Renewable Energy Update

Renewable Energy Update

September 01, 2006

The share of electricity supplied from renewable forms of energy is 90% in Norway and 59% in Austria. The average is 15.7% for the 25 countries of the expanded European Union. Renewables have farther to go to catch up in the United States, but they are the fastest growing segment of the US market.

A panel of six experts talked at a Chadbourne conference in June about the use of wind, sunlight and biomass to generate electricity in the United States — where is most of the action, what returns are equity investors earning, have wind farms performed as expected, is the United States on the verge of a boom in solar projects, and what is the biggest risk for investors putting money into renewables?

The panelists are John Eber, managing director of energy investments at JPMorgan Capital Corporation, Lance Markowitz, a senior vice president and head of the equipment leasing division at Union Bank of California, Ned Hall, vice president of wind generation at The AES Corporation, Ciaran O’Brien, senior vice president for finance for the US subsidiary of Irish wind company Airtricity, Rhone Resch, president of the Solar Energy Industries Association, and Brian Robertson, chief financial officer of SunEdison. The moderator is Keith Martin from the Chadbourne Washington office.

Size of Wind Market

MR. MARTIN: John Eber, can you give us a sense of how large the wind market is in the United States for equity investors who are prepared to take part of their returns in the form of tax benefits? How many deals are expected this year?

MR. EBER: The market has expanded considerably. We have seen seven deals come to market so far this year for about 1,100 megawatts, and we are expecting at least five more for maybe another 1,200 megawatts. That would be a sizeable increase over what we have seen in prior years.

MR. MARTIN: How many deals were there last year?

MR. EBER: Final count, I think we had about 600 megawatts and maybe five transactions.

MR. MARTIN: Those are just the deals where wind companies need investors who can use the tax subsidies that the US government offers on wind farms, correct? Those are not the figures for all wind farms that went to financing last year in the US market.

MR. EBER: Correct.

MR. MARTIN: Ned Hall, turning to the nature of the US wind market, there are just a few dominant wind developers, and there are others who are trying to gain market share. Who are the dominant players, and who are the up and coming?

MR. HALL: Of course, I would like to think AES will be a dominant player. The way we try to differentiate ourselves is we bring a global footprint, about 26 countries, to our mix. Our strategy started out as a focus in the US, spreading to Europe and very quickly to the rest of the world. Since I am sitting here with Airtricity, I need to respect their accomplishments, especially in a very short period of time in the US market. I think they will be one of the top five constructors in the next two years, given the numbers that they are talking about. Obviously, everybody is playing catch up to FPL and PPM.

MR. MARTIN: So the biggest is FPL Energy. What share of the market is FPL Energy?

MR. HALL: They are approaching 4,000 megawatts out of a total installed capacity in the US of 12,000 to 13,000 megawatts, and they are probably adding 600 to 800 megawatts a year. I think to be a serious player, you need to get to scale of more than 500 megawatts, but no one other than FPL is probably approaching 1,000 megawatts at this point.

MR. O’BRIEN: I concur. I think what you will see is FPL will eventually settle around 20% of the market going forward,

and the other players like PPM Energy and AES will start catching up, but FPL are so far out in front at this point that it is difficult to see other people catching up very quickly.

MR. MARTIN: Let me offer some statistics. Current capacity is 9,134 megawatts. The

figure 12,000 to 13,000 must count what is currently under construction.

MR. HALL: Yes. Worldwide, wind companies installed around 11,500 megawatts last year.

MR. MARTIN: In 2005 in the US, 431 megawatts were installed. This year, 3,000 megawatts are expected in additional capacity in the US. Lance Markowitz, what other types of projects are you seeing besides wind in the renewable sector?

Other Renewables

MR. MARKOWITZ: People are coming in to talk about solar. There is some activity in geothermal. Biomass is also under discussion, but frankly, wind is the dominant player at the moment in terms of activity. Wind accounts for at least 80% of the renewables market.

MR. MARTIN: John Eber, you have some data, too?

MR. EBER: In terms of megawatts, wind is over 90% of what we are looking at for this year. In terms of dollars, it is probably 85% because solar is so expensive on a per- megawatt basis.

MR. MARTIN: What else have you seen besides wind?

