WIND PROJECT ECONOMICS AND INDUSTRY UPDATE

WIND PROJECT ECONOMICS AND INDUSTRY UPDATE LISA CHAVARRIA McElroy, Sullivan & Miller, L.L.P. 1201 Spyglass, Suite 200 Austin, Texas 78746 (512) 327-8111 lchavarria@msmtx.com State Bar of Texas 24 TH ANNUAL ADVANCED OIL, GAS AND ENERGY RESOURCES LAW COURSE October 5-6, 2006 Houston CHAPTER 6

LISA CHAVARRIA McElroy, Sullivan & Miller, L.L.P. 1201 Spyglass, Suite 200 Austin, Texas 78746 (512) 327-8111 e-mail: lchavarria@msmtx.com BACKGROUND, EDUCATION AND PRACTICE Lisa Chavarria works for the Austin law firm of McElroy, Sullivan & Miller, L.L.P. Her practice focuses on energy law specializing in wind power. She negotiates wind energy leases on behalf of landowners and wind companies and has written extensively on the topic. Lisa is the co-chair for The University of Texas School of Law s 2007 Wind Energy Institute. She is a member of the State Bar of Texas, Travis County Bar Association and Austin Young Lawyers Association and is admitted to practice before the United States District Court for the Western District of Texas. Before joining McElroy, Sullivan & Miller, L.L.P. she earned a degree in Government from The University of Texas at Austin and a J.D. from The University of Texas School of Law where she also studied law at Queen Mary University in London, England. Lisa has written and contributed to several articles including: Author of Windpower: Prospective Issues, Advanced Oil, Gas & Energy Resources Law Course, sponsored by the State Bar of Texas, San Antonio, Texas 2004, also published in the Texas Bar Journal, Vol. 68, No. 9 (October 2005); Author of Developments in Wind Energy: An Update on the Wind Industry & Wind Leasing Issues 2 nd Annual Ernest E. Smith Oil, Gas & Mineral Law Institute Houston, Texas 2006, sponsored by The University of Texas School of Law; Author of Where One Size Doesn t Fit All: Contrasting the Methane Gas Lease, Wind Lease and Oil and Gas Lease, 31 st Annual Ernest E. Smith Oil, Gas & Mineral Law Institute Houston, Texas 2005, sponsored by The University of Texas School of Law;; Co-Author of Wind Leases in Texas, Agricultural Law Seminar, sponsored by the Texas State Bar Midland, Texas 2004; Co-Author of Anatomy of a Wind Energy Lease, Advanced Oil, Gas & Energy Resources Law Course, sponsored by the State by the State Bar of Texas, Houston, Texas 2003; Co-Author of Regulatory Update and Statutory Preview, 25th Annual Oil, Gas and Mineral Law Institute, Houston, Texas 1999, sponsored by The University of Texas School of Law.

