State of the Tax Equity Market: a moderated discssion at the American Wind Energy Association fall finance conference, October 2008

Project Finance Newswire

November 2008

The US government subsidizes wind farms through tax subsidies that pay a little more than half the capital cost of a typical wind farm. Most developers cannot use the tax subsidies directly and end up bartering them for capital to pay project costs. The developer finds a bank, finance company, investment bank or insurance company to own the project in a partnership with him. The investor is allocated 99% of the economic returns from the project, except possibly cash, until the investor reaches a target return, after which the investor’s interest in the project drops to 5% and the developer has an option to buy out the remaining interest of the investor. Cash may be distributed 100% to the developer until he gets back the capital he invested, after which cash follows other partnership items and goes 99% to the investor.

The American Wind Energy Association hosts a fall finance conference each October in New York. The conference this year came at a time when US share prices were tumbling, the credit markets were frozen and Congress had just passed a massive Wall Street bailout bill. Six panelists talked about whether it is still possible to raise tax equity for wind farms and on what terms. They are David Berry, director of finance for Horizon Wind Energy, Jack Cargas, a managing director at Bank of America, Clay Coleman, director of corporate finance for Iberdrola Renewables, John Eber, managing director and head of energy investments for JPMorgan Capital Corporation, and two tax equity arrangers, Tim MacDonald, senior vice president of Meridian Clean Fuels, and Phil Mintun, managing director of Capstar Partners. The moderator is Keith Martin with Chadbourne .

MR. MARTIN: It is hard to avoid the elephant in the room. The credit markets are frozen. The headlines in the newspapers this morning are about the huge drop in US share prices. Jack Cargas, what is the current state of the tax equity market and is it still possible to get tax equity?

MR. CARGAS: Is it okay to give a Joe Bidenesque response? Yes. [Laughter]

MR. MARTIN: As long as you do a parody of both vice presidential candidates and wink coyly at the camera.

MR. CARGAS: I guess this is the part of the conversation where we were asked not to be glum, but it is quite difficult. There has been a sea change in the tax equity market, much like the sea change in the capital markets as a whole. The tax equity market remains open, but new deals have to be very, very clean.

MR. MARTIN: What is an example of something that is not clean?

MR. CARGAS: How about a wind farm that is highly levered in west Texas, a part of the country where projects run the risk of being curtailed or knocked off the grid because there is too little transmission capacity.

MR. MARTIN: Phil Mintun, you have been out in the market lately looking for tax equity investors to fill gaps in existing syndicates. How is it going?

MR. MINTUN: It is harder than it has ever been in my experience, which goes back in renewable energy projects five years and in tax equity in general 18 years. The closest parallel I can think of to what is happening today is the trouble the airline industry went through raising lease equity. The airlines ended up sheltering taxes the old-fashioned way by not making money. That was an industry-focused event. What we are seeing here is an impact on tax equity for wind that reflects a larger trend in the economy.

MR. MARTIN: David Berry, you are in the market today trying to raise tax equity for a portfolio of wind deals. How do you see the market?

MR. BERRY: Thanks for not calling on me first. It is definitely hard going. You have a limited number of players. Many of the players who did deals last year are not bidding on deals currently. As to whether we are experiencing a tsunami or a sea change, my gut is that this is a blip on the radar. I’m not saying things are going to be as easy as they were last year come this time next year, but I think these deals offer a very attractive risk-adjusted return to banks, so if you have temporary issues of adequate capital resources, liquidity and tax capacity, if you believe in the US economy and if you believe in the banking sector, then you have to believe those issues will resolve themselves and we will return to a pretty well-functioning market.

MR. MARTIN: John Eber, is it still possible to raise tax equity?

MR. EBER: I love dealing with the developers because they are such eternal optimists. It is a tough market as Phil Mintun said. Having said that, though, it is also a market that has grown at an incredible pace over the last few years with a very limited number of investors supplying the equity. We need time to catch up with the growth in demand for tax equity. The global financial meltdown is contributing to the current difficulties.

MR. MARTIN: Tim MacDonald, do you have a different view?

MR. MacDONALD: Yes. At Meridian, we take a broader view of the tax equity market, since we are raising equity for more than just wind or even renewable energy projects. We see a lot of change. The banks who had been supplying much of the tax equity for wind may not be there in as large numbers going forward, but there are other players in the wings waiting to take the stage. They have not been in the market to date because they have not been able to compete at the yields the banks have been offering. We see tax equity increasing in price, but not drying up.

MR. MARTIN: Clay Coleman, your company, Iberdrola Renewables, had a deal in the market earlier in the year and pulled it back. Did the decision to pull the transaction have to do with the market or was it something unique to the deal?

MR. COLEMAN: It was the market. I think I am more pessimistic than others on the panel. We really see this market as ugly with a blood-red capital “U.” I think the chances of getting a new deal done in the market in the fourth quarter are slim and, even looking into 2009, we are facing a severe supply-demand imbalance for tax equity, which is mainly driven by the ramp up in demand from developers. You are going to need a lot more tax equity in 2009 than we had even in 2007, which was the high water mark for tax equity investment in renewable energy. If anything, the amount of tax equity that will be available is shrinking. A lot of projects will not attract tax equity next year.

