Risk Analysis – General Discussion

1. Risk Analysis – General Discussion

2. Risk Topics Discussed • General Categories of Risk • Wind Speed and Capacity Factor Risk • Long-term versus short-term risk • Probability versus errors studies • Electricity Price Risk • Volatility and trends in prices • Alternative inflation rates • Alternative Risk Analysis Techniques

3. General Risk Categories • Risks During the Construction Period • Cost over-run (turbine prices, exchange rates, interconnection costs, land costs) and delay risk not covered with fixed price contracts • Technology – the plant does not work as expected • Risks During Operating Period • Price Risk • REC spot prices • Changes in Default Rates • Changes in Generation Price • Changes in Transmission and Distribution Price • Production Risk – wind speed variability, and availability of turbines • Operation and Maintenance Cost – O&M contracts and escalation • Other Risks • Interest rate changes • Lifetime of turbines • Changes in permits

4. General Comments on Risks • The biggest risks banks take in the wind sector are performance risk and regulatory risk, as well as the risk of availability of wind. • Performance risk is the risk that the turbines do not function properly or are not repared quickly enough when something happens, or the electrical lines are not available, or any other technical problem occurs that prevents the electricity from being produced or sold. • To prevent such problems, we make sure that contracts are in place for the long term operation and maintenance of all necessary pieces of equipment, and that the people or companies that are responsible for these tasks are able to do them and have an incentive to perform properly (i.e. they are paid enough to do their work, they are penalised if they don't and their reputation is at stake if something goes wrong). • This means that (i) we set the terms of what we want to see in the contracts (with the help of technical experts), (ii) we check that our client has signed contracts that fulfill our requirements and (iii) we have the right to step in and take over the project if this is not done. • Additionnally, we get the independent experts to go through the project sites and technical data to confirm check that all works properly, that all likely needs and scenarios are covered for, etc... and these experts are responsible towards us for that advice (i.e. if they tell us something patently false about out turbines, we can sue them). • We also make sure that the project is properly insured - and again, we define what must be insured and check that it is done and is in place.

5. Classification of Risks

6. Fixed power contract No Capacity Factor Risk No Electricity Price Risk O&M risks covered by contract Comparable to lease Return should not be much higher than interest rate Varying price contract Accept Capacity Factor Risk Accept Electricity Price Risk O&M risks covered by contract Comparable to share of savings Analyze by evaluating share of savings Risk Allocation Table

7. Construction Risk and Mitigation

8. Construction Risks and Mitiagation

9. Technology Risk • Many turbines of much larger sizes, from the 3.6 MW to the new 5 MW class, have found a great deal of favor with the lending community, • normally requires that a turbine prove itself through one or two years of more or less fault-free operation in a number of projects. For example, most offshore wind projects can operate profitably only with large turbines; otherwise, the installation cost per MW would be disproportionate and could render the entire project uneconomical. • Almost all recently built offshore wind projects, or those under development, involve turbines in excess of 3 MW, and many of the upcoming projects already plan to use 5 MW technology. • Despite relatively little experience with this technology, banks appear prepared to finance these turbines, and the DSCRs required for those projects are only marginally, if at all, higher than those of onshore projects.

10. General Technology Risks - History • The wind energy market also poses some other technology-related problems • A series of problems with gearboxes – probably the most strained piece of equipment in a wind turbine – sent shockwaves through the market in the 1990s, and stories about faulty gearboxes continue to resurface at regular intervals. • Turbine foundations pose another problem, with reports of cracks in the concrete leading to serious difficulties and posing considerable risks to the project. • Example: • Southwest Mesa uses the NM700 turbine and has four years of operating history. There have been serial failures in certain gearboxes, which affected 59 of 107 turbines. There have also been problems with stall-induced vibrations, and turbine shutdown due to overproduction. NEG Micon has replaced all affected gearboxes under warranty service.

11. Technology Risk – On Shore Projects • The technology risks, lying mostly with the reliability of the turbines, are generally under control today. • Most of the technology has existed for many years • Lenders with experience in wind energy, such as Commerzbank, HVB, Fortis or RBS, are comfortable with both the technology and its manufacturers. • Banks will finance the equipment produced by the majority of turbine manufacturers. • Financing a wind project, for example, consisting of 1.5 MW turbines, produced by an established and rated manufacturer, no longer poses problems.

