- Email: [email protected]
Leasing wind turbines (and its alternatives)
PERGAMON
Renewable Energy 16 (1999) 872-877
LEASING WIND TURBINES (AND ITS ALTERNATIVES) JONATHAN H JOHNS FCA AT11 Ernst & Young UK Renewable Energy Unit, Broadwalk House, Southernhay West, Exeter, EXl lLF, UK Tel: 44 1392 433541 Fax: 44 1392 42483 1
ABSTRACT The financing of wind farms has historically consisted of a mixture of traditional debt and equity, with debt generally being provided by high street or specialist banks, through inter-company loans, or from International Funding Agencies (IFA’s) via National Funding Agencies in developing countries. The use of more innovative fmancing methods has to date been limited. One possible method of attracting finance for wind farms is the leasing of wind turbines, and this paper sets out the reasons leasing is particularly appropriate for renewable energy (RE) projects (in particular wind farms), the effect leasing may have on returns available to investors, and some of the obstacles that have to be overcome by the RE and wind industry to increase the utilisation of leasing. This paper concludes by discussing the possibility of using a pan-European leasing company as a means of providing overseas aid to developing countries, thereby facilitating the implementation of wind energy in these importantregions. 0 1998 Published by Elsevier Science Ltd. All rights reserved.
BACKGROUND & YOU I
of Worldwide
m Wmd Enerev
World-wide investment in wind energy has been estimated to total fl71 billion by the end of 2020, with rapid growth from around El2 billion in the ten year period from 1990 to 2000 up to f 116 billion in the ten year period from 2010 to 2020. 0960-1481/99/S-see front matter 0 1998 Published by Elsevier Science Ltd. All rights reserved. PII: SO960-148l(98)00291-2
WREC 1998
873
The graph below illustrates Ernst & Young’s estimate of regional investment in wind energy between the years 1990 and 2020: Estimated
investment
by regiorr 1900-2020
Note: Wind energy includes wind and small scale Nrbines used for generating electriaty or pumpingwater
It can be seen that North America is predicted to be the most significant wind energy market in the world, with total investment between 2010 and 2020 estimated at approximately f56 billion. Both Western Europe and the Pacific/China regions are also estimated to represent considerable markets during the periods studied. Other regions, such as Latin America, Mid East and North Africa and Sub-Saharan Africa are estimated to remain relatively undeveloped in terms of wind energy until the 2010 to 2020 period. used Fy A view of the typical financing structure used in wind farms in the UK can be expressed as follows:
The actual sources of finance used in specific wind farms varies considerably by the type of developer and the scale of the wind farm. Larger wind farms in the UK tend to be owned by large corporates, such as regional electricity companies or power generating companies (or their subsidiaries), and are developed either in-house or purchased from specialist developers. In such cases finance is usually sourced through inter company loans from the parent company(s), (effectively underwritten from Corporate Eurobond or equivalent financing). Medium sized independent projects tend to be project fmanced using special purpose vehicles, with a traditional mixture of debt and equity and sometimes some other form of fUnding such as grants or donations, for example those available from the EC.
874
B’REC 1998
The financing of small community schemes is very much dependent upon the resources available to the project proposers. In the UK community based financing has been aided by the Enterprise Investment Scheme, the conditions of which have been relaxed in terms of capital invested, by the 1998 Budget. Community based financing is particularly common in Scandinavian and Benelux countries and Germany where it has been supported by local banks and electricity purchasing regimes. In the developing world, local tax based incentives and/or World Bank or other IFA assistance has often been an important prerequisite of financing.
