TODAY’S STUDY: SMARTER NEW ENERGY INCENTIVES

Supporting Renewables While Saving Taxpayers Money

September 17, 2012 (Climate Policy Initiative)

Executive Summary

Renewable energy deployment in the United States is booming. Renewable electricity generation has more than doubled since 2005,1 bringing reductions in air pollu¬tion and greenhouse gas emissions. The doubling was financed largely through private investment mobilized by state and federal incentives and other policies, leading to substantial expansion of the renewable energy industry.

While solar and wind costs have fallen, rising deployment has increased the cost to government of providing the incentives. Key federal policy incentives are now begin¬ning to expire, just as federal lawmakers are looking for opportunities to reduce the deficit. It is therefore impor¬tant and timely to review the performance of federal renewable energy incentives.

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In this paper, we address three specific questions:

How important are federal incentives for encouraging renewable energy deployment?

How cost-effective are these incentives as currently structured?

How could they be improved?

Incentive design influences how renewable energy projects are financed; project finance in turn affects the overall cost of electricity generation. Using detailed finan¬cial modeling, we have evaluated the impact of current federal incentives on the cost of three typical grid-con¬nected utility-scale renewable energy projects—a large wind, a small solar photovoltaic (PV), and a large solar PV facility.

Under current law, a wind facility operating by the end of 2012 receives a production tax credit (PTC) of $22/MWh for electricity generated in its first 10 years while a solar PV facility operating by the end of 2016 receives an invest¬ment tax credit (ITC) equal to 30% of eligible project investment costs.

This analysis demonstrates how the federal government can modify these incentives to save money, while sustain¬ing strong support for U.S. renewable energy deployment.

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Key Findings

1.Federal incentives have been critical to the viability of most renewable energy projects.

••The federal incentives available to projects financed in 20102 bridged roughly half the gap between the costs of renewable electric¬ity generation and expected market prices for electricity.

••To bridge the remaining gap, projects have largely been deployed in areas that meet one or more of the following requirements: complementary state policies apply, there are significantly higher than average wholesale electricity prices, or develop¬ment of conventional electricity generation is constrained.

••The recession and resulting state fiscal con¬straints mean that in the absence of federal incentives, it is unlikely that states and ratepayers alone would have filled the gap.

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2. Wind is now almost viable based on federal incentives alone. The gap for solar PV is narrowing.

••Recent cost reductions and performance improve¬ments mean that if current federal incentives are sustained, a large wind project built in 2013 will be nearly cost-competitive.

••Steep reductions in solar PV costs over the last two years mean solar PV projects will be more cost-competitive in 2013, but will still need some state or ratepayer support to be viable.

3. Tax incentives leak money.

••A stand-alone large wind project has limited tax liabilities. As a result, project developers can only use tax benefits many years after they are received, and realize just one-third of their potential value (Figure ES-2).

••Project developers therefore enter into financial arrangements with outside investors with tax liabilities—tax-equity financing—to use the tax incentives as they are received.

••However, these arrangements are costly and only enable developers to realize two-thirds of the value of the incentive—an inefficient use of government money (Figure ES-2).

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4. Government can save money while providing the same support for projects by using taxable cash incentives rather than tax incentives.

••A 1603 Cash Grant half the size of the current investment tax credit could deliver the same benefit to a solar PV project in 2013 at half the cost to government (Figure ES-3).

••Taxable cash incentives can be even more cost-effective for governments than non-taxable cash incentives such as the 1603 Cash Grant.3

••If the wind production tax credit was delivered as a taxable cash incentive, it would almost halve the cost to government while delivering the same benefit to wind projects (Figure ES-3).

5. But we must mindful of how different incentives impact the risks borne by government.

••Investment-based incentives shift some project performance risks to the government, as the government pays a fixed fraction of the project’s cost regardless of project performance.

••Production-based incentives reward performance equally across all projects, but carry greater price-setting risks. This is particularly acute when technology prices are hard to predict.

