By Eli Katz

Global clean energy investment fell 34% in the first half of 2011, weighed down by low natural gas prices in the United States and subsidy cuts in Europe. However, by the third quarter 2011, it had turned into a 16% increase, helped by falling costs for solar panels and wind turbines. Energias de Portugal and Electricité de France folded renewable energy subsidiaries that they took public just three years ago back into the parent companies. The US is unlikely to act on carbon. The political parties are at the loggerheads over an energy policy. A “super committee” of 12 members of Congress is supposed to find a way by November 23 to reduce the US budget deficit by at least $1.2 trillion.

What is the market likely to look like over the next two years if public policy remains stalled or, even worse, there is backtracking on support for renewable energy? In the longer term, what renewable energy technologies have the best chance of standing on their own without public policy support?

A panel discussed these and other subjects at the Chadbourne global energy and finance conference in June. The panelists are Bill Green, senior managing director of Macquarie Infrastructure and Real Assets (MIRA) Inc., Joseph Slamm, managing director of Hudson Clean Energy Partners, and Stephen Herman, managing director of Energy Capital Partners. The moderator is Eli Katz with Chadbourne in New York.

MR. KATZ: Bill Green, with all the headwinds facing renewable energy, why is it still an attractive space for you?

MR. GREEN: The simplest way to think about it is that until we invent cold fusion, there are four ways to generate power on this planet: coal, nuclear, natural gas and an assortment of renewables. Each of these strategies at the macro-level has challenges, and those challenges are different in every part of the world. In the United States and Canada, it is difficult to site a new coal-fired power plant. Nuclear has proven itself to be very expensive. Those costs are only going up after Fukushima, so that leaves us natural gas —abundant, relatively clean — and renewables. Our view is that, despite the short-term blips on the radar screen, renewables and gas are the foundation of forward generation.

MR. SLAMM: The headwinds come from a number of different places, not the least of which is we are now in a down cycle on commodities. We are also in a volatile period in terms of public policy as a consequence of the stress in the overall financial system and markets. We are in a transition phase of moving toward economies of scale that will allow renewable energy to compete head to head with fossil fuel. The world has changed from even a year and a half ago. Budgets and jobs are the main focus for public policymakers.

The long-term fundamentals of renewable energy have not changed. Headwinds can be a good thing. GE and Siemens are squeezing 20% more output compared to a few years ago out of the same wind turbine gear boxes. Necessity leads to invention.

Change-in-Law Risk

MR. KATZ: Let me make the question a little harder. Steve Herman, my sense is that not only have people stopped talking about climate change in Washington, but they have actually started becoming a little negative on it. There is even some backtracking at the state level. How do you deal with that uncertainty as you make investment decisions?

MR. HERMAN: “Cap and trade” has become a term of derision almost like Obamacare. We get very granular. How can we make this project work? Yes, we have to assume risk — we are not in the government bond investment business — but we evaluate everything, assign a probability, look for creative ways to address the some risks, and perhaps decide to assume others.

MR. GREEN: Let’s also get granular about policy uncertainty. Here are a few “on the ground” realities.

Thirty states have mandatory renewable portfolio standards. The biggest challenge to these RPS targets came in the last election cycle in California where a group of well financed oil companies and others got together to overturn AB 32, the climate change statute in California. The effort was dressed up as citizens in favor of job creation. It lost. The loss was important because, as a citizen vote, it basically gave us a bellwether of how the RPS would fare. I don’t know whether we will ever see a national clean energy standard, but there are 30 states today with such standards covering a majority of the US electricity market.

Point two: what happens these days on Capitol Hill is a tremendous amount of posturing. We can talk about the macro policy issues all day long, but development is fundamentally a local game. Things happen at a local level. They are driven by local needs, transmission, demand for power and utility politics. Will Sarah Palin be president? Will we build renewables? On the ground, when we go to work on Monday, the question is: are power purchase agreements still being issued? Yes. Can the good developers get them? Yes. Are there still a lot of developers? Absolutely. And does that create an environment where we can build and finance new projects? Yes.

MR. HERMAN: To illustrate Bill’s point, the day before yesterday the Illinois legislature passed, by veto-proof margins, a bill that will allow two coal gasification plants — making pipeline-quality gas — to be built in Illinois, effectively guaranteeing a price of $9+ an mcf. This is important to Illinois because the state has a lot of coal. It is a jobs bill for the state. The bill had broad support from both Democrats and Republicans.

MR. KATZ: Let me ask a specific policy question about the Treasury cash grants for renewable energy projects. The deadline to start construction of remaining projects to qualify for grants is the end of this year. The current betting is that the deadline will not be extended. What happens when the cash grant goes away?

MR. SLAMM: Cash subsidies are more efficient than tax subsidies. A little known fact is that developers waste 30% of the tax subsidies converting them into current cash in the tax equity market.

My partner, Neil Auerbach, will be talking on Capitol Hill tomorrow about a bill that is supported by no fewer than 80 Republican congressmen — and, interestingly enough, the conservative think tank the Heritage Foundation — to form a trust fund patterned after the trust funds that were used to build the interstate highways and broadband in the United States, fund it with a surcharge on oil and gas and actually pay cash for renewables. It is getting a lot of traction on the Republican side because it is budgetary neutral, which is the name of game right now. I do not think either political party is against clean energy. The key is to get the most clean energy at the lowest cost.