MR. MARTIN: Jack Cargas, if somebody brings you a deal for the first time next week, is it too late to close in 2008?

MR. CARGAS: It is very close to too late. I generally agree with what Clay had to say, although he may be categorizing me as one of the optimists. I think that you can get equity for the right transaction and there may be the opportunity to get a new deal closed, but some of the very large transactions that are in the market now will be very difficult to get done this year. I think transactions will get done in 2009. The direct answer to your question is if the transaction is very, very clean, there is a chance you can still get it closed by the end of the year.

MR. MARTIN: John Eber, I think you told me there were 12 to 14 institutions that invested in the wind market as tax equity in the last two years. Which is the right number, and how many institutions are still in the market today?

MR. EBER: Fourteen sounds right. If you mean this week, I count six. I had seven two days ago, but another equity investor dropped out. Nine institutions have put tax equity into wind deals so far in 2008.

MR. MARTIN: Phil Mintun, do the numbers sound right?

MR. MINTUN: Yes. When you project forward into 2009, there is a lot of uncertainty. Wachovia, which was one of the bigger investors, is being fought over by Citibank, which has been an investor, and Wells Fargo, which has been an investor. The suitors could step into net operating losses that take not only Wachovia but also the winning bidder out of the market. That said, I guess I am optimistic that the number will be larger than six next year. We have lost people in the credit crisis. The institutions don’t exist anymore. I am an optimist because if I thought this trend of shrinking numbers of tax equity investors will continue well into 2009, then I would probably be thinking about another way to earn a living.

Current Yields

MR. MARTIN: Tim MacDonald, how much does tax equity cost today in the wind market?

MR. MacDONALD: It is hard to give you a price today with events moving so quickly. Also, every deal is different.

MR. MARTIN: David Berry, do you have any way of describing where rates are currently and where they are headed?

MR. BERRY: They are significantly higher than they were last year. I think you are looking at probably a minimum of 100 basis points higher than a year ago.

MR. MARTIN: Would any of you disagree that rates are 150 to 170 basis points higher today than they were a year ago, and that’s for benchmark deals, which are portfolio deals with multiple projects that offer investors risk diversification because the projects are in more than one state and involve more than one turbine type.

MR. EBER: That’s about right.

MR. MARTIN: Where do you see rates going? If interest rates are coming down because of the economic dislocation in the economy as a whole, will that pull tax equity yields down? John Eber?

MR. EBER: Short term interest rates don’t have as significant an effect on yields in the tax equity market as you might think. Tax equity yields today are being driven more by the risk premiums that institutions are being charged for putting out capital for long periods of time. Interest rates in the broader economy are coming down, but the risk premiums institutions must pay to raise capital are going up. That is affecting yields. The imbalance of demand for tax equity to available supply is driving them up further.

MR. MARTIN: Phil Mintun, what happens after we get through this period where even large corporations with decent credit are unable to issue commercial paper. Suppose the Federal Reserve Bank starts lending and the credit markets unfreeze. Will tax equity yields come down?

MR. MINTUN: I think you have to decide first what you think are the long-term effects of the turmoil we are going through today. Will the markets be changed permanently by the experience? Beyond that, you need a healthy market where a number of participants are looking to do each deal to have any chance of bringing down yields.

MR. MARTIN: John Eber, you are my keeper of statistics. How many deals do you expect this year, how many with project-level debt, and how many with back-levered debt at the sponsor level?

MR. EBER: We expect 15 to 16 deals to close this year. I am estimating that will be about $4 billion worth of tax equity that will get raised for wind farms. Most of those are the all-equity PAPS structure. Three of those 15 or 16 deals will have project-level debt. In terms of actual dollars raised, those three represent a much smaller amount, probably 6% or 7% of the dollars raised. I count six or seven deals that are using back leverage. A lot of people in the market raising tax equity are large companies with plenty of their own capital and they aren’t using any back leverage. I haven’t seen any deals this year using the pay-as-you-go structure.

MR. MARTIN: Jack Cargas, what is a PAPS structure?

MR. CARGAS: The acronym stands for pre-tax after-tax partnership structure, and it means that the tax equity investor puts in the entire purchase price in cash up front.

MR. MARTIN: Tim MacDonald, what is a PAYGO structure?

MR. MacDONALD: In a PAYGO structure, the tax equity investor pays some amount up front and then makes continuing payments over time that are a percentage of the production tax credits it receives.

MR. MARTIN: Clay Coleman, tax equity investors tend to prefer the PAPS structure. They tend to prefer putting all their cash in up front rather than over time as they receive tax benefits. Why?

MR. COLEMAN: We have bid out our transactions both ways and consistently found that tax equity money is 50 basis points cheaper under the PAPS structure compared to the PAYGO structure.

I think there are two reasons. First, the institutions we deal with like to put all their money up on day one. If they have to fund over time, then they have to work out how to source and price the additional funding. They would rather avoid the complexity. The other issue with PAYGO is some tax equity investors have had a hard time with their auditors figuring out the appropriate accounting for it. The PAPS structure is a more traditional structure in terms of accounting treatment. The auditors find it easy to address. A PAYGO structure reduces the number of potential investors.