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Policy Recommendations

Our work identifies two clear steps policymakers can take to improve the cost-effectiveness of federal renewable energy incentives:

Extend the PTC as a taxable cash incentive for production (TCP) – In the near term extend the $22/MWh PTC for wind, but deliver it as a $21/MWh TCP. This would:

••Maintain the same effective level of support for wind projects.

••Reduce the cost of the incentive to federal and state government by around 40% for every unit of clean electricity generated.

••Avert a bust in the wind industry, and stimulate deployment even in states or regions with no local or state policy supports.

Give solar PV projects the option to take a 20% 1603 Cash Grant in lieu of a 30% ITC – This option could increase the value of the incentive to the project while reducing the cost to government of providing it…

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Conclusion and Recommendations

We used financial modeling of three representative project cases based upon cost, performance, and financ¬ing data for projects financed or deployed over the last three years to assess the impact and cost-effectiveness of federal policies. We found that:

Impact – Federal policies have played a crucial role in helping enable the recent boom in the deployment of wind and solar. They covered about half the gap between renewable energy costs and electricity market prices, enabling a six-fold increase in wind and solar generation in spite of a deep global recession. Recent reductions in the cost of electricity from wind and solar mean that the PTC alone (if extended) could fully bridge that gap for new large wind projects, and that the gap for solar has been significantly narrowed.

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Cost-Effectiveness – Tax incentives are not the most cost-effective way to support renewable energy projects. Projects can only realize their full value if they can offset them with tax liabilities external to the project—a risk for investors which increases financing costs. Investment incentives can provide the same benefits to projects as production incentives at a lower cost to government. However, investment incentives shift some project risks to government. With both types of incentives, govern¬ment bears some risk in setting the right level for the incentive. This risk is greater for technologies with rapidly shifting costs but can be better managed by investment-based incentives because they adjust with changing costs.

Potential Improvements – We find that a taxable cash incentive for production (TCP) would be more cost-effec¬tive than the PTC. Cash sidesteps the illiquid tax equity market. The production-based incentive allocates project cost and performance risks to private sector actors who are willing and able to bear them. In the event that the PTC is extended into 2013, our analysis suggests that the government could save more than 40% on incentive costs per MWh by delivering it as a TCP of $21/MWh over 10 years rather than a tax credit of $22/MWh.

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Our work identifies two clear steps policymakers can take to improve the cost-effectiveness of federal renewable energy incentives:

1. Extend the PTC as a taxable cash incentive for production (TCP) – In the near term extend the $22 / MWh PTC for wind but deliver it as a $21 / MWh TCP. This would:

»»Maintain the same effective level of support for wind projects.

»»Reduce the cost of the incentive to federal and state government by around 40% for every unit of clean electricity generated.

»»Avert a bust in the wind industry, and stimulate deployment even in states or regions with no local or state policy supports.

click to enlarge

2. Give solar PV projects the option to take a 20% 1603 Cash Grant in lieu of a 30% ITC – This option could increase the value of the incentive to the project while reducing the cost to government of providing it.

This analysis has important limitations which we hope to address in future work. We have not considered policy measures such as national renewable portfolio standards, reverse auctions, or cap and trade systems which rely on market mechanisms to set price levels. These mecha¬nisms could be much more cost-effective in the long term if the gains in the economic efficiency of using markets to determine price levels are not offset by expense of incen¬tive price volatility. As our previous work (CPI, 2011) sug¬gested that incentive price volatility could lead to higher financing costs, it is an open question as to which policy option would be most cost-effective. We have also not considered options to eliminate the stop/start problems of temporary tax provisions (BPC, 2011).

Finally, a number of policy options have been proposed as alternatives or complements to current policy, such as the use of Master Limited Partnership or generalizations of Real-Estate Investment Trusts for renewable energy. The comparative cost-effectiveness of these proposals, and their interaction with the federal policy alternatives considered here, is another area for potential future work.

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