Frozen Credit Markets and Falling Oil Prices Create Challenges for Renewables Projects
Chadbourne held a “green business summit” in New York on October 17. One of the panels discussed the state of the credit markets and what the inability of even large corporations to borrow money, combined with falling oil prices, means for renewable energy projects in the United States. The panelists are Brian Goldstein, managing director for syndications at BNP Paribas, Steve Cheng, a managing director in the global energy group at Credit Suisse, Paul Ho, a principal at Hudson Clean Energy Partners, a private equity fund, and Rahul Advani, a vice president and one of the founders of another private equity fund called Energy Capital Partners. The moderator is Todd Alexander with Chadbourne in New York.
Bank Debt Market
MR. ALEXANDER: New York City cab drivers tell me there is no commercial bank money for renewable energy projects because of the general freezing of the credit markets. Brian Goldstein, true or false?
MR. GOLDSTEIN: It is pretty cold out there. There is some money, but certainly the challenge is not just with renewable energy projects but with credit for the economy as a whole. Capital is limited and scarce. There are debates within banks that have money to lend about how to allocate the capital among sectors. In general, we will see a retraction toward much stronger credit profiles and higher pricing to allow recovery of costs of capital.
Speaking to the trends across all sectors, banks are having a tough time finding capital to lend. The nine largest banks lost a total of $323 billion over roughly the last 18 months.
MR. ALEXANDER: What are credit spreads for renewable energy projects today compared to six months ago, assuming you can even find someone to lend money?
MR. GOLDSTEIN: Our cost of funds was 64 basis points over LIBOR in September and is now 72 basis points over LIBOR. The credit spreads that are charged not only have to cover my LIBOR costs, which is what I must pay to get my money to lend to you, but I now also need at least another 75 basis points on top of that before I can start to charge you a credit spread for the credit risk. And because the perception is that the risk of lending to you has increased because of general economic conditions, I need to charge a larger credit spread to compensate for the perceived risk in the overall market, which has driven these spreads well above 200 basis points for investment grade transactions.
Just to show you the difference in our cost of funds and Treasuries, there is an index that tracks the difference between three-month US Treasury bills and three-month LIBOR. It jumped to over 450 basis points earlier this month. That means that, on average, banks incur 450 basis points more than the Treasury rate before they reach the point of starting to recover their bare costs of funding.
MR. ALEXANDER: How much of a secondary market are you seeing for debt instruments and how are yields in the secondary market affecting your ability to finance new projects?
MR. GOLDSTEIN: They are making it incredibly challenging. Most of us are trying to arrange loans on your behalf, underwrite those loans if we can, and then sell them to investors, whether they are banks or institutional investors. The distress in the market means that a lot of investors need to sell the paper they already hold. Supply and demand drive secondary pricing for people trying to offload assets. They are having to sell those assets at a loss. One of the real problems in our ability to underwrite paper is that the secondary markets generally trade 200 basis points higher than what we are trying to do on the primary issuance market. Therefore, either the primary issuances have to price higher to match the secondary issuances, or they have to wait until the market settles and secondary pricing comes back in line with where we believe the primary issuance should be.
MR. ALEXANDER: Does that have an effect on the size of deals that can be placed in the market? Does it favor larger deals? Renewables projects tend to be on the smaller end of the market.
MR. GOLDSTEIN: Smaller is better. We are seeing a limited appetite to underwrite and take the distribution risk. As a result, we are clubbing deals, and a smaller deal makes it significantly easier for us to arrange a lending syndicate to underwrite the full loan amount.
Institutional Debt Market
MR. ALEXANDER: Steve Cheng, Credit Suisse has been one of the leaders in the term B loan market and on other capital market raises. Does what Brian said also describe the state of the capital markets?
MR. CHENG: The difference is that the term B market is probably even more shut down than the bank market. There are a few institutions who still have the liquidity and appetite to do smaller deals, but the cost of funds is being driven by the spreads in the secondary market. A year and a half to two years ago, the sweet spot in the market was in the single B to single B plus-rated area. Deals were getting done at 200 basis points over LIBOR with those credit characteristics. Today, if you have a single B or single B plus credit, the number will start at 1,000 or 1,200 basis points over LIBOR. That implies yields of 16% to 18%.