MR. EBER: We are seeing a little bit of solar. There are a couple large solar transactions in the market and maybe a couple geothermal deals and a few biomass as well.
MR. MARTIN: Have any solar deals closed to your knowledge? MR. EBER: I haven’t seen any of size.
MR. MARTIN: Brian Robertson, have you seen any?
MR. ROBERTSON: We closed a fund called Sunny Solar

Fund with Goldman Sachs and Hudson United Bank last year. We expanded that this year to double in size. It’s a collection of about 30 smaller projects. One of the problems with solar projects is they typically sit behind the customer’s meter. They go on rooftops. They are smaller distributed generation facilities, so we batch them up into larger tranches so that the deal has enough scale to interest someone like John Eber.

MR. MARTIN: Have any biomass deals closed this year?

MR. EBER: On the equity side, I have not seen any that have closed.

MR. MARTIN: Lance Markowitz, have you seen any biomass deals close in the last year or two?

MR. MARKOWITZ: One.

MR. MARTIN: Why is biomass so slow to take off? Wind is the lion’s share of the market, and solar is up and coming.

MR. HALL: My view would be price. Wind is the lowest-cost renewable. Biomass, solar and everything else is still in the double digits in terms of price per kilowatt hour. In the case of biomass, it has been very difficult to find reliable sources of fuel. A lot of attention has been paid recently to efforts to use crops that are specifically grown for use as fuel, but no one has reached construction on a project using “closed-loop” biomass as far as I am aware.

MR. EBER: Another reason that biomass has been slow to develop may be that such projects were only recently made eligible for production tax credits. When production tax credits were first authorized for biomass projects in late 2004, it was only for five years of credits. The tax subsidy was not overpowering. The energy bill last August extended this to 10 years. These projects are longer in the development pipeline.

MR. MARTIN: The average share of electricity generated from renewables in the countries of the European Union is 15.7%, but it reaches as high as 90% in Norway and 59% in Austria. Any idea what it is in the United States?

MR. HALL: Counting hydroelectricity, it is about 10%.
MR. MARTIN: Any idea what share of that 10% wind represents? MR. HALL: It is probably less than 1% of the 10%.
MR. MARTIN: And solar is?
MR. O’BRIEN: Less than one tenth of 1%.
MR. MARTIN: So there is enormous potential for growth. Rhone Resch, what is the rate of growth overseas in solar energy installations?

MR. RESCH: For the last six years, we have seen a compound annual growth rate of 37% in solar, driven mostly by Germany and Japan, and with the United States in third place. The growth rate in the US over the same time period is about 6%.

Equity Returns

MR. MARTIN: Focusing still on our two equity investors, what returns should an equity participant investing in renewables expect in the current market?

MR. MARKOWITZ: For tax equity deals without any debt, returns have been 7% to 8% and trending downward in the last couple years from higher levels. For leveraged deals, it gets pretty dangerous to quote numbers because there are so many different structures and levels of risk, but the returns are closer to double digits.

MR. MARTIN: Interest rates are trending upward. Is that expected also to push up equity returns?

MR. EBER: It should. The number of potential equity investors has been small for the last couple years, but as the number has increased, there has been more price competition. More importantly, those of us who have been doing deals have gotten more comfortable with them and are willing to take a little lower return thinking that we understand the business risks a little better. So, they should go up, but they haven’t. Time will tell.

MR. O’BRIEN: Sorry, John. I think I’d prefer to see the market talk about spread over 10-year interest rates as opposed to those kinds of figures. This has always caused a big problem at wind conferences. People get figures in a form that makes it hard to compare structures. In an unleveraged deal, which is probably the biggest part of the market, we think the spread over 10-year interest rates should be very close to project finance-type yields, which is about somewhere between 120 and 175 points, depending on the structure.

MR. EBER: Tax equity has never been the priced the same as debt. It is a scarcer commodity. You know if you lend money, you will be paid back. If you invest equity, you will share in tax subsidies that have value only if your corporation can use them over the 10-year period such subsidies are

offered to wind farms. The debate ought really to be what premium equity should get over debt for using the corporate tax capacity.

MR. MARTIN: Is there any reason to think that returns would be any different for the solar market or for biomass than they are currently in wind?

MR. MARKOWITZ: Sure. Solar and biomass are more shallow markets. Developers have fewer investors with a good enough understanding of risk to bid. There may also be a perception that the risks are a little higher.

