Brazil is set to be the new Wind Energy powerhouse, but which way does the wind really blow?

Contributed by Mark McHugh Bauhaus Capital Partners

In the renewable energy auctions held in Brazil on August 25th and 26th market forces yielded a significant reduction in wind energy prices. Wind energy contracts were awarded totaling more than 2 GW, at an average tariff of R$130.86 (US$ 75) per MWh. Prices bid for wind energy were lower than biomass and comparable with small hydro. The authorities are declaring a major breakthrough, placing wind energy firmly in the mainstream. It is perceived to be an important step towards achieving or possibly exceeding the government target of 15GW from alternative energy sources by 2035. However, as the dust settles industry insiders believe that project returns are now approaching the cost of capital, creating controversy as to how much of the contracted capacity will actually get built.

As one of the BRICs, quick to rebound from the global recession, the Brazilian economy continues to advance at a fast pace with projected GDP growth rates for this year approaching 8%. Government plans are targeting rapid expansion in green energy, as part of a major push on infrastructure investment. March saw the launch of the second four-year growth acceleration program (PAC 2), which envisages R$11 billion (US$7 billion) in renewable energy investment. Brazil already occupies the high ground with the best energy matrix of any of the major economies―48% of total energy usage is from renewable sources.

At the same time, Brazil is playing catch-up on the world stage, as one of the fastest growing wind energy markets. Capacity grew at 75% in 2009. The present aim is to achieve 5GW of installed wind capacity by 2014. In their recent report IHS Emerging Energy Research—“Latin America Wind Power Markets and Strategies: 2010 – 2025,” concluded that Brazil will lead the region with 31.6 GW installed by 2025. This is considered an optimistic view. However, longer-term the overall prospects for wind energy along Brazil’s 9,600 km wind-swept coastline are not in doubt. The estimated potential is a massive 144 GW and could be doubled with higher towers over 100 meters.

The first tentative steps towards creating today’s burgeoning wind energy industry were taken in 2002. The original PROINFA program provided government incentives for alternative energies through feed-in tariffs and twenty year contracts with guaranteed demand.  A number of government tax incentives and discounts on transmission tariffs have further encouraged development. Perceptions at the beginning were that wind energy would always be expensive and would be unable to fulfill a significant part of projected energy demand. Nonetheless, efforts were focused on wind and biomass. Energy planners were particularly keen on wind energy, because of the complimentary nature between wind and hydro. Hydro schemes still represent 75% of total installed capacity and 90% of electricity production in Brazil. When hydro-flows are at their best from January to June, there are lower winds and vice versa. Effectively by holding water in the reservoirs, hydro can act as a virtual storage system for wind energy.

Early entrants in the Brazilian wind energy market enjoyed comfortable returns based upon the highly
attractive feed-in tariffs ranging from R$ 258 to 294 (US$ 150 to 170) per MWh. By the end of 2009, fifty four wind farms were contracted under PROINFA, with a total 1,423MW capacity―thirty five of which are now in operation. Despite the relatively high prices paid, most observers agree that government stimulus was essential to nurture the embryonic wind sector. The PROINFA program has been an important step toward establishing a longer term healthy industry.

The next stage in the process came in December 2009 with the first national wind energy auction sponsored by Brazil’s National Electricity Regulatory Agency (ANEEL). It moved away from the feed-in tariff system, which depends on monthly production and produces an unstable income pattern. Bids were based upon a quantity of MWh annually divided by twelve to smooth monthly income.  The auction contracted 1,806 MW capacity over a twenty year period, at an average price of R$ 148.39 (US$87) per MWh, with the lowest bids at R$ 131.00 (US$75) per MWh. The substantial fall in prices began to raise fears about the long-term viability of the wind industry. This was especially true at the bottom end of the scale, where yields were perceived to be approaching the cost of capital.

With turbine manufacturers and international developers facing increasing competitive pressure in their traditional markets of Europe and North America; Brazil with its stable economy, high projected growth rates and hereto attractive profitability has invited increasing attention from the global industry.

There are now many major international players from the wind turbine industry present in Brazil―Alsthom, Enercon, Gamesa, GE, IMPSA, Siemens, Suzlon, and Vestas.  These companies have, or are in the process of, establishing manufacturing facilities to meet local content targets. Also knocking on the door are the Chinese, including Asia’s largest wind turbine manufacturer—Sinovel. They are very competitively priced and hoping to establish a bridgehead through offering financing from Chinese banks. Spurred by this intense competition, costs per MW of installed capacity today have fallen by more than 30% compared to PROINFA.