MR. ALEXANDER: Those sounds like hedge fund returns rather than lending rates. Do you see an opportunity for new entrants to come into the market to compete with the traditional lenders because the spreads today are closer to equity yields?
MR. CHENG: There are still institutional investors with funds who need to put money to work. However, some investment funds are basically shutting down. They need to set aside cash to meet redemptions. Cash is a very valuable commodity today.
MR. ALEXANDER: Do you think some of these funds will be able to raise new capital with a seven- to 10-year life and put it to work earning these high returns? That would help with market liquidity.
MR. CHENG: The money is already there if borrowers are willing to pay such high yields.
MR. ALEXANDER: Let me ask about another trend. Credit Suisse has been at the forefront of creating financial structures that mimic either a physical output or a physical input. These structures are different forms of hedges. Are lenders willing to accept hedges in today’s market as a way of managing risk?
MR. CHENG: Deals are still getting done. People are still taking counterparty risk, but they are a lot more careful about evaluating counterparty risk and are trying to offset it. One way to offset it is by charging a higher interest rate.
MR. ALEXANDER: Brian Goldstein, do you agree?
MR. GOLDSTEIN: Yes. Banks recognize that there is counterparty risk in a hedge structure or synthetic power purchase agreement. If the counterparty is investment grade, we might have argued in the past that it was a 30 basis point risk while it is 200 basis points in the current market. We can either increase the spread to reflect the risk or we can reduce the loan tenor.
In wind deals, for example, with 10-year hedges and merchant risk on the back end, the argument internally is whether to push the credit structure back to where it was in the mid- to late 1990’s where you had very short mini-perm loans and lending limited to technologies that have been proven commercially viable.
MR. ALEXANDER: Paul Ho, you are with a private equity fund that invests in renewables. How have you been affected by the freezing of the credit markets and the downturn in the economy?
MR. HO: We are definitely affected. Renewables projects have tended to be financed in the tax equity market. Some traditional tax equity players like Wachovia, AIG and Lehman are out of business. Tax equity yields are headed up. Last year, you could get tax equity for a wind deal, for example, at a 6% or 7% after-tax yield. Now it is probably pushing toward 8%, and that is if you can even get the money. The pool of potential tax equity capital has been shrinking. Solar, geothermal and biomass companies are facing the same problem.
There has been a lot of discussion about how to increase the amount of available tax equity. One proposal that received some attention in the past was to allow master limited partnerships to be used by wind and solar companies. MLPs can be used today for oil and gas pipelines, coal reserves and other fossil fuel-related businesses. We think that would help level the playing field. It would eliminate a preference that causes capital to be directed more heavily today toward fossil fuel instead of renewables. But it is only part of the solution, since the MLP market is limited in size when you compare it to the amount of capital that a GE or AIG could marshal.
Another proposal has been to make it easier for utilities to take the tax subsidies from these projects. The Wall Street bailout bill that cleared Congress in early October makes it easier for utilities to claim tax subsidies on solar projects.
In the near term, I expect a serious slowdown through at least the end of 2008 in financings for renewable energy projects.
MR. ALEXANDER: Rahul Advani, you are also at a private equity fund. Do you want to add to anything Paul Ho said?
MR. ADVANI: I agree with Paul on his assessment about the near term. The dissolution of some key players in the tax equity market will seriously reduce the supply of tax equity.
The fact that the bailout bill let regulated utilities claim a 30% investment tax credit on solar projects — they had been barred from claiming the credit before — has caused people to take notice. You take notice when your offtakers are going potentially to be supplying meaningful parts of your capital structure. That means they will be more deeply involved in the development and structuring and have more influence over the project than they had before.
General Repricing of Risk
MR. ALEXANDER: How does the higher cost of debt affect your fund? Does it create new opportunities?