MR. RESCH: It is also a very different product. When you look at solar, you are providing peak power. It is 8 a.m. to 6 or 7 p.m. every day. There is a different pricing mechanism for solar. I would argue that in states like California, you will receive a premium for that product so that the margins should be greater.

MR. MARTIN: Brian Robertson, you were chafing.

MR. ROBERTSON: Yes. We have been looking at debt and tax equity term sheets in some larger projects that we have under development. We have had some success making the case that the equity returns should be lower for a leveraged solar project than a wind project because the solar tax credit is taken at inception. There is no risk of losing the ability to take part of the tax credit over time. Sunlight is also a more stable resource. It is less variable than wind. There are no moving parts in the typical solar project, and the assets have a 25-year life. We view solar as less risky than wind, and other people are starting to see it that way, too.

MR. RESCH: You also have to figure that solar is perhaps seven years behind wind. We did not have the luxury of the production tax credit. We still do not have a production tax credit, but we have an investment tax credit. That 30% investment credit has been in effect for maybe five months, and already we are starting to see a lot of interest in it. I think what you will see in the next 18 months is how the industry can put it to work.

Too Much Equity?

MR. MARTIN: There has been a perception in the market in the last year-and-a-half to two years that there are too many equity chasing after just a handful of deals. I am starting to wonder whether this view is correct.

MR. MARKOWITZ: I think that is absolutely correct. It was less true a couple of years ago, but now there seems to be a renewables conference every week, and you see hundreds of people at these conferences. And that is for a wind market with maybe 10 deals.

MR. EBER: I agree. It is not as big a market as people think. It was four or five deals a year for three years in a row. There will be 12 deals this year. There is a lot of pent-up demand. The developers on this panel will tell you they get called on by a lot of prospective equity investors.

MR. MARTIN: Ned Hall, are you having money thrown at you by people who are desperate to get into the wind market?

MR. HALL: It’s not quite like the Dilbert venture capitalist yet, but hopefully, we will get there. It is not as robust right now as the bank market. Obviously, there have been very significant new entrants on the equity side. The partnership flip model for equity participation is still relatively novel for a lot of people, but there have probably been enough projects closed using that model that we are seeing broader acceptance in the advisory and investing communities. Frankly, one reason why the FPLs and PPMs have been dominant in the wind market is the other developers lacked the tax appetite to take full advantage of the tax subsidies. It was actually enjoyable to hear Mike O’Sullivan of FPL say at the Global Windpower 2006 conference that he is starting to feel the heat.

MR. O’BRIEN: I would add that one of the things that acted as a constraint for developers was the need to get 15- year contracts to sell electricity to secure financing and the fact that contracts were awarded through RFP processes. That made the thing very complicated, as did the fallout after Enron collapsed. When I arrived here two years ago, you could not talk to anyone about a power trade for seven years or a gas hedge. Today, all the investment banks have power traders and they are able to provide developers with alternatives to power purchase agreements in some markets. The equity investors who are looking for purely contracted deals should know the market has moved on. Today, we are into synthetic power purchase agreements with hedges.

When you look at these deals, the tax subsidies account for 60% or 70% of the returns. The equity should be focusing on the quality of the hedge counterparty rather than chasing down contracted deals.

Solar Surge?

MR. MARTIN: Let’s switch focus now to solar. There was an interesting quote in sparkspread.com earlier this month. Jim Wright, who is a former managing director of Carlyle/Riverstone, has launched a fund to invest in utility-sized solar projects. “There is a perfect storm developing in solar,” Wright said. He said he is aware of some 50 solar projects that are awaiting financing. Rhone Resch, do you have the sense that there is a tremendous surge in solar projects all of a sudden and, if so, what is driving it? Is it the 30% investment tax credit?

MR. RESCH: No, it is not. There are 22 states and the District of Columbia that have renewable portfolio standards that require utilities to supply a certain percentage of their electricity from renewables. The biggest states for solar are California and Arizona. Many of these RPS states have solar set-asides or solar carve-outs. We see a market of between 7,000 and 8,000 megawatts in the next 10 years driven mainly by the California solar initiative and the renewable portfolio standards at the state level. In 2005, just for comparison’s sake, we installed about 105 megawatts of photovoltaic cells and one megawatt of concentrating solar power.

