Renewables To The Fore? Are renewables finally poised to take off, or is the huge interest in them merely a sign that there is little other greenfield activity in the market?

Renewables To The Fore? Are renewables finally poised to take off, or is the huge interest in them merely a sign that there is little other greenfield activity in the market?

August 01, 2003
The following are excerpts from a discussion that took place in San Diego in June.  The question was, “Are renewables finally poised to take off, or is the huge interest in them — as evidenced by attendance at conferences this year — merely a sign that there is little other greenfield activity in the market?”

The speakers are Michael Polsky, president of Invenergy, an independent power company in Chicago, Merrick Kerr, chief financial officer of PPM Energy, a US subsidiary of ScottishPower, Jayshree Desai, director of finance for Zilkha Renewable Energy in Houston, Jerome Peters, senior vice president and managing director of United Capital, a prominent lender to the renewable energy sector, and Christopher Moakley, president of Meridian Energy, which is in the business of raising capital for energy projects that receive tax subsidies.  The moderator is Keith Martin, a Chadbourne lawyer and editor of the NewsWire.

MR. MARTIN: Michael Polsky, you were probably more prescient than most people in the merchant power industry.  You had a power company called Skygen that you sold at the top of the market.  Now you have started a new company — Invenergy — to focus on windpower projects.  Do you know something that the rest of the market has missed?

MR. POLSKY: I don’t know.  I can tell you why we are looking at wind.

After I set up the new company, we looked at various options, including trying to buy distressed assets, which was the subject of the earlier panel.  I don’t see a lot of asset sales because people have nothing to sell.  With the collapse in prices, many equity owners no longer own any equity in assets.  So the reason we don’t see any merchant sales is not because people don’t want to sell, it is because they have nothing to sell.

So we came to look at wind.  I think we will hear today that there are a lot of challenges in wind.  When I started Skygen in 1991, most merchant power companies were heading overseas because they thought that was the place with the greatest opportunities.  We stayed focused on the US.  We always seem to be slightly out of step with the rest of the market.  Here we go again.  We like aspects of wind generation because the projects usually have long-term contracts and, in that sense, are similar to the earlier generation of independent power projects in which we have expertise.  In addition, you have the fact that many people see wind as a positive thing environmentally.  There is a push by governments around the world to do renewable energy.  Whether these factors make for a good future in wind, I don’t know.

MR. MARTIN: Merrick Kerr, Scottish Power has set a goal of building 1,000 megawatts of wind capacity in the US through its subsidiary, PPM Energy.  Why has the company devoted so many resources to wind?

MR. KERR: When we decided to build unregulated business in the US, we looked for the best point of entry into the US market.  It was in 2000.  Most of the greenfield activity was in gas generation, but was that the future? The fundamentals pointed to wind as the place for us.  There was no dominant player in the US market.  We had experience with wind back home in Scotland.  There was also the fact that our sister company, PacifiCorp, which is a regulated utility, has a tax base to use the production tax credits that the US government offers as an inducement to generate electricity from wind.  That may give us a little bit of an advantage over other wind developers.

Enforced Demand

MR. MARTIN: One of you argued on a conference call we held last week to prepare for this panel — I believe it was Michael Polsky — that the only way the wind business works is if the government orders utilities to buy the output.  Jayshree Desai, do you agree?

MS. DESAI: I agree that something has to stimulate demand, and RPS will allow us to compete more effectively with some of the other alternatives.

MR. MARTIN: And “RPS” is —

MS. DESAI: A renewable portfolio standard.  Certain states have adopted laws requiring that a certain percentage of the electricity that utilities supply to their customers must come from renewable fuels.  For example, Texas has one, and it has accounted for the huge growth in the wind industry in that state.  I do think that in order to compete effectively and have the good guys win, you have somehow to stimulate demand.  I do not see that happening without an RPS.

MR. MARTIN: How many states have renewable portfolio standards now?

MS. DESAI: I want to say 13.

MR. MARTIN: The European Union also has a law setting a goal for utilities to generate a certain percentage of electricity from renewable sources.  Does anyone know the percentage? I believe it is moving toward 20%.