MR. ADVANI: You could see what has happened lately in the markets as a wholesale repricing of risk. The focus at Energy Capital Partners is not just on the renewable energy sector but the energy market as whole. What we saw in the last few years was lenders started assigning more value than may have been warranted to asset values. You saw lenders willing to lend and write commitments for projects that were greater than what I thought some projects had in total enterprise value. The banks assumed ever increasing asset values. That got people excited about development pipelines, especially for renewables projects. We saw big payments being made for wind and even some biofuels projects.
Today, there is a wholesale repricing. There is a renewed focus on the credit quality of the offtake arrangements. Debt yields are going up because of the higher perceived risk. Maybe the world of 6%, 7% and 8% yields is gone. Maybe we are living in a world of more expensive debt. Maybe we are living in a world of more expensive tax equity.
You need to ask yourself on a relative basis, how should I look at my equity returns? Do I now need to earn more? Don’t I need a higher yield than the lenders and tax equity investors given that, as the true equity, I am going to be taking the most risk in the capital structure?
I don’t think there will be a convergence of risk premiums so that everybody will be looking at 15% or 20% returns. Delineation will remain.
MR. ALEXANDER: You paint a bleak picture for the developers.
MR. ADVANI: I don’t mean to. At the end of the day, good projects will get financed. One of the reasons we are investing in renewable energy projects is because, relative to a lot of the other assets in the energy sector, they are better investments. You are usually dealing with proven technologies. You have the ability in many projects to build on a fixed price. You know what the project will cost to build. You may have the ability to enter into a 20- or 25-year offtake contract with a utility who needs the electricity from renewable sources to comply with state renewable portfolio standards. There are large tax subsidies.
Solar, Biofuels and Wind
MR. ALEXANDER: Steve Cheng, let’s talk through the various renewables sectors starting with solar. We have seen such a run up in interest in solar. There is probably a solar conference every two weeks somewhere in the US. Is the huge interest in solar a classic sign of a bubble like the dot-com bubble or do the economic fundamentals make sense?
MR. CHENG: You have a lot of publicly-traded solar companies, particularly manufacturers of solar equipment, and their stocks are being battered in the market. However, it is hard to assess an industry based on how well stocks perform. What drives up or drives down stock prices may have nothing to do with the fundamentals of the industry. In the longer term, solar and wind are the two leading renewables technologies that have shown the greatest potential.
MR. ALEXANDER: Rahul Advani, do you think the great interest in solar is a sign of an overheated market?
MR. ADVANI: Solar is a great product, wind is a great product, and renewables are a great product because, once they are built, they draw on a free source of energy. I agree with Steve Cheng that stock prices can be a distraction and may mask the fundamentals. However, I did a quick check this morning about what evidence there is of a bubble. I don’t mean to pick on just one company. First Solar is an industry leader. It has a market capitalization today that exceeds the combined market capitalizations of Dynegy, Mirant, NRG and Calpine. Sunpower has a smaller market capitalization, but it is still greater than the market capitalization of FPL Energy. There are still signs of euphoria in the solar market.
We are talking for the most part about proven technologies, but there is still a lot to be proven, like how the projects will perform on a utility scale. There are also emerging new solar technologies that hold out the promise of lower costs and greater efficiencies. You have a lot of people placing bets that their technologies will be the key to bringing down costs of solar power and will find acceptance in the market, but these are bets rather than sure things.
MR. ALEXANDER: Will the cost of capital for developers of utility-scale solar projects be low enough to allow them to generate their electricity for less than 18¢ a kilowatt hour?
MR. ADVANI: I think so. The really large utility-scale solar thermal projects are still off in the future. You won’t see them begin to come on line until 2010, 2011 and 2012. The good projects that are using proven technologies will succeed.
MR. ALEXANDER: Let me shift to a sector where there was clearly a bubble — the biofuel sector. Stock prices for biofuels companies have fallen as much as 90%. What do you see as the future for this sector, Paul Ho?
