The Global Windpower 2004 conference this year in Chicago attracted 3,000 people. However, the wind market has remained slow this year because a production tax credit of 1.8¢ a kilowatt hour that the US government offers as an inducement to build new wind farms expired last December. Congress is expected to renew it, but has been unable, because of partisan bickering, to pass any tax or energy legislation. Meanwhile, many institutional equity investors have been teeing up wind projects as a possible area for investment when the market revives. A number of European wind companies have moved into the US market. Other renewable projects — for example, ethanol facilities and geothermal and biomass power plants — are also attracting interest.

A panel at the Chadbourne conference in June talked about opportunities in the renewables market. The speakers are James J. Moore, Jr., president and CEO of Catamount Energy Corporation, Jerome J. Peters, Jr., senior vice president and group director for project finance at United Capital, Ciaran O’Brien, chief financial officer of Irish wind developer Airtricity, and Michael O’Friel, vice president and general counsel of Wheelabrator Technologies, Inc. The moderator is Todd Alexander from the Chadbourne office in Houston.

MR. ALEXANDER: It might be useful to start with a few facts, especially about wind farms and ethanol.

There are 6,400 megawatts of installed wind capacity in the United States. Of that amount, 1,700 megawatts of capacity was installed in 2003. During the past five years, wind capacity in the US has been growing at an annual rate of 28%. The industry has been largely on hold this year while waiting for Congress to extend a production tax credit for wind farms. The United States rewards wind developers with a tax credit of 1.8¢ a kilowatt hour on their electricity output.

Turning to ethanol, the interest in ethanol is being driven by high oil prices and the bans in California, New York and other states on a gasoline additive that competes with ethanol called MTBE. In 2003, the United States produced 2.81 billion gallons of ethanol. That was a 32% increase over the output in 2002. During the last three years, ethanol production capacity in the US has increased by one billion gallons. This year alone, $1.5 billion has been committed to the construction of new ethanol plants.

With that background, let me start by asking James Moore: Are wind projects economic without the production tax credit?

MR. MOORE: Production tax credits are necessary in the short term because most existing power contracts for wind projects are based on PTC economics. As long as they are the short-term driver, the industry will go up and down with PTCs.

If the PTC went away, I think the wind industry would be viable, albeit at a slower pace, and it would take a few years to adjust. Remember that you have renewable portfolio standards that will drive demand regardless of PTCs. I spent my career in gas and moved to the wind side three years ago. As part of my due diligence, I looked at the economics. Many wind proponents argue that wind is cheaper than gas today. That is not entirely true when one takes into account the intermittent nature of wind. But in Texas, we are doing deals today with costs of production of $40 a megawatt hour. We are selling the power net of the PTCs to utilities for plus or minus $24 a megawatt hour. If the renewable energy credits, or RECs, are worth $8 or so, then the utilities are getting windpower for $16 a megawatt hour. To compare that to gas, even if you have a 7,000 heat-rate plant and $5 gas, you’re at $35 a megawatt hour.

The bottom line is the cost of wind is competitive with gas if wind is considered part of a mix of electricity sources. It cannot compete as a standalone solution. Add the environmental and national security benefits, and it is clear we will have an increasing installed capacity in wind for the next 10 or 20 years.

MR. ALEXANDER: Jerry Peters, do you share that view? I think I have heard you say some wind projects could go forward regardless of what happens with the PTC.

MR. PETERS: The key is the renewable portfolio standard. We have no federal RPS currently, but many states have RPS’s that force the utilities in those states into the competitive market and to find renewable resources. For example, in California, a number of existing power projects are being repowered to run on renewable fuels. This is occurring without the PTC. You have four or five states concentrated in the mid-Atlantic and northeast with renewable portfolio standards and where there is a market for renewable power at rates of between 5¢ and 6¢ a kilowatt hour, which makes wind viable without the PTC.

MR. ALEXANDER: Do you share that view, Ciaran O’Brien?

MR. O’BRIEN: Yes, based on our experience in Ireland where we have managed to build a retail supply business based on wind, although our wind speeds are higher than they would be in some parts of the US. The other point I would make is that climate change initiatives are potentially very significant to this business. The RPS in the UK has had a massive impact on development of the wind business there. Last year, the UK government awarded 7,200 megawatts of wind offshore alone for developers.

