What practical lessons are developers taking away from projects in Mexico and Chile? How do risk-adjusted returns compare on Latin American projects to projects in the United States? Four developers — one wind, one solar, one geothermal and one hydroelectric and coal — discussed these and other questions at the Chadbourne 25th annual global energy and finance conference in late June. The panelists are John Haberl, a director with The AES Corporation, Natalie Jackson, managing director for project finance at SunPower Corporation, Greg Raasch, co-founder and executive vice president of geothermal developer GeoGlobal Energy, and Niels Rydder, CEO of wind developer Oak Creek Energy Systems. The moderator is Todd Alexander with Chadbourne in New York. MR. ALEXANDER: Niels Rydder, it is a big world. You have worked in many different countries. Why pick Mexico as your next focus? MR. RYDDER: We picked Mexico about two and a half years ago when we started to sense the opportunities in the US were waning. I have been here for 30 years, and there have been many times when we have had to take a break from the US market because production tax credits have expired. Each time, we looked elsewhere so that we could maintain a stable business. The first time, we went to Europe and then to Canada and now to Mexico. MR. ALEXANDER: Why Mexico? MR. RYDDER: I work for a subsidiary of Marubeni Corporation. Unfortunately, my share of the market is limited to North America, so it is Canada, the US or Mexico.We saw an opportunity in Mexico two and a half years ago, but I have to admit that is a totally different discussion than we are having today. The projects on which we have been working were under a legal regime that is about to change. [Ed. See “Mexico is Set of Open its Power Sector” in the June 2014 Project Finance NewsWire starting at page 32.] Many more opportunities are opening up. The Mexican market will soon be in transition. Whether we should stay in Mexico is actually another question. MR. ALEXANDER: We will come back to that. Natalie Jackson, SunPower is owned 60% by the French oil company Total. You, too, have the whole world to choose. Why are you devoting so much energy to Mexico and Chile? MS. JACKSON: We have been thinking about where we want to focus after 2016 when the current tax subsidies for solar expire in the United States. We have identified certain markets, but we continue to explore others, particularly in the Middle East and Africa because of Total’s presence there. We began looking at Latin America two years ago. We identified Mexico and Chile as two of the most attractive markets based on sunlight and the political and regulatory climates. It was helpful that Total already had people on the ground in both countries. We are in the middle of building our first large project in Chile in the Atacama desert. We are the solar panel supplier and EPC contractor. For future projects, we are co-developing with Total, and we are looking to hold an equity position as well. It was possible two years ago to see that changes were coming to Mexico, but we saw opportunity in Mexico even before the latest changes. Given the possibilities that we see with the changes, we are pretty excited about it, but we recognize that it will develop on a slower time frame than Chile. We have offices now in Mexico and Chile, and we are actively developing our second and third projects in Chile. MR. ALEXANDER: Greg Raasch, why Chile? MR. RAASCH: GeoGlobal Energy is the other renewable, geothermal. We have to go where the resource is, and it turns out that Chile has some great geothermal resources. Chile is blessed with 10% of the world’s volcanoes, and there is a huge need for power in Chile. Some of you may have read that last week the government finally cancelled the Hydro Aysen hydroelectric project, which removes 2,500 megawatts from the 10-year plan, so Chile is a great place to do business, and it is going to be an exciting place in the next five to 10 years. MR. ALEXANDER: John Haberl, AES was a pioneer years ago in Chile. MR. HABERL: Our strategy has changed over the last couple years and may change again. We used to be in 28 countries. We have been selling assets that no longer fit our strategic plan. We remain in 21 countries today. Chile and Mexico are two of those countries. We own a publicly-traded subsidiary in Chile that has about a $4 billion market cap. MR. ALEXANDER: Why exit seven other countries, but hold on to assets in Chile and Mexico? MR. HABERL: We chose to remain in countries where we feel we have a competitive advantage. We have a very significant presence in Chile. We have 1,000 megawatts of additional generating capacity under construction in Chile. Our new strategy is to build in places where we have a presence and we think our development efforts will be more successful as opposed to the strategy in the past of going anywhere there was a deal. Similarly in Mexico, we have 1,000 megawatts: one project where we sell to the CFE and two self-supply projects. We have been more successful in self-supply, but with the new regulations, Mexico will become an area of increasing focus. Mexico in Transition MR. ALEXANDER: Clients are always asking lawyers where we see new deals as a way of picking up market intelligence. My answer the last few years has been Mexico. I have been telling them everybody is looking at Mexico, and the country looks fantastic. However, I was just down there a few weeks ago and, with all the reforms that are going on, it looks horrible, especially for renewable energy projects. Everything seems paralyzed. Niels Rydder, your company is a developer with long experience in these markets. Which of these two views is more accurate? MR. RYDDER: The primary focus in Mexico currently is a little like it was in the US last year. We are trying to preserve as many projects