LEASING AS A FORM OF FINANCING WIND FARMS A significant attraction of leasing is the way in which finance houses are able to share some of the benefits gained from offsetting capital allowances against their profits with the asset operators (lessees), providing a cheaper source of finance than conventional loans. In this way leasing companies have rapidly expanded their market share. In the UK under the current capital allowance regime (25 per cent reducing balance on plant and machinery), businesses which find leasing attractive are those, particularly in manufacturing, who continue to experience low marginal rates of taxation or indeed tax losses. RE projects tend to have tax losses in early years due to the high level of capital allowances and are therefore suitable for finance leasing in particular. In the UK it was thought that the Finance Act 1997 adversely affected the prospects for leasing on the basis that some wind turbines (i.e. those with a life greater than 25 years) would be classified as long life assets and would therefore be less attractive to leasing, with lower capital allowances of 6% per annum. However, Inland Revenue Tax Bulletin No 30 indicates that until technology is proven, such assets are likely to be regarded as “not long life assets” (dependent upon manufacturers statements), and therefore eligible for higher rates of capital allowances. Accordingly the advantages of leasing described remain available to the UK industry. Leasing (and HP) enables a business to diversify its sources of finance, analyse more closely the cost of an asset in respect of the income stream generated from it, accurately budget for costs, and fix interest rates. In considering asset based finance as a source of finance, RE developers should also consider other capital requirements such as working capital and the attitude of lenders if they do not have security over the whole of the project. Although not all of these benefits (for example economies of scale from bulk purchase) are likely to be available to lessors in the RE industry, it is primarily due to the relative immaturity of the RE industry that leasing is not yet a common-place alternative to senior debt. A further complication is that residual values of RE equipment are likely to remain uncertain and therefore the credit standing of the developer is a more important factor (than would be in the case of a car lease, for example, where the asset is readily sold at relatively predictable values). The continuing maturity of the RE market (in particular wind energy) and the estimated high levels of investment, make leasing appear likely to feature as one of the more significant sources of finance in the future. The characteristics of RE projects are similar to those in the water and conventional energy industry, where the use of leasing is widespread, partly because the majority of such projects are backed by companies with strong financial covenants. Many RE projects involve RECs, generators or local authorities with a similar status to companies involved in the water and conventional energy industry. In addition, a guaranteed income stream (such as in the case of NFFO in the UR), helps to compensate for the lack of certainty as to residual values. As the reason for using leasing is primarily tax driven, a developer of an RE project should consider the other forms of tax planning available, which in the case of corporate entities involves the use of group and consortium relief. In some cases these can be more attractive than leasing in which case senior debt financing should be used.
875
WREC 1998
There are two main types of lease and one allied form of debt, hire purchase, which we describe below (using UK GAAP): Lease w part of a tw An operating lease involves the user (the lessee) paying a rental to the owner of an asset (the lessor) for the hire of that asset, for a period of time, which is normally substantially less than the asset’s useful economic life. The asset is not capitalised and rentals are charged to profit and loss. B. A finance lease is structured so that the lessor will recover all, or substantially all, of its original investment, together with a return on the finance provided from the lessee. This is determined by what is known as the 90 per cent test. The asset is capitalised and depreciated over the shorter of the lease term (including secondary period), or its useful life. (onlv where y This is not a type of lease but is similar in many ways to a finance lease. The major difference is that legal title to the asset passes to ,the purchaser at the inception of the agreement and therefore capital allowances flow to the facilitator (whereas under leasing they flow to the lessor). The asset is capitalised and depreciated over its useful life. As the effectiveness of leasing is primarily tax driven, the tax regime operating within specific countries and the availability of fiscal incentives for the development of RE determines whether the application of leasing will be effective within a particular country. The table below summaries the possible application of leasing wind turbines in the six largest wind markets (in terms of installed capacity during 1996):
India
Specral mxamn rreatmenrfor windprojecrs
Possible odvarmges of lensmg
No special taxation roles apply to wind energy.
The leasing tax deduction rate is usually higher than the tax depreciation rate on owned assets. Care however needs lo be taken in drafting the lease to ensure that the deduction vests in the correct person.
5 yearincometax holiday.
Similar to the
UK.
100% accelerated depreciation in the fust year. Denmark
Income tax credits. Capital grants for wind energy have now stopped
Sunilar to the LJK
Spain
No special taxation rules apply to wnd energy.
In broad terms the tax allowances available on leased assets are accelerated as the rate of allowances on leases is twce that of owned assets.
UK
No special taxation rules applyto wind
energy.
