The US wind industry appears to be on a record installation pace, and is set to exceed 3,000MW in 2006, an increase of 25% over 2005's record installation of 2,400MW, and the numbers keep increasing.

Joe Slamm, a vice-president, at Goldman Sachs, says that President George W. Bush's mention in the state-of-the- union address of the importance of renewable energy, plus the talk about flex-fuel vehicles, macro trends and prominent advertising by firms like BP have generated a tremendous swell of private equity from investors that are trying to understand wind.

"For pretax investors, the mystery of wind is starting to go away, and now there is a lot of interest in tax relief and those same investors are interested in renewable energy, a technology that makes everybody feel good," he said. "I think the bottom line is great."

Robert Young, a division director at Macquarie Bank, says that "our sweet spot as far as investing in a developer in the US is finding a middle size company that has developed projects in the past, who is passionate about wind, and not a Johnny-come-lately. To date we have invested development capital into a 160MW project. In 15 months, we helped put all the pieces together. We would like to repeat that process."

Utilities: loving the product, buying the company

Utilities are also more comfortable jumping into the game, says Mike O'Sullivan, a senior vice-president at FPL Energy, since they have already had a positive experience, most likely as a result of buying wind from developers. With utilities looking for a way to grow their rate base with low risk and in a politically acceptable way in their state, they recognise wind can quickly and favourably satisfy ratepayer, shareholder, and political and state regulatory interests. "Investing in wind may be a good ratepayer, shareholder and public policy decision. And in the utility world, it is hard to match up those three interests."

Another, often unspoken, reason for utility interest in developing rate-based wind have been developer stumbles on delivering as promised on awarded power purchase contracts. Whether the result of a bid from an inexperienced developer, or an experienced developer hitting a regulatory, environmental, interconnection or cost of turbine road block, not delivering a promised wind project on an awarded power purchase agreement embarrasses utilities in the eyes of regulators and politicians. So what is the solution? "Utilities do it themselves," says O'Sullivan. "It is a trend that is here to stay...we will see more of it."

Not only are increased utility interest and the increased flow of investment capital into the wind industry an indication of wind's move into the energy and financial mainstream, so is the cost of capital. According to Randy Swisher, the executive director of the American Wind Energy Association (AWEA), the cost of capital has declined considerably in the past three or four years. "We are talking 300-400bp in the last several years."

Turbine costs hit returns

Despite the falling cost of capital, concerns exist within the industry regarding future rate of returns and how the business is changing. The principal culprit in 2006 is higher turbine prices. These have increased, in some instances, by 50% in the last few years.

"An increase in the cost of equipment is something that hurts all of us," says FPL's O'Sullivan. "At some point it will destroy demand. You can't deliver a commodity that continues to increase in price. That trend will result in a confluence of events that is not good for the industry. We have absorbed some of the costs...but returns have come down."

Swisher acknowledges that some returns on equity now run into single digits. Adds Invenergy's CFO, Jim Murphy, "Tax equity investors are looking for 9%-ish returns on leveraged deals and 200-300bp lower for unleveraged deals. After leverage and syndication of tax equity, developers are expecting double digit returns, in the high teens or better,"

Manufacturers, meanwhile, are enjoying record backlogs. Not unlike the gas turbine frenzy of 1999, 2000 and 2001 – a three-year period during which GE put more than 200GW of gas turbines online – wind turbine manufacturers are sitting pretty, with order books full for the balance of the year and 2007. "We have enormous demand for 2006 and 2007," says Robert Gleitz, GE Energy's Wind Product Line Leader. "And orders for 2008 are filling up rapidly with several deals, including a 334 turbine order for 1.5MW turbines from Airtricity."

The $550 million GE deal with Airtricity provides a good example of the changing nature of wind project development in the US and, importantly, how deals get financed. The Irish developer has an ambitious program in place through 2008 and beyond, including California and Canadian markets. The new dynamic is long-term relationships between large players, larger deals, and a more pronounced role for private equity and balance sheet financing.

Powerful friends

Although Airtricity did not disclose its specific financing plans for its US project pipeline – "we will go to the debt markets" said Ciaran O'Brien, senior vice-president and head of finance for Airtricity's operations in the US – the company recently raised Eu250 million in early June from equity investors in a deal that valued the company at Eu800 million. NTR, Ireland's largest private sector developer and operator of public infrastructure, invested Eu127.5 million to maintain its 51% shareholding in the developer, while UK investment and advisory firm, Ecofin, invested Eu122.5 million for a 16% shareholding.

The cash infusion in part was used as a deposit to secure a supply of turbines for Airtricity's development plans in the US for 2008, a year presently not covered by the production tax credits that are viewed by many developers as a significant driver of the market.

