by Stefan Schmitz
Once considered mere hobby horse projects for environmentalists, wind energy developments are now treated with the same respect as any other type of large energy project. Their financing has also graduated from the largely asset-based financing applied to early, smaller projects, to major project finance structures accepted and applied by the international financial community. Stefan Schmitz considers the issues involved.
The financing for every wind project, just as with every other kind of project finance, comes from a combination of both equity and debt. The split between equity and debt depends on the individual project and, most importantly, on the risk profile of each project. The higher the risk, the greater the share of equity will be required by the lending banks. The risk of an individual project is also decisive for the level of debt which a project can take on.
The individual requirement will be calculated by the so called debt-service cover ratio (DSCR) which states the number of times loan principal and interest are covered by cash flow available for debt service (revenues minus operation costs, but before interest, taxes, depreciation and amortization). Again, the rule is that the higher the risk, the higher the DSCR, since a larger multiple of cash flow has to be held in relation to debt-service. Consequently, the project can take on less debt and requires more equity, which in turn reduces the risk exposure of the banks. For example, if a wind project generates a net income of a1 million per annum and the bank requires a DSCR of 1.3, the project could take out a loan for which the debt service would be a770,000 per annum.
The key to financing a project is bankability – that is, the project has to be structured and set-up in a way that debt-providing banks are willing to take on and accept the risk to lend to such a project. Although, strictly speaking, bankability refers to the position of the debt-providing banks and the structure associated with it is aimed to protect the position thereof, equity investors, which very often come in and assess the project at a much earlier stage, will have similar expectations and will not invest in a project which is unlikely to be accepted by debt providers. After all, their investment – being subordinated to bank debt – may be insufficiently secured and, if so, the returns on their investment may end up being well below their expectations.
Project finance
Funds are not lent directly to those behind the project, but rather to a special purpose vehicle (SPV), set up for the sole purpose of owning the project and to enter into all agreements, including the loan agreement. The entity initiating the project is reduced to the role of ‘sponsor,’ with obligations dependent upon the project structure.
In addition, the loan is not repaid by the sponsor from its own revenue. Debt is serviced entirely via cash flow through the project and the SPV – with the sponsor removed, to a large extent, from the risks of the project. This means the debt does not appear on the sponsor’s balance sheet, and the risk associated with a project has no direct influence on the creditworthiness of the sponsor. However, while favourable for the project sponsor, this structure exposes the lenders to significant risks. If something goes wrong, their recourse against the sponsor, with its typically larger balance sheet, will be limited or none. In order to make this situation acceptable to the banks, the project will be structured in such a way that their risk is as low as possible and so that they can step into and take over the project if things were to go wrong, a so-called step-in right. This process is also called ‘ring-fencing.’
This safety net for banks consists of a set of complex agreements and the involvement of an array of technical and other experts who can identify and quantify any risk in a project, helping to eliminate or mitigate these risks. As a result of their expert opinions, a bank may decide not to finance a project at all, or to finance it at a higher interest margin. But, most of all, the opinion solicitation process helps banks draft loan agreements in a way that addresses risks to the lender and, if at all possible, removes them entirely, so that if problems materialize, it is not the project and its cash flow which suffers.
Technology risk
In a wind project, the most obvious risks relate to technology, wind supply and off-take agreements for the power so produced. The technology risks, lying mostly with the reliability of the turbines, are generally under control today. Most of the technology has existed for many years, and lenders with experience in wind energy, such as Commerzbank, HVB, Fortis or RBS, are comfortable with both the technology and its manufacturers. Consequently, banks will happily finance the equipment produced by the majority of turbine manufacturers. Financing a wind project, for example, consisting of 1.5 MW turbines, produced by an established and rated manufacturer, no longer poses problems.
Indeed, even many turbines of much larger sizes, from the 3.6 MW to the new 5 MW class, have found a great deal of favour with the lending community, which normally requires that a turbine prove itself through one or two years of more or less fault-free operation in a number of projects. For example, most offshore wind projects can operate profitably only with large turbines; otherwise, the installation cost per MW would be disproportionate and could render the entire project uneconomical. As a result, almost all recently built offshore wind projects, or those under development, involve turbines in excess of 3 MW, and many of the upcoming projects already plan to use 5 MW technology. Despite relatively little experience with this technology, banks appear prepared to finance these turbines, and the DSCRs required for those projects are only marginally, if at all, higher than those of onshore projects. This may seem surprising, considering the complex risks associated with an offshore wind project. However, turbines are only one part of any project, and risk allocation in offshore projects varies significantly from that for onshore projects, which makes such DSCRs possible.