WIND PROJECT ECONOMICS AND INDUSTRY UPDATE I. TEXAS INDUSTRY UPDATE In July 2006 Texas surpassed California as the state with the highest installed cumulative wind power capacity. As of July of this year Texas had installed 2,370 megawatts ( MW ) of capacity compared to California s 2,323 MW. Although the margin is slight, Texas s accomplishment is momentous; whereas California s first commercial scale wind installation was completed in 1981 the first Texas commercial scale wind farm went on line in 1995. The most significant challenge to the Texas wind industry s continued growth is ensuring transmission keeps pace with wind farm construction. Since wind development began in Texas transmission constraints have been a challenge for the industry. One source of the problem is geography - whereas the largest concentrations of wind farms are in remote parts of the state (i.e. McCamey and Sweetwater), areas with the highest electricity consumption are urban. With this problem in my mind in August 2005, the Texas Legislature passed legislation intended to address present and avoid future constraint problems for renewable energy. Senate Bill 20 requires the Public Utility Commission ( PUC ) working with the Electric Reliability Council of Texas ( ERCOT ) designate competitive renewable energy zones 1 (also referred to as CREZ ) throughout the state. CREZ are to be in areas in which renewable energy resources and suitable land areas are sufficient to develop generating capacity from renewable energy technologies. 2 SB 20 requires that the PUC designate CREZs and develop transmission plans to deliver wind generated electricity from the CREZ to customers throughout the state. The difference between the amount of time needed to build a wind farm and the time required to design, permit and construct transmission lines delays or altogether precludes the construction of some wind farms. Whereas lead time for the construction of a wind farm is about one year, the lead time for the completion of a transmission line is about five years. The purpose behind the designation of Competitive Renewable Energy Zones is to expedite the process of identifying areas which have good wind resources but are in need of additional transmission to get the electricity to a load center. Senate Bill 20 allows the PUC to issue a Certificate of Convenience and Necessity ( CCN ) in anticipation of the installation of renewable energy projects in a region. Under the former law, CCNs could not be issued unless the applicant demonstrated the need for additional transmission capacity to meet consumer electricity requirements or the ability of a transmission project to lower electricity costs to consumers. Under the old structure, a utility would not build a transmission line until it had commitments from generators confirming that the new lines would be utilized ensuring the utility would recover its costs. This arrangement has been problematic for wind development which, for financing and operational purposes needs transmission before the wind farm is built. Under Senate Bill 20 the PUC can authorize cost recovery before such commitments and showings are made. This in turn will allow wind farm developments to move forward in areas that do not presently have adequate transmission. ERCOT contracted with AWS Truewind 3 to identify potential CREZs based on the consistency of wind patterns and the sufficiency of wind generation potential. After reviewing wind data for the state AWS has been able to provide ERCOT with projected capacity factors for areas throughout the state. Capacity factor refers to the wind turbine's actual energy output for the year divided by the energy output if the turbine was able to operate at full capacity for the entire year. 4 A reasonable capacity factor is 25% to 30%. A very good capacity factor is 40%. Some of the preliminary wind data shows parts of the Panhandle have a capacity factor over 45%. In identifying potential CREZs, ERCOT also considered the extent of potential upgrades needed for existing transmission lines and determined the level of stakeholder interest for areas throughout the State. The illustration below shows proposed CREZ areas throughout the State as identified by ERCOT. It should be noted that although ERCOT does not manage the electrical grid for the entire state of Texas (the Southwest Power Pool manages the Panhandle, far west Texas including El Paso is managed by the Western Electricity Coordinating Council and parts of East Texas are under SERC Reliability Corporation), SB 20 required that ERCOT consider all areas of the State for potential designation as a CREZ. 1

Proposed CREZs Illustration Courtesy of ERCOT II. NATIONAL INDUSTRY UPDATE Wind is big business in the United States. In 2005 2,500 MW or more than $3 billion worth of new generating equipment was installed in the United States. 5 It is expected that 3,000 MW will be installed in 2006. As of the date of this paper 10,000 MW of wind power had been installed in the United States. The surge in wind installations can be attributed to many factors. Foremost among them is high consumer demand for increased renewable energy sources. When wind first became available Texas consumers opted to pay more to use wind power. With the high cost of natural gas consumers who opted into wind power programs are now paying less for their electricity. The present availability of the Production Tax Credit ( PTC ) 6 is another significant factor driving this year s increase in wind installations. The 2005 Federal Energy Bill extended the PTC until December 31, 2007 motivating many developers to move projects forward in order to take advantage of the PTC before it expires. In order to qualify for the credit a wind farm must be completed and generating power while the credit is in place. For this reason when the credit expires (as it has three times over the last six years) wind development comes to a stand still. The expiration of the PTC also impacts the wind industry in other significant ways. For example, all wind turbine vendors active in North America in 2005 sold out of turbines and many industry experts blame the turbine shortage on the expiration of the PTC. Whereas manufacturers receive a glut of turbine orders after each PTC renewal, orders for turbines plummet when the PTC expires. The overwhelming demand for turbines and the resulting shortage has led to a significant rise in the cost for turbines, and in turn, a significant rise in the overall cost of building a project. Some turbine manufacturers require that a deposit of at least 20% of the total turbine order be paid at the time the order is placed. The deposit amount can be a significant amount of money. For example, a 150 MW wind farm that uses a 2.0 MW machine will need 75 turbines. A 2.0 MW turbine costs approximately $2 million making the total cost for turbines about $150 million and the 20% deposit $30 million. The recent weakness of the American dollar relative to the Euro puts a further financial strain on wind companies as most turbines used for domestic wind farm developments are manufactured in Europe. Wind farms generate revenues for landowners and for the numerous companies involved in their financing, construction and manufacturing. In addition to acquiring the surface rights to use the property a wind company usually must secure financing for the project, contract to purchase turbines, negotiate a power purchase agreement, engage a contractor to build the wind farm, and secure a transmission service provider. The illustration below shows the key players involved in a wind project development. 2