MR. MARTIN: John Eber, do you see a renewed interest in PAYGO or is it pretty much a relic?

MR. EBER: I was thinking about that the other day. PAYGO was created because it is an investor-friendly structure. It is better for investors who cannot write a big check today but have a steady and predictable tax base and want to invest in renewable energy. These are generally not financial institutions. Reviving the PAYGO structure may be one of the many things we can do over the next year or two to expand the number of potential tax equity investors. It comes with a cost. Tax equity is more expensive under PAYGO than PAPS, and the question will be whether the economics of the underlying project still work with a higher cost of capital.

MR. MARTIN: Do you agree with Clay Coleman that tax equity tends to be 50 basis points more expensive if a PAYGO structure is used?

MR. EBER: You can’t compare the yield in a PAPS deal to a PAYGO deal. Because the tax equity is investing over time, you need to discount back all the expected future payments to simulate an upfront investment today and then measure your benefit stream against that to get what we would call a deferred equity yield. On a deferred equity yield basis, the two structures should show an equivalent cost of money, but on a pure IRR basis, the investor yield in a PAYGO transaction will look higher.

MR. MARTIN: Phil Mintun, in a PAYGO structure, does the tax equity investor charge for keeping its capital committed for the 10-year period that the production tax credits are expected to run and over which the investor will have to make payments?

MR. MINTUN: I agree with John that the deferred equity yield concept is one investors use, but we have also seen that the developer ends up paying a premium on a nominal basis, and you could say that a commitment fee for the future use of money is effectively built into the yield.

Bailout Measures

MR. MARTIN: David Berry, what effect do you see the Wall Street bailout bill that passed Congress in early October having on the market, both because the bill may help unfreeze the credit markets and because it extended production tax credits for wind farms?

MR. BERRY: It can help the market if banks get some of these bad loans off their balance sheets. If funding costs come down, it will make it easier for banks to commit to long-term deals. The extension of the production tax credit obviously is key for deals next year. I’m not sure if banks are going to be ready to start looking at deals for next year yet, but the effort in the bailout bill to unfreeze the credit market is a step in the right direction. I think with the PTC extension, once the funding costs or the costs for capital from banks is a little clearer, then people can start working on their 2009 deals.

MR. MARTIN: John Eber, you said 15 or 16 deals will probably be done this year. That compares to 18 last year. How many of those 15 or 16 remain to be closed before year end?

MR. EBER: My guess is the bulk of them are in the process of closing now — at least half. We have seven deals in our shop alone that are in the process of closing.

MR. MARTIN: So you are going to spend Christmas in a conference room at some New York law firm?

MR. EBER: I have some poor folks working for me who will. [Laughter]

MR. MARTIN: Phil Mintun, do you agree there will be 15 or 16 wind tax equity deals this year?

MR. MINTUN: Yes. My numbers for tax equity deals this year are a little higher, but I am guessing the discrepancy in John’s number is just wind energy. I agree that more than half of the 2008 transactions are still in the closing stage.

MR. MARTIN: Jack Cargas, what effect do you see the Wall Street bailout bill having on the market?

MR. CARGAS: The fact that the PTC was extended makes us more interested in projects that were not certain to get into service this year. If the PTC had not been extended, we would have been sitting on the sidelines early next year until Congress passed an extension.

MR. MARTIN: Clay Coleman, has Iberdrola been affected by the Wall Street bailout bill or is it a nonevent?

MR. COLEMAN: We have not seen lenders starting to lend again yet. Nothing has been implemented from the bailout plan as yet other than the extension of the PTC. Looking forward into 2009, our biggest issue is the size of the market in terms of overall dollars. In 2007, the amount of tax equity in the market peaked at about $5 billion for wind farms and, since then, we have had one of the big three investors leave for an indeterminate amount of time and another of the big three is in an uncertain position. The market will struggle in 2009 to get back to the level of tax equity in 2007. The problem for developers is we need the market to double in size from where it was in 2007 and there are not nearly the number of players coming into the market to allow it to double. Transactions are going to have to be squeaky clean and even the clean ones are going to face some pretty severe pricing pressure.

MR. MARTIN: Your parent acquired a New England utility. Will that mean that you no longer need to go into the tax equity market — you can use the tax benefits yourselves?

MR. COLEMAN: We have spent a lot of time analyzing our own tax capacity because not only do we have a New England utility, but we also have a gas business that generates a fair amount of taxable income. We have been working on models to project the crossover point at which we would be able to use not only the production tax credits but also the 5-year depreciation from our future projects. The Energy East acquisition will add marginally to our ability to use the tax benefits ourselves. Our current thinking is it gives us the ability to use only 10% of the tax subsidies from projects ourselves.

Expanding the Investor Pool

MR. MARTIN: David Berry, we have heard from everybody on the panel — except you so far — that one of the biggest challenges next year will be to increase the pool of potential tax equity investors. What do you think will be the key to doing that?

MR. BERRY: I agree that it will be a challenge. Some of it will happen naturally as investors who have been out of the market are attracted back by slightly higher yields. A couple of insurance companies that have been in and out of the market are now more solidly in it because yields are increasing. We also need to reach out to new kinds of investors, like consumer goods companies, technology companies and smaller banks.