MR. MARTIN: Are you seeing membership surge in your trade association?

MR. RESCH: In the last two years, we have gone from about 70 members to 220 members. So, yes.

MR. ROBERTSON: One hundred megawatts of solar equates to about $600 million of purchases of systems. Three years ago, 100% of solar was purchased by an end customer. They just paid cash, and that was it. The market is moving today to PPA models where the customer is just buying electricity under long-term contract; he or she is not buying the solar system. Approximately $100 to $120 million of the $600 million will be financed this year based on offtake contracts.You would not have seen solar showing up on an institutional financier’s radar before now.

MR. MARTIN: There are two types of solar projects. What are they?

MR. RESCH: The first is concentrating solar power and this is desert southwest for the most part. There are three different technologies, but the one with which everyone is most familiar is a parabolic trough that concentrates the light on to a receiver tube that has oil or molten salt that runs a Rankine cycle power plant with natural gas as a backup fuel. There is one such plant under construction today in Nevada. It is a 64- megawatt plant in Boulder City, Nevada. There are about 1,500 megawatts of PPAs for other types of concentrating solar power plants. These are utility-scale power plants.

The other technology is photovoltaics, or PV, as a direct conversion of sunlight to electricity. That’s what I have on my house. That’s what you tend to see powering street signs and telecommunications facilities around the country.

But you are also beginning to see it on on commercial roofs in large, increasing numbers in states like California, Nevada, Arizona and New Jersey.

So, there are two very different types of projects. One type might be 50 to 300 megawatts in size, while the other is in the single digits to tens of megawatts potentially.

MR. MARTIN: Brian Robertson, on what type of project is SunEdison focused?

MR. ROBERTSON: We are focused on two types of deals that correspond to the two types of technologies. We are working on utility-scale deals where the financing is based on the credit of a utility. We are also working on distributed generation photovoltaic projects. In PV projects, you are financing based on PPAs with retail customers — for example, big box retailers with multiple installations.

When you compare cost of power with people talking about wind at $60 a megawatt hour, fully delivered retail power from solar at peak times is more like $150 to $200 a megawatt hour.

MR. MARTIN: Perhaps one reason solar is taking off more rapidly in Europe is that people there are accustomed to paying 25¢ or 30¢ a kilowatt hour while, in the United States, we are not. How does solar make headway in the United States when the cost of solar electricity remains so high?

MR. ROBERTSON: Fossil fuel prices are helping us by driving up retail electric rates. In some states like Hawaii, we are only a year or two away from solar being cost competitive without a subsidy. In states like California where PG&E has raised rates by 20% this year, solar electricity is at 16¢ or 17¢ a kilowatt hour. We are four or five years away from being able to compete on cost, but it is not a pipe dream. There is a path to get there. This is a market by market and utility by utility determination.

Three things are contributing to the growth in solar today. One is the federal investment tax credit. It went from 10% to 30% this year. The second is electricity rates are going up rapidly in many parts of the country, scaring consumers who have no effective way to manage the volatility. Third is the myriad state incentives that sometimes are in the form of an upfront grant and sometimes are in the form of a production- based incentive where the generator is paid by the kilowatt hour of renewable energy it produces.

MR. RESCH: The other trend in evidence is the price is coming down. We have seen an historic decrease of about 6% per year in the cost of photovoltaics, and I think we will see an even greater decrease in the cost of concentrating solar power in the near term. Part of this is due to the influx of new manufacturers in the last couple years. The manufacturers now include such companies as General Electric, Kyocera, Sharp, BP, Shell, Sanyo — both big electronics manufacturers and big energy companies. This means there is competition both on the technology side and in the scale of manufacturing that is unprecedented in the solar industry. It is this competition that is driving down prices.

Potential Growth

MR. MARTIN: The big story at the Global Windpower 2006 conference this week is that the industry has set its sights on a 20% share of the US electricity market within 10 years. Ned Hall, do you think that is achievable?

MR. HALL: I think you have to expand your thinking to the world and focus on the level of worldwide demand versus manufacturing capacity. The simple answer is we can achieve whatever we are willing to pay for. To meet a target of 20% or even 10% of the US market, you would need to think of wind turbine manufacturing as appliance manufacturing. The industry would have to make a new turbine ever 15 minutes and a blade every five minutes to get to the volume needed. The infrastructure to do this is not in place today. There are two obstacles tied to price: will we pay the price, and will the price motivate enough manufacturing to meet the targets?

