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Wind Turbines Kill Babies

by crankykarsten Thu Dec 31st, 2009 at 12:59:41 PM EST

Windturbines kill Babies

Now that I have your attention I can start with my diary. Of course, babies are not directly killed by wind turbines, well not directly at least, but maybe indirectly if you think around a couple of corners. These corners need first be mastered so what will now follow is a diary which might be a bit long and tiresome but I ask you to bear with me as I believe it might be very interesting and eyes-opening for some of you.

To start off, I will briefly describe the business cases behind the different phases of a wind farm (developing, constructing and operating). I will then describe a seemingly very good investment product of BigBank, to then expose the ugly reality of that nice product by doing a quick investment return calculations and will end with some open issues and thoughts as I still can't make up my mind if this product is really as evil as I describe here.
My goal here is not to say that a certain bank is doing something that I don't approve of (I haven't seen a product exactly like that, though some which are similar...) but to show how one has to always be very careful when investing and that banks will always try to profit exorbitantly by either ripping off unknowing investors (which is the case here) or rent seeking (e.g. High Frequency Trading and similar practices)

A side note, Jérôme has many excellent articles on the economics of wind power and electricity generation in general so I won't go into details here regarding the economics but rather recommend his wind power series found here. My focus here will be a bit different as you will see...

I welcome any feedback / corrections that you might have.

I. The life cycle of wind farms

Generally you can divide the life of a wind farm into three stages, the development, the construction and finally the operation of the wind farm. Each of these phases requires different skills / know-how and different amounts of capital, which is why different players are active in each phase (currently with considerable overlap depending on which markets you look at).

I.1 Development phase

The development of a wind farm is first and foremost a time consuming affair. It consists mainly of walking from one regional and local authority/government to the next getting all kinds of paperwork done to receive the various permits/licenses necessary to build and operate a wind farm. Then there is a bunch of technical stuff which has to be done like finding out how much wind is blowing, how turbines best fit into the landscape / topography (called siting) and figuring out how/where to connect to the electricity grid (to then get the grid operator to let you connect to his grid).  And last but not least the tiresome task of NIMBY (Not In My BackYard)-prevention by going to town hall meetings of surrounding villages where people have all kinds of fears of those ugly and unhealthy beasts (and some people are just grumpy and cranky and want to protest for the sake of pissing people off)

As I said, this is very time consuming but there is not too much investment costs you have to shoulder except the time that you spend working in the development of your wind farm instead of real working (i.e. for pay). The only real costs are a meteorological (met)-mast (a little tower to measure the wind at e.g. 30m height) and perhaps some software for the engineering planning which you should perhaps better get done by smaller specialized engineering/planning companies anyway.

So let's do some math (if there are any wind developers reading this I would glad if you could correct of verify some of these assumptions!):
I am assuming an onshore wind farm with a peak capacity of 30MW.

 -Cost of not working for 3 years while developing a wind farm: let's say EUR 100,000 p.A. = EUR 300,000, this will give you a nice income and a big enough budget for driving around the whole day from one authority to the next and all that tiresome public relations work.

 -Cost of the met mast: EUR 50,000

 -Cost of engineering planning: EUR 100,000

Makes a total cost roughly EUR 450,000.00 to fully develop a wind farm of 30MW. Although half a million Euros is a lot of money, it is not totally out of the reach of everyone and if you find some people to support you it might work. And of course, if you are a real wind freak, then you can do this all for a lot less by developing in your spare time, using friends who have engineering know-how etc... (that's in fact how many of the earlier wind farms were developed)
You now have a fully developed wind farm. To actually BUILD the thing you will need a LOT more money (see next phase), or you could now sell your wind farm to an investment fund or to a utility who have the money.

The price, you ask? Well, it depends on many parameters like the wind conditions and the electricity price but in the heydays before the crisis it was around EUR 150,000 per MW. I.e. in this case 30x150,000= EUR 4.5 million! Not bad for an investment of half a million. That return will make even hedge fund managers jealous, though just like them, there is a lot of risk involved in developing a wind farm! What risk you ask? Well, the risk that you don't ever get all necessary permits / licenses to build and operate the wind farm. And in that case 3 years of work are down the drain!

So to sum it up: during the development phase you need mainly time and patience and only a little bit of money.

Now to the next phase...

I.2 Construction phase

Building a wind farm onshore is not as hard as offshore and the risks are relatively well understood. The only caveat I sort of see is that currently you need to contract with several parties (i.e. the wind turbine contract, the civil works contract (roads and foundations) and the electrical contract (grid connection)), so there are some interface risk issues, though not nearly as complex and risky as offshore and in most mature wind markets you will find experienced and competent contractors for all tasks. Nonetheless a nice turn-key contract from a strong industrial company would be nice, especially in the more exotic markets/countries where experienced contractors are not as easily available...

