LOOKING FOR THE BIGGEST NEW ENERGY BANG FOR THE BUCK

Paying for Renewable Energy: TLC at the Right Price; Achieving Scale through Efficient Policy Design
December 2009 (DB Climate Change Advisors/Deutsche Bank Group)

SUMMARY
Everybody in the New Energy world has surely heard by now about the Feed-in Tariff (FiT) and many will be aware that it is where the big money in Europe and many other places around the world is moving.

FiTs – above retail rates guaranteed to New Energy builders over an extended time period – have been used with varying degrees of success. At their best, they drive growth.

Paying for Renewable Energy: TLC at the Right Price; Achieving Scale through Efficient Policy Design, from DB Climate Change Advisors (DBCCA) of the Deutsche Bank Group, describes the successes of the FiT in Europe and demonstrates, byt the bank's interest, that big German money is looking hard at FiTs. The question the bank seems intent on answering is WHICH FiT? The DBCCA report argues for an “advanced” FiT with TLC – transparency, longevity and certainty - which amounts to a set of carefully designed policy provisions.

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Because it is an example of an “advanced” FiT that has TLC, the German program is widely recognized as the most successful FiT design. It has driven enormous capacity growth and job growth and generated economies of scale. It has accomplished Germany’s goals of (1) improving energy security, (2) bringing the cost of energy down by increasing energy supply and (3) increasing access to emissions-free New Energy.

The U.S, has so far rejected the FiT in favor of federal tax credits, state and local rebates, Renewable Electricity Standards (RESs) at the state level and other market oriented concepts such as Renewable Energy Credits (RECs), bonds, loan guarantees and grants. The DBCCA paper looks at the incentives used in the U.S. and describes how they can be reconciled with an advanced FiT.

The DBCCA paper combines work previously done on the German FiT with its Global Climate Change Policy Tracker and assesses 4 other FiTs (France, Netherlands, Spain and Ontario), identifying their advanced and TLC qualities, especially (1) cost/price discovery processes and (2) the flexibility to respond to markets while remaining transparent.

The paper describes U.S. New Energy policies and the resulting electricity markets as complex and fragmented and lacking in TLC. DBCCA sees the U.S. goal of a “pure market” at the lowest cost as a dubious proposition and concludes by describing a breakthrough concept in New Energy investment, a standardized power purchase agreement (PPA) that is a hybrid of the U.S. PPA and the European FiT. It integrates the advanced FiT with TLC and existing U.S. policies to get the biggest bang for every buck invested in New Energy.

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COMMENTARY
The benefits of New Energy include environmental, security and economic opportunities. They warrant government spending and demand well-designed New Energy policy. By its results, the German government’s policy work is demonstrably the guidepost.

Factors to be considered:
(1) How much New Energy is delivered from the policy and does that meet desired goals?
(2) How many jobs does the policy create?
(3) What are the costs to the electricity ratepayer and/or the taxpayer?
(4) What is the impact on the economy (i.e., industry growth and exports)?

Other key economic implications:
(1) What is the impact on energy security (i.e., changes to the imports of fossil fuels)?
(2) What is the effect in the electricity market and on power prices?
(3) Is there a measurable impact on innovation and patents?

The most successful policy to date at driving New Energy growth is Germany’s. It’s 3 broad goals: (1) Improve energy security; (2) Provide cost effective energy; and (3) Lower energy’s environmental impact. The German Federal Environment Ministry’s analysis has demonstrated the success of the FiT on these terms.

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The primary stated goals of New Energy policies, according to the DBCCA paper, are to: (1) Meet emissions reduction targets, (2) Increase energy security and (3) Create “green” jobs.

To meet emissions reductions targets, most of the developed nations have implemented cap&trade systems. Because New Energy incentives such as the FiT drive the pursuit of more cost effective New Energy technologies, they become defacto Research, Development and Demonstration (RD&D) incentives.

The best incentives give investors TLC (Transparency, Longevity and Certainty) in return for their capital. This means they can clearly see a predictable return on their investment over a reasonable period of time. TLC can only come through public policy with public support.

On the other hand, an advanced FiT can work with RECs and RESs to create transparency by standardizing New Energy prices and terms. With this TLC, U.S. New Energy builders have a solid basis to form power purchase agreements (PPAs).

Because of U.S. regulatory complexity, standardization of PPAs must take place at the state level. Costs can be absorbed by ratepayers or spread across the tax base. The benefits of job growth, secure energy and emissions-free energy would follow.

