The German power market should be an exciting one over the next decade as the country embarks on a major construction programme to replace ageing capacity.

But project finance business will not be coming from the big four utility companies – RWE, E.ON, EnBW and Vattenfall – which control most of Germany's power generation. They will either finance construction from their own cash flow or take out corporate loans, which offer little in the way of margin and fees.

Nonetheless, there are project opportunities – albeit niche. The fact that so much of the country's capacity needs replacing has created opportunities for new entrants to build power plants. In addition, there will be no new nuclear power plants built. Existing ones will be replaced by conventional power stations and renewables.

The government has passed legislation and created incentives to encourage the rapid construction of conventional and renewable capacity. For example new gas and coal fired power stations that achieve efficiency targets will receive free carbon credits for 14 years. "Some people are thinking more of coal fired stations because of the rising prices of gas. They see coal as being a more stable energy source," says Andreas Ufer, Senor Vice President with KfW IPEX-Bank.

Co-ops have margin clout

With at least 20,000MW of new capacity needed there is a gap in the market for new entrants. The new sponsors are a combination of smaller city- and state-owned retail utilities and foreign companies. These smaller utilities have been forming consortia to build their own capacity to bypass the big players to access cheaper electricity – and their ideal funding route is project finance.

Two deals have been done so far. Trianel, blazed the trail last year with a deal for an 800MW combined cycle gas turbine (CCGT) power station in North Rhine-Westphalia with WestLB as sole lead arranger (for a full deal analysis search 'Trianel' on www.projectfinancemagazine.com). Trianel was formed originally as an energy trading vehicle by a consortium of local utilities keen to improve their bargaining position (26 German, two Dutch, and an Austrian utility). The financing was for Eu359 million over 20 years and priced at 60bp over Euribor, stepping up to 95bp over time. Trianel is now planning another 800MW project, probably coal fired.

The second deal was by regional utility, Mark-E, which got together with Norway's Stadtkraft to build a Eu220 million CCGT generating 400MW last year.

And more deals are already underway. Germany's fifth largest energy provider, Steag, has teamed up with Austria's EVN to build a coal fired 750MW plant in Watsum for Eu800 million to be operational by 2010. It is being presented to banks for a September/ October financial close. Another project is a 750MW coal fired plant in Herne. The company is currently negotiating with regional and municipal utilities to take a stake in it, and it is due to come on line in 2011. It has yet to be presented to banks.

But although new deals are happening, "margins are way too cheap. The margins on the two financings that have closed so far are below 100 basis points," says Frank Beckers, Co-Head of Project Finance and Capital Advisor at Deutsche Bank. There are at least another five to six deals in the pipeline within the next two years and they are also likely to be done on very tight margins possibly 50-100 basis points over Euribor as competition between banks is intense. "There are not enough deals and there's a lot of liquidity. The German market is over-banked," says Bernd Rupieper, Director of Structured Finance, Energy, Renewables & Utilities Group with IKB Deutsche Industrielbank AG.

Captive power boom

As far as margins are concerned, the captive-corporate power market is more attractive than municipal-led deals like Trianel. In many cases high-energy users find it cheaper to have their own power source. They usually want to outsource the management and ownership of the plants to a third party.

However, the process has been complicated by IFRS accounting rules, which makes removing the project from the balance sheet difficult. This has apparently led to some potential projects being dropped. Solutions include teaming up with other energy buyers. This also enables much bigger power stations to be built and economies of scale.

Many of these power stations burn waste material and receive a payment for doing so. Since July 2005 putting rubbish into landfill sites has been banned in Germany creating a lucrative market for incinerators. "These deals are very sweet. You have three potential sources of revenue from these plants: selling the electricity, the steam and the payment for burning waste," says Rupieper.

The electricity from these plants can also be sold into the local grid if the corporate user runs into problems. This creates a safety net for lenders and makes them more tolerant of higher corporate credit risks.

Some deals have been structured whereby the corporate user buys 80% of the electricity and the local utility the balance. According to bankers all these different combinations and structures make it impossible to talk of a "typical" margin. Also, credit ratings and equity participation differ depending on the sponsor. Power projects come in many sizes, but typically they are 50MW-200MW and require Eu50 million to 250 million in financing with 10 to17-year tenors.