12. Completion Guarantee • Example: • If any turbine in these projects is not complete by the end of 2003, FPL Group Capital will make the portfolio financially whole on the next payment date for lost revenues and PTCs until the turbine achieves completion. This obligation includes the loss of all PTCs for any turbine that is not placed in service by the end of 2003. • If a turbine is not placed into service by the end of 2003, which is highly unlikely, FPL Group Capital will essentially buyout the turbine to make the portfolio financially whole. • Could this apply in the Q7 case

13. Construction and Maintenance Agreements • Lenders prefer to have one turnkey construction contractor responsible for all engineering, procurement and construction and to whom the project company can shift the risks of project completion. • This minimizes the potential for finger-pointing between engineers and contractors and provides the owner with a single contracting entity responsible for completion of the project. • Most project financing construction contracts are fixed-price contracts, and owners will make an effort to limit the circumstances under which the construction contractor is entitled to change orders adjusting that contract price. Payments typically are made on a milestone or completed work basis. • Retention often is withheld. This payment procedure provides incentives for the contractor to keep on schedule and useful monitoring points for the owner and lenders. • A detailed and well-articulated scope of work is very important and should take into consideration all deliverables and obligations of the project company under the power purchase agreement. Ambiguities in the scope of work can lead to costly disputes during construction. A well-defined scope of work also will facilitate negotiation of more precise warranties. Warranties commonly requested by owners and lenders include a defect warranty for design and workmanship and some form of serial defect protection for systemic problems.

14. Liquidated Damage and Performance Damages • Owners and lenders also will typically request performance guarantees. These guarantees usually come in the form of an availability warranty (accompanied by a power curve test of certain proxy turbines shortly after completion of the project or as a condition to final completion) or a power output warranty based on actual generation. • These warranties may be included in the construction contract but often are covered in a separate agreement containing the ongoing service obligations of the equipment supplier. • If the project does not meet the guaranteed levels of performance, the contractor typically is required to pay damages to the sponsor, and if the project performance exceeds the guaranteed minimum levels, the contractor may be entitled to bonus payments. • Owners and lenders also may request additional lump sum damages for projected lost revenue if the project is unable to achieve guaranteed power curve or power output levels by a particular date.

15. Contingent Facility • There are some additional funds available should there be cost over-runs or a delay in construction • We rely on fairly standard construction contracts, which have a given price and date, and usually include penalties if commitments are not meant. • There will need to be real problems that are not covered by normal contractual terms, and banks will have a final say on whether any money is provided. • It is fairly unusual for banks to put up such reserves (usually, this is done exclusively by the investors) • In this case it gives banks additional control over construction and a higher certainty that the project will be built successfully. Banks were willing to do after studying the plans and contracts in much detail and were comfortable with the technical challenges, the solutions used to solve them and the backup plans.

16. Insurance Program • You can buy insurance that compensates you if some things that should not go wrong do go wrong. • Insurances make money because they charge you a slightly higher fraction of revenues than the probability of that thing happening. • Risks like lighting, boat accidents, mechanical failures or weather events are known to insurers and they can quite easily quote prices for such circumstances. • In this case, the project has managed to get insurance coverage for a fairly comprehensive set of events, which brings additional comfort to the lenders.

17. Operating Period Risks

18. Wind Speed Risk • A potential and significant risk for any energy project is the underlying resource for its generation – in this case wind. Identifying the availability of wind is paramount. This has two aspects. • The first is the question of whether a particular site has sufficient wind speeds. This issue is addressed by the lending banks insisting on long-term – usually at least 12 months – wind measurements, which are then used as the basis for a number of wind studies. Banks usually insist on at least two of those coming from reputable wind experts. These wind studies give an estimate of the annual electricity output of a project, based on a probability curve, usually 75% or 90%, that the project will generate x number of full load hours. Depending on the wind turbine used, there is therefore a 75% or 90% respectively, probability that the turbine will generate y kW/h per year when in service.

19. Wind Speed Variability • The variability of wind will remain a key obstacle to achieving investment grade ratings even if there are supportive support schemes. • Stress scenarios computed from historic analysis of wind variability • Over a long-term period such as 10-years, average wind energy production is likely to be achieved, but the fluctuations from year to year make highly leveraged transactions difficult to achieve. Independent wind studies are necessary with high confidence that debt service could be paid in the face of wind fluctuations • Studies – 4% to 6% variation from year to year

20. Wind Speed Variability • Standard and Poor’s: • The variability of wind will remain a key obstacle to achieving investment grade ratings even if there are supportive support schemes. • Stress scenarios computed from historic analysis of wind variability • Over a long-term period such as 10-years, average wind energy production is likely to be achieved, but the fluctuations from year to year make highly leveraged transactions difficult to achieve. Independent wind studies are necessary with high confidence that debt service could be paid in the face of wind fluctuations • Studies – 4% to 6% variation from year to year • Difference between P90 or P95 for one year and P90 or P95 for multiple years • Risk that the study has not been performed well

21. Example of Wind Speed Variability Analysis - FPL • Understand the difference between long-term and short-term wind speed risk – the changes are much higher in the long-term.