In Ireland, we don’t have an RPS. We have had to build a retail supply business ourselves to show that wind can be competitive with other fuel sources. We see northeastern states like New York with high retail prices. That type of opportunity may exist here as well.

MR. ALEXANDER: Michael O’Friel, want to add anything?

MR. O’FRIEL: There are some issues with the RPS programs that are currently in place. One issue that we fight constantly is what is considered a renewable. Some states try to distinguish between good and bad renewables. As a waste energy company, we are always fighting the battle with environmentalists over whether municipal solid waste should be included in the RPS requirements. For example, New York just proposed that MSW not be counted as a renewable.

The other issue with the existing RPS programs is the purchase requirements for utilities are still fairly low. They are significantly lower than what is required in Europe. I do not think you will see a lot of renewables being developed outside the wind industry the way RPS’s are structured today.

Unlevel Playing Field

MR. ALEXANDER: Jerry Peters, how are PTCs viewed by lenders?

MR. PETERS: Is there a better way to encourage renewables?

MR. ALEXANDER: Yes.

MR. PETERS: I have a problem with the PTC for two reasons. First, it really only applies to one renewable technology and that is wind. There are many others. The second problem is it creates a situation where you don’t have a level playing field due to the fact that on a standalone project basis, you generate more tax shelter with the PTC and the ability to depreciate the cost of the project over five years than the project can use. The only companies that can benefit from the tax subsidy are a few large corporate developers with lots of other income. The greatest incentives go to the very largest taxpayers — Shell, Florida Power & Light — because they are the only ones in a position to receive the full benefit.

On the other hand, an RPS — at least as they are currently structured — is not much better. As was already mentioned, in some states hydroelectric power is not a renewable and in other states it is. I have a project in Connecticut that does not qualify as a renewable in Connecticut but does in Massachusetts. Therefore, I sell my renewable energy credits in Massachusetts. At the same time, I have two projects in Massachusetts that don’t qualify as renewables in Massachusetts, but they do in Connecticut, and I sell my rights in Connecticut. I think the best solution would be a federal RPS that would create a market for renewables nationwide.

MR. MOORE: Two Saturdays ago in Barrons, the second article in the on-line version was about wind energy and GE was quoted as saying it thought it could get the 4¢ wind cost down to 3¢ over the next decade or so. That’s really the long-term answer.

MR. O’BRIEN: We talked yesterday about who is best equipped to do development. It is hard for a small developer without a tax base — whether he be US or he be European — to start in this space. The other point to make is the successive short extensions of the PTC do not give the right market signal for this industry. A longer extension, perhaps with a lower value, would probably suit the industry better.

MR. ALEXANDER: All of that said, should we expect a frenzy of activity as soon as the PTC is renewed by Congress?

MR. O’BRIEN: Absolutely.

MR. MOORE: Let me interject two things. Many companies in this business lay off developers and slow down or stop spending money whenever the PTCs are suspended. Our view is that the PTC will be renewed. It enjoys a lot of political support on both sides of the aisle in Congress. Consequently, Catamount keeps plowing ahead with the expectation that the credit will be renewed.

Two big things have happened to the wind industry in my short three years. One is GE entered the business in a fairly big way and even ran television ads based on its corporate view that renewables and wind technology are one of the best growth bets GE has as a company. GE brought a lot of credibility to the industry. Some of the lenders were still thinking Kenetech and 8¢ power. Those days are gone. GE has given a veneer of respectability to the business. You have several other big players also moving into the industry.

The other big thing is what Jerry Peters mentioned: the ability to use the entire tax benefits within a project. Babcock & Brown worked with us on our first project in Texas that closed last year and did a phenomenal job of structuring the deal so that the tax credits could be used by third parties. The Chadbourne paper in the conference booklet explains how this is done, so it is not a secret how to do it. Bank One and Key Bank invested in Sweetwater last year down in Texas and they took the PTCs, depreciation and depreciation bonus, and Catamount and Babcock invested their own money as cash flow investors and received cash-on-cash returns.

