs (Build Absolutely Nothing, Anywhere, Near Anyone)!

In addition to the human complaints, wind projects suffer from a number of potential environmental threats to their permitting, the main ones being the potential damage to birds and bats. The potential to damage birds is now less of a practical issue as the larger turbines typically used today rotate much more slowly and evenly than earlier, smaller turbines, so if any bird were to be struck by a blade, some might suggest that it was an appropriately Darwinian improvement to the gene pool! Nevertheless, the emotive nature of the issue and the string opposition that some people have to these projects, still means that much time and cost is taken up with projects at a preliminary stage undertaking detailed environmental studies.

Another permitting and development issue is that of land rights. Sometimes the land that the project is to be built on is bought freehold by the project developer. For most projects, particularly larger ones, this is not a practical solution due to the large acreage over which a wind farm is built and the access needed to it, so leaseholds or access rights are needed. These can involve a number of different parties and so be a time-consuming and costly exercise before the project’s construction can commence.

As a result, banks typically lend to a project at the end of the development period when all permits and planning consents have been obtained. The risk of getting to this stage is normally borne by equity, which is one reason why the projects in the wind sector began small and have only grown in size as financially larger developers have invested in the industry.

TeChnOlOGy

As with all technologies, in the wind sector it has to be proven. There are now over two decades’ worth of precedent and therefore an established, standard format of wind turbine (three blades on a horizontal axis, affixed to a tubular tower), should be fairly predictable.

However, this is not the case as there are still evolutions of models as manufacturers of wind turbines seek to increase the size of each individual turbine, improve efficiencies, adapt to sites with lower wind speeds and increase reliability. On a small scale there are also firms which are re-visiting some of the basic structures and experimenting with

some of the early concepts: one- or two-blade turbines, vertical axis rotation and even unmounted, kite-style prototypes. These are, on the whole, small scale so let us focus on the evolved, established structures.

Perhaps the biggest technical concern, for a lender, is the gearbox. Over the years there have been issues with these working, reliably, for long periods of time and there have been many reports of more frequent maintenance and early replacements being required. This has improved of late but it will be important to consider if there are key components of a turbine that are being procured from a third party and, if necessary, that they are only procured from a reputable, reliable and creditworthy third party who is in turn providing warranties for their performance, to the principal turbine manufacturer.

Turbines constantly evolve in size: 600kW used to be the standard size, then 1MW, 1.5MW and now 2MW and 3MW are standard, with larger models underway, driven by the offshore wind industry. As these models grow, it is not unusual for a manufacturer to claim that, for example, their new 3MW turbine is proven as it is essentially the 2MW model with longer blades. This should not be acceptable and a lender will want to see the 3MW model having worked, in numbers (ie not just one prototype), for at least a year, before being willing to finance it. Even then it will be important to check that the new turbine can be fully insured and, if necessary, the manufacturer stand behind it with warranties for the percentage of time that it is available to generate (typically 95 per cent to 97 per cent of a year, less in the first year as teething issues are resolved), and warranties for the ‘power curve’. The power curve is the amount of power produced for the level of wind speed.

Where there are residual concerns or uncertainties, then the lenders can consider a lower percentage of debt being provided to the project, in order to increase the debt service cover ratio and so the buffer of cashflow expected to be generated and the debt service;

and/or establishing a maintenance reserve account (MRA). An MRA can be used to cover additional work on repairing the turbines, but should not be a proxy for a fundamentally unproven turbine, where a fleet-wide flaw could financially ruin the project.

Figure 13.2 the power curve

Wind speed (m/sec.)

Power (KW)

2500 2000 1500 1000 500 0

0 5 10 15 20 25 30 35

COnSTruCTIOn

For most project financings the ideal commercial structure governing the construction of the project is a lump sum, turnkey engineering procurement construction, or EPC contract. This is where the contractor assumes all of the risk of delivering the entire project, for a fixed price. Because of the historical beginnings of wind projects, where the projects were put together by small contractors and on a small scale, the EPC contracting approach was not used. Instead, they tend, even today, to be built on a multi-contract approach, with separate multi-contracts being given for the wind turbines (sometimes abbreviated to WTG, or Wind Turbine Generator), the connection to – or construction of – the electrical substation which in turn connects to the grid, and then a ‘balance of plant’ contract, or set of contracts, which can involve any combination of all the peripheral work. This includes the construction of access roads to the wind turbine sites (remember, these are normally built at high altitude, away from communities so access is usually needing to be created); the foundations and civil works on site for the turbines;

and the electrical work on the site.

The potential issues, which a developer and financier will wish to protect against, are, in general terms, the standard ones of delay and cost over-run. In the construction period this typically arises through poor workmanship, interface issues and site-specific issues.

Briefly these are caused by:

• Poor workmanship – Admittedly this is an issue for any construction project, but can be exacerbated in wind projects because of the multi-contract approach and consequently certain packages of work, particularly in the balance of plant, being given to small, local contractors who can lack the experience and ability to perform to the required standard and timeframe. The attraction of using local contractors is that it can be cheaper than using national or international firms, and it provides employment to the local community. Given the problems with local opposition to wind projects (see the Permitting section above), this involvement of local contractors is frequently an intent of project developers – or even an undertaking given to the local community in order to assist their approval of the project – and so the consequential problems it can cause do keep occurring.

It is therefore very important to make sure that the local contractors have relevant experience, are properly managed and are creditworthy for their warranties and/or liquidated damages committed to in their contracts. Their creditworthiness is often a problem if they are truly local companies, so typical credit enhancements may need to be considered, for example on-demand letters of credit, third party or bank guarantees and insurance for their insolvency.

• Interface issues – Because of the number of different contracts and different contractors that can be involved – even for small wind projects – there can be difficulties ensuring that each package of work is completed on time (particularly where another package of work is reliant on the previous package being completed before they can begin).

Poor workmanship can also have consequential effects on a package of work reliant on it, for example if the foundations are not to the correct specification, then the reliability of the towers could be at risk. Finally, there is an obfuscation of overall responsibility, as the blame for a time or cost overrun will be passed from one contractor to another if it is not clear who was responsible for each package and the

overall project management did not identify the responsibility and issues as they arose.

• Site-specific issues – Due to the remoteness of a wind turbine site and the large distance over which the turbines are deployed, there can be an increased risk of site problems. These are typically geotechnical, as the foundations need to be checked to ensure the ground is not solid granite or too soft or even that there are underground caves, as are found in porous rock. The biggest delaying factor for a wind project, and so a double revenue hit as it can cause additional costs whilst teams have to stay on site for longer and a loss of income generation, is perhaps very obviously: excessive wind! This problem arises as the sites are, one would hope, naturally very windy and the wind turbine needs to be assembled by crane, lifting the tower in sections, the nacelle at the top of the turbine and the blades. Due to the required precision this can only be done at low/no wind speeds.

Unfortunately, this last risk cannot be contracted against, but it is possible to factor weather windows into the construction programme and obligate the contractors to

Unfortunately, this last risk cannot be contracted against, but it is possible to factor weather windows into the construction programme and obligate the contractors to