There are a couple of policy things we might do, too, that I suspect we may get to later in this discussion. The industry probably needs to lobby Congress or the Treasury Department for changes in the tax laws that help expand the investor pool — changes like how tax credits can be passed through to investors and how deal structures can be guaranteed to make them less risky for investors and more palatable to new kinds of investors. We need to have that conversation as an industry, agree on a coherent position and go try to make it happen.

MR. MARTIN: Tim MacDonald, Meridian is out calling on Fortune 200 companies constantly trying to gin up tax equity. What do you think is key to generating more interest in wind?

MR. MacDONALD: I think there is already a tremendous amount of unanswered interest. The bad news is the pricing. The guys that are not playing in the banking club need higher returns than the market is offering today.

MR. EBER: It is going to take more than just yield because the amount in dollars you need to be willing to put out the door to participate in these deals is huge. The average deal we are working on today is $300 million of tax equity, with the typical investor doing around a 25% or 30% share to participate in a syndicate.

You have to be willing to write checks for a couple hundred million dollars on the large deals and maybe a hundred million dollars on the small ones. So, in addition to yield, you have to have a lot of capital available, which is why the industry historically has fallen back on banks and insurance companies, places that have a lot of capital available and are used to moving out large dollar amounts, and that is one of the big challenges for nonfinancial institutions. There are a few people you can think of that fit the bill, but trying to get them into an energy project finance deal is quite challenging.

MR. MacDONALD: May I disagree?

MR. MARTIN: Go ahead.

MR. MacDONALD: At Meridian, we have been doing multi-investor funds in the affordable housing sector for more than 20 years. Until this year when the housing sector fell victim to the same problems that are pulling down the larger economy, we would do $250 million funds once a quarter and John is right that we would do them with smaller tickets, but there is a market that would like to be supporting renewable energy. There are alternatives to the large-ticket investors.

MR. EBER: Those multi-investor funds are finding the current market a very challenging place to operate. There are a lot of banks that are not willing to lend today to fund companies that are trying to aggregate assets or act as a bridge to when they can pull the investors in.

I agree with Tim that there are plenty of investors who can do smaller-ticket investments. The question is whether there is a way to bring them into a market where the capital requirements are huge and the capital must be delivered in fairly quick order.

MR. COLEMAN: GE put a billion dollars into the market last year. How many of these smaller investors do we need to score hits with in order to replace a single GE?

MR. MacDONALD: We routinely raise a billion dollars in the housing market using multi-investor funds, so I would argue that it is possible to do. There are prudent players who know how to participate in these partnership structures. They are just not as supportive of the industry on pricing as the banks have been.

MR. MARTIN: Phil Mintun, you have been searching for additional investors to fill gaps in existing syndicates. Why is it so hard to find an investor here or an investor there to fill such holes?

MR. MINTUN: One of the challenges is perhaps that we call the investment tax equity. When you tell a corporation you are looking for equity, the corporation has a certain return requirement in mind that is not met currently by this product and this industry. You get a lot of people who don’t even get beyond the first question. They hear “equity” and then they hear 6% or 7% after-tax returns, and the two don’t match.

MR. EBER: They want higher returns than even the developer is earning.

MR. MARTIN: Does it help that everyone with money in the stock market is seeing the value of his holdings going down? Therefore, any positive return is above market.

MR. MINTUN: I don’t think that is going to be the selling point for this business. [Laughter]

Guaranteed Return Structures

MR. MARTIN: David Berry, what about guaranteed return structures? What are they and would they be a way to attract new investors?

MR. BERRY: In partnership flip transactions, just to step back a minute, the tax equity investors have a preferred yield, so the developer may get the initial cash but, after a certain point, all of the cash and tax benefits will go to the tax equity investors until they get their preferred yield. Thus, JPMorgan makes its yield before we as a developer make a profit on our investment. A guaranteed return would reduce the risk that the investors never hit their yield. If you get to year 10 when the deal is expected to flip and the investors have not reached their target yield, then an insurer would come out of pocket and pay the tax equity investors what they need to hit their flip yield and their interest would be reduced to 5% or whatever residual interest was negotiated.

I think such structures might open up the market to new investors. You need really three things to be a tax equity investor. You need a tax appetite. You need liquidity. You need project finance know-how. The guaranteed return structure would remove one of those barriers to entry, if you will. You don’t really need project finance know-how if you have a credit-worthy entity guaranteeing the return.

The guidelines the Internal Revenue Service issued in October 2007 for partnership flip transactions said that guaranteed returns are okay, but the guarantor cannot be the developer, turbine vendor or electricity offtaker or anyone related to one of those three. It is a tough time for insurance companies, but if any of them can come up with a product whereby they are guaranteeing these yields, I think they can stand to make a decent amount of money doing it.

Another thing we should think about is whether allowing sponsors themselves to guarantee the returns on the deals might be one way to increase liquidity in the market. We would not be wild about doing that in a healthy capital market. It would require a lobbying effort and a change in position by the IRS.

MR. CARGAS: With respect to insurance companies and the like offering guarantees on the returns in these transactions, a lot of investors who are currently in the market are going to be thinking about the guarantees that they have on their affordable housing portfolios and some old lease-to-service-contract structures from guarantors who seemed bulletproof a couple years ago and are today either being replaced or collateral is having to be posted.

