Starwood Energy’s investment strategy is built on three pillars: Transmission assets, gas-fired generation, and renewables. This year, the Greenwich, Conn.-based affiliate of private equity firm Starwood Capital has been active in all three of those areas, signing a $287 million debt financing for the Shannon wind project it jointly owns with Alterra Power (PFR 7/1), acquiring almost 1,000 MW of gas-fired capacity in three different markets, and—most recently—in partnership with Abengoa Transmission & Infrastructure, sealing the contract to finance, construct, own and operate a 114-mile transmission line between Delaney, Calif., and Colorado River, Ariz. (PFR 7/17).
Brad Nordholm, the ceo and managing director of Starwood Energy, and Himanshu Saxena, managing director, talked to PFR editor Richard Metcalf last week about the appeal of transmission assets, the evolution of the debt finance market, the prospects for mergers and acquisitions in PJM, the emergence of non-utility offtakers in the renewables space, and the impact of President Obama’s Clean Power Plan.
PFR: What makes transmission contracts attractive to a private equity firm such as Starwood in the current market conditions?
NORDHOLM: Transmission in North America is hugely attractive as an investment because it’s essential energy infrastructure, a hard asset that has probably the most desirable form of contracted cash flow, either a bilateral contract or a tariff, with high investment grade entities or the government behind it. It has perfectly structured and recurring cash flow over a long period of time, attributes that investors—particularly investors in what you might call core energy infrastructure—find most desirable. Also, while there are barriers to entry for almost all kinds of power generation assets, the barriers to entry for transmission are probably higher than anything.
PFR: I understand that your joint venture with Abengoa, DCR Transmission, will be seeking debt financing for the Delaney-Colorado River transmission line. Can you say anything about what stage you are in that process?
SAXENA: Right now we are in the development phase of the project and not yet ready for construction financing. When we are, then we’ll come to the market. We expect that there will be pretty robust interest both from banks and institutional investors in financing the construction of that project.
PFR: How is the market for debt financing for transmission projects evolving?
SAXENA: The market is continuing to get better for borrowers. We’ve seen the pricing continue to come in, terms continue to get better. Banks are once again willing to lend for very long periods. There’s pretty strong competition between the institutional lenders and the bank lenders, which is leading to very attractive terms. What can change that? We don’t see a trigger event other than what will happen at the Federal Reserve this year. If the Fed starts to raise rates faster than we expect, then perhaps the cost of liquidity and cost of funding for the banks might go up, and it could slow down the momentum. But the balance between the number of quality projects looking for financing versus number of banks and institutional lenders looking to invest continues to work in the favor of the borrowers. In transmission especially there aren’t that many projects coming to the market for financing, and when they do, they end up being highly subscribed.
PFR: Moving on to generation assets, will mergers and acquisitions in the PJM zone increase once the capacity auction results there are announced?
SAXENA: The market for M&A for PJM assets in 2015 for the last few months has been on pause, waiting for the PJM auction to be cleared up. I think the expectation is that when the auction results come out, people will have a better view on what PJM wants with the capacity performance product and how the market is responding to that need, and that will provide clarity for valuations. And with more clarity comes more transactions.
PFR: What kinds of portfolios do you expect to come to the market when M&A activity picks up?
SAXENA: I think both single assets and large portfolios will come up for sale. There are at least three large portfolios currently in the market. Those sale processes have been pushed out pending the PJM auction because it was hard for buyers to come up with a view on value with this much uncertainty, so large portfolios are in the market, there are more portfolios that are expected to come to market and they are all waiting for this uncertainty to be lifted.
PFR: But only if there is the rationale for those transactions in the first place. What is the driver behind this activity?
SAXENA: I think some of it is that companies like American Electric Power that have unregulated generation businesses have been thinking for a while about bringing those assets to the market, simply because it doesn’t fit with the rest of their portfolio. That kind of seller is opportunistic, but ultimately they have to be sellers. Then there are the financial players who are simply looking to recycle capital and sell assets that have matured in their portfolios. So between the strategic selling and the financial selling I think there is a fair bit of capacity that will come to market in late 2015 and early 2016.
PFR: Do you expect opportunities to arise for Starwood Energy out of this process?
SAXENA: We like the PJM market, we like investing in places where there is a liquid market, and if there is a capacity market that makes it even more interesting. With this clarity coming in, we do expect more assets will come to market, which will increase the probability that we will find something that is interesting to us.
PFR: Would that include uncontracted assets?
SAXENA: It will. We look at uncontracted assets selectively. For the right price, in the right market, we are buyers of uncontracted assets.
PFR: How do you see the market for renewables?
NORDHOLM: We think it’s very interesting. The big story about renewables over the last five years is that we’ve had a precipitous drop in building costs, specifically for wind and solar, and we’ve had a marked improvement in their efficiency and performance. Putting that together means that in the right locations, solar and wind power generation technologies are becoming economic, they’re becoming very competitive and that creates opportunity. So for us, as a firm that will get involved in the creation of new renewable power generation assets, we have to do it in a disciplined way, but it’s a very interesting time.
SAXENA: Another recent development is that you’ve seen several counterparties that are not classic utilities interested in buying renewable power for very long tenors. They’re doing it sometimes to manage their costs, other times because it’s a great story for them to power their warehouses and data centers with renewable energy. You’ve seen deals being done by corporations like Microsoft, Google, Yahoo, Amazon, even companies like Ikea and Walmart. This year there have been as many industrial and tech buyers buying wind over the long term as utilities buying wind. That is a very positive development, because now you are no longer subject to a utility commission approving a contract, and a utility going through a full request for proposals process.
