The tried and tested renewable

A fair wind has been blowing for the wind energy sector for a number of years now. Global warming – which even President George Bush recognised as a fact of life last year – is inexorably moving up the political agenda. Governments around the world have set themselves some pretty challenging targets to reduce their greenhouse gas emissions by 2010-12 and some, including the UK, are so worried about the danger of black-outs next decade as the first generation nuclear reactors are shut down that they are almost clutching at straws where energy is concerned.

Against this backdrop, it is virtually unthinkable that any government would be prepared to cut the tax breaks and subsidies that are available to investors in renewable energy projects. In wind alone, these have been estimated to be worth approximate €5bn a year across the EU. Indeed, observers believe it is more likely that the support structures, including the feed-in tariffs favoured in Germany, Spain and Italy, are more likely to be enhanced than reduced.

Longer-term wind power is expected to become viable even without the need for government hand-holding. The rising oil price – which broke through the US$110 per barrel barrier in mid March – coupled with larger, more efficient turbines means that wind farms in places such as north-eastern USA and Italy are already able to wash their faces without the need for state hand-outs.

Another big attraction for investors is that – as opposed to more fledgling renewable energy technologies like tidal, biomass, wave and solar power – the basic technology for wind energy is already tried, tested and relatively mature. Over and above that, the sector enables entrepreneurs and investors to feel a warm glow of self-righteousness whilst they exercise their capitalist desires.

Tom Murley, head of renewables at HgCapital, says: “This business is here to stay. There was an early rush, but I believe that we have passed through that initial period of over-inflated expectations and we are now in a long-term growth phase.” HgCapital raised €300m for a dedicated renewables fund in December 2006, and about half of that has already invested. The Mercury Asset Management spin-out has also assembled what is described as the largest team of expert renewables investors London.

Michael McNamara, an analyst at investment bank Jefferies & Co, says: “Look at the macro trends. Wind is the lowest-cost renewable energy source and it has the advantage of combining that with high scaleability. This makes it a very easy solution to the reduction of carbon emissions. The EU’s energy targets are going to lead to some very attractive incentives and will ensure that wind energy continues to grow.”

On the back of such drivers, total installed capacity of wind energy has been growing fast in recent years. Average annual growth in installed capacity has been a whopping 28% in the past seven years. Currently there are some 100,000 wind turbines on ridges and plains around the world, and their total capacity is 94,000 megawatts (MW) – 1% of the world’s electricity production.

Although Europe has in many ways led the field, and remains the world’s biggest producer of wind energy with an installed capacity of 57,000 MW, the boom in European wind energy appears to be slowing and may have plateaued. Last year, the continent’s installed capacity grew by 18% – a marked slowdown on the 22% growth seen in previous years, and far slower than in the go-go markets of US and China. The European Wind Energy Association blames this on slow administrative processes, problems with access to national electricity grids and legislative uncertainty.

The UK – where the meteorological conditions are the most favourable for wind energy in Europe – provides something of a case study in how European wind energy has failed to live up to early expectations. Access to the national grid has been a thorny problem in the UK, with wind farm projects capable of generating thousands of megawatts currently on hold across the highlands of Scotland largely due to protracted delays to doubling the capacity of the inter-connector to England – the region where the electricity is needed most.

However Thomas Rottner managing director of Platina Finance, a London-based private equity firm whose main focus is on wind energy, believes that the real reason wind energy has failed to take off in the UK is because of the country’s planning regime.

“Planning is the showstopper,” he says. “Having a more democratic and decentralised approach to planning is all very well but the downside it is easily hijacked by well-funded opposition groups who barge into council meetings and terrify councillors with threats of lawsuits.”

Many in the industry are banking on offshore wind farms – where planning permission is clearly less of an issue – to take up the slack. However there is a problem with offshore wind. Some of the early offshore projects have turned out to be loss-making, largely as a result of the additional costs associated with maintaining turbines at sea. The British Wind Energy Association recently admitted that the levels of risk associated with offshore wind mean that “there are fewer potential suppliers of offshore wind projects within the existing manufacturing base.”

A related problem is the global shortage of turbines and other vital components. Given the recent explosive growth in the sector, the world’s leading manufacturers of wind turbines – including Denmark’s Vestas, Spain’s Gamesa and US-based GE Wind – cannot keep pace with the demand. This is causing annual costs rises of around 15% and some severe supply chain bottlenecks.

Rottner says: “In order to get a turbine gearbox delivered by 2010, a wind farm developer needs to place their order today.”

Murley adds: “The world’s developed economies are targeting an additional 30,000 MW of installed wind capacity each year, for each of the next five years. But there’s one small problem with that – the current maximum annual production of wind turbines is 18,000 MW.”

The problems are particularly acute for smaller wind energy players seeking to get their hands on turbines. Several wind farm projects have recently had to be scrapped for want of turbines.

Thanks to superior buying clout the new super-elite of the wind sector – the likes of Spain’s Iberdrola Renovables, France’s EDF Energies Nouvelles, Portugal-based EDP Renovaveis and Perth-based Scottish & Southern Energy – have had first call on turbine supply.

Murley believes that industry players acquired five times more wind energy generating capacity than financial players in the period from January 2006 to February 2008. The hiatus in the supply of turbines is having a clear effect on asset values, causing operational and already functioning wind farms to soar in value in recent months.

The flipside has been the emergence of opportunities for private equity to invest on the supply side of the wind industry. Here there are opportunities to boost capacity or bring in innovations in turbine, component and blade design and manufacturing.