MR. MINTUN: AIG is what Jack is trying to say.

MR. EBER: I agree with Jack. It is not a good time to be talking about guarantees to experienced investors because I don’t think they will make a difference until we get through this disruption and we can figure out who is really credit-worthy enough to stand behind that guarantee for the next 10 years.

MR. CARGAS: I wonder if the sponsor guarantee, like David mentioned, is a good idea because you would not have had the same sort of experience with the sponsors. You think of the sponsors as being decent credits and having some financial wherewithal.

MR. BERRY: You are saying you would rather do business with utilities than other financial institutions?

MR. CARGAS: Banks don’t trust each other. [Laughter]

MR. MARTIN: Tim MacDonald, Meridian has a lot of experience with guaranteed return structures in affordable housing. Many people have suggested there are companies who have invested in affordable housing deals and never put money into wind, but they might be interested in wind if they can use the same structure. Do you think that is true?

MR. MacDONALD: I think it is. In our experience, the guaranteed return structure not only reduces the risk to the investor of reaching his return, but it also produces more favorable accounting for the investment. However, you need a credit rating behind the guarantee that, as Jack mentioned, is evaporating on us. That’s the immediate problem.

You need someone credit-worthy to take the intermittency risk and the performance risk. Guaranteeing a housing deal is pretty simple because the affordable housing tax credit is tied to the amount invested and, as long as the housing portfolio does not fail totally, there is not a lot of risk to be guaranteed. We struggle with how to get somebody to wrap the guarantee around the base case financial model in a wind deal.

MR. BERRY: Project finance banks have typically underwritten debt on these projects of a P99 performance level, which means that there is a 99% chance that there will be at least as much wind as forecasted in the base case model. In some of these partnership flip deals as the terms have become a little less favorable for developers, the deal will flip on schedule in a P95 case. What that tells me is the risk is not so enormous as to cause a rational insurance company to shy away from it. I agree there is an issue about what insurers have the reputation and balance sheet to stand behind guarantees, but the risk itself is not an unreasonable one for a financial institution to take.

MR. MARTIN: Clay Coleman, what are the main risks that would have to be covered by a guarantor if you wanted to go the route of guaranteeing just some of the risks in a deal?

MR. COLEMAN: There is very little wind risk in a traditional PAPS deal because, as David pointed out, if the investor does not reach his target yield on schedule, he just stays in the deal longer at a 99% level until he reaches his return. There is a slight reduction in the overall rate of return to the investor because the additional return expected out of the tail or residual is not reached as quickly as originally projected, but we are really only talking about a few basis points reduction in overall yield.

The big risk that the investors are taking is tax risk. They have to have tax capacity. They have to be in a position where they know they are going to be paying taxes for the next six years because that is the depreciation period. It is the period when these wind farms are generating enormous tax losses. If they don’t have the tax capacity, then they must carry the losses forward or plan on selling out of the portfolio in order to pass the benefits on to someone else.

MR. MARTIN: Phil Mintun, guaranteed return structures are challenging to do because they increase the tax risk. What is the challenge?

MR. MINTUN: There has long been attention in tax-advantaged investing to what proportion of your return comes from the tax structure of the transaction rather than the underlying business. Many of you may have heard of LILO and SILO transactions that were done in the 1990’s in which the IRS has argued that the transactions were pure tax plays. Those deals have ended up in litigation and, so far, the courts have been deciding them against the taxpayers. There is today a very significant reluctance for investors to take a lot of tax risks in these deals.

Investors have not had a good experience over the last 10 years, and anything that you do to these structures that increases the tax risk would be viewed unfavorably. The fact that the IRS came out late last year with a safe harbor for partnership flip deals was a very positive event because it took the tax structural risk, as distinct from the tax capacity risk, off the table.

The world is changing, but I would be very surprised to see people looking to add a lot of tax structural risk to these transactions.

Crossover Point

MR. MARTIN: David Berry, is it possible, if tax equity yields keep increasing, that they will reach a point where it just does not pay to raise tax equity because straight debt is cheaper? How do you determine where that point is?

MR. BERRY: Sure. We are not quite there yet, but it is absolutely possible. What we do is the analysis that Clay Coleman discussed earlier, which is you can carry both production tax credits and losses from accelerated depreciation forward. We would figure out at what point in time in the future we would be able to use them. There is a time value hit to our keeping them because a tax equity investor presumably would use the credits and losses immediately. Compare the tax value hit with the cost of doing the transaction. Tax equity is an expensive form of financing, particularly for companies like Iberdrola and Energias de Portugal, which owns Horizon, that can raise corporate debt on the balance sheets at quite attractive rates.

MR. MARTIN: Clay Coleman, do you think wind companies are even close to the point where they conclude tax equity is just not worth it?

MR. COLEMAN: The most conservative forecast you can do of your tax capacity is a self-sheltering analysis on a project-by-project basis, which is each wind farm uses its tax benefits as it has EBITDA to utilize them. You can elect 12-year straight line depreciation on a wind farm and, given the EBITDA figures we are looking at for wind farms today, you more or less match your EBITDA line in the first 12 years with the depreciation deductions and then start to use the PTC at the end of that period.