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Key aspects of the DBCCA advanced feed-in tariff (FiT) design (with TLC):

(1) A policy and economic framework that allows it to be linked to pre-existing mandates and targets. In France, the target is to obtain 23% of their power from New Energy sources by 2020; In Germany, it’s 30%; in the Netherlands and Spain, it’s 20%; in Ontario, it’s to end the use of coal by 2014.

(2) Core elements:
(a) All New Energies qualify for a subsidizing tariff; The French and German FiTs include Wind, Solar, Geothermal, Small hydro, Biomass and Biogas; the Netherlands covers only Wind, Solar, Biomass, Biogas and CHP; Ontario covers Wind, Solar, Hydro, Biomass and Biogas; and Spain covers Wind, Geothermal, Small hydro, Biomass, Biogas and PV and CSP Solar.
(b) Each New Energy has a tariff detailed to its qualities;
(c) Each New Energy has a tariff with a standard offer and guaranteed payment;
(d) Grid interconnection is assured for New Energy projects; and
(e) The tariff is guaranteed for a significantly long term of 15-to-25 years.

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(3) Supply/Demand elements:
(a) The central system must accept the New Energy; France and the Netherlands do not require this.
(b) The tariff is available to all New Energy suppliers who qualify; France, Germany and Spain include Independent power producers (IPPs), communities and utilities, Ontario and the Netherlands do now allow participation by utilities.
(c) The transmission system operator pays; and
(d) The ratepayer pays in Germany, France and Ontario while the taxpayer pays in the Netherlands and both pay in Spain.

Other qualities of Structure and Adjustment in an advanced FiT with TLC:

(1) Price Setting:
(a) The price is fixed; Netherlands has a hybrid fixed-variable price system and Spain has both fixed and variable systems.
(b) The price is set by the cost of generation; and
(c) The price is set to an internal rate of return (IRR) target; In France, it’s 8%; in Germany, it’s 5-to-7%; it’s 11% in Ontario and 7-to-10% in Spain; Netherlands' system doesn't require an IRR.

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(2) Price Adjusting:
(a) There is an established Degression Rate; France has a degression rate for wind, Germany has a degression rate and the others do not.
(b) There is periodic review of the Degression Rate; France has no review but the other countries do. And
(c) The entire system is targeted to achieve grid parity.

(3) Project caps are set according to the context, i.e., according to how the program is working to meet its goals.

(4) Developers are allowed the choice to accept the FiT or to accept other incentives.

(5) All transaction costs are minimized.

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Policy Outcomes

(1) Investor Internal Rate of Return (IRR): 7% in France; 7-to-9% in Germany; 9-to-11% in Ontario and 7-to-10% in Spain;

(2) Job Creation (7,000 wind jobs in France, 280,000 jobs in Germany, 2,000 wind jobs in the Netherlands, an projected 50,000 jobs in Ontario and 188,000 jobs in Spain);

(3) New Energy (up to 13.3% of power in France, 15.1% in Germany, 7.6% in the Netherlands, and 20% in Spain);

(4) Emphais on wind and solar;

(5) Ownership.

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In the U.S., the electricity market is complex and the incentive system (primarily RESs and RECs) does not create TLC in the PPAs that support New Energy.

35 states have RESs and there is a proposed national RES. RECs are used to track compliance with the RESs.

The incentive vehicles in the U.S. New Energy markets have been and continue to be the production tax credit (PTC), the investment tax credit (ITC), convertible investment tax credit and low interest loan guarantees. The compromised tax equity market in the 2008-09 recession has severely hampered growth but new mechanisms, especially grants and loan guarantees, have sustained the New Energy industries.

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The complexity is due to the fact that U.S. markets are regulated state-by-state. In addition, the power generating industry is fragmented into hundreds of players from small municipal cooperatives and community supported wind farms to multibillion dollar investor-owned utility holding companies operating in multiple jurisdictions.

States have a wide variety of regulatory structures (including regulated and deregulated states and hybrids), interconnection capabilities, and natural resource assets. Electricity prices vary widely. (Average 2009 electricity price in the U.S.: ~$0.12 /kWh; in New York: ~ $0.192 kWh; in West Virginia: ~$0.0792 k/Wh) This makes a standard national FiT challenging.

