by Bill Cooke
Green Car Congress attended the Renewable Energy Finance Forum - Wall Street (REFF-Wall Street) conference (23-24 June) sponsored by Euromoney Energy Events and the American Council on Renewable Energy (ACORE). ACORE is an organization of member companies and institutions that are dedicated to moving renewable energy into the mainstream of America’s economy.
Ed Feo is a partner with the law firm of Milbank, Tweed, Hadley & McCloy and was voted one of the “Five Most Influential People in Renewable Energy” in 2008 by Euromoney / Institutional Investor. He identified three major themes in 2009 for renewable energy: “Energy markets are undergoing their most fundamental changes since the 1930s; cap and trade is the most complex issue outside of health care; and schisms exist within the energy community that will grow stronger over time.” Although not part of the conferences formal structure, the themes were addressed in the presentations and panel discussions.
Energy Markets in a State of Change. Dr. Don Paul is the Executive Director, University of Southern California Energy Institute and a former vice president and chief technology officer of Chevron. Dr. Paul addressed a positive change—the days of increasing US oil consumption may be over.
“We reached peak oil consumption in the US in 2008 and the same is true in the EU and Japan.” Dr. Paul still sees significant growth in the developing world. Supporting Dr. Paul’s calculation, Dr. Kristina M Johnson, Undersecretary of Energy - US Department of Energy (DOE), shared the department’s goal for the US “to conserve 3.6 M barrels/day of oil within the next 10 years”.
Other than the good news on oil consumption, very little was said in regards to transportation fuels. Biofuel projects are going to have trouble getting financing from Wall Street this year because all of them have questions about the long term pricing of petroleum; most of them have concerns about the pricing stability of their feedstocks; and many of the cellulosic projects have concerns about the conversion technologies.
Renewables account for approximately 10-15% of the global energy infrastructure investment and according to New Energy Finance renewables have been hit hard by the global recession with a 47% in Q1 2009 vs. Q1 2008 ($13.3 Billion vs. $28.3 Billion in 2008). Many participants at the conference expect a 30% decline for the year overall.
The stimulus package is designed to address the recession and in the short term people were anxiously awaiting two key components of the plan: clarification on the details behind “grants in lieu of tax credits” and awards of loan guarantees by the DOE from section 1705. On 8 July, the US Treasury provided guidance on the grants while timing is still unclear on when the first block of loan guarantees will be awarded.
Matt Rogers, Senior Advisor to the Secretary (DOE) for the Recovery Act, adds: “This effort is not about the next 3-4 years—it’s about the next 20 years. We need to set up the correct infrastructure to do it right the first time around. Speed and timeliness are important, but we also need to make sure we are supporting the best projects by administering our programs in the most efficient and effective way possible”. As another panelist pointed out, “The New York Times is well-equipped to write the article about how Stimulus Funds have been wasted”.
Neil Auerbach is a Managing Partner at Hudson Clean Energy Partners which is a global private equity firm investing in renewable power, alternative fuels, energy efficiency and storage. Auerbach’s calculations project that “In order to meet the administration’s renewable energy goals, $217 billion will be required by 2012.” Rogers expects slightly more spending: “The US will spend $250 billion on renewable energy over the next two years with $ 40 Billion coming from the government.”
Attendees believe that renewable energy needs two elements to be successful: technical progress leading to lower costs and a price on carbon.
Lowering costs by helping technologies cross the Valley of Death between pilot scale production and commercialization is the charter of the proposed Clean Energy Deployment Administration (CEDA) which was discussed by attendees. (Earlier post.)
Costs are also falling due to classic economics. Auerbach adds that due to economies of scale and over capacity in the industry “wind energy should have a 20% reduction in equipment costs within the next year ” and he has seen realistic projections of “solar, with a 10% tax credit, being competitive with baseline generation in 2020”.