If the project is loss making, it may be possible to effectively access some of the tax allowances on the plant by way of leasing. This is aclueved by the lessor being able to claim tax allowances on the turbine and then share that tax saving with the lessee by way of reduced lease rentals.
tax creditsfor investors in green funds.
Finance leases are treated as hire purchase contracts and therefore there is no advantage over straight forward purchase. VAMILwill apply to Dutch resident lessors and therefore advantages similar to those obtained on operating leases. VAMIL does not apply to non-Dutch resident lessors.
Income
VAMIL, the Accelerated
Depreciation of Envinmmental Investment Scheme enables companies that pay income o* corporation tax to choose when to depreciate capital investments in windtwbines. undervAh4E_hubinescanbe depreciated in the fast year, depreciation can be deferred, or turbines can be depreciated in ‘WOCW when the company is making profits
WREC 1998
876
The advantages of leasing over loan finance, with and without a finance lease structure, are best evidenced by a comparison of IRR’s achieved, which for wind shows the following impact.
Wind
Gearing ratio %
Loall RR%
Lease RR%
Benefit of lease over loan %
81
18.1
22.5
4.4
Geartng ratio includes mezzamne f-we, (unsecured debt). If this was also provided by the equity shareholders, rather than by a thud party financial institutions, then the IRFl’s for both loan and lease would be reduced by a similar amount wthout affectmg the trend shown.
vtoT_ The benefits of finance leases over loan finance are affected by changes in corporation tax rates and the rate of capital allowances (or asset depreciation) on each asset type. As these rates vary from one country to another, it can be expected that the IRR of a project using lease finance will also vary. MAIN BARRIERS TO OVERCOME As the success of attracting new and more competitive sources of finance, including leasing, to the RE industry largely depends upon the financiers’ understanding of RE, one of the major challenges facing the industry is the education of the financial community. To assist with this education, Ernst & Young have developed a risk model comparing different RE technology investment profiles and comparing investments in RE to more conventional investments. The graph below demonstrates the risk and return profile of various generic RE projects compared to some more conventional investments:
Generic RE projects show less favourable returns than many of the returns available to the private investor, which may explain the relative lack of specific RE investment vehicles that facilitate private investment. However our work demonstrates that many RE projects represent investment opportunities reasonably close to the market line, with large wind and hydro (in the context of NFFO), and landfill gas appearing to out
877
WREC 1998
perform the FTSE 100, and some of the tracker investment vehicles that have proved so popular with general public investors. If RE investments were marked by reference to these benchmarks then greater uptake may be possible, accordingly further education of the investment community is required. In addition, several other developments are likely to be required in order to encourage the leasing involvement in BE, for example:
industry’s
(a) improved availability of information on the operational performance and residual value of underlying equipment; (b) the availability of extended manufacturer’s guarantees and maintenance and output warranties; and (c) the direct involvement of manufacturers in their own leasing subsidiaries, set up with the backing of financial institutions. This could be particularly beneficial to both existing manufacturers and importers wishing to shelter the profit on their domestic activities. A PAN EUROPEAN LEASING FUND A central fund could be established to lease equipment to RE projects therefore reducing the need for other investment in project development in terms of both cost and lead times. The objective of such a fund would be to create a simplified process generating economies of scale for financing capital equipment and enabling the finance of equipment to projects outside of Europe. Fund participants could include the EC, equity houses and equipment manufacturers. In addition an EC grant could be used to fund the difference between what the local project can sustain in terms of a payment mechanism and what is required to satisfy the equipment funding repayment. To assist the funding of payments it is possible to link the payment mechanisms to the output of the scheme and the local culture in the recipient market. Benefits can be obtained through bulk buying of equipment which could improve the penetration of EC BE equipment in export markets. The use of bulk buying can be applied to most technologies as the equipment is, in most cases, relatively portable. The updating of equipment would also be easier to implement thus assisting in the mass application of a particular technology. This will also facilitate the transfer of an element of project risk. The timd couId also be linked with an EC guarantee and could even fund itself through loan securitisation e.g. through it’s own bond issue. This type of mechanism could be targeted to specific countries.
