How I stopped worrying and learned to love the financing of Wind Power.
This is a diary in a series about energy policy, the second relating to Wind Power. Here we walk foreign roads through the darkness of how Wind Power is currently financed. No Bucks no Turbines. How financial manipulations can actually accomplish something.
Wind is one of the most transparent sources of electric power in that almost all of its effects are right out there. We build funny looking buildings, connect then to the grid and deal with the fact that a varying amount of electric power come out of them. We have to spend money keeping them running, and that's it, until you look at taxes and investment, then its like walking through a forest on a moonless night. That is bad until you realize Coal or Gas financing is more like underwater swimming in a river where someone has kicked up the mud.
The reason I am trying hard to understand this is that many people have doubts on the viability of things like wind energy because they feel it doesn't pay over time when compared in a “true” way, without subsidies, or so the story goes. I think this is a bad argument since there is no “true” way in energy. All big electrical producers are subsidized in one way or another and many societal costs are not monetized currently. There is a truth here though -- if the economic values are way out of whack, then it does weigh against an investment. In the case of wind energy we can see where government incentives have overcome uncertainty and the (justified to some degree) inner inertia of power companies in the past few years. Those policies will have to change going forward since economic times have changed and views of viability of wind are becoming more established. Tax policy certainly has driven Wind deployment, and will continue to do so.
Most people I think could save the rest of this diary for when they can't sleep, but for some it may be interesting.
Doubts and Incentives
First, listen to what a Power Company might have said in, say, 2003 (and some today):
Wind Power totally does not fit the model of how we have worked in the past. It is intermittent, not controllable at the generating end, and uses technology that is not familiar. No one knows how much money it will take over time to manage and repair these things but it must be more than the GE's and such say. It always is. Those bloodsuckers, they always find ways to get money from us. Will the generator building companies even be around in 20 years? We'll have to manage this crap like a weird change in demand not like a good solid coal plant. We'll have to build power lines to nowhere to get power from this stuff. We have to get capital up front in a big lump sum and get the payoff through 20 years! We can't even get loans for this. No one will take this risk without huge returns that will make this power more expensive than coal or Natural Gas. We just spent billions putting in new gas turbines over the last couple years and you want us to do this? People will laugh at us when the wind dies in summer and our people get called before committees when there is a brownout – just because we were forced away from the stuff we know works. Forget it!
On the other side people were saying, look, wind power is clean, it is relatively predictable over time, we are getting better at these predictions. There will be no uncertainty over availability or price of fuel. Plus once the capital is spent the operating expenses are small compared to the income! You only need to build out the power turbines and interconnect once. The more you put in the more variations average out in production, the easier and cheaper it becomes to manage and operate. You deal with those bloodsuckers all the time anyway, so what is the big deal, if you can't deal with operations costs what the heck have you been doing at your older plants? Of course a GE wants a piece of the profit flow, but they want that to keep getting bigger too.
(I pick on GE because I think they can deal with it.)
Setting the Market
Federal and State governments have other non-economic priorities and have added things affecting costs to reflect some of them. Foreign control of resources, pollution, greenhouse gas production and other concerns have led to four government actions that tipped the scale toward accelerating development of wind.
First, governments said, we want renewable energy. You power companies won't do anything and have no direct incentive to do so, so we will impose an incentive. You MUST have (for example) 15% of your power coming from renewable sources in 10 years. This is a kind of “Renewable Portfolio” market setting policy – it changes the way everything is valued in the general electricity market. The majority of states have something like this in place or in the works.
Second, governments try to directly monetize some the advantages in using clean power with Renewable Energy Credits. (REC's) These are generally per MWh certificates that are created for each amount of defined, renewable energy sold. The power companies can sell and buy these credits separately. They can be used to show compliance with the Renewable Portfolio standards, or to allow companies to sell renewable electricity programs to customers for a little more money and still prove to them that they are actually using renewable power, even if indirectly. For example I personally pay a little more per kWH on my electric bill to get 50% renewable. The power company can prove overall compliance with this by showing that the REC's that it has cover all the people paying for renewable power to the level requested. So this is a new product with its own market. The power companies can either produce the renewable power themselves and use their own REC's or buy REC's from others who produce renewable power. It is interesting that the premium on purchasing this renewable power for me has come down as more wind power has been introduced into the mix.
Third to directly make renewable power more competitive, the government created a Production Tax Credit (PTC) that has ranged from about 1.5 cents per kWh to the current credit of about 2 cents per kilowatt hour. This is for the first 10 years of production by a facility. The PTC has been a major contributor to wind power growth in the last decade. It encourages the most production possible as opposed to just building plants to take advantage of depreciation. It can lead, in combination with depreciation, lead to building ahead of distribution capacity. Then you get nasty situations like Wind Generators paying Power companies to take electricity off their hands because they will get the PTC and still make money. Isolated incidents like this are echoed all over the place as an indictment of Wind power when it it is a planning issue. Wind is fast to put up, power lines and distribution networks not so fast.