Cap and Trade Disappointment. While everyone agrees that Barack Obama has made a huge difference in the future of renewables, attendees were worried about the cap and trade provisions of the 2009 Energy Bill. They were hoping it was going to be more aggressive in combating carbon directly through a stronger cap and trade and indirectly with a higher federal renewable energy standard.
Schisms or “Areas of Concern”. The renewable energy community may prefer “areas of concern” over the term schism, but significant issues were reiterated. Who is going to take the lead on building the transmission capability that is needed: private industry, states or the federal government? Who has enough political capital to deal with the unhappy landowners along the transmission corridor? Is tax equity dead? Or is it alive but too expensive and if so, what is the more affordable replacement? How does the US deal with local and state economies with high carbon economies and little renewable resources? If ultimately the majority of the money for renewable projects needs to come from private capital like Wall Street and if Wall Street craves certainty how is Wall Street going to handle the next twenty years if they turn out to be as chaotic as the last twelve months?
Long-Term Optimism. Feo mentioned only three themes, but a fourth theme, continued long-term optimism, was apparent. In a recent survey conducted by New Energy Finance which reached 106 institutional investors with $1 trillion under management, “75% of the them expect to increase their renewable investments by 2012”.
China continues to defy easy classification. In connection with this year’s Group of Eight conference in Italy, China reiterated its opposition to participating in emission reduction plans while at the same time drafting a $440-billion renewable energy package.
The US is in a race for global dominance in the new energy economy with China. As an investor, I’m not choosing sides, and the good news is the whole world will win with the innovation it will drive.—Neil Auerbach
Auerbach adds that the supporters of renewable energy should “focus on the rewards. A low carbon economy will be the primary means of wealth creation over the next 20 years.”
Details Behind the Conference
One year ago ...
Last year’s conference had a much different tone. Oil was trading at $140/barrel and expected to hit $200 by the end of the year—economics that made almost any kind of a renewable fuel program attractive.
Annual investment in the global renewables industry had grown from $16.5 billion in 2004 to $117 billion 2007 with the first three quarters of 2008 averaging 29% higher than 2007. Within the US electric power sector the biggest question was whether the Production Tax Credits (PTC) were going to be extended beyond 2008.
What is the PTC and why does it matter? Renewable energy projects are frequently financed with project rather than corporate finance. The law firm of Baker and McKenzie has put together the excellent “Project Finance Primer for Renewable Energy Projects”. In project finance, the investors and lenders are making their decisions based solely on the projected returns of the given project and not the sponsoring individual or company. Generally, there are three parties involved: The sponsor or developer, equity investors and debt lenders.
The sponsor is the person who is responsible for the overall execution and has the greatest risk/reward. In general, the sponsor’s goal is to use as much cheap debt financing and as little equity as possible to complete the deal. The sponsor wants to get returns from 10-20% for his or her investment.
Equity investors are frequently tax equity investors which provides the project developer with capital in exchange for getting the PTC. The tax equity investor uses the PTC to decrease their tax liability from profits they’ve made outside of the project. The tax equity investor shares in some of the project’s risk but are frequently guaranteed a certain level of profit prior to the sponsor making a profit. The trade-off is that their upside may be limited once they reach their guaranteed profit. Generally, tax equity investors expect a return in the 8-12% range.
Lenders expect the lowest returns, 6-8%, but the most security. Projects are rated by agencies such as Standard and Poor and need to be investment grade to attract a wide variety of capital sources. Standard and Poor’s investment grade ratings range from AAA to BBB- with an AAA project (the best) having almost a nil chance of default, an AA rated project having a 1.5% chance of default and a BBB project having 10.5% chance of default. Interest rates go up with the chance of default.
The PTC had become an integral part of raising money for renewable energy projects. From 2005 until 2007 JP Morgan estimated that close to 60% of the MWs of wind capacity installed in the US were from projects that used tax equity financing. Although the amount of tax equity varies dramatically by project, the law firm of Baker and McKenzie reports that tax equity once provided up to 60% of a project’s capital. The PTC varies by technology but is in the range of $0.021/kWh and can generally only be claimed for first ten years after the facility is placed into service.
