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M&A Waiting Game

Utilities protect their balance sheets.

Fortnightly Magazine - August 2009

significant impact on renewable energy projects. Given that electricity from renewable sources is more expensive to produce than electricity generated from fossil fuels, incentives play a fundamental role in this sector. While some countries, such as Germany, use feed-in tariffs (guaranteeing producers a higher rate for energy generated from renewables), in the United States, tax incentives such as the production tax credits (PTCs) and the availability of five-year MACRS (modified accelerated cost recovery system) depreciation have played an important role in making renewable projects competitive.

These tax benefits cannot be sold; therefore, developers must attract third-party investors or have taxable income high enough to utilize all the tax benefits. These third-party investors, known as tax-equity investors, were represented by banks such as JPMorgan Chase, investment banks such as Lehman Brothers and insurance companies such as New York Life. The combination of the economic downturn and the credit crisis has reduced the taxable income of these tax-equity investors and therefore the attractiveness of investing in such projects. Given the lack of tax-equity investors, and the rise of return requirements needed to attract investors, we have seen the cancellation of wind projects and delays to a host of other investments.

Government intervention may help this beleaguered sector. The American Recovery and Reinvestment Act of 2009 , which provides a $787 million stimulus package, includes a number of provisions affecting renewable power, including $6 billion in loan guarantees for renewable energy and power transmission projects that commence construction by Sept. 30, 2011, and an up-front cash-grant program administered by the Treasury that will provide 30 percent of a project’s cost for renewable projects (such as wind and solar) in lieu of a tax credit, if the project is started and completed within certain time frames specified by the act.

While the long-term outlook for renewables remains strong, especially if Congressman Henry Waxman’s proposed bill on a carbon cap-and-trade program coupled with a national renewable energy portfolio standard is enacted, the short term is not so rosy for many of these small businesses. The renewable energy industry should expect consolidation in the short term as smaller developers sell out to larger players due to lack of project financing.

Coming Off the Sidelines

Looking ahead, we can expect an austere year for M&A in 2009. While there were nine transactions with a value above $500 million in 2008, probably no more than one or two will be completed this year. In this market, large-scale transactions will be slow and frustrating to execute. Companies will need a razor focus on how a transaction’s benefits will translate to customers, negotiating with multiple regulators across state lines regarding the fear of job losses and staying the course over 12 to 18 months.

The biggest issue is capital expenditure. It’s estimated the U.S. power and utility industry will be required to spend over $2 trillion in capital investment in new power plants, transmission and distribution systems and environmental compliance over the next 20 years. 2 If the economy worsens, putting capital budgets under threat, this could affect both long-term profitability and