NORDHOLM: We think this is one of the big stories, one of the big trends. One way to describe it is the disintermediation of the public utilities. It used to be that these companies would buy their power from the public utilities. Now they’re contracting with independent power producers like ourselves and others to get their power directly. And they’re doing it from these renewable power projects. That is something new and quite dramatic.
PFR: But it’s only possible for non-utilities to buy power directly from generators in certain states, isn’t it?
SAXENA: That’s right. Texas is one state where you can do it. There are other states where you cannot, and in those states you have other, synthetic, structures. We have seen buyers that are looking for contracts for difference, for example. They are entering into purely financial agreements instead of physical agreements to buy power, so they are hedging their cost but not really taking possession of the electrons. So, the structure of the trades and the deals are different on a state by state basis.
PFR: But that doesn’t affect the economics or the viability of this trend?
SAXENA: If it’s appropriately structured then it does not.
NORDHOLM: Behind-the-meter solar, rooftop solar, is another example of that disintermediation theme, and in that case it’s more universally embedded in policy—more states allow it. But in both the wholesale or commercial power purchaser market and the residential, commercial and industrial solar power purchaser market, we’re seeing the economic competitiveness of some of these renewable technologies create further incentives to disintermediate utilities.
PFR: And does that create opportunities for private investors such as Starwood?
NORDHOLM: It does. We have been active in that in the past through one of our affiliates, andwe do expect this will continue into the future. Because these renewable technologies are economic, they’re competitive, under current policies, that in and of itself creates more investment opportunity for companies like ourselves.
PFR: Do you think we’ll see uncontracted utility scale renewables, such as merchant solar, in the future?
SAXENA: We’ve seen a lot of developers talking about merchant solar and it hasn’t happened in the U.S. so far. The key is whether lenders and tax equity investors are interested in financing solar and wind projects with no contract of any kind, and the answer so far is no. So what we are seeing is not totally merchant solar projects but a lot of discussion about building solar projects with five to seven-year hedges. We’ve seen a number of such projects being discussed in Texas. People are looking for five to seven-year assurance, and beyond that they are exposed to merchant pricing. Some of those projects may get done.
NORDHOLM: With solar and wind projects, the cost of production approaches zero. When the wind blows and the sun shines they are going to produce electricity, and if they were merchant you’d be realizing the market price for electricity at the time it’s produced. So there’s an intellectual case for doing merchant solar and wind, but if you can’t finance, you don’t have an efficient cost of capital.
PFR: But there have been wind farms that have been financed on the basis of hedges.
SAXENA: There have and there’s a pretty well-developed market for that. We’ve done it ourselves. In general, you have a creditworthy counterparty, either a bank or another counterparty, provide you with a long-term hedge. We’ve done deals with a 13-year hedge. That provides us with long-term revenue assurance, and based on that revenue certainty we can finance those projects with tax equity investors and lenders.
PFR: You see 13-year power hedges much more frequently than 13-year power purchase agreements. What’s special about the 13-year duration on power hedges?
SAXENA: It’s my lucky number. [Laughter] No, it’s an interesting question. If you look at utilities, they are looking at buying power for a very long period of time, because they are buying power for their own use and for the use of their customers. But when you have an intermediary such as Citigroup or Morgan Stanley or Shell, they are simply making a market—they are buying the power from the wind farm, slicing and dicing it, and selling it to customers on the other side. So they may be selling power for three years to one customer, another three years to another customer, and they may be managing that open position by buying gas. The longer the tenor goes, the harder it is for the banks to manage that risk on their books. So the banks can’t go beyond certain tenors. They would much prefer a five-year trade to a 15-year trade. But tax equity investors want longer-term assurance. Production tax credits are a 10-year product, so at the minimum you would need 10-year certainty. Tax equity investors want some buffer on top of that, so the tension between what the tax equity investors want versus what the banks can give results in a sweet spot in the 12 to 13 year range.
What was your reaction to the recent Clean Power Plan announcement by President Obama? Has it influenced your strategy?
SAXENA: We were pretty excited to see the details of the Clean Power Plan. It creates a tremendous investment opportunity for us over the next several years. The CPP will significantly change the way we make and use electricity in the U.S. and any change of this magnitude creates opportunities. For us, we’re thankfully on the right side of history in this debate: We don’t own any coal-fired generation and we don’t plan to buy any. We believe that over time, with or without CPP, coal has to be replaced with gas-fired and renewable generation, and those are the two areas where we have very strong expertise and interest. We expect that utilities and others, even in reluctant states, are going to start incorporating the clean power plan in their long term planning process, whether it’s utilities in the southeast or in other markets where there has been limited penetration of renewables. Even as they are fighting it in the courts, you will start seeing more renewables RFPs, even before the rules are fully set and the legal challenge is fully completed. This will create very interesting development opportunities for us.
NORDHOLM: We don’t see this as having an impact on our strategy, we see it as affirming our strategy, and with our focus on renewable technology, transmission and natural gas-fired generation, we’ve been honing our expertise and experience for this new environment.
PFR: Are there any other areas to watch out for in the second half of 2015 in terms of power M&A or project finance?
NORDHOLM: We’re always paranoid. It’s our business to be concerned about world events. We’re concerned about election cycle politics in Washington; we’re concerned about interest rates and the potential impact they might have These are the things to be mindful of, but we’re generally quite enthused about the overall trends that we’re seeing in the market.