The wind energy market also poses some other technology-related problems with which most banks are quite familiar. A series of problems with gearboxes – probably the most strained piece of equipment in a wind turbine – sent shockwaves through the market in the 1990s, and stories about faulty gearboxes continue to resurface at regular intervals. Turbine foundations pose another problem, with reports of cracks in the concrete leading to serious difficulties and posing considerable risks to the project.
For offshore projects, technology issues are even more prominent. Setting up a turbine in water 20 or more metres deep, possibly on a sandy base, buffeted by high waves and strong tides and surrounded by salt-infused water and air, is a different story altogether from erecting one on flat ground onshore. These projects may be designed in a variety of ways, and the technology involved depends on water depth and tidal strength. They range in size and complexity from relatively simple gravity foundations, which may suffice in more shallow waters with small currents, to monopile and tri-pod constructions used in deeper and tidal waters, to even more complex structures or floating devices, similar to the platforms in the oil and gas industry.
Difficulties in connecting wind turbines to the grid can also contribute significantly to the risks and costs of a project. While the costs and risks of grid connection for onshore projects are mainly concerned with distance and the possible crossing or tunnelling of rivers, roads or tracks, the situation is completely different for offshore projects. Depending on the location of the project, cable must be laid over many kilometres of hostile and inaccessible environment and, usually, ploughed into the sea bed. As a result, costs for grid connection can constitute a very large share of the total investment in an offshore project, easily 40%. This contrasts sharply with onshore where, for most projects, costs for grid connection account for around 10% of total project cost.
Multi-contracting
Ideally, banks like to have one company construct a wind project on a turnkey basis. Under this scenario, one contractor provides the turbines, is responsible for building the foundations and the grid connection, and enters into only one agreement, commonly referred to as an engineering, procurement and construction (EPC) agreement. For onshore wind projects, these agreements are customarily offered by the turbine manufacturers. Since these companies usually do not have construction capabilities in-house, they subcontract the project, yet remain liable for the work.
The EPC arrangement is preferred by banks because the project company, as the principal for the work, has only one contractual partner. This is important for the banks because the cash flow, for example to make up for loss of income under the off-take agreement with a utility, would not be stopped by internal disagreement, or in worst cases litigation.
The balance sheets of turbine manufacturers are considered strong enough to back warranties under EPC agreements. For offshore projects, however, the situation is completely different and requires another approach.
Although, for example, GE and Siemens have entered the offshore market and the balance sheets of those two companies – counted among the world’s largest international engineering firms – would be considered sufficiently robust to back up a project finance deal, offshore wind parks are not usually built on a turnkey basis by one provider. First of all, not all offshore manufacturers can show a balance sheet of the size of GE or Siemens, but also, the turbine manufacturers themselves are reluctant to take on the risk alone. The solution applied by the offshore industry thus far has been multi-contracting, in which the tasks and risks of project construction and turbine supply are shared among a number of companies, each responsible primarily for the provision of its own services or equipment, yet also integrated into the whole project. In most circumstances, banks will accept up to three parties providing services or equipment for a project under this approach – the turbine manufacturer, the construction company and the grid connection or cable company – although a higher number of parties has been seen as well.
A so-called ‘interface agreement’ is used to tie the various service and equipment suppliers together with a step-in right for the lenders. This complex and sophisticated agreement regulates how these parties and their responsibilities relate and interface with each other. Although these agreements are nothing new and have been used successfully in other industries, they are relatively new to the wind energy business.
Interface agreements also contain obligations regarding information and co-ordination of respective tasks. Banks usually insist on a clause outlining how the parties will deal with a contingency in which none of the service or equipment providers is obviously at fault and admits responsibility.
Nonetheless, because interface agreements for large offshore wind projects are comparatively new, these contracts usually require a substantial understanding among the drafting lawyers of the risks and issues involved. So far, only two wind projects have been financed as true project finances, but many more are planned which will require this type of contractual arrangement. It can be expected that they will develop over time as they are applied to more and more projects.