Still, building an onshore wind farm is relatively simple if the homework in the development phase (i.e. planning everything properly) was done correctly and the main challenge of building a wind farm is having enough money to do so as wind farms are very capital intensive investments (see Jérômes wind power series).

So let's do some math again:
Rule of thumb for building a wind farm in a mature market (although prices are currently declining): EUR 1.5 million / MW, whereof roughly a million Euros go to the turbine supplier and half a million go to the "balance of plant" i.e. roads, foundations, and grid connection.

For the 30MW wind farm this leads to total investment costs of roughly EUR 1.5 million / MW x 30MW = EUR 45 million. As you can see, this is a lot more than the half million for the development! This shows very nicely why the local farmers / enthusiasts who develop a wind farm cannot so easily realize their wind farm (unless they just inherited considerable amounts from unknown uncle in the US who happened to be hedge fund manager ;-)). I won't go into the financing of the investment costs in detail but refer, again, to Jêrômes excellent wind power series (I sound like broken record player).

Whereas in the past, smaller wind farms could actually be done by smaller investors (thanks to (highly leveraged) project financing), in today's environment the high up-front investment costs mean that you need very capital rich investors to actually build a wind farm of any real size, and currently that's mainly the utilities...

Now to the operational phase

I.3 Operational Phase

Operating a wind farm is a lot easier than operating a gas- or coal-fired powerplant let alone a nuclear power plant. Generally, the turbines produce and feed electricity into the grid whenever there is wind (regardless of demand, thanks to most regulatory regimes supporting wind farms), so all you have to do is make sure that the turbines turn where the wind is blowing (which is done automatically) and to service them properly (which is either done by specialist companies or more and more often by the turbine manufacturers themselves). All you as owner need to do is make sure you properly file your annual statement and pay your taxes... Really, it's that easy! That is why the investors in this phase of a wind farm can be a lot different than the previous investors/owners. Since you need no real technical abilities anyone with a long investment horizon looking for stable (because often government-guaranteed) income is a perfect investor, that is why more and more financial investors such as pension funds and (life-) insurance companies are investing in wind farms...

Now that I have briefly reviewed the different phase of the life cycle of a wind farm I want to briefly draw your attention to a how a possible financing structure might look like.

II. The "feel-good sustainable renewable energy fund" financing product by BigBank

Without going into much detail here is the premise of this fabulous new fund is the following: You as an environmentally-friendly, pro-development of emerging countries and generally do-good-for-the-world investor now have the opportunity to invest in wind farms in emerging markets around the world! To minimize your risk the fund will only invest once the wind farm is already in operation. To sum up, you are investing money in poor countries (good), in a source of renewable CO2-free energy (good), taking little risks (good) and actually making money with that (really good).

Well, no, not all is good. Let' look a bit deeper into how the structure of the fund works.

The wind farms in which BigBank invests will be fully developed by the time BigBanks buys the project from the original developer as BigBank does not have the know-how to develop a wind farm. As BigBank also has no experience building wind farm, BigBank will look to not buy 100% of the project but rather have co-investors in the project who have the know-how to build the wind farm (for example the wind turbine manufacturer) or at least demand a full turnkey, fixed-date, fixed-price contract for the construction of the whole wind farm (i.e. turbine delivery and erection, civil works and electrical works / grid connection).

As soon as the wind farm is then fully constructed and operational BigBank will sell its stake to the "feel-good fund" who will then own it for the whole life time of the wind turbines (i.e. 20+years), and live happily with the monthly revenues from the sale of the electricity produced by the wind farm. Since the fund buys the wind farm only once it is fully operational the investment is very low risk (see my phases above).

To summarise: you invest in a FUND from BigBank. This fund then investes in wind farms which BigBank itself bought and built and brought to operation and then sells to the fund. It is important to keep in mind that the fund is not the bank and vice versa, they are actually two different investors each with their own incentives / goals...

Now, what's the problem, you might ask? Well, the astute reader might already have noticed that BigBank is taking no risk whatsoever as i) the project is already fully developed, ii) the construction is done on a turnkey basis by a reputable turbine manufacturer (within a fixed timeframe and for a fixed price) and iii) the exit out of the project (via sale to the fund) is secure at the point BigBank buys the project from the developer. So this leaves us no choice but to ask nasty questions like "what could BigBank's incentive be to do this? Are they altruistic and only want to jump-start projects?" (Remember bankers are evil and only do stuff for their own bonus).

So let's dive into the return calculations and valuation of projects to see if this might yield an answer...

III. The (financial) return of projects - the internal rate of return

Now we get to the bit which could potentially be very boring (if I haven't lost you already) but I'll try to do this with simple example calculations and not too much theory.