Fourth, the Federal government, to overcome the fear and initial reluctance to invest created special depreciation rules for renewable power. Government has credited 100's of billions of dollars equivalent to oil, coal and gas companies for write offs for resource depletion and exploitation over the years, such as the 15% of sales depletion allowance and 70% drilling cost credit for oil companies that was in effect over the last years. There are no resources to deplete so things like depletion credits don't make sense for Wind Power, but instead since the major cost is the capital cost for building, an accelerated depreciation rule was created. All businesses depreciate physical items and even major software systems, that is, they write off the value of these systems over time, reducing their balance sheet. This makes sense as 20 year old equipment is not worth the same as 1 year old equipment that does the same thing. The old stuff might be rusted out and ready to spill things on the ground. Governments allow this to be taken off income for tax purposes based on lifetime values. Renewable Energy facilities got a special very short term double 5 year depreciation schedule. That is, they can depreciate double the cost of the facility over just 5 years as opposed to more “standard” depreciation for power plants like 150% of the cost over 15 years for, say, a Natural Gas plant. This is the subsidy that gets many people's backs up, yet it is quite similar in aim to the depletion allowances that fossil fuels have enjoyed. It is dangerous, in that it encourages people to build crap installations that generate squat, or in areas with inadequate transmission, just to get the tax write-offs. That is where the PTC somewhat balances by encouraging production.
These actions were successful in jump starting Wind Power so that it is becoming a player, and I hope they work as well in the future. The financial crunch will hit Wind hard and might put Wind power in the doldrums for the next year or two. I hope I'm wrong. There are some provisions in the Stimulus package that will have a direct impact here. I'll look at them after the next section.
Putting Things Together
So we can now understand how the last couple years doubling of Wind Power capacity was financed.
On the income side we have two direct income producers and two tax reducers
- Income from sale of electricity.
- Income from sale of REC's.
- Production Tax credit.
- Depreciation Allowance
The last two depend on having enough income and taxes so that you can use the credits. The second one depends on whether you as a producer need the REC's for yourself. You could count the premium price charged for renewable power into this slot also. Given these possible profit centers one can look at various ways to get the most out of a Wind Energy Investment. A paper from Lawrence Berkeley (LBNL-63434) (1) about Wind Project Financing Structures gives all the dirty details. Thanks to Mark Bolinger of LBL for referring me to this paper. The following is my condensed version.
Generally debt has not been used much to finance Wind Power in the U.S. because of doubt. Either a straight forward investment by a corporate entity or an equity finance scheme that allows “flipping” income and tax benefits among investors has been used. The way this works is that one investor looks for the near term tax advantages and the other looks for the income stream long term. So these two investors create a new “entity” (isn't corporate speak wonderful) that will have contracts with each such that, for example, the “Tax” investor gets 90% of tax benefits and 90% of income to some pre-arranged time when the percentage flips and the long term investor gets the cash and any left over tax benefits, which won't be that much as the Tax benefits are front loaded to the first few years of deployment.
Straight forward internal corporate finance in projects has the advantage of simplicity and quickness. No contract negotiations mean that even though this leads to higher per MW deployed costs externally, it still could be better timewise and in reduced internal costs. Major Wind Power investor FPL has sometimes used a 20 year 10% rate of return of capital as a decider on whether to invest in a project (1).
Still, much of the construction in the last 3 years has been done with some variation on the combined structure I described. There are different ways to split the pie with each side of the investment looking at rates of return on different things. Some of the Tax investors look at 6% returns on what are fairly short term investments on their part where the longer term investors look at 9 to 10% 10 year returns. These returns grow with time and 20 year return estimates can be much higher. These return rates I am giving are built from a model that the LBL paper uses to categorize quite a variety of investment strategies.
The model gives levelized capital cost of energy produced for 20 year project lifespan. This is behind the numbers in my previous diary. Levelized 20 year costs ranged from about $48 to $63 per MWh depending on the investment strategy. The single Corporate finance case is the most expensive, but most clear, and most likely to be done by those who would get higher prices for the power. Those numbers are historical for the 2005-2007 timeframe now and quite low for new deployments, so I would take them as relative numbers. Costs have risen since then for things like turbines, so the cost should be at least a third higher than this now. Of course the deployed wind did have cheaper equipment costs back then so these numbers would be closer for the deployed generation producing energy now.
Stimulus Provisions
Currently the credit crunch has hit Wind projects. Construction companies have laid people off. The stimulus package has provisions that should help. I don't know that deployments will keep up to the pace of last year.
- $14 billion to extend tax breaks ( I think e.g. depreciation allowances ) over 10 years.
- $13.1 billion to extend the Production Tax credit for three more years.
