Friday, August 26, 2011

Energy Subsidies for "Fat Cats" (Part Three)

My third post on the U.S. renewable energy sector. I'm finally getting to the tax policy angle, where the "fat cats" on Wall Street are enjoying the good times, again. [I originally intended to finish this off in three posts. I realized that it will take four.]

As I described in my last post, "traditional" power plants burn coal and natural gas to satisfy most of our electricity demand. In the past decade, policymakers have begun pushing the development of "renewable" energy resources (primarily wind and solar) through a carrot and stick approach. The "carrot" involves tax subsidies for the development of wind and solar generation facilities. The "stick" involves a government mandate, often labelled a renewable portfolio standard ("RPS"), that requires utilities to source a fraction of their electricity from renewables. In the U.S., various states have enacted RPSs with various degrees of "teeth," but there is no national standard.

I'm focusing on the "carrot," but a quick observation on the "stick." Regulated utilities pass along costs to their customers. If a utility pays higher costs to source higher-cost "renewable" energy, then utility ratepayers (me, you, your kids, your grandma, your landlord, your employer, your local mall) will see the increased costs on their electric bills. Ultimately, higher utility costs are borne by individuals, directly or indirectly. Public Utility Commissions ("PUCs") exist to "protect" ratepayers from higher costs. Because renewable energy is still higher cost than energy from fossil fuels, PUCs will serve as a natural "check" on demand for renewables.

Back to the "carrot." Congress has enacted a set of tax subsidies to encourage renewable energy development. If you've done any interstate driving lately, you've probably seen "wind farms" (clusters of wind turbines on towers) popping up like dandelions. Those wind farms, and solar generation facilities currently under development, could not get off the ground without tax subsidies.

So why can't renewable energy developers get their projects into commercial operation without tax subsidies? Because an investment in renewables is non-economic under current market conditions. By non-economic, I mean that an unsubsidized renewable energy project would have negative risk-adjusted returns to its investors. For example, assume a wind farm or solar generation facility costs $10 million to develop. Based on current technology costs, financing costs and electricity rates, the investment might only yield a 2% average return over its operating life. But an investor can get a risk-free 3% return by investing in 30-year Treasuries. No rational investor would invest $10 million in a highly risky start-up venture (a wind farm or solar generation facility) with lower expected returns (2%) than a risk-free return (3%). [Note that 2% is a hypothetical number for easy discussion purposes.]

As I discussed in my last post, policymakers could tackle this issue using one of two approaches. The first approach would involve an across-the-board increase in electricity rates. For example, Congress could impose a carbon tax, which would increase utility costs for coal and natural gas. This would increase rates for electricity from traditional power plants (because the cost of coal and natural gas are passed through to electricity consumers). In turn, utilities could pay higher rates for renewable energy without causing "green rate shock" to electricity consumers.

Congress has rejected this approach for political reasons (higher electricity rates are politically unpopular; and higher costs for coal will decrease investment and union jobs in the coal mining industry). Instead, Congress has enacted tax subsidies for renewable energy development. The tax subsidies, when added to prevailing electricity rates, are sufficient to motivate investors to allocate capital to renewable energy projects.

The tax subsidies historically included tax credits and accelerated depreciation. This is where things get tricky and interesting. I've been talking about "tax subsidies" very loosely. Let's get into the anatomy of a deal.

So how do developers make these deals work?

Let's say you are a wind developer. You have identified a strip of windy farmland in Iowa, and you want to lease the land and install a series of towers and wind turbines. Of course, the farmer in question probably doesn't need much electricity; you'll need some infrastructure (converters and transmission cables) to connect your generation facility to the regional "grid" and transmit the electrons to Des Moines or Omaha. On the cost side of the ledger, you have (i) cost of land, (ii) cost of equipment (wind turbines, converters, hardware and integrated software), (iii) cost of infrastructure (towers, transmission), (iv) cost of financing, and (v) "soft costs" (attorneys, engineers, consultants and accountants necessary to get permits, conduct environmental studies, project wind patterns, draft leases, arrange financing, and pay the bills). Let's assume the total cost, from the planning phase to commercial operation, is $100 million.

How about revenues?

You've identified a Midwestern utility that is willing to sign a long-term power purchase agreement ("PPA") and pay slightly above-market prices for the electricity from your windfarm. They'll take all the electricity you can generate, but the amount of electricity generated depends on the technology (the efficiency of the wind turbine) and the wind itself. If the wind blows more than expected, the project will generate more electricity, more revenue and more earnings for its owners. If the wind blows less than expected, the project will generate less electricity, less revenue and less earnings for its owners. Ultimately, you know that you'll have a revenue stream from the project, but you can't predict the operating cash flows with precision (because they depend on wind flows).

To recap: you need $100 million to get your project past its commercial operation date ("COD"). You have a long-term PPA, which is expected to generate sufficient revenues over time to generate an average 5% cash yield on the project. (For example, the owner will receive $5 million in net cash from the project annually, measured in today's dollars.) That yield may be higher, or it may be lower, depending on how much the wind blows after COD.

Where do you get the $100 million?

You probably don't have that cash lying under your mattress. You can't borrow from a bank, because a bank is not comfortable with your credit profile (a developer with no assets). You need equity from somewhere. But as noted, the cash yield on your risky new wind farm (5%) is not attractive relative to a risk-free yield (3%).

Our developer friend needs a dose of "tax equity." Remember, Congress has chosen to subsidize renewable energy development through tax credits and accelerated depreciation. As a developer, you don't have sufficient taxable income to absorb the tax credits and depreciation from the project. However, plenty of large corporate taxpayers have U.S. taxable income, i.e., "tax appetite" that would permit them to reduce their own tax liabilities by tax credits and depreciation from the project. Some of these large corporate taxpayers are even willing to participate in the renewable energy space, despite the risks. Never fear, "tax equity" may be here!

Why is "tax equity" willing to participate in a deal that a "normal" investor would not touch?

A normal investor may not be interested in a risky start-up business that yields 2% more than a risk-free return. However, a "tax equity" investor can use the credits and depreciation from the project to offset taxes that it would otherwise pay to federal and state tax authorities. The decrease in cash-tax liability is economically equivalent to an increase in operating cash flow. For example, if the project generates $5 million in tax credits and $20 million in depreciation expense in Year 1, the effective yield for that year would be 18% ($5 million operating cash flow, plus $5 million in tax credits that save $5 million in taxes, plus $8 million in tax savings from depreciation expense ($20 million times 40% assumed tax rate)).

Who is actually participating as "tax equity" in renewable energy deals?

Stay tuned for my next post.

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