The developers market can be segmented into four main categories―large international developers such as Spain’s, Ibedrola/Gestamp and Acciona Energia; Brazilian utilities like CHESF and CPFL; mid-size Brazilian developers including, Renova, Brennand, Eolica; and a number of smaller Brazilian entrepreneurs who are looking to sell licensed projects with PPA. In general international developers have been slow to capitalize on the boom in the Brazilian wind energy market and leverage their procurement muscle and international expertise in project execution. Less experienced Brazilian developers have been more successful in winning bids, which is arguably why projects are slow to get going. Red tape also appears to be holding up the process. None of the seventy-one projects awarded at the end of 2009 has yet commenced construction. The first projects are expected to start building in the first quarter of 2011 and all must be completed before the end of 2012 to meet the conditions of the auction.

The latest round of auctions on August 25th and 26th has produced even more intense competition. The average price achieved for wind energy was R$130.86 (US$75) per MWh, a 12% reduction from Dec 2009. Wind tariffs are now lower than biomass and comparable with small hydro.

Overall Results of August 2010 Auctions




The inexorable pressure on project financial returns is further bringing into question the economic feasibility of many of these projects. There is growing concern that some players in their desire to establish a strategic position in the Brazilian wind energy market and to “place a flag on the map” are aggressively pricing and undermining the long-term profitability of the market. Time will tell—there is three year grace period in which owners must complete construction and projects become operational or there is the risk forfeiting their bid bond.

Nonetheless from the perspective of the regulator, the auction was a resounding success. According to Nelson Hübner, Director of ANEEL:

“The results of the energy auction represent a new paradigm in power generation in Brazil because they confirm it is possible to produce wind energy at a price that is competitive with those of thermal plants, which are more polluting.”

As the tariffs are falling it is anticipated that there will be a trend for developers to move away from the regulated market and seek PPAs in the open market, where better prices are achievable. The regulated market with tariffs set by government auction represents 70% of the Brazilian electricity market. The remaining private market consists of special consumers, traders and self-generation. Individual or groups of consumers with a demand of 3MW qualify as special consumers and are free to negotiate and enter into bilateral contracts with generators.

The majority of bank financing in the renewable energy sector to date has been through the national development bank, BNDES and government owned banks―Banco do Nordeste and Caixa Federal. All seventy-one projects from the 2009 auction are using some form of government funding. Bank debt has a maturity of sixteen to twenty years, with interest rates in the range of 7 to 9%. For a developer, bank debt typically represents 70% of total funding, with private capital providing the remaining 30%. To date here are few international banks involved in project financing—principally Banco Santander and Standard Bank. Citibank, Black River Asset Management and Liberty Mutual are participating through their equity in SIIF Énergies do Brasil, one of the key participants in the PROINFA program. What is more, as investment levels ramp up there is a growing opportunity for international investment in conjunction with local financing.

Declining profitability has a number of potential consequences. It is expected to impact the type of investors willing to participate in the Brazilian wind energy sector favoring: utilities, IPPs, green funds and pension funds, which are able to take a longer-term view. Private equity investors, typically aspiring to higher rates of return and a three to five year exit, will find it increasingly more difficult to meet their investment objectives.  In the same way, it will be harder for the smaller entrepreneurial and less experienced developers to compete against the scale and negotiating power of the larger players. This scenario will likely result in a shake-out over the next couple of years, as developers re-asses their project portfolios. It is anticipated that a wave of M&A activity could result before construction deadlines expire.

Given the pressure on profitability, there is no longer any margin for error for developers. Projects need to be financially optimized to be successful or may simply never get funded. Brazilian developers must seek ways to increase their negotiating power and expertise to maximize value. Specialist advice on project financing can add significant value. It is more and more important to present projects to international investors in a language they understand, to ensure projects are ‘bankable’. Financial leverage and effective risk management are two of the most important drivers of profitability for the potential investor. Expert financial structuring, as applied in Europe and North America, incorporating such alternatives such as vendor finance will undoubtedly become a critical success factor, as the industry matures.

Contact Mark McHugh at mmchugh@bauhauscp.com

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