- $285 million for 2008 and 2009 deployments for a 30% Investment Tax Credit which can be substituted for the PTC and (I think) retained over some time. This is to try to keep momentum going now.
- $872 million for a 30% credit on Federal subsidy money used to finance Renewable Energy Projects. I think this means if you are an entity that got Federal Subsidy money and you invest that in Renewable Energy instead of executive bonuses you get a Tax credit. Hmm...
- $1.6 billion in Clean Renewable Energy Bonds available to finance new construction by co-ops and public utilities who are tax exempt and thus can't use the Tax incentives. This could be important.
- $6 billion in loan guarantees based on the 2005 Energy Policy Act for backing private loans for transmission improvements and other Clean Energy projects.
- $4.5 billion to the DOE for specifically the electric grid and transmission modernization.
The last two will impact the cost of Wind in that more areas for deployment will become available and lower operating costs will like likely result because of good “averaging” of power over larger areas.
Hat tip to Axel000 (2) for the research! You can see a lot of “I think” in there and some of that is likely wrong. But I hope the reader can slot what these amounts are into the categories I gave before to get an idea of what is happening. The use of debt financing will likely increase as more public utilities and co-ops need and want to get into Wind Production. As an aside looking at these few provisions I can't help wonder how people count the size of the stimulus package. With all the tax credits, and loan guarantees I have no real feel how much is real spending, how much will really be reductions in tax income, and how much is things like guarantees where there may be no fiscal impact at all.
How can we judge?
The new provisions all are somewhat similar to the existing incentives. We can look at the last few years and see some kind of guide to what we are “buying”. Others like the grid distribution investments and odd subsidy credits are more hazy.
Let us look at ballpark figures. and take high (but round!) numbers for costs. If we look at 2006, 2007 and 2008 (3) we get that roughly $2,000,000 per MW * 16000 MW deployed or about $32 billion was invested in Wind Energy deployments in the U.S. This is more than 2/3's of Wind Generation deployed in the U.S. now.
The Federal government gave about 95 billion kWh * 2 cents per kWh in Production Tax credit (actually less because the PTC was lower before) so say about 1.9 billion in tax credits over three years, with a little less than half in 2008 so about $0.9 billion in credits in 2008.
The 5 year double declining depreciation on $32 billion invested (and lets just assume it was all in the last year so this is a quite large overestimate) would be $12.8 billion of of revenue at marginal 35% tax rate gives (an overestimate) $4.4 billion of depreciation tax credits in 2008.
These tax credit numbers are overestimating the real cost for several reasons. Looking at percentage of equity invested in various things from 2006 to 2008 the odds are that if companies didn't invest in wind a large fraction of the money would have ended up in worthless derivatives costing the government even more real money in terms of bailouts and lost taxes from loser banks. Second even if invested in other tangible energy areas, those also, for example, allow depreciation so the comparison would be to a 15 year 150% depreciation schedule. But let us put all of that aside and just look – for perhaps $5 billion in tax credits per year we got a power source from negligible to 1.4% of produced electricity and over 6 times the investment leverege in the U.S. So less than $10 billion/year in similar incentives could easily get us to 15% Wind electrical power production in 10 years with a small acceleration beyond 2008 deployment levels. Plus as the installed base gets larger and the credits end there will be increased tax revenue from mature units. That actually could be a problem – it might be worth it to take units apart and deploy new for tax reasons, but we are on the growth curve now so that won't be an issue to deal with for 5 years at minimum. The thing with Wind energy though is that investment is mostly cumulative – the more you spend, the more wind energy production you get over time. The ongoing fuel cost isn't there.
It is always fun to compare things like this to fighter planes or Aircraft Carriers, but I'll resist and say that wind energy has created over 70,000 jobs in the U.S. and it could be more. Here is an example where relatively small tax policy issues can have ever increasing impact of how things are done. We haven't even looked at the other good things wind energy has going for it in terms of pollution, local industry and such.
In any event with current tax policies Wind is quite competitive in actual selling price for wholesale power with the other current big electricity producing players, and should be so even for several doublings of its current deployment, and seems a pretty good investment opportunity, especially given how other fancy ones fared over the past couple of years. It is the only renewable right now that can say that. Thermal Solar I think may well go there.
Next: Lifetimes a fly in the ointment? I want to look at real lifetimes of Wind Deployment to get some idea of how long these things will really last, 20 years or 30 at similar operation cost. It could make a big difference. Right now all the plans are for 20 year lifetimes. If the real lifetime is 15 years that is bad, if it is 25 or 30 on average that means investments over time will increase. Luckily we have had deployments with enough numbers that we can get some naive ideas on this.
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Notes
(1) (LBNL-63434) - Wind Project Financing Structures
(2) Axel000 Diary on Stimulus Energy Provisions
(3) Wind By the Numbers Part 1 Diary