Eight months ago ...
By the time REFF West occurred in October 2008 the climate had changed dramatically. Oil was trading in the sixties and destined to drop to the low thirties in late December which made almost all forms of renewable liquid fuels uncompetitive.
The financial markets were struggling as well. GE Finance shared a slide that showed an International Monetary Fund prediction that global losses were expected to reach $1.2 trillion, which meant an associated reduction in tax liability. Acconcia, one of the world’s leading developers of renewable energy, showed a slide with number of tax equity providers being reduced from 12 player to 6 with such high profile names as AIG and Lehman Brothers being among the casualties. Iberdola Renewables thought capital constraints, in addition to income reductions among potential tax equity partners would impact the market for tax equity. Overall, the consensus among the people presenting was that tax equity financing may or may not be dead but it was severely wounded.
With the loss of tax equity, developers had to return to more traditional sources of capital but unfortunately they were drying up as well.
Climate change projects had always had a stronger appeal to international investors than US investors. Kevin Parker, Global Head of Asset Management, Deutsche Bank commented that several years ago “We raised $12 billion for climate change funds..Only $50 million came from investors domiciled in the US.”
DB Climate Change Advisors are full service asset managers dedicated to investing in trends driven by climate change. Parker is head of a group that manages more than €500 billion across a broad range of asset classes.
Michael Eckhart comments that “The Europeans appear to be five years ahead of the US” in investing and “during the 2004-2008 boom period, as much as 90% of senior debt for US renewable energy projects came from foreign banks. Many of those foreign lenders have reduced their participation due to banking issues at home.”
In a flight towards quality, lenders want the highest quality projects even if they can get higher interest rates with increased risk. John Anderson, Head of Power and Project Finance, John Hancock summarizes: “We are measured by the quality of our underwriting and to outperform our peers we need to minimize our losses. It is not how can we get low cost capital to take more risk. It is how do we lower the risk so low cost capital can participate. There is not a lot of upside on a 7% coupon but there is a lot of downside.”
John Hancock is the 2nd largest life insurer in the US and Anderson’s team manages a $12-billion portfolio. Anderson has worked in power industry finance since 1992.
The ways you lower the risk in your project is to have signed Purchase Power Agreements for the energy you generate; use proven technology; and have enough equity invested so that no matter what happens the project it is always worth more than its debt liability. The trade-off for the sponsor is that all of these factors reduce their upside.
Grant Davis is a Managing Director at New York Life Investments. NY Life Investments is the investment management subsidiary of New York Life and manages in excess of $200 billion of assets for New York Life and other clients. Davis is responsible for the firm’s Energy and Project Finance group and has more than 25 years of experience in corporate finance and investments.
Davis gives the following synopsis: ”In 4Q 2008 the markets were frozen. In early 2009, some liquidity began to return to the market, but banks shortened their tenors (5-7 years) and went to wider pricing (Libor + 300 points). Institutions continued to have appetite for longer tenors (7-30 years), but spreads had widened (Treasury + 600 basis points) in line with capital markets pricing.”
[Tenor refers to the length of the loan; one of the outcomes of the crisis was a commitment by many banks to stop issuing loans with tenors that were significantly longer than their typical deposits. The LIBOR is the London Inter-Bank Offered Rate and is an industry benchmark interest rate. The 300 refers to 300 basis points with a basis point being 1/100th of a percent (300 basis points = 3%). It is used to differentiate interest rates between investment to eliminate confusion with the term “percent increase”. For example, a jump from 4% to 6% is a 50% increase in interest rate while a jump from 18% to 20% is a 11% increase rate but both are a change of 200 basis points.]