For an average project, we are finding that the reduction in the internal rate of return from using that versus an efficient immediate monetization of the tax benefits is about 300 basis points. Therefore, even if you have nothing outside of wind and you have no tax capacity other than that, you can calculate how much of a premium you are prepared to pay for tax equity above a debt yield.

Our position is a little bit better than the numbers one gets on with this “self-sheltering” analysis since we have some tax capacity outside of wind. We can use the tax benefits ourselves today on a certain number of projects with some delay. Obviously, as we continue to build new projects, we will reach a crossover point. We have done the calculation and there is a ceiling on what we are prepared to pay for tax equity and the numbers today in the market are pretty close to the ceiling.

MR. MINTUN: There are two points. Our analysis is that the breakeven rate for tax equity yields where the sponsor says “I don’t want to do this deal, I’m just going to keep this on my own books,” is very high. The more relevant question perhaps is, with project IRRs where they are today and forgetting the financing, at what point does a poorly-functioning tax equity market make people say, as they look at their capital spending budgets, “Is this a sector where I should be investing a lot of money?”

MR. MARTIN: David Berry, how are increasing electricity prices likely to affect the tax equity market?

MR. BERRY: They make it more likely that developers will be able to absorb the tax benefits themselves.

In 2003 and 2004, we were doing deals with power prices in the $20 to $30 per megawatt hour range and, with the tax credits at $20 a megawatt hour, there is no way a developer can even come close to using tax credits against the operating income of a project. Today, you are looking at power prices of $70 a megawatt hour or north of that, and they go up every year. Unfortunately, turbine costs also go up every year, but we are essentially at a point where we can use the production tax credits against the operating income of a project or you can, as Clay put it, elect 12-year straight-line depreciation and use the depreciation against the operating income of the project.

The issue is that we cannot use both the accelerated depreciation and the PTCs against the operating income, and therein lies the need for tax equity.

MR. MARTIN: Just one more math question for Phil Mintun. If a developer who can use the tax benefits itself keeps 100¢ on the dollar in terms of value, how much does that developer keep if he monetizes the benefits — 80¢ on the dollar? Is it possible to quantify?

MR. MINTUN: It varies from project to project. If you look at the present value of the after-tax cash flows to somebody who can use all of the benefits currently compared to the present value of the after-tax cash flows to the sponsor after a tax equity deal, the number is about 85¢.

MR. COLEMAN: We don’t agree with that.

MR. MARTIN: What’s your number?

MR. COLEMAN: If you think in terms of the self-sheltering analysis that I talked about, our returns are dinged by about 300 basis points if we carry the tax benefits forward for our own future use compared to immediate use of the tax benefits. Assume the tax equity investor is giving us 50% of the total capital for a project. In a PAPS structure, if we have to pay the investor a premium of 300 basis above what we would pay on an after-tax basis to borrow the capital and you multiply the 300 basis points times 50%, you get to 150 basis point impairment, if you will, in your overall economics. It’s really almost a 50-50 split on the monetization of the tax benefits.

MR. MARTIN: Any other views on the panel?

MR. EBER: What Phil described is a present-value analysis, and you can really skew these numbers depending on what discount rate you use and whether or not you can back lever the deal. Companies will have different views depending on their discount rates and what other assumptions they might layer into the structure.

MR. MARTIN: One good way for new tax equity investors to get into the market would be to buy small pieces of existing deals. They can see the paperwork and learn about the transaction. Is there a secondary market in this paper? Also, this paper is a little like a bond. As yields go up, the value of the bond goes down. How do you deal with that problem if you are a reseller?

MR. EBER: There is a secondary market, but it has not been very active until this year. We tried to get it going last year by selling new investors small pieces of existing deals in an effort to jump start a secondary market. Unfortunately, three of the four investors we picked are out of the market now because they lost their tax capacities. Currently there is a market from a few investors who overindulged in deals they did last year taking larger pieces of deals than they could absorb. They are now selling their positions at a loss because the positions are like bonds and so, if you wrote a deal in the low sixes and now the flip returns are in the sevens, the only way you can sell your position is to take a sizeable loss. Some people are doing that just to get paper off their books. It is paper that they never really intended to hold long term.

Underperformance?

MR. MARTIN: Jack Cargas, is it true that tax equity investors price based on a P50 case projection?

MR. CARGAS: They are asked to do so in most requests for bids issued by my friends at the other end of the table. We do, in fact, size transactions and price at P50, but also look at a range of other sensitivities to determine what we think is a more realistic view of how the project might perform. The P50 forecast is just not what it purports to be and so we have to look at other scenarios. We not only look at other P sensitivities, but we also look at other availability numbers, different from what is offered in the bid documents. For example, we are regularly asked to assume a 97% or 98% availability factor.

MR. MARTIN: John Eber, how have wind farms performed in practice? What does actual performance to date suggest is the appropriate P case on which to price?

MR. EBER: Our portfolio has been consistently about 10% below the P50 case. I think all the leading consultants have confirmed over the last year that the wind farms on which they have done projections have consistently underperformed by about the same percentage. They don’t have a clear answer as to why. Availability is probably the biggest reason for underperformance, but a lot of it is still unaccounted for.