as possible through grandfathering. The primary focus of the wind association, for example, is to decide which projects can be grandfathered under the old rules and which projects work under the new rules. It is not yet clear how projects work under the new rules. As a developer, you want everyone else to stay away from Mexico and leave it to us. We are perfectly happy to be alone in that market.MR. ALEXANDER: Natalie Jackson, the solar market has not been great in Mexico. Only one large project has been done to date. MS. JACKSON: The country has favored wind. The sole large solar project was a merchant deal in Baja. We are all waiting to see the new rules for opening the power sector to more private investment and specifically what happens to renewables. We expect that the rules will be more favorable than they have been. The solar resources are great in certain parts of Mexico. We have been actively developing projects in the country for a little over a year and a half, and we have found some good sites. Our plan is to focus on a couple projects where we are pretty advanced in terms of getting permits in the hope that those projects will be grandfathered. These are self-supply projects rather than under the small producer contracting scheme. Merchant in Chile MR. ALEXANDER: Let me shift focus to Chile. Unlike Mexico, Chile is not in the midst of structural reforms. Developers usually do not feel they have a project until they have signed a long-term power purchase agreement to sell the electricity. Chile seems to be moving in a unique direction with lenders willing to finance merchant projects. John Haberl, how important is it to AES to have a PPA in Chile? MR. HARBERL: The market in Chile is well functioning, so people will take some merchant exposure. One of our new projects currently under construction is at a mine, and we were able to get contracts in place prior to construction so that the financing was arranged on a partly contracted basis with the lenders taking the remainder of the merchant risk going forward. Our other new project is a hydroelectric facility. It was a lot more difficult to get a contract for it because the construction period is so long and offtakers do not want to wait five years, and there is some uncertainty around when the project will be finished, so we went to the banks and asked whether they would finance the project on a merchant basis. Most said no, so we ended up relying on the multilateral lending institutions. The multilaterals have a good understanding of the market and actually, in some cases, preferred that we not enter into a contract because of their experience with a contracted hydroelectric project where construction was delayed. The local banks in Chile were also comfortable with the market and were willing to let us go into construction with no contracts. We have an obligation to put contracts in place during construction MR. ALEXANDER: Why is AES comfortable taking merchant risk in Chile? MR. HABERL: We know the market very well. We are a top-three power producer in the country. The hydro project is not far from Santiago, which is a major load center. The project is zero variable cost, so it will always be dispatched. In the north of the country where our mine project is located, it is a little more difficult because the merchant markets have been soft and there is competition from gas with nearby LNG facilities. So we ended up on the project contracting for 100% of the electricity output before closing. MR. ALEXANDER: Natalie Jackson, does SunPower have the same view as AES of merchant risk in Chile? MS. JACKSON: Our first project is fully merchant and was financed with the Overseas Private Investment Corporation. We could not have secured financing from the commercial banks either locally or internationally. Our next projects will not be merchant. Our management is not comfortable moving forward with another merchant project at this point, so we are looking actively for offtakers. The challenge with talking with the mining companies is they are looking for 24-7 power. That is not what a solar project produces. There are a lot of solar developers chasing contracts, and the offtakers do not want to commit until they know there is a viable project. Many of them are saying we will contract with you when you complete the project. That is not very helpful for financing. We are finding that there are local commercial banks and a couple international commercial banks that will agree to a pretty low debt service coverage ratio for the contracted piece of the project and a different debt service coverage ratio for the merchant piece with an ability to borrow more if you add a PPA later. Chile is also talking about possible reforms. The way the local electric distribution companies are procuring power is not very favorable for renewable energy. We are hoping that some of that will change. MR. ALEXANDER: It does not take long to build a solar photovoltaic project. Have you given any thought using your own equity to build and then financing the projects after they are in service? MS. JACKSON: We are weighing out all our options. We would like to be in construction with our next project by late 2014 or early 2015.start drilling geothermal wells in Chile before you have a power contract? MR. RAASCH: We did. MR. ALEXANDER: I guess you will then. [Laughter.] MR. RAASCH: Two years ago, we drilled the largest geothermal well in Chile and for that matter in South America. It is a 12-megawatt well. We decided on that basis to move ahead with building a demonstration plant. It will be the first geothermal power plant in Chile. The PPA market is poorly developed in Chile. It is hard to get a long enough tenor, and the PPAs impose terms that make projects difficult to finance. Therefore, we approached the multilaterals, and we got term sheets from