MR. KERR: It depends on the country.  For example, in the UK, it is 10% by 2010 and 20% by 2020.

MR. MARTIN: California just adopted a stiff RPS.  Does anyone know the percentage?

MS. DESAI: I believe it is 20% by 2017.

MR. MARTIN: And what is the percentage of renewable energy generated currently in California?

MR. POLSKY: About 11%, not counting hydroelectric power.

MR. MARTIN: Are there other factors that are contributing to the growing interest in wind besides RPS?

MS. DESAI: Spiraling natural gas prices make electricity generated from wind better able to compete with electricity from power plants that run on gas.  The war in Iraq has also given a boost to wind developers.  It reminds people of the need to do things that reduce our dependence on imported oil and gas.  So there are other things that are helping push the interest in wind, but, not to sound like a broken record, there must be something more in order to turn windpower companies into more than just developers of one-off projects.  To have a real business, there must be a renewable portfolio standard.

MR. MARTIN: There are 37 states without RPS.  Without RPS, what do you have?

MR. POLSKY: Not much more wind development than you have right now.

We see the same thing happening with wind that we saw with gas in late 1990s.  Everyone is rushing to grab potential sites in anticipation that something will happen and they can flip sites to someone else who will develop or complete development.  You see tremendous activity going on in the wind market as far as acquiring sites.  But I think that is where it stops until buyers can be found for the electricity, and they are hard to find.

MR. MARTIN: If utilities are required by law to buy in 13 states, is it still hard in those states to find a buyer?

MR. POLSKY: First of all, I don’t know what percentage of electricity those 13 states represent.  For example, it was very soon — within a few years — after Texas introduced its RPS that the percentage requirement for renewable electricity was met.  Minnesota has been fairly active in this area, but the threshold percentages phase in over time.  Most take until 2010 or 2015 to ramp up.

I personally feel that electricity from wind is less expensive than from gas today.  But the only people who can buy are the aggregators because of the intermittent nature of output from wind farms.  We don’t have 100% capacity factors.  Therefore, you cannot go sell wind on the retail market or to industrial users or to anybody who needs a level supply of electricity.  There are a few exceptions like universities or some other entities that buy wind indirectly, but — in general — the only potential buyers are aggregators, and aggregators like utilities don’t want to bother with it.  So no matter how inexpensive wind is in relation to the alternatives, you need an RPS in order to stimulate demand.

MR. MARTIN: Is there a role for the Morgan Stanleys and other electricity traders of the world to act as aggregators?

MR. POLSKY: I don’t think these guys will aggregate because they are in the business of making money.

MR. KERR: What the customer wants to buy is a shaped product, and that is what wind companies will have to offer to thrive.  PPM has done that for some customers with help from intermediaries.  But the cost advantage that wind has right now against gas quickly disintegrates because of the prevailing transmission tariffs for wind electricity.  If you can find a Bonneville Power Administration or another entity that like to handle transmission for you, then the cost is a couple of bucks and no more.  But if you have to do it yourself, you are quickly talking about —

MR. MARTIN: The reason that transmission is expensive is the intermittent nature of wind output means that wind farms must reserve more capacity on the grid than they are likely to use? Or is it that wind farms are built in windy areas where people tend not to live so that the electricity must travel a long distance to reach consumers?

MR. KERR: Both.

MR. MARTIN: Jayshree Desai, what has Zilkha’s experience been in competing on cost against electricity from gas-fired power plants?

MS. DESAI: You have to look on a state-by-state basis.  In some states, we are able to compete very effectively.  In other states, the price of gas is so low that we have no chance of winning a power purchase agreement solely on the basis of cost.  Even in states where we enjoy a cost advantage, we still meet resistance from some utilities that just do not understand our product and resist dealing with a potentially intermittent supplier.  Wind developers face the additional hurdle of having to educate utilities about the benefits of drawing electricity from a diversified portfolio.  Notwithstanding this, at the end of the day, wind developers must be able to compete on price.  If your price is not competitive, you are not going to win the contract.