First off, there are many ways to calculate the return of your investment. In this case I will use the internal rate of return (IRR), which is closely related the present value calculation as the IRR is the rate of return which will make the investment's cash-flows equal the investment costs, i.e. yield a net present value of zero. It is also the most widely used ratio/metric to help make investment decision such as investing into a power plant.

But enough theory, let's look at an investment case:
You buy a wind farm in period zero for 1000. The wind farm will generate after-tax profits of 110 p.A. starting one year later in year one for 20 years. Your cash-flow stream will thus look like this:

0    -1.000,00 €
1     110,00 €
2     110,00 €
3     110,00 €
4     110,00 €
5     110,00 €
6     110,00 €
7     110,00 €
8     110,00 €
9     110,00 €
10     110,00 €
11     110,00 €
12     110,00 €
13     110,00 €
14     110,00 €
15     110,00 €
16     110,00 €
17     110,00 €
18     110,00 €
19     110,00 €
20     110,00 €

Note: I have made the simplified assumption that this project fully financed by equity and not leveraged with debt as this would only make it more complex and would not add value for the sake of my analysis of BigBank's incentive to set up the "feel-good fund".

If you then let Excel calculate the internal rate of return for this (real easy, just pick insert formula IRR and mark the cells with the cash flow), Excel will return an IRR of 9.06%. It is not 11% as one might assume at first since the invested amount of 1000 yields a return 110. The reason for this is, among others, that the IRR calculated the return of the invested capital and this declines over time and is actually zero at the end of the 20 year period (i.e. the wind farm is then worthless (for the sake of the calculation, in reality it is a real cash cow until it breaks down but that's another diary).

What parameters influence the return? Well, you have mainly two parameters, changing the investment cost or changing the profit. As the profit is a set parameter in most wind farm projects (either set by the government through e.g. a feed-in tariff, or through the Power Purchase Agreement (PPA) with a strong off-taker, usually a utility) the only thing left is the investment cost.

If we raise the investment cost to e.g. 1250 but leave the profits the same, the return will be 6.11%. If we lower the investment cost to e.g. 750, the IRR goes up to 13.5%

So, how does all this fit into BigBank making BigBucks with the "feel-good fund"? Well, it's actually very simple: BigBank buys the project for the "market" price of 1000 at time zero, fully knowing that it can sell the project not quite a year later when the wind farm is in operation to the fund at a price of 1250, making a nice profit of 25% in less than a year and with practically no risk.

You might now ask, won't the "feel-good fund" managers protest? Well, that depends on what their mandate is! If it is to invest in emerging market renewable energy projects which yield a certain minimum return, then they don't really care if the investment they make is "too" expensive as long as it fulfills the investment criteria. The investors are willing to sacrifice a little bit of return for a good conscience (i.e. stable, often government guaranteed-returns and practically no risk). This is aggravated by the fact that the "feel-good fund" will probably be marketed to charities, churches, endowments, pension funds, etc. who themselves have goals of ethically investing their capital.

And that's where the title of my diary comes from: in this structure wealth is transferred from charities (who might help poor babies in Africa get vaccinated) to greedy bankers who need their BigBonus to finance their new Maseratis. And, similar to many structures, it actually takes future profits (i.e. cash made from selling electricity) and turns them into current profits which are realized today via the overpriced sale, thus inflating/distorting the picture of the economy (but that's another diary again)
OK, ok, enough BankerBashing...

IV. There is no black and white...

Above I analysed the (possible) thinking behind the "feel-good fund" and have demonstrated that the "feel good fund" is actually transfer of wealth from fund investors to the bank or the bankers.

However, that is how the world works - a carpenter can produce a table for 200 and then sell it for 300, just as Porsche can build a car for EUR 50.000 and sell it for EUR 80.000. If a buyer has utility from buying the table or the car, then the producers of these goods are allowed to command a premium from the buyer, after all, the buyer is not forced by anyone to actually buy the expensive table or car!

In this case, however, things aren't that easy as the fund managers are entrusted by the fund investors to prudently invest the money in a given framework (e.g. a minimum return for a certain kind of investment) and the managers have fiduciary duty to do their best with the money. If the fund managers are employed by the same company selling them the investments this obviously causes conflicts of interest and the question should be whether these conflicts of interest are properly taken care of...

The next thing that I am not sure about is whether this product is a bad thing when in the end, good things are made possible that without this product would not have happened? I.e. the wind farms in the emerging countries might never be been built were it not for the fund. The counter argument here is that in today's world, there is a lot of money floating around and looking to be invested, so if these projects are economical then they will find the money necessary to build the wind farm. Where this other money comes from we, of course, do not know either.

Maybe some you have an opinion on this and can weigh in with good arguments for either side...

Anyway, I hope this was an interesting read for those of you able to make it all the way through. It is my first diary and I am not a good writer so I would be happy for any feedback whatsoever!