MR. GREEN: I think in the near term the end of the cash grant program will cause some panic, but we were building renewable energy projects well before there was a cash grant.

MR. HERMAN: I am sorry if the grants disappear, even though the fact the program is ending is creating opportunities for us since we have money to lock in to help developers start construction. But let’s assume the program disappears. Either costs have to come down or consumers will have to pay more for electricity if they want the country to rely more heavily on renewable energy. Renewable energy projects will be more expensive to build. Developers will have to pay more to cover the capital costs of their projects. There may be ratepayer backlash if prices in PPAs increase.

MR. KATZ: Why would utilities sign out-of-the money PPAs if you do not force them to do so?

MR. HERMAN: It will fall back on the states to decide how important this is as a matter of local policy, just as Illinois decided to promote coal gasification projects. The state was willing to have gas consumers pay $9 for gas to create more demand for Illinois coal. Now, maybe $9 gas does not quite do it, so the developer will then have to go to the supplier of the gasification equipment and the EPC contractor and say, “Let’s work together. How are we going to make this work at $9?” If they have other opportunities, they may say, “We don’t want to do this.” Or if they need the business, they may say, “We will work together to figure out how to do this, and we will take some of the risk with you.”

Opportunities

MR. KATZ: That is the free market solution. However, we are not sitting in a room full of people who work in renewable energy because of a free market solution. Joe Slamm, looking ahead, Hudson seems really good at getting into portfolio companies early and then exiting nicely. How do you assess new technologies, and what sorts of opportunities do you think will be big over the next two to three years?

MR. SLAMM: We have a very simple method. It is maximum efficiency and lowest cost. Suppose we are looking at a value chain company that makes a widget. We have invested in a couple of solar manufacturers, and their goal is to reduce the cost of their products. That is what we want them to do. Whether the company is a manufacturer or a project developer, the lowest-cost producer wins. Lower costs mean higher demand for the products.

Look at what Germany has done with its solar tariff. The tariff was scheduled to step down every three years. We don’t do that here. We ask for the same subsidy every year. Now that the commodity cycle is low, the commodity cycle is doing it for us, but the federal side is not doing it yet.

We were building wind farms in 2001 with wholesale electricity prices of $20 to $29 a megawatt hour. It worked because the equipment was half the price that it is today. As the commodity cycle went up, natural gas prices started going through the roof, and GE said, “Thank you very much. I’ll take that!” and made a lot of money during that period. Now that trend has reversed. The first thing that GE and Siemens did was to say, “Okay, instead of cutting margins, we are going to increase the efficiency of the machines.” Could they have done that five years ago? Sure. Why didn’t they? Because the margins did not require it.

My partner, Daniel Gross, says the margins in solar up and down the value chain are still approaching somewhere in the 40% range. Manufacturers in other industries are in the 10% range. There is still room to go. Policies that promote cost efficiency and innovation win. We get eventually to the point where there is no longer any policy debate, and we are just competing on “We have the best machine, we have the best wind resource, we have the best geothermal resource.” We are moving in that direction a lot faster than we thought.

MR. KATZ: Steve Herman, where do you think the big opportunities will be two and three years from now?

MR. HERMAN: To answer your question directly, I don’t think it is useful to try to pick whole classes of investments that will be winners. Yes, we all make these judgments, and I may spend the next month looking at companies in a particular market because I think something will come of it, but you really can’t pick classes. You have to pick within classes.

You start with a thesis. Let me give an example. Suppose you decide renewables are the place to be, but wind and solar are hampered by their intermittency, so the way to go is biomass. No one has done much biomass recently. The capital costs are very high per installed megawatt, but biomass is a very broad term. For example, it covers waste energy. We are trying to find a suitable technology. We are not venture capitalists so it has to be proven to some extent. It must be a technology that will allow biomass to compete in a particular location given a lot of different facts. We are spending tremendous time learning about technologies that have been deployed in other parts of the world that can now be deployed here. It is a long process.

After several months of study, I may throw up my hands and say that the current conditions do not allow for it, but I am not ready to dismiss biomass just because it has high capital costs and wholesale electricity prices are down. We are willing to invest the time to explore whether there are any unique circumstances, and we like the fact that few others appear to be putting in the same effort.

MR. KATZ: Quickly Bill Green, pick a winner: is it solar over wind? Is it a particular segment of solar?

MR. GREEN: I am bullish on solar thermal. I think turning photons into electrons at low cost and integrating storage has enormous potential. In the next two to three years, we should see more commercially-proven technologies emerge.

MR. HERMAN: I agree with that. When we first got into solar, we thought solar thermal was the way to go. We found PV was coming down quickly in cost, so we switched to PV, did well and exited. But one of our key people said solar thermal is going to come back because it has much more flexibility than PV. The utilities recognize that there is more dispatch ability with thermal solar. They can only take so much PV, and people are going to figure out how to get the costs down to compete with PV. It is just a matter of time. ¥