What has happened is a lot of liquidity has come into the wind industry because there is not a lot going on in other sectors. This year, we have four lenders or after-tax institutions that will invest in the second phase of Sweetwater. Last year, we were oversubscribed. The ability to offload the tax benefits to an institutional investor is a major breakthrough for this industry, and goes a long way to solving the problem that only the balance-sheet guys could invest. Now you are seeing the Catamounts and the Babcocks being able to play alongside the Shells and FP&Ls. That is a major breakthrough in my view in terms of driving the size of this industry the next few years.

MR. O’BRIEN: My observation before even having moved here is a lot of equity is available in the US market. Recent transactions have been significantly over subscribed. I am very, very enthusiastic by the response that we get from our European lenders who have operations over here and from new US lenders who are very, very keen to get into the space. There are a lot of people chasing the same type of structure and getting good results with the PTC.

MR. ALEXANDER: Jerry Peters, is there too much competition on the bank side for these deals?

MR. PETERS: From a debt side, the main lenders continue to be the European banks. It seems like the US banks left the industry 15 years ago and never came back. I see a lot of banks hoping to play as tax equity investors as well. But I return to my earlier comment about an RPS. In this country — and it is not true in Europe — the wind industry is driven by how cheaply you can produce a kilowatt hour, and if you are bidding to supply power to a utility in a public auction where the sole criteria for being awarded the transaction is the lowest cost per kilowatt hour and you are a developer who must bring in a tax equity to compete and pay the equity part of your return in exchange for using its tax base, you are giving away part of your profitability. The person who has to put a tax deal together with Key Bank or Bank One is not going to be as competitive as FB&L who can take full advantage of the tax subsidy. That’s an unfair playing field. That’s why an RPS would be better.

Ethanol

MR. ALEXANDER: Let’s move to another topic — ethanol. It is another growth area, but one that does not seem to rise and fall whatever is happening in Congress.

MR. PETERS: Ethanol is a very hot market right now. A billion and a half dollars will be spent this year by the ethanol industry, and it is driven primarily by the replacement of MTBE as a winter oxygenate in about seven states. The removal of MTBE from gasoline will create a demand of about 5 billion gallons a year and that will cause the industry to have to grow by about 70% from where it is today at about 3.7 billion gallons.

MR. ALEXANDER: That is 70% growth over what time period?

MR. PETERS: Five years. It has the potential to require a lot of investment. Historically, that money has come from agricultural banks because corn is the basic feedstock and farm-state banks feel they know the grain business. There has not been a lot of interest yet by other banks to enter the market, but, project lenders have never exhibited much discipline in resisting the herd mentality. When there is the potential to put a lot of money into a given industry — and the barriers to entry into the ethanol market are not huge — this leads naturally to fears that the same thing that happened the merchant power market could happen in ethanol.

MR. ALEXANDER: There are no long-term offtake contracts.

MR. PETERS: Ethanol has sold in the past for unleaded fuel prices plus 52¢ a gallon, which is the amount of a so-called excise tax benefit. One gallon of ethanol makes 10 gallons of 10% ethanol blend, and for each gallon of ethanol blend you produce you get a break of 5.2¢ on the fuel tax that must be paid to the federal government. Put differently, each gallon of pure ethanol is worth 52¢ of excise tax savings. Today, with unleaded prices being at about $1.10, by adding 52¢, you have $1.62 value of ethanol and it currently costs about 85¢ a gallon to make it. So there is huge profitability in this industry.

Roughly 25 to 30 projects are currently under development. All are looking for capital. If all are built, I wonder what the ethanol market will look like.

Europe

MR. ALEXANDER: One last question for Mike O’Friel. Are US renewables companies able to compete in the European market?

MR. O’FRIEL: There is a fairly well developed waste energy market in Europe. For example, Germany has a huge number of waste energy plants. France has a large number, too. There are many big players. The projects tend to be government-sponsored projects where the government will eventually take over the facility and the role for the developer is to build, own and transfer it. That is not really something that my company is interested in doing. It is a fairly competitive market. We have looked in the past at possible projects in Europe, but have no current interest in the European market.

MR. O’BRIEN: We haven’t seen any US developers really in Europe. Europe is so much further ahead in relation to its development than the US. James Moore here is active in Scotland. Most of the traffic across the Atlantic has been in the other direction, and most of the lending for US projects is done initially from European headquarters and then localized here. The US accounts for 25% of the global power market over which 1% comes from renewables. We think renewables are an enormous opportunity in the United States, PTC or not.