And Happy New Year to all of you!

... to all cases in which investment trusts are operated by officers of another, closely related institution, financial or otherwise.

In fact, it may be generalised to all similar revolving door situations: The problem is that the widows and orphans entrust their money to money managers (or industrial policy to industry insiders, or regulatory power to lobbyists) whose institutional loyalty (and institutional incentive structure) is to their fellow Villagers first, and the widows and orphans second.

Actually, the wind farm is probably a poor example, because 6 % real return on investment is not a bad gilt-edged return (and it is gilt-edged if you invest in a well-managed wind project in a country where the regulatory regime is reasonably stable).

A better example would be investment banks sponsoring investment trusts staffed with the banks' own officers, who then turn around and purchase the banks' own structured products. In that case, not only can the banks and fund managers over-price the products, they can also under-assess the risks. And for widows and orphans, undeclared risk is a bigger problem than low returns.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri Jan 1st, 2010 at 02:02:44 AM EST
good points Jake, thanks! Sometimes you develop tunnel vision and only think about your "problems", when in fact, when seen in a far broader view, it's not that much of a problem. In fact, when compared to your example of buying the banks own structured products, my evil fund is almost saintly ;-) And it actually invests in "real stuff" as opposed to some weird structured products. I used to work at a bank (on the sales side) and there was really a lot of structured product crap (which I never sold but had in my incentives/goals to sell) which was a LOT worse than overpaying for a wind farm.

Thanks again for putting that in perspective!

PS one of the reasons I left the bank was the pressure to sell BS like most of the structured products.

by crankykarsten (cranky (where?) gmx dot organisation) on Fri Jan 1st, 2010 at 04:04:14 AM EST
[ Parent ]
... is what the alternative is.

I can't see any baby killing going on - indeed, quite the reverse. The charity / church / endowment is spending the money that it can spend on whatever its vision or charter of a good deed is.

And then the charity / church / endowment has funds it has for investment to ensure a stable flow of income over the future to be able to keep doing that spending.

And of course it would certainly prefer its investments to not be making things worse faster than the revenue those investment provide can be used to make things better, since in that case it would be doing more good burning up the money in a bonfire (in a chamber with exhaust treated, of course).

Now BigBadBank steps in to squeeze a little bit extra out of the transaction - but if a fund is available that has similar positive externalities and offers better return (say, MediumSizedSlightlyLessBadBank does the same trick but squeezes less off the top), then they can invest in that fund instead.

Provided BigBadBank cannot monopolize the process - and as described they enter too late into the process to be able to monopolize it - then the amount they can squeeze of the top is due to the baby killing effect of other available investments, and the "evil" is that baby killing could be reduced by still more if less was sliced off the top.

But that is a general ill of the system itself, and not increased because the wind farm was developed.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Fri Jan 1st, 2010 at 03:54:03 PM EST
[ Parent ]
indeed, I meant that the charity could have MORE money if BigBank wouldn't sell the wind farm overpriced but for a fair price and could thus save more children like you said tat the end. Like I said in the intro, it is a very indirect link and mainly to get your attention...

And as you also state at then end, it is a general ill of the system (which many "normal" investors were not aware of in the past, though now the media does every so often direct attention to such topics such as here in Germany where there were quite some stories on the bad advice that banks were giving their clients (as they are selling products and not advice)) and money invested in a wind farm is pretty clearly one of the "better" investments that one can make for the good of the earth and mankind...

by crankykarsten (cranky (where?) gmx dot organisation) on Sun Jan 3rd, 2010 at 07:55:06 AM EST
[ Parent ]
if the charity only needs an appropriate return to invest in such projects, and the bank provided that, it's a good transaction for the charity, which fulfills all its goals, and a good one for the bank which can make money in the process.

Presumably the charity can consult several banks to see which one offers the best overall package?

What is trickier is if the proposed structures end up putting other risks on the charity than what it expected to bear, or that the structure is sold as something it isn't (as happened with whole classes of the "structured products" of recent years).

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Sun Jan 3rd, 2010 at 09:02:31 AM EST
[ Parent ]
indeed, I meant that the charity could have MORE money if BigBank wouldn't sell the wind farm overpriced but for a fair price and could thus save more children like you said tat the end.

But that's comparing to a hypothetical bank which is not a commercial corporation. Indeed, on that standard, people who give money to the charity are not baby killers because they "could have given a little bit more" ... so its not a pragma that stands up to scrutiny.

The standard is, are those children better off if the BigBadBank does the action - in the way that it does actions - or if the BigBadBank does not do the action. Clearly, provided the BigBadBank is not granted a monopoly, they are better off if the BigBadBank does engage in the financing then if it does not.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Jan 7th, 2010 at 10:31:48 PM EST
[ Parent ]

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