Renewable Energy 16 (1999) 872-877
LEASING WIND TURBINES (AND ITS ALTERNATIVES) JONATHAN H JOHNS FCA AT11 Ernst & Young UK Renewable Energy Unit, Broadwalk House, Southernhay West, Exeter, EXl lLF, UK Tel: 44 1392 433541 Fax: 44 1392 42483 1
ABSTRACT The financing of wind farms has historically consisted of a mixture of traditional debt and equity, with debt generally being provided by high street or specialist banks, through inter-company loans, or from International Funding Agencies (IFA’s) via National Funding Agencies in developing countries. The use of more innovative fmancing methods has to date been limited. One possible method of attracting finance for wind farms is the leasing of wind turbines, and this paper sets out the reasons leasing is particularly appropriate for renewable energy (RE) projects (in particular wind farms), the effect leasing may have on returns available to investors, and some of the obstacles that have to be overcome by the RE and wind industry to increase the utilisation of leasing. This paper concludes by discussing the possibility of using a pan-European leasing company as a means of providing overseas aid to developing countries, thereby facilitating the implementation of wind energy in these importantregions. 0 1998 Published by Elsevier Science Ltd. All rights reserved.
BACKGROUND & YOU I
of Worldwide
m Wmd Enerev
World-wide investment in wind energy has been estimated to total fl71 billion by the end of 2020, with rapid growth from around El2 billion in the ten year period from 1990 to 2000 up to f 116 billion in the ten year period from 2010 to 2020. 0960-1481/99/S-see front matter 0 1998 Published by Elsevier Science Ltd. All rights reserved. PII: SO960-148l(98)00291-2
WREC 1998
873
The graph below illustrates Ernst & Young’s estimate of regional investment in wind energy between the years 1990 and 2020: Estimated
investment
by regiorr 1900-2020
Note: Wind energy includes wind and small scale Nrbines used for generating electriaty or pumpingwater
It can be seen that North America is predicted to be the most significant wind energy market in the world, with total investment between 2010 and 2020 estimated at approximately f56 billion. Both Western Europe and the Pacific/China regions are also estimated to represent considerable markets during the periods studied. Other regions, such as Latin America, Mid East and North Africa and Sub-Saharan Africa are estimated to remain relatively undeveloped in terms of wind energy until the 2010 to 2020 period. used Fy A view of the typical financing structure used in wind farms in the UK can be expressed as follows:
The actual sources of finance used in specific wind farms varies considerably by the type of developer and the scale of the wind farm. Larger wind farms in the UK tend to be owned by large corporates, such as regional electricity companies or power generating companies (or their subsidiaries), and are developed either in-house or purchased from specialist developers. In such cases finance is usually sourced through inter company loans from the parent company(s), (effectively underwritten from Corporate Eurobond or equivalent financing). Medium sized independent projects tend to be project fmanced using special purpose vehicles, with a traditional mixture of debt and equity and sometimes some other form of fUnding such as grants or donations, for example those available from the EC.
874
B’REC 1998
The financing of small community schemes is very much dependent upon the resources available to the project proposers. In the UK community based financing has been aided by the Enterprise Investment Scheme, the conditions of which have been relaxed in terms of capital invested, by the 1998 Budget. Community based financing is particularly common in Scandinavian and Benelux countries and Germany where it has been supported by local banks and electricity purchasing regimes. In the developing world, local tax based incentives and/or World Bank or other IFA assistance has often been an important prerequisite of financing.
