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Going green in Latin America

Is the Region’s Renewable Energy Industry Ready for PE Investment?

For the past few years, Latin America’s energy sector has caught the attention of many private equity funds looking to invest in the region. In 2005, over $300 million was invested in the sector, almost a third of the $1 billion that was invested in the region.

While this is not a new phenomenon (i.e. energy-focused private equity firm Conduit Capital Partners has been operating in the region since 1993), there is an undercurrent of change taking place in the industry. Private equity and venture capital folks are beginning to look at the renewable and clean energy industries as a viable option for investing their funds.

A multitude of reasons are causing several funds in the region to have a green focus. For one, the spike in oil prices in the last few years has meant that some renewable energy projects have been able to become more cost-efficient and therefore more profitable than some fossil fuel plants, which did not used to be the case.

Additionally, many Latin American countries have favorable climates for renewable energy (ethanol production in Brazil, for instance). Finally, as awareness increases for the environmental necessity of clean energy alternatives, a select group of limited partners are becoming more interested in investing in green energy funds.

Who’s Investing

In the private equity world, limited partners that are willing to sacrifice returns to invest green are few and far between. One fund that has managed to raise capital on such a premise is the Central American Renewable Energy and Cleaner Production Facility (CAREC), managed by E+Co Capital- Latin America.

CAREC, a mezzanine fund, is close to finishing its goal of raising $20 million (see story on page XX). The fund is targeting an IRR of 12 to 13 percent, which is lower than many other funds in the region.

Most of the fund’s support thus far has come from development banks and development funds, including Finnish development fund Finnfund, Belgian development fund Bio, Netherlands development fund Triodos, the Central American Bank of Economic Integration and the Multilateral Investment Fund of the Inter-American Development Bank. The fund is also hoping to raise money from a handful of high net worth individuals in the US.

Most funds do not follow E+Co’s model and instead seek to pitch a fund to limited partners that not only seeks to make green energy investments, but also offers competitive rates of return compared to other emerging markets funds. FE Clean Energy Group Inc., for instance, operates a $31.6 million renewable energy and energy services fund, known as the Fondelec Latin America Clean Energy Services Fund, which seeks to compete with other energy funds in the market.

According to Chairman George Sorenson, the fund’s returns are competitive with other funds in the Latin American energy market. “The projects we enter into must be economically competitive from a return standpoint,” he said. “We therefore have stayed away from certain projects.

In certain countries, for instance, the tariff regimes are such that wind energy projects are not economically profitable, and we won’t go there,” he added. While the Clean Energy Services Fund has attracted the MIF and two Mexican development banks as limited partners, it also has major commitments from groups such as the Tokyo Electric Power Company and Sumitomo Corporation.

Scott Swensen, the Chairman of private equity energy fund Conduit Capital Partners, is of the view that a strictly renewable energy fund cannot generate returns as high as a more diversified energy fund that includes fossil fuels. “I believe there are limitations inherent in some of the green technologies that reduce your ability to generate the highest returns,” he explained.

Swensen believes that risk factors, such as a change in environmental conditions or a drop in oil prices, can have a significant negative effect on renewable plants such as hydroelectric or wind plants.

Such risks make it difficult to attract both limited partners and debt financing for deals. “With some of these technologies, it is unlikely that you will be able to sign long-term revenue contracts where you have a capacity payment, because you can’t guarantee that you will be available. You get paid only for the energy that you deliver,” Swensen said.

Despite the doubts that Swensen expressed, Conduit does invest in renewable energy projects in addition to fossil fuels. Forty percent of its Latin Power II fund was dedicated to renewable energy, including both hydro and geothermal plants. Because it is environmentally conscious in complying with World Bank and country-specific standards with all of its energy projects, Conduit does not normally have a problem with turning away green investors, according to Swensen. He did add that Conduit has turned away some limited partners that have requested a fund mandate of investing at least half of its capital in renewable projects.

According to Sorenson, there has been an evolution in the types of limited partners looking to invest in renewable and clean energy funds. “When we first started,” he explained, “half of our investors had a strategic orientation and were either participating in the industry or understood it quite well. The other half of our investors, such as the MIF and the Asian Development Bank, wanted a decent return, but also wanted to foster economic development and environmental sustainability.”

Now, those investors continue to show interest, but new limited partners, such as pension funds, private equity funds of funds and insurance companies, are beginning to show interest as well. “Limited partners are beginning to see renewable energy as a viable sector where they can get reasonable rates of return,” Sorenson said. This phenomenon of more traditional financial players being interested in the sector has only come about in the last 18 months, he added.

Risk: Renewable vs. Fossil Fuels

It is clear that there are often high risks associated with renewable energy projects. One of the main concerns for green investment funds is the possibility of a drop in oil and/or natural gas prices.