MR. MARTIN: Are things getting better or worse?

MR. EBER: It is hard to say. These numbers are a little deceptive because 2008 has turned out to be a very good wind year and so sites we have that had underperformed significantly due to wind for two or three years in a row are actually performing well this year. It depends where you are in the weather cycle, but I think we have seen a systemic and consistent underperformance. The engineers say that has not happened in Europe, but it has been true of American wind farms. Part of the problem is these projects are really big, far bigger than anything they’ve dealt with in Europe. The sites are complex, and the forecasting methodology they have been employing in Europe does not work as well for conditions in the United States.

MR. MARTIN: What does a 10% shortfall equate to in P terms? Is it P84?

MR. EBER: About P80. Every wind farm is a little different in terms of how large a standard deviation you give to get to P80, but roughly that.

MR. BERRY: Keith, you asked if things have gotten better. I think they have. One thing is the developers have gotten smarter and have been more open about potential performance issues. We run wind numbers about 4% lower than where we used to. We price our tax equity deals accordingly.

It is important not to get too excited about the wind numbers being wrong because a lot of the underperformance is attributable to availability issues that have been specific to manufacturers. You have also seen projects in Texas, for example, that cannot get their power out because of curtailment problems. Finally, look at the history of the US wind power in terms of the number of turbine years. There is a huge concentration in west Texas, and 2007 and 2008 were statistically low wind years there.

I agree with John that there was a correction needed, but we think 4% is closer to the mark.

MR. EBER: I think most of the debate right now is what is the right correction. We are finance guys and we don’t really know the right correction. We just know what is going on within our portfolio. We started investing in 2003 and have wind farms from Maine to Hawaii and it is a large sample. We have enough of a sample to say that performance is consistently below what was originally projected, but we are not certain why.

It is highly inefficient for a sponsor to do a wind deal and overproject the wind because our equity is expensive and, if the sponsor is paying attention to maximizing and optimizing our equity, the sponsor should never want to go beyond the 10-year flip period and start paying us back entirely in cash. It is just not prudent for a developer to be in that position.

Therefore, I think we are both a lot better off to underestimate how the project will perform and, if every deal starts flipping in eight or nine years, then you can achieve your peak efficiency because the developer may be in a position at that point to use the remaining production tax credits itself or it can re-monetize the remaining credits by selling down another position in the project. The developer does not want to be in a position of having to help the investor reach its return by paying in cash. The currency he should use is PTCs.

MR. MARTIN: Jack Cargas, how does the choice of turbines affect the ability to finance a project in the tax equity market? Are each of the following brands financeable: Vestas, GE, Siemens, Gamesa, Clipper, Nordex, Suzlon/RePower?

MR. CARGAS: What turbine type is selected by the developer is important. We have only financed three of the turbine brands you mentioned: GE, Siemens and Gamesa. Vestas is obviously a well-established brand. We are prepared to look at other turbine types as well, but would have to give them a thorough scrubbing before deciding whether to participate in projects with those turbine types.

MR. MacDONALD: One of the problems that we see when people bring an unproven turbine to us is the manufacturers seem to think that they can offer warranties and other support to the turbine on a par with what a GE or Siemens offers, and that just isn’t true. Manufacturers with unproven brands have to go back and offer the same kind of warranties that Vestas was offering when Vestas was a small vendor, and that’s a big problem.

Absorption Issues

MR. MARTIN: Phil Mintun, we are running into more absorption issues in the tax equity market this year. IRS rules allow as much as 99% of the tax subsidies to be allocated to the tax equity investor in theory. However, in practice, it may be impossible to get him a 99% share. Why?

MR. MINTUN: It gets very technical, but the problem is that investors are running out of capital account or outside basis. These are measures of what an investor put into the deal and what he takes out. They usually cannot go negative. A deficit is a sign that the investor took out more than his fair share. Construction costs have been escalating, with the result that projects are less profitable and there is less of a cushion to absorb the tax benefits and make sure that the tax equity can get its return by the target date 10 years out.

MR. MARTIN: David Berry, you told me earlier that deals are getting less efficient in terms of the tax equity investors’ ability to absorb the tax subsidies and that tax equity investors today absorb the full production tax credits but only 65% to 70% of the depreciation. Is that correct?

MR. BERRY: They absorb only that fraction of the accelerated nature of the depreciation. In the typical deal, we will attempt to pass through 99% of the depreciation deductions to the tax equity investor, but after the investor runs out of outside basis, the investor must carry the remaining depreciation forward in time. There is a time value loss in the investor being unable to use the depreciation immediately.

MR. MARTIN: One solution to having too little capital account is for the tax equity investor to step up to something called a deficit restoration obligation. The investor declares itself willing to put money into the tax equity partnership when the partnership liquidates if the investor still has a deficit in its capital account at that time. Jack Cargas, have you noticed a greater reticence this year by equity investors to step up to deficit restoration obligations?

MR. CARGAS: It’s an interesting question. When we first got into this market, which was only 18 months ago, we were very concerned about DROs. We wanted to do a clean deal without a deficit restoration obligation. Over time, we have become more comfortable with the concept and have agreed to step up to DROs, so that might be slightly counter to the response you were expecting.