LEASING AS A FORM OF FINANCING WIND FARMS A significant attraction of leasing is the way in which finance houses are able to share some of the benefits gained from offsetting capital allowances against their profits with the asset operators (lessees), providing a cheaper source of finance than conventional loans. In this way leasing companies have rapidly expanded their market share. In the UK under the current capital allowance regime (25 per cent reducing balance on plant and machinery), businesses which find leasing attractive are those, particularly in manufacturing, who continue to experience low marginal rates of taxation or indeed tax losses. RE projects tend to have tax losses in early years due to the high level of capital allowances and are therefore suitable for finance leasing in particular. In the UK it was thought that the Finance Act 1997 adversely affected the prospects for leasing on the basis that some wind turbines (i.e. those with a life greater than 25 years) would be classified as long life assets and would therefore be less attractive to leasing, with lower capital allowances of 6% per annum. However, Inland Revenue Tax Bulletin No 30 indicates that until technology is proven, such assets are likely to be regarded as “not long life assets” (dependent upon manufacturers statements), and therefore eligible for higher rates of capital allowances. Accordingly the advantages of leasing described remain available to the UK industry. Leasing (and HP) enables a business to diversify its sources of finance, analyse more closely the cost of an asset in respect of the income stream generated from it, accurately budget for costs, and fix interest rates. In considering asset based finance as a source of finance, RE developers should also consider other capital requirements such as working capital and the attitude of lenders if they do not have security over the whole of the project. Although not all of these benefits (for example economies of scale from bulk purchase) are likely to be available to lessors in the RE industry, it is primarily due to the relative immaturity of the RE industry that leasing is not yet a common-place alternative to senior debt. A further complication is that residual values of RE equipment are likely to remain uncertain and therefore the credit standing of the developer is a more important factor (than would be in the case of a car lease, for example, where the asset is readily sold at relatively predictable values). The continuing maturity of the RE market (in particular wind energy) and the estimated high levels of investment, make leasing appear likely to feature as one of the more significant sources of finance in the future. The characteristics of RE projects are similar to those in the water and conventional energy industry, where the use of leasing is widespread, partly because the majority of such projects are backed by companies with strong financial covenants. Many RE projects involve RECs, generators or local authorities with a similar status to companies involved in the water and conventional energy industry. In addition, a guaranteed income stream (such as in the case of NFFO in the UR), helps to compensate for the lack of certainty as to residual values. As the reason for using leasing is primarily tax driven, a developer of an RE project should consider the other forms of tax planning available, which in the case of corporate entities involves the use of group and consortium relief. In some cases these can be more attractive than leasing in which case senior debt financing should be used.
875
WREC 1998
There are two main types of lease and one allied form of debt, hire purchase, which we describe below (using UK GAAP): Lease w part of a tw An operating lease involves the user (the lessee) paying a rental to the owner of an asset (the lessor) for the hire of that asset, for a period of time, which is normally substantially less than the asset’s useful economic life. The asset is not capitalised and rentals are charged to profit and loss. B. A finance lease is structured so that the lessor will recover all, or substantially all, of its original investment, together with a return on the finance provided from the lessee. This is determined by what is known as the 90 per cent test. The asset is capitalised and depreciated over the shorter of the lease term (including secondary period), or its useful life. (onlv where y This is not a type of lease but is similar in many ways to a finance lease. The major difference is that legal title to the asset passes to ,the purchaser at the inception of the agreement and therefore capital allowances flow to the facilitator (whereas under leasing they flow to the lessor). The asset is capitalised and depreciated over its useful life. As the effectiveness of leasing is primarily tax driven, the tax regime operating within specific countries and the availability of fiscal incentives for the development of RE determines whether the application of leasing will be effective within a particular country. The table below summaries the possible application of leasing wind turbines in the six largest wind markets (in terms of installed capacity during 1996):
India
Specral mxamn rreatmenrfor windprojecrs
Possible odvarmges of lensmg
No special taxation roles apply to wind energy.
The leasing tax deduction rate is usually higher than the tax depreciation rate on owned assets. Care however needs lo be taken in drafting the lease to ensure that the deduction vests in the correct person.
5 yearincometax holiday.
Similar to the
UK.
100% accelerated depreciation in the fust year. Denmark
Income tax credits. Capital grants for wind energy have now stopped
Sunilar to the LJK
Spain
No special taxation rules apply to wnd energy.
In broad terms the tax allowances available on leased assets are accelerated as the rate of allowances on leases is twce that of owned assets.
UK
No special taxation rules applyto wind
energy.
