Big news today in the state of Massachusetts, where state officials announced a plan to pour $2.2B into energy efficiency measures, including a target of tripling the number of home energy audits, etc. On a per capita basis, at least, it would put Massachusetts ahead of any other state in the U.S. A terrific example, a great initiative... Great to see! It will make Massachusetts an even more attractive region for energy efficiency startups, tech or otherwise.
On other policy topics... I haven't spoken much about feed-in tariffs here in this column. For one thing, the economist in me tends to favor simple tax-based solutions rather than mandates or price setting, so I've never seen FITs as particularly attractive intellectually.
But recent conversations with those in the project finance industry have been changing my mind... a bit.
If policymakers want to see big roll-outs of renewable energy technologies, project finance is a vital player. No matter what incentive scheme is put into place, someone is going to have to pay for the project. According to New Energy Finance's figures, clean energy "asset finance", at $92B globally, dwarfs the dollars going into venture capital, government and corporate R&D, IPOs and other public issuances, etc. No matter how many technologies are invented and introduced to the market, unless project financiers are willing to bankroll actual steel in the ground, the new generation capacity will never be built.
As we've discussed on this site in the past, project finance is very different from venture capital and other investment asset categories. Project financiers typically target returns much lower than what VCs target. To make that work on a risk-reward basis, the investment must have absolute minimized risk. This is why there is a big capital gap between the venture capitalists and the project financiers: The VCs see their role as getting the company to a point where the technology has been successfully commercialized. The project financiers will wait even further, however, until all details of implementation are completely understood and underwritable. So the VCs will fund only a new tech up through project #1, and the project financiers still see too much implementation risk at that point, and projects number 2, 3, and 4 have a hard time getting built built.
What kinds of risks do they care about?
- Input / supply risk
- Technology risk
- Demand risk
- Offtaker credit solvency risk
- Offtake price risk
To address the capital gap, various government policies are there to help juice the returns for investors. Investment or production tax credits, 48C manufacturing tax credits, etc. And there are also mandates out there such as renewable portfolio standards. These certainly help and have their merits. But they don't really address the above risks. And even if the returns are enhanced through the incentives and mandates, project financiers are not used to having to assess such risks in this way.
A feed-in-tariff can directly address three of the above risks. In most applications, the FIT is a requirement for the local utility to purchase whatever power is produced by the targeted technology, at a set price (this is obviously a simplified version of a FIT). This means that, to a project financier assessing a FIT-driven project, the demand risk is taken care of -- the utility is required to buy the power. The offtaker credit solvency risk is minimized, since most large utilities are very credit-worthy. And the offtake price risk is obviously intended to be set.
I've spoken with a few project financiers who say that they are much more likely to invest in a region where there's a FIT in place, than in a region where there are tax incentives, even if the impacts on project IRRs are comparable. The FIT just creates a lot more certainty for the investor.
Certainly FITs aren't a panacea. Setting the price right is a challenge and prone to political inefficiency, for one. The requirement for utilities to purchase power at such a high price also means that they'll have to pass that price along to consumers or otherwise get government support to cover the difference -- it's not a big deal when the volume of FIT-driven power purchases are low in relation to the overall generation mix, but of course the idea is to dramatically drive up that volume, so it can get costly in a hurry. And it being a politically-driven system, when things get costly there's danger that the FIT price is reduced much sooner than expected by the market. This crushed the solar market in Spain, and is also happening now in Germany. It's critical, therefore, that any FIT be designed so that if there are future FIT price reductions existing projects are grandfathered in, otherwise project financiers won't perceive the policy as truly addressing the above risks for any given project.
But if policymakers want to see dramatically accelerated rollout of clean energy generation technologies, project financiers will have to be the ones supplying the lion's share of the capital required. And if project financiers are to do this, FITs are definitely worth giving serious consideration.
Here's a link to much better thinking on the topic by the good people at NREL.