MR. MARTIN: Jerry Peters, you are making something of a specialty of lending to power projects that use renewable fuels.  Why is wind attractive given what we have heard today that there is really no wind business unless utilities are required to buy the output?

Competitive Edge

MR. PETERS: First, let me say that I don’t view wind as being any more attractive than any of the other renewable assets I have in my portfolio.  But the key really comes down to what renewables can do that no other fossil fuel generation asset can do: renewables can produce at a fixed price.  They can offer to the marketplace that is willing to buy their electricity a fixed price over a long term.  Not many gas-fired plants being built or that were built in the last 10 years can make the same offer.  Another thing that wind has going for it is technological improvements in wind turbines over the last 10 years have led to a dramatic reduction in capital cost per megawatt of installed capacity.  The capital cost is now approaching a level at which wind farms can compete with four or five dollar gas.  And wind is not alone in this respect.  Improvements in geothermal technology and in bio technologies have put other renewables projects in the position to compete effectively on price, as well.

People forget that each individual in the United States produces about seven pounds of garbage a day.  Most of this garbage is organic.  When you deprive it of oxygen, it produces methane.  A large number of landfill gas projects have been developed in the last 10 years.  These projects are in a position to sell gas for less than the cost of competing natural gas and, add on top of that, that they can agree to supply the gas at a fixed price under a long-term contract.

MS. DESAI: Keith, if I could add one thing.  I agree that wind has 20-year long-term PPAs, but in one state we are facing a situation where the utility refuses to enter into a 20-year contract.  This sets up a struggle between what can be financed versus what the utilities want.  I don’t know whether there is a way to overcome that hurdle.  Will banks ever be willing to finance wind farms on the basis of shorter-term PPAs? We have the problem in certain states that we are not going to be able to sell our electricity unless we find a solution to that problem.

MR. MARTIN: Let me probe further on what the wind industry needs to succeed.  Isn’t the wind industry divided on the question whether it wants a national renewable portfolio standard? The fear is that if the US government orders utilities nationwide to buy or produce a certain percentage of electricity from renewable fuels, it will impose a weaker standard than the industry has been able to get from the states.  Michael Polsky, do you agree?

Wind as Infrastructure

MR. POLSKY: Let me make a broader statement about renewables, wind in particular.  I think people have to look at wind as a national infrastructure project, okay? Wind remains largely untapped in this country as resource.  It will always be available.  That is why Europe went the way it did.  The Europeans are not stupid.  And there is something to be said for the approach Europe adopted to encourage wind.  They did not do it through tax credits, but a cost-based system where a minimum price is set for electricity from wind or renewables with the result that there is the same incentive for smaller developers without a tax base to develop wind projects as for larger companies to do so.

Wind is an infrastructure project, and the utilities are not in the business of building public infrastructure.  That is a job for state or national governments.  At the end of the day, the debate should not be about subsidies for this or that.  It should be about creating a national renewable infrastructure.  Look at what has happened with gas.  Everybody thought gas was plentiful.  And maybe it is plentiful, but $6 gas certainly is very expensive.  We see what happened with nuclear power.  Nuclear energy is not economically competitive today.  I personally believe that wind and renewable fuels in general are like the United States highway system.  If the highways had to be economically justified up front, no one would ever have built the interstate highway system.  I think we as a country are ignoring a source of fuel on which we can rely not just for the term of a 3- or 5-year PPA, or for this generation, but forever, and the government will have to make a decision.  If we don’t make that decision, then wind farms will not be built.

MR. MARTIN: Merrick Kerr, why is it so important to the industry that General Electric has jumped into the business of manufacturing wind turbines? Why is this such a great source of excitement among wind developers?

MR. KERR: It is the promise of further improvements in technology.  Let me add to what Michael Polsky said.  If we are going to get the utilities to buy our electricity today, then the price must be at least close to the price for electricity generated from natural gas at the point where they buy it.  I agree that to make a real business, the industry needs an RPS.  If you just look at the states that have an RPS today, you are talking about 20,000 megawatts of capacity.  If the RPS were extended to the entire country, that would create the potential for 60,000 megawatts.