Wind resources
A potential and significant risk for any energy project is the underlying resource for its generation – in this case wind. Unlike fuel projects, such as oil or gas, the energy source of wind is free and does not depend on a supply agreement. At the same time, this means that wind farms cannot simply buy the underlying fuel to compensate for any shortfalls, so identifying the availability of wind is paramount. This has two aspects. The first is the question of whether a particular site has sufficient wind speeds. This issue is addressed by the lending banks insisting on long-term – usually at least 12 months – wind measurements, which are then used as the basis for a number of wind studies. Banks usually insist on at least two of those coming from reputable wind experts. These wind studies give an estimate of the annual electricity output of a project, based on a probability curve, usually 75% or 90%, that the project will generate x number of full load hours. Depending on the wind turbine used, there is therefore a 75% or 90% respectively, probability that the turbine will generate y kW/h per year when in service.
However, these studies are based on the wind measurements for previous years and for a particular site, and while the studies accommodate the fact that the year in which the measurements were taken may have been a particular good or bad year, there is no guarantee that there will not be substantially less wind in the future. Off-taking utilities are largely able to mitigate this risk because it is possible to get very accurate wind forecasts, which enables alternative sources to be used in order to maintain grid stability and supply if necessary. For the project itself, however, no wind means zero cash flow. Such risk could, in theory, be hedged or covered by insurance, and while some attempts have been made in that respect, such tools are not yet a common feature and thus remain a risk which has to be factored in.
Operation and maintenance
The problems inherent to wind projects do not, of course, end with construction and commissioning. These projects will be financed only if banks are satisfied that the turbines can and will be operated and maintained for a period of about 20 years – significantly longer than it takes to repay any loans.
Operation and maintenance (O&M) of a project is of supreme importance because it is linked to electricity generation and cash flow – the sole source of loan repayment revenue. Banks like to see a comprehensive O&M service package from an experienced provider attached to any project. In most cases, these services are provided by turbine manufacturers because the contracts they offer dovetail nicely with manufacturing warranties. O&M services may be provided by other parties, which banks will accept if they have the necessary track record and financial strength. O&M contracts for wind projects usually warrant technical availability, stipulating that the turbines be operational for a percentage of time in a given year (usually 97%), which equals about 354 days per year.
For offshore projects in particular, the issue of O&M requires special attention. The costs can be significant and can have a major influence on the economics. A few years ago, many argued that the cost of serving an offshore project would render any development uneconomic. This bleak outlook appears to have been overcome by experience, but costs are still significant. For example, Vestas has a team of 25 permanent maintenance personnel assigned to the Horns Rev project.
Access to offshore projects is particularly difficult. As soon as waves reach about 1.5 metres – fairly standard in the winter and some spring and autumn months in most waters – turbines cannot be accessed by boat. Access can be extended by attaching heli-hoists to the nacelle allowing engineers access by helicopter, but even this is not always possible.
Off-take agreements
The question of how much money will be generated per kWh of electricity production stands at the heart of every financial model for a wind project. Together with the expected number of kWh, as predicted in wind studies, this is a key component of bankability. The off-take regime actually consists of two elements: the plain tariff figure and the duration and certainty of that tariff. Lenders want to be sure of a price that allows the project to operate profitably and meet its debt service obligations. They are also concerned about the sustainability of the tariff, whether it is fixed or subject to fluctuations, and the parameters for those changes. The greater the certainty, the better the bankability. The most advantageous, and easiest to finance, off-take regime is provided by countries that have a so-called feed-in tariff – a statute obliging utilities to purchase electricity generated from renewable sources at a set price for a certain period, usually 15 to 20 years. The conditions are even better if these laws provide for an indexation of the tariff. In countries with feed-in tariffs, in principle, projects do not even require a power purchase agreement (PPA), because off-take terms are regulated by law.
In countries not offering feed-in tariffs, project developers need to negotiate a PPA with an off-taking company, usually a utility. The more certainty and longevity they can negotiate, and the better the quality of the off-taker, the better for the financing. Banks prefer large, well-rated companies which can guarantee and meet obligations under long-term PPAs. The less risk associated with this key aspect, the more comfortable banks will be – and that level of comfort will ultimately be reflected in the required DSCR and the interest rate the borrower obtains for the loan.
The future of finance
As wind development projects have become more widespread and larger, so the methods and techniques for raising finance for their construction have become more sophisticated. The rigorous requirements of the international financing community impose discipline on all those involved in manufacturing, erecting, operating and maintaining a wind project. All aspects of a project must be considered and, overall, this inevitably improves the quality, reliability and economics of the entire wind market. This development looks likely to continue as the financial community becomes more adept at considering the risks involved in developing both on- and offshore wind.
Stefan Schmitz is a partner in the London office of law firm Squire, Sanders & Dempsey.
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