The Public Utilities Regulatory Policy Act (PURPA), the first (1978) New Energy incentive, was stymied by regulatory complexity and remains an example of failure to regulators and industry players.

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Because of these factors, U.S. New Energy policies are complex and disaggregated at the state and local levels. Some electricity prices are bundled into rate cases (regulated), marketed wholesale on an exchange (de-regulated), and are managed through power purchase agreements (PPAs) in both regulatory structures.

PPAs have elements similar to FiTs. They define the revenue requirements and payment term for the project between the electricity supplier and the New Energy supplier. This maximizes the incentive and minimizes the risk for the New Energy producer. It guarantees a New Energy supply toward meeting the RES requirement for the electricity supplier.

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Unlike FiTs, PPAs are market-based and fall sharply short of TLC in many ways. They are set by law and are not standardized. There is no mandatory grid interconnect and many New Energy projects presently wait to get into the U.S. transmission system. Administrative and transaction costs are high. There is very little transparency or certainty except after an agreement is negotiated.

Federal production tax credits (PTCs) and investment tax credits (ITCs), state and local tax credits, loan guarantees – in conjunction with the tax equity market – are alternative New Energy incentives. These incentives frequently expire, are amended or – as is currently the case – suffer from a lack of demand in the tax equity market.

Presently, thanks to the aggressive intervention by the Obama administration, the ITC/PTC can be converted into a cash grant but this is scheduled to expire in 2011.

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(1) In regulated U.S. markets, electricity is priced through a rate case based on a bundled cost of service negotiated between a state regulatory agency and the utilities.
(2) In de-regulated markets, electricity costs what is determined by spot and forward wholesale markets for generation, transmission and distribution.
(3) In both regulated and de-regulated markets, a longer-term contract called a Power Purchase Agreement (PPA) can be negotiated.

Core elements of the PPA:
(1) Energy volume: projected availability, capacity and/or energy production (MWh);
(2) Duration: length of contract; and
(3) Pricing: There is no FiT-like standard payment schedule.

Markets have frequently been too volatile or not effective in providing certainty, even for fossil fuel generators. Most electricity generators therefore sell forward their power in PPAs and similar contracts. This nevertheless lacks TLC in that it lacks transparency.

The RES establishes a certainty through a required volume that adds a definitive volume of emissions-free energy and a predictable level of energy security. Many RESs create incentives for specific New Energies with “carve-outs" and other provisions similar to FiT tariff-based provisions.

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Many state RESs do not have binding penalties for non-compliance, leaving their effectiveness in doubt. “Trophy PPAs” are not uncommon, contracts that will not be fulfilled. Some states have per kilowatt-hour penalties for utilities that are “short” of New Energy, ranging from $0.01 kWh (Montana) to $0.05 or more (Texas, Washington). In some states, penalty payments cannot be passed to ratepayers.

If the U.S. introduces a “carbon tax” or a cap&trade system that puts a price on emissions, it will raise the average around-the-clock (ATC) electricity price. Right now, RECs, the certificates proving RES compliance, are both a “proxy” for a CO2 tax and also represent the premium on the levelized cost of electricity (LCOE) for New Energy.

As the LCOE rises due to a price on emissions, RECs lose their value. Anticipating this, developers are less inclined to invest in New Energy. None of this is at play with an FiT.

The Clean Energy Deployment Administration (CEDA) has the potential to extend low cost government guaranteed debt financing (loan guarantees) through 2011. This helps dramatically with New Energy project economics. Equipment cost, financing cost, and plant availability are the largest constraints affecting returns and define the minimum delivered power price a developer can negotiate with a utility.

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The Production Tax Credit (PTC) has been the subsidy of choice in the U.S. since 1992 but it has been allowed to lapse 3 times (1999, 2001 and 2003). The result has been hesitations in New Energy investment. The investment tax credit (ITC) can now be chosen instead of the PTC.

In February 2009, Congress included several provisions in The American Recovery and Reinvestment Act of 2009 (ARRA) to make the tax credits more useful in a compromised tax equity market situation, including a 3-year extension of the PTC, the allowing of PTC-eligible projects to choose a 30% uncapped ITC, and the option for a cash grant, or convertible ITC, of up to 30% of the capital cost of qualifying projects that begin construction in 2009/10 and begin producing before 2014 (wind) or 2017 (solar).