One of the projects in the pipeline is from Europe's largest copper refiner Norddeutsche Affinerie AG. With Kraftwerk it will be commissioning a 100MW substitute fuel power station for Eu320 million. As part of a PPP scheme it will burn waste for the City of Hamburg.

There is talk of a deal from specialist infrastructure services contractor, Infraserv Knapsack. Another infrastructure service contractor, Infraserv Hoechst, is also planning a plant. There's also a 60MW waste and gas fired plant from tin plate manufacturer Rasselstein for Eu65 million on the table.

Renewables to go offshore

One of the most dynamic sectors of the German power market has been renewables, which has helped compensate for the dearth of conventional power projects over the last 10-15 years.

For wind, which is the leading renewable sector, project finance structures are heavily standardised. Nearly all are structured to take advantage of special purpose KfW Förderbank subsidised loans. The money is channelled through commercial lenders who guarantee the loan and charge a margin for absorbing the risk.

Depending on the size and attractiveness of the wind farm, overall margins come in at 4-5.5%. Tenors tend to be around 15 years. Equity stakes vary depending on the wind study and the size of the reserve account.

All renewable projects sell their electricity at guaranteed fixed tariffs for 20 years on a take-and-pay basis. These are guaranteed under Germany's Renewable Energy Law. There are also incentives to be up and running quickly with the guaranteed tariffs for each new year lowered.

However, building activity in the wind sector has been declining since its peak in 2002. This is because all the best sites are now taken leaving developers to go after smaller and more marginal ones.

There is the possibility for "re-powering" older wind farms. This is an upgrade to the latest turbines to achieve better yield. However, numerous environmental and planning issues such as the height of the new windmills is delaying the process. And most bankers accept that many re-financings are likely to occur within the framework of the original project with the same lenders.

The big hope for new wind business is offshore. Utilities and developers have been busy staking out claims along the North Sea and Baltic coasts.

Before this sector can grow there are numerous environmental, planning, logistical and technological hurdles to overcome. But bankers are optimistic that it will happen – but concensus is split on when. Some forecast 2008. Others think it will take longer because turbine manufacturers are completely booked out and prefer to focus on safer on-shore projects of which there are many across the world.

Wind equity

With the wind sector well and truly matured in Germany there has been a flurry of equity investors buying up wind farms. Australian investors led by Macquarie bank and Babcock & Brown are a notable presence. But the Danish, thanks to favourable tax treatment at home, have been the most aggressive. Last year, it was still possible to achieve 11% returns on equity that is now down to 5-6% or even lower, say industry sources.

Also, there is a growing appetite for refinancing renewable projects with bonds. A recent example was the Breeze 2 financing led by Bayerische Hypo- und Vereinsbank, which comprised 330MW from 39 wind farms in Germany and France of which 15 are operational. The Eu470 million issue, listed on the Luxembourg Stock Exchange, comprised of bonds with 5.29% and 12% coupons due 2026 and 6.11% due 2016. More deals such as this one are expected.

The fact that some of the wind farms built in 2000-2004 have run into trouble doesn't seem to deter investors or financiers. One industry source says many were built on overly optimistic wind projections. Wind speeds have been lower than expected for the last two to three years which has led to some projects being restructured. Either loans are lengthened or interest rate payments are weighed more towards the end of the loan.

Apparently, bankers have been "understanding" partly because wind speeds are likely to accelerate again in coming years in line with long-term weather cycles. In the meantime, some investors have had to suffer zero returns on the more troubled projects.

Solar parks are also rapidly spreading across Germany. These are financially structured like wind projects with use of KfW Förderbank loans. Tenors tend to be around 15-17 years.

But solar deals tend to be very small. To date the largest is a 10MW solar park in Bavaria closed last year. And some developers are reported to be having trouble making their projects bankable as the returns are sometimes too low.

Many bankers still need to gain a better understanding of the sector. Like wind, similar incentives need to be up and running quickly along with guaranteed tariffs. Solar also has the benefit of being more reliable than wind power and has lower operational risks as they have no moving parts. However, bankers say that in practice this makes little difference to margins when compared with wind, partly because both kinds of projects can be promoted by KfW Förderbank. "The framework for solar is ideal for financing, but we need some bigger deals," says Beckers.