'Something's got to give': Why Wall St is uneasy with the renewable energy boom
Tax credit extensions are fueling renewables, but financiers are uneasy with how the buildout is manifesting itself
Financiers and CEOs see a strong year ahead for renewable energy deals, but they also see challenges stemming from that growth.
“The market will be similar in size and scope to last year” when $13 billion of renewable energy deals closed, John Eber, managing director of energy investment at J.P. Morgan, said at the 13th annual Renewable Energy Finance Forum in New York.
Eber also noted that last year was the first year that solar power outpaced wind power with about $6.8 billion solar deals closing and $6.4 billion of wind deals closing.
Patrick Woodson, chairman of E.ON North America, sees the industry heading into a period of “massive growth” with 50 GW of renewable resources being built over the next four years.
Other speakers, such as Pooja Goyal, a managing director at Goldman Sachs, agreed with that outlook. But Goyal noted that the “market is getting off to a slow start; developers are waiting to see if costs come down.”
Declining costs were cited several times as one of the key drivers for the sector. Michael Polsky, president and CEO of Invenergy, went as far as saying the Environmental Protection Agency’s stalled Clean Power Plan is “irrelevant” to the growth prospects of renewable energy.
“Growth will be driven by cost declines,” he said.
“The business proposition for renewable energy is so compelling” it is becoming mainstream, especially compared with other alternatives, Polsky said. New nuclear and coal-fired plants are not viable options and, although there is still room for natural gas-fired plants, he said a lot of people still remember how volatile gas prices can be, strengthening the case for renewables.
But while that policy situation has created the chance for growth, many stakeholders expressed concern about how the renewable energy buildout is manifesting itself, including worries about the competitive behavior of developers, tax equity's role in financing projects, and the overall consequences for organized electricity markets.
Several speakers noted that low power purchase agreement prices are driving deals as utilities vie to lock in low prices. Ted Brandt, principal and CEO of Marathon Capital, referenced those low prices and said they would present a growing challenge to the industry.
“The competition is brutal out there,” Brandt said. “Wind-on-wind and solar-on-solar competition is killing these businesses.”
The problem, said Polsky, is there is a lack of discipline that is causing a “race to the bottom” with developers, especially bigger players, bidding in lower and lower prices just to win bids. That kind of “spiral behavior” may win bids, but it does not build a company, he said.
Polsky says that by tweaking assumptions of the forward price of gas or power, companies can get the results they want. Or, as Jim Hughes, CEO of First Solar, said, “People are creating value for themselves by shorting the cost curve.”
Larger developers are building large projects with no more due diligence than figuring out the lowest cost is to win the bid. That means “it is going to be a much harder business to be in,” Hughes said.
(Hughes is stepping down as First Solar’s CEO at the end of June and handing the reins to CFO Mark Widmar.)
Tax credit worries
The behavior of their competitors aside, bankers and CEOs at the conference were also concerned about renewable energy incentives, particularly tax credits.
The December passage of legislation extending renewable energy tax credits was cited several times as a key driver behind expected growth in renewable energy deployments.
The legislation extended the Production Tax Credit (PTC) for wind power until 2020, but with a stepped-down phase-out, beginning with a 20% reduction in the incentive in 2017 and progressing to 40% and 60% reductions in 2018 and 2019, respectively.
The Investment Tax Credit (ITC) for solar power was extended to 2024 for large-scale solar plants, but with a 4% a year step-down starting in 2020 until 2022 when it drops to 10%. For residential solar, the ITC is extended to 2020, with a phase-out that drops to zero in 2022.
Bankers and developers alike expressed concern about the eventual expiration of the credits even though, for the PTC at least, the extension was the longest since the program’s inception.
“Something has got to give,” Woodson said. “You can’t lose 20% of PTC value and think this run is going to continue. It will be enormously challenging to build new projects beyond this window.”
The PTC has been a key driver for wind power projects, but at least as important has been the financial innovation that allowed developers to monetize the tax credits they often could not use.
The "partnership flip" structure strips out tax credits and delivers them to an equity owner in a partnership. Under that structure, a developer holds a minimum level of equity with about 90% of the equity transferred to a partner that can use the credits to offset taxable earnings, or that can package those credits and sell them to other parties with a tax appetite.
To set up a partnership flip, a developer, Acme Co., would form a partnership with a bank, First National. In the partnership, the bank would contribute 99% of the equity in the project and, therefore, be entitled get 99% of the tax credit as well as the taxable income or losses. The developer would receive the cash flows. When the after tax rate of return is achieved, usually timed to the 10-year expiration of the PTC, the partnership structure "flips," with the developer taking 99% of the equity in the project.
The partnerships typically last for as long as the PTC last, 10 years. During that time the equity owners collect the tax credits. At the end of the 10-year term, equity ownership flips back to the developer.
Until the recent extension, the PTC had gone through a series of two year extensions, created a boom bust cycle for wind development with projects flooding into the market just before expiration and coming to a sudden halt until the legislation was extended.
From a political perspective, the two-year cycle provided political coverage by reducing the “cost” of the tax benefit as measured by tax scoring models that measure the impact taxes have on the economy.
Think of tax scoring as how much a legislative measure costs in terms of taxes, either in terms of how much taxes it would impose or, in the case of the PTC, how much tax revenue is not paid (remember the PTC is a tax credit, so someone is not paying taxes). By extending the PTC for only a year or two years, the tax "score" is kept lower than it would have been it the PTC were established for 5 or 10 years. It is a bit artificial, but it makes it easier to swallow or an easier sell, from a certain perspective.
The recent extensions were more generous than past extensions, but the phase-out provisions were envisioned either as a “glide path to grid parity,” or as a bridge to provide financial support until the Clean Power Plan takes effect.
In addition to the fact that the Clean Power Plan is now jeopardized by legal challenges and the Supreme Court stay, concerns about the eventual expiration of the tax credits is heightened by a tightening of the tax equity market in the wake of the 2008 financial crisis. For years after the crisis, financial concerns and tighter regulations shrunk the number of banks active in the tax equity market and reduced the earnings of companies that had previously been able to use tax credits to reduce their tax payments.
Those concerns have abated, but they have not gone away entirely. Skip Grow, managing director and head of the clean technologies group at Morgan Stanley, says the biggest constraint to the growth of the renewables market is a lack of tax equity capacity. Sandy Reisky, CEO of Apex Clean Energy, and Jeff Weiss, co-chairman and managing director of Distributed Sun, also listed tax equity as among their biggest concerns.
Power market impacts
But while the incentives pose some worries, stakeholders agreed that the current extension will bring a multi-year boom. Looking further out, though, that flood of new renewable resources is likely to have profound effects on power markets.
That is already apparent in Texas, the leading state for wind power capacity.
“I don’t see fossil fuel plants as viable in Texas at this time,” Polsky said. The state has seen negative power prices in recent months as subsidized wind drives nighttime prices lower, squeezing baseload plants.
As wind and solar power resources continue to grow in other markets, they will continue to put downward pressure on energy market prices. Polsky said that benefits consumers, but it is not sustainable for generators and developers.
Renewable resources with zero fuel costs have already disrupted power markets, wreaking havoc with coal and nuclear plants from Illinois to Massachusetts. Grid operators like PJM and ISO-New England have responded, attempting to raise prices in capacity markets or strengthen so central-station plants have enough financial incentive to stay online.
Utilities, especially those with a lot of baseload generation, largely say those efforts have been insufficient, and that more market protections are needed to prevent large coal and nuclear plants from retiring prematurely. It's a debate that is sure to continue, Polsky said, predicting that as even more renewables come online, “we will have to revisit how markets are organized."
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