By William A. Monsen and Briana Kobor

California is tightening the rules on how utilities can use electricity products, including unbundled renewable energy credits, from power projects in neighboring states toward meeting state targets for renewable energy use. The new rules could end up in court over whether they impede interstate commerce in violation of the US Constitution. In the meantime, development of some projects in nearby states has slowed and valuations for such projects have fallen.

The new rules apply to renewable electricity and RECs sold under contracts signed with California utilities after June 1, 2010. Amending an older power contract could subject the revised contract to the new rules.

California’s regulations for meeting renewable energy goals are continuing to evolve amidst controversy. A bill the governor signed in April 2011, called SB 2 (1X), increased the amount of electricity from 20% to 33% that utilities and other load-serving entities in the state are required to supply from renewable sources by 2020. Renewable energy currently accounts for 21% of electricity delivered by California’s investor-owned utilities to their customers.

SB 2 (1X) reworked the state renewable portfolio standard or RPS program to divide renewable energy products into three categories.

Category 1 is largely electricity from sources inside California or that can be delivered to California. The category includes renewable electricity that is directly connected to a California balancing authority (CBA). Examples of CBAs are the California Independent System Operator, the Sacramento Municipal Utility District and the Los Angeles Department of Water and Power. Category 1 also includes energy that can be directly scheduled from the generator into the CBA without substituting electricity from another source, meaning that the seller must obtain transmission service from its first point of interconnection to a CBA. While firm transmission rights are not required to be considered as a category 1 resource, such transmission rights would make the out-of-state renewable resource more attractive to purchasers in California. Finally, category 1 also includes electricity delivered under an agreement for dynamic transfer to a CBA. Category 1 is aimed at ensuring that electricity generated by the RPS-eligible resource is consumed in real time by California customers.

Category 2 is output from renewable energy resources that has been firmed and shaped prior to being delivered into a CBA. An example of a resource that provides firmed and shaped power would be a wind generator that delivers energy to a third party and then the third party delivers energy at a different time or with a different pattern than the original generation to the ultimate purchaser in California. Even though these types of transactions usually involve out-of-state renewable generation, this is not a requirement for such an arrangement. Since the firmed and shaped energy is delivered with a pre-determined pattern, this product can provide firm energy to the purchaser if the delivering entity obtains firm transmission rights to the CBA.

Category 3 includes unbundled RECs as well as electricity that does not fit in the first two categories.

The following table summarizes the three resource categories:

SB 2 (1X) places different limits on the percentage of energy supplied by resources from each category during three compliance periods.

In the early years of the program, SB 2 (1X) allows utilities to meet a larger percentage of their RPS compliance obligations with category 2 and 3 resources such as unbundled RECs or firmed and shaped generation from out-of-state resources. However, the percentage of renewable electricity that must come from category 1 sources, generally sources inside California or that deliver to a CBA directly, increases over time. The three compliance periods are: prior to 2014, from January 1, 2014 through December 31, 2016, and January 1, 2017 and beyond. The figure on page 12 shows the targets for each category for each of the compliance periods.

The level of category 2 and 3 resources — in which most out-of-state resources are expected to fall — declines from 50% of total RPS compliance by the end of 2013 to 25% by the beginning of 2017. Category 3 resources get hit the hardest: an individual utility (such as Pacific Gas & Electric) can meet no more than 25% of its RPS obligations in 2013 from category 3 sources, and this level shrinks to 10% for 2017 and beyond.

These definitions and targets mark a significant departure from California’s previous approach. Under the prior RPS rules, there was no required minimum amount of directly connected or dynamically scheduled resources. Also, firmed and shaped resources (now category 2) were key tools for utilities to meet their near-term compliance obligations.

On the other hand, the new RPS law does not present much of a change in the ability of utilities to use unbundled renewable energy credits, called “TRECs,” for RPS compliance, at least through the end of 2014. TRECs are renewable attributes associated with generation from renewable resources. However, unlike bundled renewable transactions, the purchaser of TRECs does not also take delivery of the physical electricity generated by the renewable generator. Until now, the policy of the California Public Utilities Commission has been to allow utilities to use TRECs to meet up to 25% of their RPS compliance obligations through 2013. SB2 (1X) did not change this. However, it did extend restrictions on TREC usage for RPS compliance after 2013. (For a full discussion of California TRECs, see “Using Tradable Renewable Energy Credits in California,” by Laura Norin and Heather Mehta of MRW & Associates in the March 2011 Project Finance Newswire.)

Help For California Projects?