John Anderson of John Hancock mentioned that during the same period there was “a 300-400 basis point spread for securities (10% vs 6%) with the same rating (A-) based upon the sector” which was unfavorable and unusual. The entire purpose of rating securities is to apply similar interest rates to investments with the same level of risk.
A 400 basis point spread can result in a huge difference in project viability. Neil Auerbach of Hudson Capital points out “Every 100 bps increase in cost of debt = $2-$5 MWh cost of renewable energy.” Following that logic, a 400 basis point penalty in borrowing cost would increase your delivered price by $0.008 to $0.02/ kWh which is significant when you are competing against coal with an ex-works price of $0.05/ kWh total.
While at Goldman Sachs, Auerbach was part of a team that invested $1.5 billion across several sectors and had an “82% IRR, largely realized”.
Five months ago ...
With a new commitment to Renewable Energy by the Administration and a Stimulus Fund one attendee at the show commented “Federal policy was aligned with Renewable Energy and Electrical Efficiency business interests in ways we might only have dreamed of” as recently as last year.
On February 17, 2009 the American Recovery and Reinvestment Act was signed into law. The structure of the act makes summary difficult but Morgan Stanley calculates that $97 Billion of the $787 Billion total package went into Energy Funding.
The stimulus package was good news, partially offsetting the fact that global renewable energy investment dropped by 47% in Q1 2009 vs. Q1 2008 ($13.3 Billion in Q1 2009 vs. $28.3 Billion in Q1 2008).
Getting Money into the Economy
There are two programs in particular in the stimulus package upon which people have been counting that have yet to release any funds.
Section 1603 Grant in Lieu of Investment Tax Credit (ITC) or Production Tax Credit (PTC). This provides the developer with a grant from the Treasury valued up to 30% of a renewable energy project’s investment as long as the project begins construction in 2009 or 2010. The grant replaces the PTC and was defined by the Treasury on 9 July 2009.
Modification of EPACT 2005 Title XVII to create Section 1705. This allows the developer of a renewable energy project to get a loan guarantee for their project with the government paying the credit subsidy cost. This program is being administered by the US Department of Energy.
People will need time to interpret key details behind the two programs. On the equity side, investors need to know how quickly can a project change hands and whether the ownership change would prompt the government to seek reimbursement. Energy projects frequently have ownership flips with different parties having ownership at different stages in order to maximize each party's ability to capitalize on incentives. On the debt side, lenders are worried about who has priority, lenders or the government, if a project defaults.
Matt Cheney, Chief Executive of Renewable Ventures was quoted in the Wall Street Journal on 8 July 2009 as saying the uncertainty of the stimulus has “artificially slowed the recovery” because companies are holding on raising private capital because they can get it more cheaply from the government, a point echoed by Keshav Prasad, a vice president of business development at Signet Solar Inc, in the same article. “We will not close on anything until we finally hear from the DOE on the loan guarantees.”
DOE and Speed of Loan Guarantees
The US Department of Energy has taken a lot of heat over its administration of the Loan Guarantee programs. David Frantz, who runs the Title XVII program in the Department of Energy, attended the conference and outlined the programs. He didn’t offer any comments on when the first batch of loans for section 1705 would be processed but he understood the urgency.
We applaud the effort that the Administration is making towards relieving bottlenecks in allocating stimulus funding for this sector. However, we also need to reiterate the importance and urgency for laying out the DOE program rules and guidance as soon as possible. Without this clarification on the lay of the land, private capital investors are unable to confidently make financial decisions and the industry will remain at a standstill. We call on the President to put a 24 second shot clock on this team and hold them to it. We think they are doing fabulous work but they need a deadline.—Michael Eckhart, President of ACORE
Neil Auerbach is happy offering some guidance on the issue: “November is too late to start seeing stimulus money, w’d be better off canceling, since the markets hate uncertainty that a delay would bring.” Auerbach hopes Treasury and DOE will provide guidance and the first batch of loan guarantees, respectively, during the month of July.
