Firebox NAPAC Paper on Wind Energy

The Economics of Wind Energy ◆ NAPAC May 2010
1
The
Economics
of
Wind
Energy

Risk, Financing and Accounting Challenges of Wind Farm
Development
North American Petroleum Accounting Conference | May 2010
Michael Schiller
Managing Director
Firebox Research & Strategy LLC
This
program
is
for
the
purpose
of
increasing
your
understanding
of

land
and
the
law
in
oil
and
gas.
Nothing
in
this
program
or
manual
is

to
be
construed
as
legal
advice
and
neither
PDI
nor
the
instructor

oﬀer
legal
advice
of
any
kind.
Please
consult
an
a?orney
in
your
area

or
state
of
business
for
any
such
advice.

2
Objectives
•  The goal of this presentation is to provide an understanding of the
economics of wind farms, focusing on their cost structure, risks,
financing challenges and accounting hurdles
•  Key areas of focus include:
–  An overview of the physical plant of a wind farm
–  An overview of the wind farm development process
–  An overview of the key contracts required
–  A review of sources of significant risk
–  An overview of financing options for wind farms; and
–  The implications of partnership allocation accounting on wind farm deal
structuring

3
Physical Plant
While a wind farm generating resource differs significantly from a thermal
resource in many respects, two in particular stand out as having
significant implications
•  A thermal plant is able to provide
capacity and energy on demand
•  A thermal plant consists of a
single utility scale capacity
resource or a cluster of a few
utility scale capacity resources in a
contained space
–  Where utility scale capacity is
defined as 20MW or greater
•  A wind farm can only provide
energy and that energy is
available only on an as is basis
•  A wind farm consists of dozens of
very small power (e.g., 1 to 3MW)
resources scattered over a very
large geographic area
1

2

4
Plant Components
Land

SubstaDon
&
InterconnecDon

Maintenance
Facility

Roads

CollecDon
System

Wind
Turbine
Generators

5
COD

Development Process
Market

Assessment

Wind
Data

CollecDon

Lease

AcquisiDon

Environmental

Studies

Community

Support

DeterminaDon

Site

SelecDon

“Early
Stage
Development”

Financial

Decision

Go/
No Go
Power

Purchase

Agreement

Go/
No Go
ConstrucDon

Financing

Agreements

O&M

Contract

Turbine

Procurement

BOP

Contracts

“Late
Stage
Development”

Environmental

&
Land
Use

PermiTng

Site

Layout

Wind

Resource

Assessment

Go/
No Go
Go/
No Go
Engineering

&
Design

6
Cost Structure
Cost Components
•  Development 2%
•  Wind Turbines 63%
•  Balance of Plant 14%
•  Interconnection 4%
•  Financing 14%
•  Other 5%
•  Total 100%
  Most wind farms require a price
of at least $65/MWh plus tax
benefits to financially work
Percent
of
Total
Cost

Development
Wind
Turbines
Balance
of
Plant

InterconnecDon
Financing
Other

7
Contracts
•  There are four major contracts that define the project
1.  Power Purchase Agreement
–  This is the price per MWh earned on each unit sold over the life of the
deal
2.  Turbine Supply Agreement
–  The bulk of the project cost is associated with the wind turbines
3.  Balance of Plant Contract
–  Cost of all non-Turbine equipment and installation
4.  Financing
–  Cost of money

8
RISKS

9
Types of Risk
There are seven major areas of risk:
1.  Public Policy
2.  Price
3.  Wind
4.  Environmental
5.  Technology
6.  Energy Delivery
7.  Operational

10
Public Policy Risk
  Public policies are the most important risks that shape the
viability, success and failure of wind farms
•  Regulation occurs at three levels
–  Federal regulations established by Congress, the Federal Energy
Regulatory Commission, Department of Energy, the US Fish and
Wildlife Service, the Environmental Protection Agency and the US Army
Corps of Engineers
–  State regulations are established by State Legislatures, State Land and
Wildlife agencies
–  Local regulations established by County governments and in some
cases, townships and cities

11
Federal Policy Risk
  Federal Public Policy is the most important and significant risk
a wind farm faces
  Economic viability is a function of the renewable energy tax credits
•  Key federal public policy risks:
–  Tax credit rules and expiration dates
•  PTC 1 year versus 3 year renewal
•  Expiration of ITC Cash Grant
–  Federal energy policies that encourage non-utility generation through
guaranteed, competitive access to the Interstate Transmission System
•  FERC rulings on RTO/ISO actions and Energy Policy Act rules on
renewables
–  USFWS regulates threatened and endangered species and administers
the Migratory Bird Treaty

12
State Policy Risk
  State policies impact the ability to develop a site
  State legislation shapes the “on the ground” reality
•  Tax policies
–  Personal property taxes, sales taxes
•  Renewable Portfolio Standards
–  Often require utilities to include a certain percentage of renewable
energy resources in their generation portfolio
–  Setasides typically only apply to solar
–  Many states also provide “escape clauses” in their legislation if the price
of the power is too high relative to retail power price targets
•  States are moving toward establishing land use policies that apply
toward wind farm development