OPIC, the Inter-American Development Bank and the International Finance Corporation. We also got some interest from commercial banks, especially ING, which had just worked with us on a successful project in the US. We have had no trouble going merchant with the international financial institutions. The 5-year running average for spot prices in Chile is $151 a megawatt hour, so merchant does not look bad in Chile. Crime in Mexico MR. ALEXANDER: Let’s focus on some other practical advice for developers. Niels Rydder, when you first went into Mexico, how did you figure out the self-supply market and how to set up your own offtake arrangements? MR. RYDDER: We bought into an existing company, so we did not start from scratch. The company we bought had been working on projects in Mexico for five years, and we bought into the company two and a half years ago. We kept part of the existing team obviously because it is best to assume when entering a new country that you do not know anything. Our biggest concern in Mexico is in which part of the country to focus our efforts. We chose to be where fewer people are and that means you have security issues, and transmission from such locations is always a big issue. MR. ALEXANDER: Your project is in northern Mexico in Tamaulipas. By security concerns, do you mean police-type security? MR. RYDDER: It is different. MR. ALEXANDER: So we are not talking about a security interest. How do security concerns factor into your risk-adjusted return? MR. RYDDER: The way to deal with security in Mexico is to take the concern seriously. You choose contractors and suppliers who have done projects there and have dealt with the situation and can demonstrate how they mitigate the security issue and have the presence to handle it. MR. ALEXANDER: How receptive have you found the bank market to projects in areas where security is a concern? MR. RYDDER: Many investors and turbine manufacturers do not want to deal with it. You have a much smaller selection of manufacturers who want to sell you turbines in those areas. Many investors do not want to do the extra diligence to understand the situation and evaluate our risk mitigation strategies, but you also have investors who see things as we do and see that if we can solve the problem, the lack of market competition is a good thing. We have to compete with all the biggest companies in the world like AES. As a small company, we have to sneak into an area where they do not want to be. Even though we are a part of a big company, we are operating as a small company.Rates of Return MR. ALEXANDER: John Haberl, what returns are you getting on your projects in Chile? How do they compare to the United States? Do you view Chile as a better investment than the United States in terms of risk-adjusted returns? MR. HABERL: Chile is a core market for us, and we view it pretty much identically as the United States.MR. ALEXANDER: So are you looking for returns under 10%? MR. HABERL: We actually have not done much in the United States recently. We have done more in Chile. In Mexico, we have been looking for more of a premium. The one thing that we do to help our returns is we try to be more efficient with our capital by selling down a piece of each project. For example, we sold 40% of a project recently to a Japanese partner, who then brought financing from an export credit agency. We sold 40% of another project to another investor who brought a PPA. MR. ALEXANDER: Is 40% a magic number? MR. HABERL: We want to maintain operational control. A lot of these players have cheaper forms of capital than we do. MR. ALEXANDER: Natalie Jackson, you will be one of the first movers in solar in Mexico. Is that an advantage or a disadvantage? MS. JACKSON: We are not planning currently on maintaining majority equity positions in our projects. We are looking for both debt and equity investors. Mexico is a great international banking market, but there are also local development banks like Banobras and Nafin that offer really attractive pricing and longer tenors and are anxious to do solar. MR. ALEXANDER: What returns are you looking for in Mexico, and how do they compare to return in the United States and Chile? MS. JACKSON: We work backwards from what we think equity investors will require. As a minority equity participant, we have our own thresholds that we set on a case-by-case basis. We are more complicated than other companies because we are a vertically-integrated supplier of solar panels for these projects. All of that said, Chile is attractive and more competitive than Mexico, say 11% to 13% in Chile for a contracted project on a levered basis and Mexico is a little higher in the mid-teens. MR. ALEXANDER: Greg Raasch, what are your returns in Chile? MR. RAASCH: We have been looking at projects in Chile with returns in high teens to as high as 20% to 21%. MR. ALEXANDER: How does that compare with a project in Germany or the US? MR. RAASCH: We have some projects in Germany that we are looking to finance currently, and the returns on them are in the mid-20s. You are probably thinking, “Germany? I didn’t know they have volcanoes in Germany.” Germany is one of those places where, if you drill deep enough, it gets hot enough. The government is shutting down the nuclear power plants and to establish a viable renewable energy industry of which geothermal is a part. Germany enacted a very attractive feed-in tariff. Germany is an incredible opportunity because it is low risk and high return. MR. ALEXANDER: How about Chile? MR. RAASCH: Chile has good returns but, at the same time, the geothermal industry is in startup there. The first person in is going to pay a higher price. It is always costly to get started. The resources look good, but there is start-up risk. Financing Terms MR. ALEXANDER: Natalie Jackson, what terms are you getting from the multilaterals