Creative Financing Structures Provide Breath of Fresh Air for Wind Power Projects
2.3.05
Nandan Nelivigi, Partner, White & Case LLP
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After wind power projects ground to a near halt in early 2004, expect a surge of activity among U.S. developers now that Congress has renewed through December 2005 the federal production tax credit, which currently provides a 1.8 cent-per-kilowatt-hour tax credit for energy generated by wind or certain other renewable sources. The bulk of development activity will occur early in 2005 in order to ensure that the wind turbines are placed in service before January 1, 2006, as required to qualify for the federal tax credits. From the date a wind turbine is placed in service, it becomes eligible for such tax credits for 10 years.
In October a new law was enacted that extended a number of expiring business tax credits, including the production tax credits under Section 45 of the Tax Code that are vital to wind power project financings and have been anticipated by the market all year. Analysts predict new installations will likely exceed 2,500 megawatts (MW) in 2005. By contrast, because of the uncertainty created by Congressional delay in renewing the tax credit, less than 500MW of new capacity was installed in 2004. The push for new wind capacity is being further supported by efforts at the state level. A number of states have mandated under their renewable portfolio standards (RPS) that a specified percentage of the electricity supplied to customers be generated from renewable sources, including wind. For example, the RPS in New York requires that the renewable sources constitute 25 percent by 2013; California requires 20 percent renewable sources by 2017.
Role of Production Tax Credits in Financing Wind Projects
To maximize the advantages that the production tax credit offers, however, requires a closer look at how wind power facilities are financed. Unlike most power projects which are financed based on their revenues from power sales, financing for wind power projects depends heavily on the production tax credits. The 1.8-cent-per-kilowatt-hour tax credit could account for as much as half of a wind farm's economics. However, the availability of the tax credits itself does not translate into cash flow, which is essential to service the debt incurred to finance a wind farm. Tax credits are useful only if they can be used to reduce federal tax liability. Entities that own wind farms are typically structured as pass-through entities (like partnerships and limited-liability companies) that do not have federal income tax liability in addition to and separate from the tax liability of the equity owners of such entities.
Therefore, in order to monetize the tax savings resulting from the production tax credits, project finance lenders require the equity owners to contribute cash to the project entity in the same amount as the tax savings resulting from the production tax credits. While there are various ways to structure such cash contributions, no matter what the form, the lenders will want to ensure that the equity owners have the ability to contribute the cash attributable to savings from the production tax credits. The lenders will require these contributions whether or not the tax credits continue to be available under the tax code or can be utilized by the equity owners during the 10-year period after the wind turbines become eligible for the credits. However, the credits are only available for energy that is actually generated, so the lenders take the risk of insufficient wind or mechanical failure because the equity investor is not required to contribute cash under those circumstances.
Small Wind Developers Can Maximize Benefits by Teaming Up with Other Investors
This requirement of the lenders presents an obvious problem in financing wind farms developed by small wind developers which may not be able to use the production tax credits or may not have a credit that is acceptable to project finance lenders. One increasingly popular financing structure addresses this problem by creating a mechanism for the wind developer to share the economics of the project with a tax-oriented investor who can make use of the production tax credits and provide the credit strength that lenders value. This structure will need to be designed carefully to comply with federal income tax rules, including, in particular, the regulations applicable to special allocations of income, deductions and tax credits.
However, pure tax-oriented investors have no appetite for risk during the construction period when the wind turbines are not yet eligible for the production tax credits. That puts the burden on the small developers to find the financing necessary to see the construction through to completion. There are a number of lenders in the market which are willing to provide construction financing or bridge financing, which will either get converted into term financing or refinanced upon completion of construction.
Bond Markets Favor Wind Farm Portfolios
Institutional buyers in the bond market have also become comfortable in financing wind farms based on a combination of revenues from power sales and production tax credits. However, institutional buyers, like the tax oriented investors, also have little appetite for construction risks. Projects likely to be successful in finding financing either in the institutional bond or private placement markets are those that are fully built and operational, and preferably that are pooled together into a portfolio of several wind farms. A portfolio of wind farms has the added advantage of built-in risk mitigation through diversification in terms of wind resource in different regions, different turbine technologies, different power offtakers and other factors.
For example, in 2003 White & Case represented the underwriter in two portfolio bond financings of seven wind farms in six different locations in the United States. Large developers are likely to continue to take advantage of the pricing and the operational flexibility offered by the bond market.
Clearly the stop-and-start approach Congress has taken so far by renewing the production tax credit for only short periods of time before letting it expire disrupts the evolution of wind power as a viable source of energy in the United States. While the better solution would be for Congress to extend the production tax credit over several years to provide industry stability, both lenders and wind power developers can realize a benefit now if they embrace flexibility in how projects are structured and if they act quickly to get wind farms online.
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