MR. MARTIN: The point is the wind industry has big ambitions. What are the ambitions of the solar industry?

MR. RESCH: We start with a very, very small base. We are a decade behind wind in terms of getting used to the incentives and growing the business. In terms of the global market, Germany is the leader in installing photovoltaics. The Germans install more than eight times the amount of PV that we install here in the United States. Germany has the intensity of sunlight of Anchorage, Alaska, and yet it dominates the world market. This makes no sense.

With respect to solar, it is not a matter of if; it is a matter of when. The resource potential of the United States is unlimited. The Western Governors Association will issue a report on Monday that identifies about 10,000 megawatts of solar that will be installed in the next decade just in the western states.

Then consider New Jersey, which is the second largest solar market in the United States. Why New Jersey? Because New Jersey is finding it cheaper to invest in solar to stabilize the grid and ease congestion on transmission lines than to build new power plants or build new transmission lines. We are starting to see public utility commissions and even utilities get into the game in order to stabilize the electricity infrastructure.

MR. MARTIN: One interesting statistic from the Wall Street Journal yesterday was the photovoltaic market had $11.2 billion in investment in 2005, but is expected to grow to a $50 billion industry by 2015. However, the growth won’t come in the next two years, right? There is a severe shortage of polysilicon for making PV units.

MR. ROBERTSON: Demand has gotten ahead of the supply. There is no question about it. Demand is driven by the programs in Germany, Japan, Spain and South Korea. These countries have launched programs that make it more economically attractive for manufacturers to supply to those markets than to the United States.

Every single manufacturer is looking at the United States and the laws that have been enacted at the state level and saying the US will be the biggest market in the world by 2008 or 2009, but the manufacturers still sell their modules in the meantime to buyers in places like Germany because that is

where they fetch the highest price. Every manufacturer is selling a little capacity into the United States in order to maintain a foothold. The challenge for solar companies like SunEdison is to convince the manufacturers to establish a full presence here earlier rather than later. It is a significant challenge.

MR. O’BRIEN: In the wind business, you have a global market for equipment and subcomponents. Wind turbines are an assembly of a lot of different subcomponents made all over the world. And if elsewhere, they are willing to pay the prices, that is where the turbines will go. The United States will be short wind turbines for a number of years because it has not yet seen a massive increase in manufacturing capacity, and places like India and China are getting the lion’s share of the turbines going forward. There are physical limits to supply. The production tax credit compounds the difficulties. Because it keeps expiring and has to be renewed by Congress, manufacturers are not prepared to commit to build factories in this market. The only two new entries have been Gamesa from Spain with a factory that will build 300 to 400 megawatts in turbines a year and Mitsubishi with an additional 300.

MR. MARTIN: Those are enough turbines for three or four projects a year.

MR. O’BRIEN: That’s all it is in this market. Something significant will have to change for wind truly to take off.

MR. RESCH: That’s definitely the case with solar as well as Brian Robertson pointed out, but one of the things that we are seeing is innovation. We are seeing new technologies and, perhaps where wind was a decade ago, we are starting to see new companies enter the market with new manufacturing techniques drawn from the high-tech industries. New flexible thin film products should be available commercially later this year, and although the market is currently about 95% polysilicon based, I think that will shift. There will be new entrants in the thin film market. This should lead rapidly to an expansion in supply because they don’t have the silicon feedstock restrictions.

Also, what is happening on the poly side is pretty exciting. We expect a full doubling of capacity in polysilicon in the next two years, with all of it dedicated to the solar market. We used to get the scraps of the polysilicon industry. We now represent more than 50% of the market for those who manufacture polysilicon. In two years, we will be more than 70% of the market. The bottom line is there is a rush to increase manufacturing capacity, and we think the shortage will be behind us in a short time.

MR. HALL: What I find interesting is that the market for all of solar, wind and other forms of renewable energy is really established by the state renewable portfolio standard programs, and the number of such programs is increasing. We expect more states to add legislation this year.

MR. MARTIN: These are laws like the 1978 Public Utility Regulatory Policies Act — or PURPA — that require utilities to supply a certain percentage of their electricity from renewables. They create demand for renewables.