According to Tom Stoner, CEO of US-based renewable energy company Econergy (which manages Latin American renewable energy private equity fund CleanTech Fund), alternative fuels and electricity plants are different in this respect.

Since building power plants is such a significant and long-term process, there tends to be a lag effect with regard to changes in oil and gas prices. Alternative fuels are therefore much more closely correlated to fossil fuel prices than is electricity, he explained.

Sorenson added, “liquid fuel projects would be hurt by a drop in oil prices; often the price we get for biodiesel or ethanol is indexed to the price of oil.”

Like any fund, diversification is a must for green energy funds. Just as a fund investing entirely in alternative fuels would be exposed to high risk of a drop in oil prices, hydroelectric investments are susceptible to lack of rain and wind power plants are susceptible to a lack of wind. For this reason, Econergy’s Clean Tech Fund and other funds in the region diversify the technology that they invest in to minimize risk.

While renewable energy plants run environmental risks, fossil fuel power plant investments are not without risk, either. While fuel costs for renewable energy plants are known (they are negligible because they are renewable), fossil fuel prices have become much more volatile.

“The predictability of the cost of fuels has been forever shaken, meaning that fossil fuel plants no longer have that advantage over renewable plants of having predictable operating costs,” Stoner said.

Carbon Credits Add to Profitability

Another thing that renewable energy has going for it – at least some renewable energy- is carbon credits. Different types of renewable energy technology are affected by carbon credits to different extents. Liquid fuel projects, according to Sorenson, are not a source of carbon credits because it is not clear how carbon credits could be derived from such an investment.

As for FE Clean Energy’s hydrocarbon plants, carbon credits can increase the return on the investment by 2 percent. Its biomass projects could see a 2 to 6 percent increase in return due to carbon credits, Sorenson said.

Conduit also brings in “a significant amount” of revenues via carbon credits in its renewable plants, Swensen said. Through its investment in Mexican hydroelectric plants Mexhidro, it generates 116,000 tons of carbon credits per year.

Conduit has a long term contract to sell the credits at a minimum of ten Euros per ton, plus 50 percent of the upside, bringing in over $1 million per year in cash flow. E+Co Capital’s CAREC fund is currently working on a biogas project in Guatemala that it wouldn’t even look at if it weren’t for the carbon credits factor, said Fernando Alvarado, the CEO of E+Co Capital.

Since its inception in January of 2005 until the spring of 2006, the European carbon credit markets steadily rose, improving prospects for renewable projects all the while. This spring, the market has experienced some volatility, as there was a major correction in the market. According to Stoner, “Volume is what the market needs, so a little volatility to create volume is a good thing.”

The Kyoto side has been relatively stable, but the treaty provisions will come to an end in 2012. Sorenson explains, “Right now without any provision extensions, it’s becoming somewhat risky to make investments in projects that bank on a longer carbon tail.” With a treaty extension, many renewable projects would become even more attractive.

Size of Funds Important

Currently, most renewable energy projects are smaller in scale. Taking a look at a few funds operating in the region, E+Co’s CAREC is a $20 million fund, Econergy’s CleanTech Fund is slightly over $20 million, and FE Clean Energy’s Latin fund is a $32 million fund. According to Swensen, “green deals often involve plants of 10 to 15 MW, which ends up requiring a $4 to 8 million investment.”

That’s perfect for the smaller funds in the region, but it becomes more difficult for a fund like Conduit’s $400 million Latin Power III fund. For now, funds of $20 to 50 million seem best suited for renewable investments.

Latin American Market

So is Latin America a good spot for private equity funds to go green? Yes, is the resounding answer from those involved in the region. “The renewable energy market in Latin American is rather advanced,” Sorenson explained. “Regarding liquid fuels, Brazil is world class.” Brazil, the lowest cost producer of ethanol in the world, is moving ahead with low cost biodiesel initiatives as well. Chile is also moving ahead with renewable projects and is looking for investors for the cause, Sorenson added.

In certain areas, legislative benefits, tariffs and tax breaks help out the returns on renewable energy investment. Certain Latin American countries do have such perks, but the legislation is still sketchy. Although FE Clean Energy hasn’t benefited from any such perks in the region, Sorenson is aware of various legislative mandates in Chile for investment in renewable energy.

Conduit’s geothermal Orzunil plant in Guatemala had a tax holiday as well, according to Swensen. The general consensus seems to be that such tax and legislative regimes are becoming more favorable toward renewable energy investment, which may have a slight positive impact on returns.

Very few private equity funds are active in Latin America’s renewable energy industry, and experts in the region agree that there’s plenty of demand for financing from local project developers. Stoner summed up the state of Latin American renewable energy: “It’s resource-rich environment, and very well-positioned and ripe for renewable energy investment.”