If the project is loss making, it may be possible to effectively access some of the tax allowances on the plant by way of leasing. This is aclueved by the lessor being able to claim tax allowances on the turbine and then share that tax saving with the lessee by way of reduced lease rentals.
tax creditsfor investors in green funds.
Finance leases are treated as hire purchase contracts and therefore there is no advantage over straight forward purchase. VAMILwill apply to Dutch resident lessors and therefore advantages similar to those obtained on operating leases. VAMIL does not apply to non-Dutch resident lessors.
Income
VAMIL, the Accelerated
Depreciation of Envinmmental Investment Scheme enables companies that pay income o* corporation tax to choose when to depreciate capital investments in windtwbines. undervAh4E_hubinescanbe depreciated in the fast year, depreciation can be deferred, or turbines can be depreciated in ‘WOCW when the company is making profits
WREC 1998
876
The advantages of leasing over loan finance, with and without a finance lease structure, are best evidenced by a comparison of IRR’s achieved, which for wind shows the following impact.
Wind
Gearing ratio %
Loall RR%
Lease RR%
Benefit of lease over loan %
81
18.1
22.5
4.4
Geartng ratio includes mezzamne f-we, (unsecured debt). If this was also provided by the equity shareholders, rather than by a thud party financial institutions, then the IRFl’s for both loan and lease would be reduced by a similar amount wthout affectmg the trend shown.
vtoT_ The benefits of finance leases over loan finance are affected by changes in corporation tax rates and the rate of capital allowances (or asset depreciation) on each asset type. As these rates vary from one country to another, it can be expected that the IRR of a project using lease finance will also vary. MAIN BARRIERS TO OVERCOME As the success of attracting new and more competitive sources of finance, including leasing, to the RE industry largely depends upon the financiers’ understanding of RE, one of the major challenges facing the industry is the education of the financial community. To assist with this education, Ernst & Young have developed a risk model comparing different RE technology investment profiles and comparing investments in RE to more conventional investments. The graph below demonstrates the risk and return profile of various generic RE projects compared to some more conventional investments:
Generic RE projects show less favourable returns than many of the returns available to the private investor, which may explain the relative lack of specific RE investment vehicles that facilitate private investment. However our work demonstrates that many RE projects represent investment opportunities reasonably close to the market line, with large wind and hydro (in the context of NFFO), and landfill gas appearing to out
877
WREC 1998
perform the FTSE 100, and some of the tracker investment vehicles that have proved so popular with general public investors. If RE investments were marked by reference to these benchmarks then greater uptake may be possible, accordingly further education of the investment community is required. In addition, several other developments are likely to be required in order to encourage the leasing involvement in BE, for example:
industry’s
(a) improved availability of information on the operational performance and residual value of underlying equipment; (b) the availability of extended manufacturer’s guarantees and maintenance and output warranties; and (c) the direct involvement of manufacturers in their own leasing subsidiaries, set up with the backing of financial institutions. This could be particularly beneficial to both existing manufacturers and importers wishing to shelter the profit on their domestic activities. A PAN EUROPEAN LEASING FUND A central fund could be established to lease equipment to RE projects therefore reducing the need for other investment in project development in terms of both cost and lead times. The objective of such a fund would be to create a simplified process generating economies of scale for financing capital equipment and enabling the finance of equipment to projects outside of Europe. Fund participants could include the EC, equity houses and equipment manufacturers. In addition an EC grant could be used to fund the difference between what the local project can sustain in terms of a payment mechanism and what is required to satisfy the equipment funding repayment. To assist the funding of payments it is possible to link the payment mechanisms to the output of the scheme and the local culture in the recipient market. Benefits can be obtained through bulk buying of equipment which could improve the penetration of EC BE equipment in export markets. The use of bulk buying can be applied to most technologies as the equipment is, in most cases, relatively portable. The updating of equipment would also be easier to implement thus assisting in the mass application of a particular technology. This will also facilitate the transfer of an element of project risk. The timd couId also be linked with an EC guarantee and could even fund itself through loan securitisation e.g. through it’s own bond issue. This type of mechanism could be targeted to specific countries.