MR. HALL: Yes, but it is a little different in a very important way. The utilities are not required to buy the electricity at any particular price. New York is probably instructive from that perspective. It passed legislation. It set up a quasi-government organization called NYSERDA to run auctions for renewable energy credits, and NYSERDA funds the program with a surcharge on retail rates. NYSERDA just spent what it had, and it made only about half of its target. There are other states that have programs. but with virtually no teeth in them, no penalty rates.

There is clearly price pressure in the entire renewable sector today due to increasing competition for the scarce manufacturing capacity. This country has a history of starting these types of efforts and then not being willing to pay what it really costs to implement the legislation. Examples are the Clean Air Act and CAFE standards. The big question for me is: will the RPSs hold given the prices that utilities are having to pay to secure the supplies of renewable electricity that they are required by law to have?

MR. EBER: Don’t you think that RPS overall is probably more important or as important as the production tax credit?

On the possibility of a PTC extension, everyone is far more concerned today about energy dependence than the last time the PTC was up for renewal. The last time, oil was less than $40 a barrel. I see a lot of people making bets on 2008, and yet there is no production tax credit for 2008 as we sit here today. Yet, people are spending money and making commitments to buy wind turbines into 2008.

MR. HALL: I completely agree. It is really RPS driven at this point. Turbine manufacturers historically have had to give guarantees to cover your loss if they fail to deliver equipment in time to qualify for production tax credits. There are no such guarantees any longer. Today people are starting to buy 2008 machines when the legislative committee of the American Wind Energy Association is saying the likelihood that Congress will extend the production tax credit this year is less than 1%. And 2008 turbine capacity is selling out as we speak.

MR. MARTIN: Are there many projects today that have stalled due to inability to get wind turbines?

MR. HALL: There is a significant amount of excess development in the business. No doubt about it.

MR. O’BRIEN: Another fact of life is the turbine manufacturers are using their leverage to force up prices. The turbine makers were not making money the last three or four years and they are making up for it this year with increases so far on the order of 20%.

MR. MARTIN: So there are big profits to be made currently not only in oil. There has been a surge in demand in the US for renewables, but it has led immediately to shortages of essential components. Let me give you another data point. Polysilicon normally costs between $42 and $60 a kilogram, which is 2.2 pounds, but prices have surged recently to as much as $150 a kilogram. Are we reaching the point in wind or solar markets where some projects that are under development are no longer economic to build because of the run up in prices for components?

MR. HALL: Absolutely.
MR. MARTIN: Is that a concern in every project or just a few? MR. HALL: I think about it market by market. Will the

market absorb the price that must be absorbed to make projects work? In the case of wind, it depends on your capacity factor and the fuel on the margin. In places like Texas, the higher turbine prices still work today. If you can get a high 30% capacity factor site with gas on the margin and can put a forward contract or PPA in place, it will work even before additional value is assigned for renewable energy credits.

t doesn’t work in most markets. As you move into the northeast, capacity factors come down dramatically to sub 30% so that you need a fairly substantial price for the renewable energy credits on top of the electricity revenue to support the project.

MR. O’BRIEN: We think in time that utilities will offer a premium for the benefits of adding a new fuel, like wind, to their resource mixes. We have not seen it yet. There is a benefit to having portfolio diversification.

MR. RESCH: You also need to factor in carbon at some point in the near future in the United States. We haven’t discussed

that yet, but the expectation is that additional costs will be imposed on electricity generators who use fossil fuels.

To kind of answer your question on solar, even though the price has gone up, installation cost has actually remained flat or gone down slightly. In

California, the California Energy Commission data shows that the module cost is increasing, but there is more efficiency in the installation. The two offset each other with the result that the installed cost of solar systems has remained fairly constant.

Economic Drivers

MR. MARTIN: We spoke earlier briefly about the significance of tax subsidies. John Eber or Ned Hall, one of you argued that RPS standards are what is really driving the market at this point. How important are tax subsidies for solar and wind?

MR. HALL: The production tax credit provided enough of a subsidy to motivate investment when turbine prices were coming down. When you could install a project for $1,000 a kilowatt, the math worked. Today we are north of $1,500. A lot of people are quoting $1,800 a kilowatt to install a project. At that price, even the PTC is not enough to motivate the invest