22. Wind Variability Risk • To illustrate the wind speed risk, the adjacent example shows capacity factors and IRR for a MA project. • Typical sensitivity analysis is based on P90 or P95 case. • If the P90 or P95 cases represent variability in one year, this is too conservative for probability assessment over the life of the project. (A worst case 10% wind speed will probably not occur for every year into the future.) • Variability in capacity factor can come from imprecision in wind studies or variability in wind speed from year to year. This difference is important in risk analysis. The wind speed difference is easier to evaluate than study risk. Effect on IRR of ranges in capacity factors

23. Illustration of Capacity Factor Risk Analysis • To demonstrate the importance of using long-term wind speed variability rather than short-term variability, we have used the most and least extreme case from the prior slide. • The P50 or expected capacity factor for the most extreme case is 21.9% and the least extreme case is 36.7%. • The 95 of the 5% worst case wind production is demonstrated by the following calculations. • Most Extreme Case • P95 Case – 1 Year: (32.3/57.6) x 21.9% = 12.24% • P95 Case – 10 Year: (41.5/57.6) x 21.9% = 15.78% • Least Extreme Case • P95 Case – 1 Year (269.9/333) x 36.7% = 29.75% • P95 Case – 10 Year (300.3/333) x 36.7% = 33.10%

24. O&M Risk • Operation and maintenance (O&M) of a project is of supreme importance because it is linked to electricity generation and cash flow – the sole source of loan repayment revenue. Banks like to see a comprehensive O&M service package from an experienced provider attached to any project. In most cases, these services are provided by turbine manufacturers because the contracts they offer dovetail nicely with manufacturing warranties. O&M services may be provided by other parties, which banks will accept if they have the necessary track record and financial strength. O&M contracts for wind projects usually warrant technical availability, stipulating that the turbines be operational for a percentage of time in a given year (usually 97%), which equals about 354 days per year. • For offshore projects in particular, the issue of O&M requires special attention. The costs can be significant and can have a major influence on the economics. A few years ago, many argued that the cost of serving an offshore project would render any development uneconomic. This bleak outlook appears to have been overcome by experience, but costs are still significant. For example, Vestas has a team of 25 permanent maintenance personnel assigned to the Horns Rev project.

25. Availability Risk • Includes risk that transmission will not be available • Example: • The project has lost material cash flows due to curtailment in the region; the transmission system in the area has insufficient capacity to flow the total production from the large number of wind projects in the area, which generally produce power at the same time of day. FPL Energy forecasts that Southwest Mesa will continue to experience curtailment through 2006 until transmission capacity is sufficiently improved. The base case assumes curtailment factors of 25% in 2003, 14% in 2004, and 1% in 2005 and 2006. • Wind turbine manufacturers offer warranties for power curve efficiency and availability in the early years of a project. But degredation over the life and efficiency losses are not guaranteed.

26. Availability Guarantee • That's the operator, Vestas, guaranteeing that its turbines (which it will be running and maintaining on behalf of the investors) will indeed produce the expected amounts of electricity, and agreeing to pay penalties if the production levels are lower than guaranteed. • The general principle here is that these guarantees should not only cover the impact of lower revenues for the investors, but rather for the lenders. • So the penalty payments take place for really degraded performance, rather than for slightly degraded performance, in order to ensure that there is still some income in the project even if things go really bad (if things go a little bit bad, we are covered to some extent by the fact that the banks already count on things going less well than normal as their "base case" scenario). • Issue • What is the cost of the availability guarantee and what are the benefits in terms of risk reduction

27. Price and Other Risks of Off Shore • While offshore wind farms are more complex and potentially more risky than their onshore counterparts, market participants say that well structured projects are perfectly suited to the bank market. • "There is no reason why the off take agreements should differ much between an onshore and an offshore wind farm," says John Pickett, a partner in the Green Energy Group at Linklaters in London. • The real areas of difference between the two are the construction arrangements and long-run O&M [operations and management] and availability assumptions

28. Risk of Realizing Electricity Prices • The value of a project depends on the price of electricity – if the electricity price is very low, then the town must pay all of the costs of the turbine without receiving much benefit. • In reviewing electricity price risk consider: • Alternative inflation in net metering rates • Alternative inflation in REC Rates