Error! Objects cannot be created from editing field codes. III. THE ECONOMICS OF WIND LEASES. People who build wind farms and enter into lease agreements do so for one reason: to make money. With this principle in mind an understanding of how wind generated electricity is sold is essential. A. How Electricity is Sold The electricity generated by a wind farm may be sold in a number of ways. A common arrangement is to enter into a power purchase agreement ( PPA ) with a utility for a fixed term and at a fixed price. The costs associated with producing wind-generated electricity are predictable; therefore, producers of wind-generated electricity can offer longterm, fixed price contracts. A second option is to sell wind-generated electricity on the spot market. Unlike under a long term fixed cost PPA, the price received for spot market sales vary from day to day or hour to hour. With the recent spike in natural gas prices, wind power became a cheaper alternative to natural gas and thus wind spot market sales have become very profitable. Although the present profitability of spot market sales makes such an arrangement very attractive to landowners it is important to remember that electricity sales could plummet in the future making a fixed PPA arrangement better in the long run. Another alternative is for the wind power producer to enter into an arrangement to sell electricity directly to a large industrial customer. Finally, a single wind farm may sell electricity using a combination of the abovedescribed methods. For example, some of the electricity may be sold pursuant to a fixed price PPA and the reminder on the spot market. The way the electricity is sold and to whom are within the sole discretion of the wind farm operator. Fortunately, the landowner and the wind company s interest in maximizing the amount obtained through electricity sales are aligned. B. The Royalty Clause. The key financial provision in a wind lease is the royalty clause. A landowner s royalty is the percentage of Gross Revenues the landowner receives. Gross Revenues, gross receipts or gross sales, as they are sometimes called, are comprised of the total amount of money generated by a wind farm through the sale of electricity. The factors that directly impact the amount of revenue generated by a wind farm are the capacity factor and the sale price for the electricity, which is usually expressed in a per megawatt hour amount. Gross Revenues will sometimes include amounts collected from the sale of Renewable Energy Credits 7 and amounts paid pursuant to a business interruption insurance policy. In the author s opinion any amounts collected in lieu of royalties should be included in Gross Revenues and paid to a landowner. A Gross Revenues definition will also typically outline what is excluded from Gross Revenues. For example, amounts collected from the sale of the wind farm or any tax credits received are for the sole benefit of the wind company and are excluded from Gross Revenues. Below is a Gross Revenues definition used in many wind leases: Gross Revenues: The aggregate total revenue actually received by Wind Company, during the applicable period of time, from the sale, to the purchaser of the electricity, of electrical energy generated and sold from the Wind Turbines then located on the Property. Gross Revenues shall also include any payments received: (a) from renewable energy credits or pollution credits that directly result from construction and operation of Wind Turbines on the Property (except for production tax credits, other tax benefits and credits, or any reimbursement thereof); and (b) pursuant to a business interruption insurance policy or by the manufacturer of any Wind Turbines under the provisions of its warranty therefore, in each case if made specifically in lieu of revenues from the normal operation of such Wind Turbines. Gross Revenues shall, not include revenues received: (a) from the sale, lease, sublease, assignment, transfer or other disposition of Windpower Facilities or any other of Wind Company s improvements, trade fixtures or chattel (or any interest therein); (b) from sales of electrical energy produced by Wind Turbines not located on the Property; (c) from any rental or other payment received by Wind Company in exchange for Wind Company s assigning, subleasing, mortgaging or otherwise transferring all or any interest of Wind Company in this Lease; (d) from the sale, modification or termination of any obligation under a power purchase contract; (e) from parasitic or other loss; (f) from sales of electrical energy for which payment is not received (including because of a default by the purchaser thereof); (g) as reimbursement for wheeling costs, electricity transmission or delivery costs or network upgrades or like cost or expense; or (h) from production tax credits, other tax benefits and credits, or any reimbursement thereof received by Wind Company in connection with the Project. It should be noted that the landowner s royalty is generally not calculated using Gross Revenues generated by the entire wind farm. Rather the royalty is calculated based on megawatt capacity actually installed on the landowner s property. For example, a landowner with a 4% royalty and 60 megawatts installed on his property does not receive 4% of Gross Revenues for the entire farm; he receives 4% of Gross Revenues attributable to the 60 megawatts installed on his property. 3