The choice of whether to choose the ITC, convertible ITC or PTC is project specific and hinges on multiple quantitative and qualitative factors (the New Energy technology, the project capital structure, the cost of capital, the availability and capacity of the project and the developer’s overall tax position). Though the subsidies are similar over the long run, there is a higher IRR with the ITC cash grant under most current short-term circumstances. But it is scheduled to expire in 2011. The question is, therefore, what comes after 2011?

Department of Energy (DOE) loan guarantees are one option. It is a $52.5 billion “clean energy” program with 2 forms of solicitation, (1) the Financial Institution Partnership Program (FIPP) and (2) a direct DOE application process.

U.S. states and municipalities implementing or considering FiT programs: Wisconsin,
California, Washington State, Oregon, Arkansas, Florida, Hawaii, Illinois, Indiana, Michigan, Minnesota, New York, Rhode Island, Vermont and Gainesville, Florida.

Representative Jay Inslee (D-Wash) and Representative Bill Delahunt (D-Mass) have a national FiT proposal.

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An advanced FiT policy with TLC can be designed to reconcile with the current U.S. market-based incentives. Standard offer PPAs can provide transparency and be aggregated and financed through the creation of a Green Bank. This could generate a New Energy boom and mitigate risk.

It is not about adopting a foreign template, policy structures or terminology but about a policy regime that reconciles best practice FiT design with U.S. New Energy policy.

(1) Standard offer PPAs make the agreement transparent, like an FiT.
(2) RECs can be bundled with PPAs to provide New Energy power producers with an extra return, making their overall IRR comparable to what can be obtained through an FiT.
(3) A minimum REC price would be necessary in some states to make the incentive comparable to an advanced FiT with TLC.
(4) The full range of other state and federal incentives could be adjusted to obtain a reasonable IRR in the 5%-to-7% range.

These provisions can be made to work at the federal or state level. A standard offer FiT-like PPA with TLC would expand the New Energy market by increasing liquidity and lowering barriers to entry. This increase in projects would accelerate technology and reduce the need for subsidies over the long run.

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A Green Bank would be a national infrastructure bank. DBCCA’s concept is modeled on the Overseas Private Investment Corporation (OPIC). It would be used to mobilize and deploy capital for New Energy development. It would be a public benefit corporation, an independent, wholly-owned government subsidiary with tax exempt status and an independent board. It would replace the Clean Energy Deployment Agency (CEDA) and operate in conjunction with existing federal and state New Energy policies.

Through the Green Bank, standard PPAs could be formulated and executed for the enormous spectrum of individual circumstances where they are needed. It could also make capital available to drive further growth while controlling the cost of debt to prevent it from getting too high to slow growth.

The Green Bank is essentially a clearinghouse for structuring and backstopping the standard offer PPAs with advanced FiT-like TLC features.

It would develop best practices like (1) a standard loan application, (2) consistent lending and verification standards, (3) robust credit analysis and (4) controlled administrative and transaction costs.

A standardized PPA with advanced FiT-like TLC administered by a Green Bank, the DBCCA analysis suggests, is the way to get the most bang out of the bucks invested in New Energy. And, from all reports, that is likely to be a whole lot of bucks in the immediately foreseeable future.

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QUOTES
- From the DBCCA policies paper: “Every country tackles renewable energy policy in a slightly different and nuanced fashion from command and control at one end of the spectrum to market mechanisms at the other. The US policy tool kit has trended toward the latter approach, driven by the fact that it is extremely hard to have a solution at a national level because of Federalism, state rights, and the political infeasibility of funding renewable energy scale-up through increased electricity rates in many parts of the country. US electricity markets were developed at a state level and have only in the last decade been integrated into regional power systems. There is no equivalent of a national railroad, interstate highway or natural gas pipeline infrastructure for electricity transmission. So in comparison to Europe, where there were a limited number of national operators in the electricity sector, the US experience has been much more disaggregated which complicates the integration of renewables.”

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- From the DBCCA policies paper: “The Green Bank’s scale and government charter status would provide the certainty and liquidity needed to enable the capital markets to purchase, pool and securitize renewable energy projects along different durations. The long-dated and consistent cash flows generated by standard offer PPAs underpinning the bank’s lending would have strong demand appeal as securitized products to institutional investors such as pension funds and insurance companies looking to optimize asset and liability matching over specific time periods. In this respect, the Green Bank could truly be transformational in scope and reestablish the US position as a renewable energy leader while also creating a liquid secondary market in government bonds.”