Airtricity, for example, started working several years ago in partnership with GE on its 25MW Arklow Bank offshore wind project, and their relationship continues in Ireland with an additional 100 megawatts of GE wind turbines to be installed there this year as well.

"The nature of our customer is changing," says GE's Gleitz. "We are seeing more and more larger players. Smaller developers do not appear to have the muscle to drive through the permitting process and to structure the larger and cheaper financings that prominent developers like FPL, PPM and Airtricity can do more readily."

At Clipper Windpower, the experience is similar. Clipper has introduced a new 2.5MW turbine, and for 2006 and 2007 the company's turbines are "mostly spoken for". Robert Gates, Senior Vice President of Commercial Operations, says "our customers are mostly large developers, and some medium-sized developers, but no small ones. Large developers are going long on turbines, and the smaller guys can't or are unwilling to do so, given their resources and the production tax credit risk beyond 2007."

The short time horizon of the production tax credits and the time required for syndicating deals for a typical project finance transactions, is changing the dynamic of the industry, says Gates. The large developers have the capital and the staying power to go long on the turbines because they can finance deals on their balance sheet, and then refinance once the project is up and running. There is still a role for the smaller developer, it is just changing, he says. They are feeding deals to larger developers, and many are being acquired.

Going large

Invenergy, for instance, has five projects totalling 337MW under its belt already. According to its CFO Murphy, the company anticipates doubling that number by the end of 2006. Unlike larger developers, he says subsidies in the form of the PTC are one of his greatest frustrations in attracting capital to the firm's projects in the US.

Large developers like FPL, says Murphy, have their own tax capacity and utility income to fall back against – a comfortable position that helps them minimize the complexity of financing. "With significant internal resources they can more readily absorb development costs, secure turbines and arrange financing. As a result the project tends to be balance sheet-oriented, which creates post construction opportunities to package projects for the capital markets when financing costs are lowest."

Most wind developers, he says, are still medium-size players that have a limited tax capacity and no operation to leverage against. With modest internal resources, absorbing development costs and procuring turbines is more challenging, never mind balance sheet construction financing. Smaller players have even fewer resources and typically hit the wall early especially with regard to interconnection rights and certainly when procuring turbines.

Although the pool of equity investors has broadened and the number of tax-oriented investors is increasing, the PTCs, tax considerations and accelerated depreciation limit what smaller developers can do. "The tax issue pulls you away from standard project financing formulas typical of other power generation projects," says Murphy. "And we cannot bring this product to the retail markets. We get calls every day asking how can we invest in your company or how can we monetize positions in your projects and help you get those out to the retail market. It is hard to do given so much of project economics are tax-oriented."

A better model for smaller developers, says Murphy, are the incentive schemes in Canada and Europe. The Canadian federal government provides about a $10 per MWh incentive called the windpower production incentive (WPPI) – a mechanism that provides a revenue credit for the developer that is a subsidy to the Ebita stream. "This is a more effective way of project financing because all of the economics of the project are captured in the Ebita, with no requirement for a tax investor. This more traditional project finance approach provides a broader universe of investors – particularly income funds and trusts, although the WPPI is not index-linked."

Several European countries provide development grants in addition to revenue subsidies in the form of feed-in tariffs. "If you are going to subsidize a wind project, do it at the cost level because these projects are more capital cost focused than operating cost focused," says Murphy. "Any reduction to capital costs is the most efficient way to subsidize wind projects. It gives the project finance community the most options."

Consolidation reigns

For several smaller developers, the changing dynamics of the industry has led to a simple solution. Sell out.
Zilka Energy was bought by Goldman Sachs in March 2005, and changed its name to Horizon Wind Energy in August 2005. It owns, develops and manages wind farms in the US. By the end of 2006 it will have 750MW in the ground, and another 600MW by the end of 2007. Says Goldman Sachs' Joe Slamm, "The company should stay on that type of pace for the foreseeable future."

Energy Investors Funds acquired a majority interest in Tierra Energy last December. In addition to pursuing wind projects in Texas, Idaho and the Northeast, Tierra owns and develops a portfolio of natural gas-fired generation projects. According to Andrew Schroeder, a partner at EIF, Tierra's thermal projects provide some diversity in cash flow.

Earlier this year Iberdrola, which has 3,600MW of installed capacity, acquired Pennsylvania-based Community Energy, which has nearly 2,000MW of capacity under development. According to Brent Alderfer, Community Energy's president and chief executive, the wind turbine shortage and attendant price increases for the turbines was one of the reasons for teaming up.

For largely the same reason Padoma Wind Power has been acquired by NRG. Padoma currently has three projects under active development independently, in addition to a pipeline of over a dozen wind projects that it is developing in conjunction with third parties.