What appears below is a projection of what a landowner would receive for the applicable royalty rates when he has sixty megawatts installed on his property with a capacity factor of 42% and a per megawatt sales price of $40.00. 1. Landowner Royalty Forecast Assumptions: Number of MW Installed on Property: 60 Capacity Factor: 42% Per MWH price: $40.00 Year Royalty Royalty Year Royalty Royalty Rate Payment Rate Payment 1 4.00% $353,203 14 6.00% $529,805 2 4.00% $353,203 15 6.00% $529,805 3 4.00% $353,203 16 7.00% $618,106 4 4.00% $353,203 17 7.00% $618,106 5 4.00% $353,203 18 7.00% $618,106 6 5.00% $441,504 19 7.00% $618,106 7 5.00% $441,504 20 7.00% $618,106 8 5.00% $441,504 21 8.00% $706,406 9 5.00% $441,504 22 8.00% $706,406 10 5.00% $441,504 23 8.00% $706,406 11 6.00% $529,805 24 8.00% $706,406 12 6.00% $529,805 25 8.00% $706,406 13 6.00% $529,805 TOTAL: $13,245,120 2. Total Wind Farm Royalty Forecast The total revenue for a 120 MW wind farm (using the same assumptions of a 42% capacity factor and a per megawatt hour sales price of $40.00) is $17,660,160 per year. Over a twenty five year period the wind farm will generate $441,504,000.00 in revenues. C. Affiliate Transactions. Electricity generated by a wind project may be sold to an affiliate of the company that owns the project. Transactions between related parties are usually met with suspicion and many landowners fear such an arrangement will allow the wind company to sell electricity at a price below market value. The problem facing both landowners and the wind company is determining what market value is in the event there is a dispute between the parties over whether the price paid for electricity reflects fair market value. Presently, there is no price index to use as a reference point. 8 To address this concern, a wind lease should provide a process for resolving an affiliate pricing dispute should it arise. For example the clause could provide that should a price dispute arise, it will be resolved by an independent third party auditor s evaluation of whether the price paid is fair. What follows are two examples of affiliate clauses, the second one outlines how a dispute will be resolved: Example 1 Each power purchase agreement that results in Gross Sales, and each agreement for the sale of renewable energy credits or pollution credits (but not production tax credits or other tax benefits or credits) that directly results from construction and operation of Wind Turbines on the Property and that creates Gross Sales, shall be the product of arms-length negotiations; or, if the transaction is such that arms-length negotiations are not practicable (such as a transaction with an affiliate), then Wind Company shall use its good faith commercially reasonable efforts to obtain a fair market price for the energy or credits that is/are the subject of such transaction. Example 2: Within thirty (30) days of receiving written notice from Landowner of an Affiliate Sale Dispute the Parties shall each appoint a Consultant to determine whether the sale to the Affiliate, or the contract contemplating a series of such sales, was at the fair market price. Within fifteen (15) days following the appointment of the two (2) Party-appointed Consultants, the two (2) Party-appointed Consultants shall appoint a third Consultant. If the 4

two Party-appointed Consultants fail to agree upon a third Consultant within such period, the AAA shall select such party within fourteen (14) days of receipt of written notice from either party. Within one hundred and twenty (120) days after all three (3) of the Consultants have been appointed, each Party shall have submitted such materials as required by the panel. Proceedings of the panel of Consultants shall be conducted as though the dispute were an arbitration under the rules of the AAA. Within thirty (30) additional days, the required determination(s) shall be made by a majority vote of such three (3) Consultants, and, as so made, shall be final and binding upon each Party and only subject to appeal to the extent such decision would be were it an arbitration decision under Texas law. Many wind leases in existence today contain the language seen in Example 1 and may give sufficient comfort to the landowner but should be accompanied by a requirement that notice be given to the landowner that affiliate sales are being undertaken. Crafting an affiliate transaction provision that is fair to both the landowner and wind company will be very challenging until a pricing index or some other external mechanism becomes available to verify market price. 1 Tex. S.B. 20, 79 th Leg., 1 st C.S. (2005). 2 Id. 3 AWS Truewind is a New York based company that provides atmospheric modeling, measurement and engineering services. 4 See AWEA s Basics: Energy Output, How Does A Wind Turbine's Energy Production Differ from Its Power Production? 5 See U.S. Wind Industry Ends Most Productive Year, Sustained Growth Expected For At Least Next Two Years, PR Newswire, January 2006. 6 The PTC allows qualified owners of wind power projects to claim a tax credit on their corporate income tax returns. 7 A Renewable Energy Credit (commonly called a REC ) is a tradable instrument that represents all of the renewable attributes associated with one megawatt hour ( MWh ) of production from a certified renewable generator. 8 Once ERCOT moves to a nodal market design, perhaps energy trading hubs representing an average price for aggregated nodes at the hub can provide a pricing index that could be referenced in the affiliate clause. 5