In defense of the Title XVII team, many of the bottlenecks they have faced were outside the team’s and even DOE’s control, and the lessons learned from the team led to the proposed Clean Energy Deployment Administration. Although pressed for speed, the Title XVII team is also responsible for due diligence.
John Anderson of John Hancock believes Wall Street can help with the due diligence. “We already perform ongoing credit monitoring that could support DOE”. Anderson recommends greater use of pre-qualified lenders. The lender evaluates, rates and prices the loan using private market process. The lender applies to DOE for a loan guarantee. The guarantee would cover 80% of the loan, the lender is at risk for the remaining 20% of loan. The pre-qualified lender provides ongoing credit surveillance, annual credit report and coordinates consents. Anderson believes this scenario could accelerate the flow of capital and “drop the cost of long term debt from 8-9% to 6%”.
John Woolard states “In today’s credit markets, the DOE loan guarantees and tax equity grant programs serve as valuable catalysts to encourage private investment” and that “with the issuance of grant guidance, we will see a significant increase in deal flow”.
Woolard is the chief executive office of BrightSource Energy, Inc and has more than 20 years of experience in the energy business. Brightsource is a leading player in Concentrated Solar Power (CSP).
Significant deal flow is crucial but it won’t result in immediate construction since most project teams will require several months to finalize financial details.
Getting renewable energy from the rural areas where it is most efficiently generated to the cities where the demand is was an issue that was discussed at the conference but no simple solutions are forthcoming.
In an ACORE conference in December 2008, GE Finance pointed out that there was approximately 300 GW of wind projects awaiting grid connection and said both DOE and American Wind Energy Association considered transmission as the #1 issue for continued wind development.
Holly Koeppel, Executive Vice President and CFO, American Electric Power points out “It takes 18 months to build a wind farm but 3-5 years to build a transmission line.”
American Electric Power is the nation’s largest owner of transmission lines and a utility with operations in 11 states. Koeppel has more than 20 years of experience throughout the utility industry.
Koeppel points out that AEP has strong relations with the local communities it serves but believes the challenges are too large to be solved locally and she is “Looking for [the] same federal authority for approving and siting interstate power transmission lines as for interstate natural gas pipelines”. Koeppel is referencing the Federal Government in the 1930s assuming siting responsibility for interstate natural gas distribution pipelines.
Don Paul from USC: “Transmission corridors will not be easy to execute. Local (County and State) control is a long held American tradition and there will be strong resistance to national solutions. What is Plan B if you can’t get transmission corridors?”
People are already wondering what happens next, with Neil Auerbach stating “The finance of renewables past the stimulus is a big concern”. Dan Reicher, who contributed to the renewable portion of the stimulus plan as part of the Presidential Transition team asks “What comes after the stimulus? What does normal operation look like? Will climate legislation provide funds?”
Reicher is the Director Climate Change and Energy Initiatives, Google and a was a member of the Presidential Transition Team.
The oil industry may be one of the sources of capital. Dr. Paul comments, “Oil and gas companies finance exploration out of their cash flows. They spend $400 billion/year.” This will likely be a major source of funding for biofuels, since oil companies are more comfortable in dealing with a market, such as oil, which has much more volatility in pricing than electrical power generation.
Dr. Paul adds that oil companies expect higher returns to cover this volatility and to cover the fact that they are self-funding the projects with their own equity. “Many projects that generate electricity have an 8% after tax return on assets while oil companies are expecting 12-15% after tax returns on assets.”
Last week, ExxonMobil Research and Engineering Company (EMRE) launched a $600-million new program to research and develop advanced biofuels from photosynthetic algae that are compatible with today’s gasoline and diesel fuels. As part of the program, ExxonMobil formed a strategic research and development alliance with Synthetic Genomics Inc., a privately held company focused on developing genomic-driven solutions and founded by genome pioneer, Dr. J. Craig Venter. (Earlier post.)