In 2006, Allianz Capital Partners and Apax Partners sold the Belgium-based Hansen Transmissions – which has an estimated 80% market share of global production of wind turbine gearboxes – to India’s Suzlon Energy for €465m. Mid-market private equity players including Gresham Private Equity are also queuing up to capitalise on surging demand for turbines and other wind energy components. In December 2007 London-based private equity firm Ludgate Environmental invested €2m in Netherlands-based Emergya Wind Technologies, which has developed a new direct-drive turbine that has no need for a gearbox.

Nick Pople, a director of Ludgate Investments, says: “There is huge global demand for wind turbines and supply simply cannot keep up. This represents an excellent opportunity for EWT.”

There was strong evidence that the listed side of the renewables market had entered bubble territory following a rash of new flotations and a surge of hedge fund money into the sector in 2006 to 2007. This led to some pretty toppy share prices.

However Platina’s Rottner disputes the notions that there was a universal bubble in the renewables sector or that this has burst in the past four months. He accepts there may have been an Internet-style bubble in parts of the solar energy market but he believes that the fundamentals in the wind sector are “fairly well defined”.

The frothiness in 2006 to 2007 is more likely to have been sparked by constraints on the infrastructure side, says Rottner. What he means is that wind energy developers have been struggling to connect to the networks of high voltage pylons that criss-cross most developed countries – without which their farms become white elephants.

“Certain markets are moving faster than others towards a saturation of their infrastructure and that is driving up asset prices,” says Rottner. “In France everyone is trying to grab existing assets before the country is constrained by a lack of grid capacity.”

This explains Platina’s decision to exit from a 36 MW wind farm at Louville-la-Chenard, south of Paris earlier this year. “That was a fabulous investment for us, with a greater than 100% return on our initial investment,” says Rottner.

While inadequate infrastructure is making France a bit of seller’s market right now, Italy is currently seen as a more attractive location for buyers. “The incentives are very high and the return per kilowatt hour is double what you get in Germany,” says McNamara. “The trouble is that planning permission is very hard to come by in Italy.”

While French wind farms receive €84/MWh for the first 10 years of operation followed by a further five years where the tariff varies between €84/MWh and €28/MWh, in Italy new wind farms are entitled to a total of approximately €180/MWh for their first 15 years of life.

Spain is also another attractive place for wind farm investment. In 2005, the Government approved a new national goal of boosting installed wind power capacity of 20,000 MW in 2010, which looks achievable given the country already has 15,100 MW of installed capacity. The strength of the domestic market has enabled local players such as Iberdrola and Acciona, a family-controlled construction and energy company, to consolidate their positions and join the world leaders in wind-generated power.

But what about the returns investors can expect to generate from wind investments? According to McNamara, a wind farm can be expected to generate an internal rate of return of 12% to13% – which he believes is attractive when compared to the 5% to 6% available from government bonds. “That looks pretty interesting particularly with a medium to long-term feed-in tariff.”

Rottner believes that there is plenty of scope for private equity involvement in the sector, suggesting that purchasers of secondary assets can expect returns of 5% to 7% while those building primary assets can expect returns of 20% to 25%. It is for this reason that some funds, including those of Platina and Hg, like to blend primary and secondary assets within the same funds.

Murley, however, sees wind energy investment as a branch of infrastructure rather than a form of mainstream private equity. Whereas most private equity funds are looking for net returns of 20% to 25%, he says that infrastructure funds typically target returns in the 8% to 15% range.

He believes that private equity-style returns are only possible from wind energy if “very aggressive assumptions about the price of power or about the cost of operating wind farms are made.” However Murley says that the bull market in alternative energy assets between 2005 and 2007 means that his funds own a number of operating assets which “we could sell tomorrow and make an unbelievable private equity-style return.”

“It’s a great time to be a seller of wind farm assets. It’s a challenging time to be buyer. We’re still buying. We’re one of the few financial investors who are buying developed assets.”

At the time of writing there is little sign that the credit crunch is limiting banks’ appetite for backing investors in the sector. According to McNamara, German and Spanish banks are “very aggressively lending” at the moment. “Borrowing costs for wind farm projects have been coming down. These banks are becoming more comfortable with lending to projects and they are also prepared to debt earlier and earlier.”

Aside from uncertainty over subsidies in some markets, poor access to grids and the shortage of turbines, another problem facing the sector is the shortage of qualified and experienced managers.

McNamara warns of a serious lack of talent in the industry (partly as a result of its recent spectacular growth). In particular there is a scarcity of people with experience of obtaining planning permission for new projects, site selection, lobbying local politicians, securing turbines and building projects. Murley says: “Wind energy has gone from being a cottage industry to being a big business in the space of five years. There are still a lot of dreamers in the industry: there are too many people in it who have found a technological solution, but who can’t actually run a business.”

McNamara believes the sector’s transformation in recent years is altering the type of player that is likely to succeed in aeolian projects.

“This is a very capital-intensive business. You need a significant balance sheet. I think the era of the small private developer is now over. That’s why Airtricity sold out to Scottish & Southern Energy.” However he concedes a role may remain for small developers to do the spade-work, wind testing, obtaining planning consents, before selling either themselves or their individual projects to larger institutions.

Rottner is confident that state subsidies for wind projects are fairly secure. This is partly because it would require primary legislation to change them and also because he does not believe many politicians would dare to cut state support for clean-energy technologies. “Once an asset is built it is pretty safe. It would be pretty hefty for a bunch of politicians to go against renewable energy.”