MR. MARTIN: Clay Coleman, are equity investors more reluctant this year to step up to deficit restoration obligations?

MR. COLEMAN: We have not had an active term sheet discussion regarding DROs or anything else for several months, so I don’t know if the picture changed. However, the major players seem fine with DROs. They allow you to pass on only the production tax credits effectively. They do not do anything for depreciation.

MR. MARTIN: John Eber, are equity investors less willing this year to agree to deficit restoration obligations?

MR. EBER: I think so. The trend this year has not only been higher tax equity yields but also investors wanting to do safer deals. They can afford to pick only the best deals because there is an oversupply of opportunities. That means that DROs are less common. I don’t think it is a go-or-no-go question with DROs. It is a question of how much an investor is willing to commit to put in as additional capital, if necessary, at the end if he has a deficit in his capital account.

We have benchmarks in our shop. Many of our partners also have benchmarks about how much of a DRO they will take. We usually cap the DRO at a level that the base case model suggests will reverse itself. The DRO is an off-balance-sheet liability that none of us expects to be called, but you want to be prudent and not build up too much of that kind of exposure.

MR. MARTIN: What is a typical percentage cap for you?

MR. EBER: It seems like a popular percentage is around 20%.

MR. MARTIN: One other solution to having too little ability to absorb tax benefits is to put debt at the project level, as that makes the depreciation easier to absorb. However, it also increases the yield the tax equity investors will require. By how much, Jack Cargas?

MR. CARGAS: We have not done a transaction with project-level debt and we are not likely to do so. I hear anecdotally that there is a delta of 200 to 250 basis points between a typical unlevered PAPS deal and a levered PAPS deal.

MR. MARTIN: Why will you not do leveraged deals?

MR. CARGAS: We think these transactions are complicated enough without having a third party at the table.

MR. MARTIN: John Eber, if the lender agrees to forbear from foreclosing until the tax equity reaches its yield or until the production tax credits run, does that mean that the tax equity yield does not bump up?

MR. EBER: No, I think the yield will always bump up because you are investing fewer dollars but absorbing the same amount of tax benefits. You need a larger return in a leveraged deal, even if the risk is the same, because you are being asked to absorb a lot more tax benefits in relation to the dollars invested and using up more tax base that could have been applied to another investment.

The biggest impediment to leveraged deals is you usually need a 20-year power purchase agreement to make a leveraged deal work and such long-term power contracts are becoming rare. Few banks will lend to a project unless there is a long-term fixed-price offtake contract.

Merchant Plants

MR. MARTIN: John Eber, how much protection would a developer have to show for power prices in a merchant deal to get tax equity financing?

MR. EBER: The preference is to get at least 10 years. If you go back a few years, all the deals had long-term PPAs. In the last year and a half, everybody has wanted to go merchant and hedges have become commonplace. However, today, with the limited tax equity available, the remaining investors are keen to do only the best deals. In this market, you need a minimum of 10 years of price protection. A PPA is even better.

MR. MARTIN: What special issues are there with a hedge in the form of a swap of fixed for floating electricity prices? Does the tax equity investor view the swap as the equivalent of debt and ask for a higher yield?

MR. EBER: I think there is a higher yield requirement when you have a swap — yes — but not as much as if you had debt.

MR. MARTIN: So if real debt bumps up the tax equity yield by 200 or 250 basis points, what does a swap do?

MR. EBER: It is hard to say. It depends on the quality of the swap provider, his creditworthiness. It depends on the terms and conditions of the swap and whether the swap provider takes a security interest in the wind farm or whether something might happen in the swap to cause the project to have to post additional security. I have seen everything from not adding much cost at all to adding 50 to 75 basis points, depending on the quality of the swap.

MR. MARTIN: We are down to the last question. Phil Mintun, what do you think will be the main topic of conversation next year for this panel? What will we be discussing then?

MR. MINTUN: It will be what happened to the huge amount of investment that had been expected to go into the wind sector in 2009.

MR. MacDONALD: I think we will be talking about how multi-investor funds work and how — [Laughter].

MR. EBER: I agree with Phil Mintun. I think 2009 is going to be a very tough year because there is a lot of unmet demand from 2008 that will roll into 2009. When you layer on top of that the 2009 demand that appears to be coming, there will be a huge gap between demand for tax equity and the available supply, unless something changes significantly like people back off projects or some significant new sources of tax equity appear over the next few months.

MR. COLEMAN: I echo that. We could see the demand for wind tax equity next year being on the order of $10 billion and the supply peaked in 2007 at $5 billion. Obviously, if you keep on jacking up yields, you can bring other corporate investors into the market, but we will arrive quickly at a point where tax equity is demanding a higher yield than the wind farm itself earns and that’s not a sustainable business model. The bottom line is I think we are going to be talking about the ongoing demand and supply imbalance for tax equity.

MR. CARGAS: In addition to that conversation, I think we will be having the same conversation we had for most of this year — the one that ended on October 3 with passage of the Wall Street bailout bill — and that is whether Congress will extend the production tax credit again.

MR. BERRY: Does the rise of energy, and renewable energy in particular, to one of the three or four most important topics in the presidential election translate into a coherent and favorable policy on the federal level for wind energy.