MR. HO: Despite the doomsday sentiment around the table, I feel like a kid in a candy store because we have money to spend. There are a lot of distressed biofuels projects. Some are looking to private equity for interim capital solutions.
On the biofuel front, we have seen the bubble burst and the publicly-traded companies are trading at a dollar or two a share. There are many challenges in that space. It is a business that requires large amounts of working capital. Many of the projects are still earning positive margins, but it is the working capital needs that are putting the companies into trouble.
The companies need more than a financial solution. In the longer run, the strategic players will be looking at moving back into the sector. The question for private equity participants like our fund is whether it is worth diving into the sector. The debt is trading at a deep discount. The question is whether we should play on the equity or debt side of the market. Adding to the uncertainty is there is a fair amount of disagreement between the two presidential candidates about what US policy should be going forward. That leaves at least some near-term uncertainty about the future viability of the biofuels market. The European Union has recently scaled back its targets. Some of the uncertainty should start to lift in the next six months. I am guessing that will bring investors back into the sector.
Another thing that warrants attention is commodity prices are coming down dramatically. We are looking at $70 oil today as opposed to $145 oil only three months ago. Ethanol is selling for $1.60 compared to $2.50 a gallon. Natural gas is under $7 an mcf. All of this has a bearing on the equity return profile of energy investments as well as how lenders look at the sector. And commodity prices could move lower still.
MR. GOLDSTEIN: We all want to do deals. By “we,” I mean lenders, equity investors and developers. What we need to do in the current market is make them clean and straightforward, and those projects that have scale and good risk mitigation will get done, because we all have an interest in finding a way to do them.
MR. ALEXANDER: Steve Cheng, wind has been the largest of the various renewables sectors in terms of scale. What effect do you see the current turmoil having on it and what is the outlook over the next six to 12 months?
MR. CHENG: Wind is capital intensive. The biggest cost is the turbines. Developers must make down payments on the turbines starting more than a year in advance. People will be scrambling to make their payment obligations over the next 12 months. Banks were willing to lend as much as 80% of the turbine cost six months to a year ago, but the advance rates on turbine loans have declined dramatically.
MR. ALEXANDER: Where are the advance rates today?
MR. CHENG: Probably less than 50%. The difference has to come out of equity. Wind developers who want to take advantage of the one-year extension in production tax credits for wind farms need to keep their places in the turbine queue and, to do that, they will be looking for other sources of capital to make turbine payments.
Impact of Falling Oil Prices
MR. ALEXANDER: Switching topics, oil prices are falling. The last time we saw a push to develop renewables was after the Arab oil embargo in the 1970’s. Oil prices were falling by the early 1980’s and interest in renewables waned. Will we see that same pattern again?
MR. HO: I’m not concerned. It is clear that the American public is as worried about energy policy as it is about the general economy. It was clear from the presidential debates that energy policy will be one of the top two or three policy priorities for whichever candidate wins the election. Renewable energy is a lot closer to competing on a purely economic footing with fossil fuel today than it was the last time around. I don’t think the government will let the opportunity pass this time to convert the economy to one based on green jobs and to wean the US from reliance on unstable sources of energy supply. Will there be a slight delay in terms of implementation of certain policy goals? Maybe. In the long run, we will find prices rising again just like in any other commodity cycle.
MR. ADVANI: At the end of the day, the future of renewable energy in this country comes down to political will. It is easy to have that conviction when oil is above $100 a barrel or when the conventional wisdom is the price will head back up or we are involved in skirmishes in the Middle East. It is more of a challenge for the politicians to remain firmly behind renewables when the economy is weak. For example, it is challenging during such periods to implement a cap-and-trade system to control carbon emissions because of the additional financial burdens imposed on power companies and electricity consumers.
The good news about political will is the cat is already out of the bag. The federal government has been slow to implement carbon controls, but the states, particularly in New England, have instituted them, and once such a system is in place, it tends to remain in place. Tax credits for renewable energy have just been extended by Congress. There are mandatory renewable portfolio standards already in place in 26 states. The policies to push renewables farther along are already in place.