13
County Policy Risk
  Counties (and other local governments) are primarily
responsible for zoning and zoning related issues
–  May impact setbacks from road and buildings
–  May establish sound impact standards that are more or less stringent
than the industry norms (50db at x meters from a property)
–  May require building permits and construction standards for electrical
work
–  May establish local property tax policies

14
Price Risk
  Power price is the second most important risk
•  Fuel price is the key factor in power prices
–  Marginal cost of hydro… ≃$3.00/MWh
–  Marginal cost of nuclear… ≃$7.00/MWh
–  Marginal cost of coal… ≃$25.00/MWh
–  Marginal cost of NG… ≃$50.00/MWh @ $5.00/mmbtu for 10k mmbtu/MWh heat rate
–  Marginal cost of NG… ≃$37.50/MWh @ $5.00/mmbtu for 7.5 mmbtu/MWh heat rate
•  Natural gas is the key benchmark price for determining the viability
of wind in market areas with lots of natural gas fired capacity
–  It is also the primary “marginal” fuel for most of the US
•  Coal is the dominant source of fuel for electric power in most of the
US

15
Fuel Mix by Region
Fuel
Source

Coal
Natural
Gas
Nuclear

Hydro
Renewables
Fuel
Oil

55%
Coal
or
greater

Primary
fuel
is
Natural
Gas

Primary
fuel
is
Nuclear

Primary
Fuel
is
Hydro

Diverse
fuel
mix

16
NG Fired Power Forward Curve

$-‐

$10.000

$20.000

$30.000

$40.000

$50.000

$60.000

$70.000

$80.000

$90.000

$100.000

Apr
'10

Aug
'10

Dec
'10

Apr
'11

Aug
'11

Dec
'11

Apr
'12

Aug
'12

Dec
'12

Apr
'13

Aug
'13

Dec
'13

Apr
'14

Aug
'14

Dec
'14

Apr
'15

Aug
'15

Dec
'15

Apr
'16

Aug
'16

Dec
'16

Apr
'17

Aug
'17

Dec
'17

Apr
'18

Aug
'18

Dec
'18

Apr
'19

Aug
'19

Dec
'19

Apr
'20

Aug
'20

Dec
'20

Apr
'21

Aug
'21

Dec
'21

Apr
'22

Aug
'22

Dec
'22

$NG
Price/mmbtu
@10kmmbtu/MWh
@7500mmbtu/MWh

Linear(@10kmmbtu/MWh)
Linear(@7500mmbtu/MWh)

Wind
price
@
$65/MWh

Crossover
Point
for
10k
mmbtu/MWh:
Summer
2015

Crossover
Point
for
7.5k
mmbtu/MWh:
Not
before
2023

Natural
Gas
Price
Impacts
on
Electricity
Pricing

(Forward
Curves
as
of
11
March
2010)

NG$/mmbtu

17
Wind Risk
  Wind is the third most important risk
  Shapes the type of resource
•  Wind resources are energy machines rather than capacity. Thus the
availability of wind is critical to determining the viability of a specific
site
•  Wind is measured using meteorological towers equipped with wind
vanes (direction) and anemometers at various heights
–  Measurement has three dimensions: Speed in meters/second, duration
(annual and seasonal) and direction
•  Wind risk determines the capacity factor – likely net available energy
production – which determines the potential revenue stream
produced by the wind farm

18
Wind as a Resource
•  Great Plains and prairie states have the highest capacity factors
overall, with wind speeds averaging in excess of 8 m/s (17.9 mph) at
80 meters (height of blade hub) and net capacity factors of 38% to
as high as 50%. Higher hub heights provide greater wind resource

19
Environmental Risk
•  Can be managed through thorough environmental research – avian
and bat studies, threatened and endangered species studies and
sensitive or threatened and endangered ecosystem or habitat
studies
•  Most agencies will work with developers on mitigation strategies
•  Typical mitigation may include wind farm layout modifications,
funding of conservation easements or habitat swaps

20
Energy Delivery Risk
•  Two components to energy delivery
–  Interconnection
–  Transmission
•  Interconnection upgrades – the cost of the substation and any
improvements to the grid that allow the power to be injected into the
transmission network at a given point – are typically born by the
developer
•  Transmission upgrades – the cost of upgrading the transmission
system to allow the injected power to reach its intended load center
– are typically born by the buyer, but imposed upon the project
economics
•  Transmission is a significant constraint at this time in most of the
US, especially in the wind-rich Great Plains states

21
Operational Risk
•  Operational risks typically impact project layout – designing tower
locations to avoid buildings, roads, and other facilities – in order to
avoid damages resulting from farm operations
•  Operational risks may include ice throw, catastrophic wind events
such as tornadoes that would knock down a tower, sound
•  O&M costs can also vary by location, maintenance schedule and
technology