Among other things, SB 2 (1X) has proven controversial because of the legislation’s clear preference for resources from category 1 and the inherent difficulty for out-of-state generators to meet category 1 requirements.

Some opponents of the new RPS rules claim that the law’s clear preference for category 1 resources creates an unfair advantage for generators located within (or in close proximity to) a CBA. Indeed, some entities claim that category 1 resources are three times more valuable than category 2 resources and are as much as 40 times more valuable than category 3 resources.

While generators located within or near CBA boundaries would have little trouble meeting category 1 requirements, more distant generators will need to meet the more nuanced requirements for scheduling without substitution or dynamic scheduling in order to qualify for category 1.

Developers working on projects outside of California are concerned that the shrinking percentage of resources from categories 2 and 3 that can be used to meet future RPS compliance will undercut their development efforts.

The Cowlitz County Public Utility District in Washington state suggested to the CPUC in a recent filing that most out-of-state generators will be unable to sign contracts that qualify for category 1 treatment. It said the new rules discriminate against out-of-state generators and, as such, violate the Commerce Clause of the US Constitution.

Commerce Clause

The Commerce Clause bars states from erecting unfair barriers to interstate commerce.

Several groups are supporting the request by the Cowlitz Public Utilities District to the CPUC for a rehearing or reexamination of how the CPUC is implementing SB 2 (1X). The groups are the Western Power Trading Forum, the Alliance for Retail Energy Markets, the Retail Energy Supply Association, and Marin Energy Authority. Two groups are opposing the request: the Independent Energy Producers Association and The Utility Reform Network.

Much of the controversy boils down to whether SB 2(1X), with its limits on different categories of electricity, discriminates based on state lines and, if so, whether any discrimination can be justified by reasons other than economic protectionism. While California generators are more likely to be located in or near a CBA, the boundaries of the CBAs are not drawn on state lines and include interconnection points that extend into parts of Oregon, Nevada, Utah and Arizona. Proponents of the program argue that this means the new rules do not discriminate against out-of-state generators. Opponents say that the requirement for a renewable resource to deliver to a CBA in order to be a category 1 resource is a burden in practice for renewable generators outside California.

Opponents also point to a statement by California Governor Jerry Brown when he signed SB 2 (1X): “This bill will bring many important benefits to California, including stimulating investment in green technologies in the state, creating tens of thousands of new jobs, improving local air quality, promoting energy independence, and reducing greenhouse gas emissions.” Many believe that the California legislation is ripe for a challenge based on the Commerce Clause.

Bust for Northwest Renewables

The uncertainty surrounding the new RPS rules in California has helped wreak havoc on renewable energy development in the Pacific Northwest. Between 2005 and 2011, installed wind capacity in the Northwest grew from 1,000 megawatts to roughly 6,000 megawatts. Randall Hardy, a former administrator of the Bonneville Power Administration, said the rush has cooled since California enacted SB 2 (1X). He sees “little or no [regional] renewables development in the next two, three years. There just aren’t any buyers out there.” With the advantages the California program gives to in-state renewables, developers of renewable resources in the Northwest may see limited opportunities for new power contracts to sell electricity into California. The fact that most utilities in the Pacific Northwest have already procured enough renewables to meet their own states’ RPS obligations through 2016 is just another blow to developers in that region.

Some of the more dire predictions regarding the impact SB 2 (1X) might have on renewable generators located far from California may be borne out if the results of the ongoing request for offers from renewable generators by the California utilities are indicative. The most recent news from the Pacific Gas and Electric Company renewable solicitation is that PG&E has decided to remove all proposals to sell PG&E unbundled renewable energy credits from the shortlist. PG&E also removed from its shortlist two offers from out-of-state
generators who did not propose direct connection to the California grid.

Market Outlook

To the extent that the new rules restrict the supply of RPS-eligible resources, economic theory suggests that projects that qualify under category 1 will be worth more and there will be a disincentive to develop new projects whose output falls under categories 2 and 3. Even in cases where out-of-state projects can qualify under category 1 or 2, the increased costs of firm or non-firm transmission rights to ensure that these resources qualify may make these projects uneconomic. If prices increase for renewable electricity from out-of-state projects, then this could run afoul with another element in SB 2 (1X): a still-to-be defined cost containment mechanism.

While it is unclear what will happen with the controversy over California’s alleged Commerce Clause violation, the new legislation is already affecting the market for out-of-state renewables. California appears to be counting on in-state renewable projects to carry the state’s needed renewable requirements, but even the future of these projects remains uncertain due to issues with project viability, interconnection and permitting.