29. Volatility in Electricity and Gas Prices • The graphs below illustrate the volatility in electricity prices.

30. Illustration of Capacity Factor Risk Analysis • To demonstrate the importance of using long-term wind speed variability rather than short-term variability, we have used the most and least extreme case from the prior slide. • The P50 or expected capacity factor for the most extreme case is 21.9% and the least extreme case is 36.7%. • The 95 of the 5% worst case wind production is demonstrated by the following calculations. • Most Extreme Case • P95 Case – 1 Year: (32.3/57.6) x 21.9% = 12.24% • P95 Case – 10 Year: (41.5/57.6) x 21.9% = 15.78% • Least Extreme Case • P95 Case – 1 Year (269.9/333) x 36.7% = 29.75% • P95 Case – 10 Year (300.3/333) x 36.7% = 33.10%

31. Risk of Realizing Electricity Prices • The value of a project depends on the price of electricity – if the electricity price is very low, then the town must pay all of the costs of the turbine without receiving much benefit. • In reviewing electricity price risk consider: • Alternative inflation in net metering rates • Alternative inflation in REC Rates

32. Analytics for Project Finance Analysis

33. Sensitivity Analysis – Cost and Benefit Analysis with Different Costs and Rate • Analysis should be performed to evaluate the point at which the project IRR becomes less than the interest rate on municipal debt. • The example below shows the IRR for different capital costs and capacity factors in a sensitivity analysis. • The range in capital cost and capacity factors causes a change in IRR from 6.9% to 18.3%.

34. Example of Sensitivity Cases in Analysis of Wind Project Financing • The slide below shows how Standard and Poor’s evaluates various risks in analyzing wind projects (without electricity prices).

35. Standard and Poor’s Risk Analysis • . Standard & Poor's has generally assessed the financial performance of this wind project portfolio based on its treatment of fully contracted IPP projects. This treatment generally requires that projects rely on proven technology, have strong O&M arrangements, benefit from effective contracts, and have a suitable cash cushion after paying debt service. Under Standard & Poor's stress case, which includes P90 (1-year average) energy production levels, the project is able to demonstrate DSCRs of 1.4x minimum and 1.45 average. The P90 (1-year average) was used because the project pays debt annually, it provides a high assurance of energy production that is consistent with IPP treatment, and reflects our concern with the lack of long-term wind data at the project sites.

36. Wind Speed Variability • P95 case lowers wind speed by 10% compared to the base case. This means that there is a 5% chance that production will be more than 10% below the base case. • “The break-even case showed that production could fall by more than 17% and the DSCR still remained at 1:1 times.” • The wind speed differential must be factored through a power curve which magnifies the differences in wind.

37. Break- even Analysis Example • This example shows a case where the project IRR is lower than the interest rate of 5%. This implies there is not enough cash to pay off debt raised fro the project and the town must make up deficits from other cash. • When there is not enough cash to make all the debt payments, there is a debt default in the model. • In the adjacent example, the debt cannot be paid by cash by the project meaning that debt is still outstanding at the end of the project.

38. Electricity Price Risk in Investment Analysis • Difference in the nature of risk for electricity price and for capacity factor risk – electricity price is more difficult to measure. • Methods of evaluating the electricity price risk • Example of electricity price risk sensitivity and break-even analysis – How much cushion do you have compared to the current price.

39. Sensitivity Analysis • The example below illustrates the capacity factor and electricity price sensitivity. The idea of the table is to show how low the electricity price can go before the IRR falls below the interest rate. More variation is driven by the electricity price than the capacity factor in this example.

40. Risks of Inflation in Electricity Prices • To evaluate how movements in future electricity prices can affect the economics of an investment, we evaluate different growth rates in both REC prices and Net Metering prices below. (The case uses a REC price without a contract) • The table below demonstrates differences in inflation rates cause the IRR to vary between 11.4% and 3.8%.

41. Scenario Analysis • Develop a downside case that is realistic (rule of thumb – 20% probability) • Evaluate whether the project IRR in the downside case is above the municipal bond rate (i.e. is the NPV above zero)

42. Assessment of Contracts • The ultimate effectiveness of such risk allocation rests on the legal system which must be proven and reliable to ensure enforceability of various contracts and agreements. • The credit quality of project finance depends on the ability of parties to uphold contracts: • Examples of problems with project contracts – Dabhol, AES Drax, PT Pation, many others. • Examples of problems with construction contracts – Stone and Webster • Change of Law and Political Risk – Robbins waste to energy plant in US

43. Off-take Contracts – PPA Agreement, Concession Agreement • Central Contract for the Project – Defines the Revenues and the Cash Flows of a Contract • Commodity project such as oil • Less need for contract because of world wide market, history of prices and forward markets that can be used to hedge risk • Infrastructure (Tollways, Airports etc.) • Part of concession agreement that defines the toll prices, the ability to construct competing roads • Electricity • Purchased power agreement (non-merchant plant), includes fixed and variable charges where variable energy charges cover the variable cost of running a plant while fixed charges cover fixed costs, debt servicing costs and equity returns