22
FINANCE AND ACCOUNTING ISSUES

23
Tax Credit Financing
  Wind energy – all renewables in fact – only work because of
federal subsidies
•  The primary subsidy is the Production Tax Credit (PTC) – a tax
credit (currently $22/MWh) that is available to owners for each MWh
produced, typically renewed by Congress annually and accelerated
depreciation (5 Year)
–  The PTC financially exposes investors to wind risk
•  The American Recovery and Reinvestment Act of 2009 (Stimulus
Bill) extended the PTC for three years and, more significantly made
available the Investment Tax Credit and a Treasury Cash Grant in
lieu of the tax credit

24
ARRA ITC and Cash Grant Options
•  The ITC is a 30% tax credit and applies to investment in generating
equipment only – not to transmission and interconnection upgrades
–  Similar to the solar ITC
–  Is available only through 31 December 2012
•  Cash Grant program was designed to monetize the ITC and accelerate
wind farm investment over the next few years
–  Must be placed 2009 or 2010 or must be placed in service by the time the
ITC expires so long as construction was started in 2009 or 2010
–  Important to note that use of the cash grant reduces the basis of the
property by 50%, thus lowering the net depreciation available to the investor
–  Cash grant is payable in 60 days from application (COD) and is not taxable
income
–  Banks consider the Cash Grant to be financeable – so long as the cash
goes to reduce debt!

25
Other ARRA Benefits
•  Extension of bonus depreciation (50% 1st Year) to investments
incurred in 2009
•  Authorized $1.6 billion in Clean Renewable Energy Bonds with one
third available to local governments, public power entities and
electric cooperatives
•  Removed restriction on use of Industrial Development Bonds to
finance projects
•  Created a DOE Grant Program (Section 1705 of the Energy Policy
Act) for generation, manufacturing and transmission projects
commencing construction by 30 September 2011

26
Tax Benefit Components
•  Production Tax Credit
–  $22/MWh for the first 10 years of operation
•  ITC/Cash Grant
–  30% of Capital Investment that qualifies for 5 Year MACRS
•  Depreciation
–  5 Year MACRS for generation related capital costs
–  15 Year MACRS for civil and roads
–  15 Year SL for financing and legal for lenders/investors
–  20 Year SL for transmission system investments and upgrades
–  39 Year SL for O&M facilities
–  Indirect (allocated) for development costs

27
Deal Structuring
  Historical pattern – Pre-Crash
•  Most wind deals are done as a “Minnesota Flip,” where the tax
equity investor retains 99% ownership until the tax benefits are
consumed, and then sells or “flips” the ownership to the developer at
FMV, reducing their share from 99% to 5% - usually 10 to 12 years
•  Prior to the Financial Crash of 2008, wind farm deals were all equity
in order to avoid negative or inverted capital account balances – and
thus raise issues with the IRS under Sec. 704 of the IRS Code
(Capital Balances and partnership allocation rules) – and to avoid
returns being squeezed by banks
•  The deals repaid the cash investment and generated return of 9%
when the tax credits and depreciation were accounted for

28
Deal Structuring
  New pattern – Post-Crash
•  The Cash Grant Program recovers 30% of the investment in 60
days, thus allowing for debt financing of the balance and allowing for
recovery of the credits and depreciation in six to seven years
–  The cash grant, mitigates the risk of reduced investment recovery and
lowered returns by monetizing the investment based on the value of the
asset rather than the energy produced
•  Debt financing changes the cash flows – the bank debt consumes
cash - and puts the tax equity investor at risk to negative capital
account balances toward the end of the recovery period.

29
Who Needs Tax Benefits?
  The current challenge is in finding investors with appetite for
the tax benefits the projects generate
  A 100MW project may generate around $55 million in Cash Grant
and $47 million in depreciation over 5 years
•  Historically, banks, insurance companies and institutional investors,
seeking to shelter earnings from investment activities, have been the
leading investors tax equity
–  The Crash has all but eliminated these participants from the market.
Pre-crash it was estimated that there were 24 active players in the
market. Current estimates put it at three
•  Other investors have been Utility affiliated Independent Power
Producers such as FPL Group’s Next ERA Energy, Duke Energy
Generation Services, and Edison International’s Edison Mission
Energy unit

30
SUMMARY

31
Wind Farm Economics Summary
•  Wind farms require tax benefits – credits and accelerated
depreciation – to be cost competitive
•  The current pressure on power prices make wind farms even under
the best of conditions marginal
•  The optimal investors in wind farms under current market conditions
are energy companies seeking to diversify their portfolio and who
can utilize the tax benefits – and whom may benefit from the Green
Tags
•  The expiration of the Cash Grant program in lieu of the Investment
Tax Credit will push projects back toward PTC benefits, increasing
the exposure to wind risk for investors and reducing the tax equity
appetite for non-financial institutions and energy companies
•  Partnership Allocation Rules (Sec. 704 of the IRS Code) complicate
the use the debt in financing wind farms

32
About Firebox
•  Firebox Research & Strategy LLC is a consultancy that assists
companies in achieving their business goals through the design and
support of business and project research, strategy, planning,
management and implementation in the Energy and other
industries.
•  For more information on how Firebox may assist your firm please
contact Michael Schiller, Managing Director, at 216-691-0955 or at
Mike@FireboxResearch.com.
Firebox
Research
&
Strategy
LLC

Mixing
Business
with
Measure®

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