and banks on financings in Mexico and Chile? MS. JACKSON: For Mexico, longer-term financing is available at fairly attractive rates. The local development banks are more interested in lending pesos, so we will have to involve an international bank in the syndicate that can lend in dollars. We are also looking at tapping into the project bond market, but any such financing would have to be in the US in dollars. MR. ALEXANDER: Niels Rydder, same question. MR. RYDDER: We are financing our first project with OPIC. We talked to the commercial banks initially, but commercial bank debt was going to be hard to arrange on terms that worked for the project. I think project bonds are the way to go ultimately, but Mexico has to turn into a more mature market before that is an option. MR. ALEXANDER: John Haberl, your hydroelectric project in Chile was financed by the development banks, which is surprising given that Chile is a fairly developed market. Was the problem the bank market is not deep enough to do a project of the size you are building? MR. HABERL: The development banks were able to participate because there is a lot of risk involved. We are digging 67 kilometers of tunnels. There is merchant risk. They stepped up because they recognized that the project was not going to happen unless they came in. They did not lend all of the debt — they put in about half — but that provided a seal of approval for the project that caused some local banks to come along as part of the syndicate. We could not have done a coal-fired power project with the development banks, but hydro is good. The project had a limited environmental impact, although development banks made us do a lot more environmental diligence than usual. The other project we have under construction is a coal-fired power plant, so the development banks are out. We had power contracts. We brought in a partner who could deliver an export credit agency, which lent a large amount of money, and we raised the rest from commercial banks. We funded about $3.4 billion in projects last year in Chile. We put in about $600 to $700 million in equity. We raised other, local equity. We sold corporate-level bonds to raise all but $100 million of the AES equity investment. The coal project was not down the middle of the fairway. It is a brownfield development from an existing facility, and we have a lot of shared services and infrastructure. The project does not necessarily work without the other project. This made for complicated discussions with the lenders. MR. ALEXANDER: So there is a lot of liquidity in the market for projects in Chile? MR. HABERL: In my view, yes. MR. ALEXANDER: The hydroelectric project is over $1 billion, correct? MR. HARBERL: You cannot just go to commercial banks and say, “I want to borrow $1 billion.” The market is not deep enough to do that. You have to have an export credit agency or multi-lateral lending agency willing to lend a significant percentage of the capital. MR. ALEXANDER: Greg Raasch, how deep is the market for debt in these countries and how do the lenders view geothermal? MR. RAASCH: Debt is not an issue. The Chilean pension plans are very active, and there was a lot of interest expressed by local banks, but none of them has geothermal experience. That is another way of saying we did not have much success with local banks, which is why we ended up going with the international financial institutions. We ticked all their boxes, so there was a lot of interest from them in doing the first geothermal project in Chile.Disadvantaged US Equity MR. ALEXANDER: Have you seen more appetite from Europeans and Asians to invest in Chile and Mexico than from Americans? From what I have seen, it looks like American investors are demanding higher returns. MS. JACKSON: We have seen a lot of interest from European and Asian funds on the equity side, but when you say American investors, what do you mean? MR. ALEXANDER: I mean US-sourced equity. MS. JACKSON: That is available, too, but US-based funds tend to have higher hurdle rates. MR. RYDDER: I can confirm that. There is also a tax issue. The tax treaty for US investors is really bad, so an American investor would have to invest through an offshore blocker corporation, which complicates things. This puts American investors at a disadvantage when competing with Asian, European and Canadian investors. The other reason is American investors are more concerned about peso risk. Every American investor to whom I talk wants to discount the pesos. Local investors have a different view. The gap in views can be quite large for projects with long-term contracts. MR. ALEXANDER: We have time for one more question. In the back of the room. MR. CRESWELL: Lachlan Creswell from Macquarie Capital. There are energy reforms underway in both Mexico and Chile. Both are high-priced markets, and that is part of the driver for energy reform. Both countries have high-quality renewable resources. Do you think that the renewable industry has a big enough voice in the policy debates to push for better structures and incentives? Natalie Jackson spoke about the difficulty getting PPAs in Chile and the uncertainty that wind developers are facing in Mexico. MR. RYDDER: One thing to pay attention to in Mexico is Mexico wants to get to 35% renewable energy by 2024, within 10 years. There is strong political support in Mexico City for renewables. There is more support there frankly than there is currently in Washington. MR. RAASCH: Chile has a 10% renewable portfolio standard of sorts that must be fulfilled by 2025. The government is very responsive to renewables. There is a bill moving through the Congress to add a $5-a-ton carbon tax on all projects. Chile is a neo-liberal economy; it has a free market, and the government does not like to get too involved, but the government is strongly behind renewable energy.