MR. MARTIN: People who are not in the wind business may not realize that the government pays as much as 75% of the capital cost of a wind project through tax subsidies.  The main subsidy is a tax credit of 1.8¢ a kilowatt hour at the federal level.  The problem with this credit is it has to been renewed periodically by Congress.  For example, this year is another year when it is in danger of expiring.  Michael Polsky, I believe you had some interesting data about how this periodic uncertainty every so often about whether the credit will be extended hurts the wind business.

MR. POLSKY: Somebody else had it.

MR. KERR: Something like 1,700 megawatts of new wind projects were built in 2001.  Last year when there was uncertainty about whether the credit would be extended, only 300 to 400 megawatts of new wind capacity was installed.  This year is another year of uncertainty.

MR. MARTIN: Chris Moakley, you had a comment about the uncertainty surrounding the tax subsidy.

MR. MOAKLEY: It is difficult to get the large institutions that supply equity to affordable housing, wind and similar projects to commit to a program where the inducement is a temporary credit.  Investment in affordable housing did not really take off until the tax credits for such projects were made permanent.

More Investors Needed

MR. MARTIN: Jayshree Desai, there is a perception in the market that there are too few potential equity investors in wind deals to satisfy the need for capital in this business.  Is it true and, if so, why?

MS. DESAI: We agree that it is a small market.  It was much easier to raise money for wind projects a couple years ago when the energy industry was booming, but now with many of the traditional energy players having fallen on hard times, we are having to try to come up with new structures that parcel out risk a little differently than in the past.  The goal is to find something to attract more nontraditional players into the market — investment banks, financial institutions, large companies with tax bases — but they are willing to take only so much risk.  There are some investors who are willing to take the wind and technology risk, but they also must have a tax base to be able to use the tax credits.  You have to find somebody who has all three of these characteristics.

Then there are some other potential investors who are willing to take price risk but not wind risk.  Some are willing to take technology risk but not price risk.  It becomes a complicated puzzle to find a structure that will attract enough equity to the project.  There are only maybe 10 or 12 players that I would go to today when I have a wind farm to sell.

MR. MOAKLEY: Keith, let me comment on that too.  The wind companies are not going to get the pure financial players as equity investors unless the financial players feel like they can make a long-term commitment to the business.  They will not devote the resources required to understand the business in order to make a one-off investment, or even to make investments for just a couple of years.  They want to see permanency in the tax credit.

Let me give you a real-life example.  I am a simple guy who has to relate things to everyday examples.  I have a wonderful wife and three beautiful daughters, and they like nice clothes.  If they walk into a store whose name they don’t know, they might say to the clerk, “You have some nice clothes here, but we worry you may not be around after this year.” Maybe the store has a nice product, but they don’t know if they can replicate their behavior by spending a lot of money there.  Now, if you put my wife and three daughters in an Ann Taylor or a Talbots, I tell you, they are dumping tremendous amounts of money and they will replicate their behavior. [Laughter].  I think that’s what the large institutional equity participants want to do as well.  They want to have some confidence that the product will be around for a while.

MR. MARTIN: Jerry Peters, we have to draw this discussion to a close.  Any final thoughts?

MR. PETERS: Yes, financing renewables is a very difficult job because of the complex tax structures required.  We are dependent on tax credits to make wind and other renewables work.  Many lenders with experience with other types of power projects will simply look for a long-term power purchase contract that ensures enough money will be generated from electricity sales to pay back the loan on schedule.  It is not as simple as that for renewables projects.  We have to look also at the entity that has monetized the tax credits.  And in some states there are renewable energy credits that are created under the renewable portfolio standard and for which there is a market, so you may have yet another party monetizing the renewable energy credits.  The lender has to make three credit decisions before advancing the loan.

MR. MARTIN: Any other points that it is important for the audience to hear?

MR. KERR: Maybe just one, and that is emissions.  A 100-megawatt gas-fired power plant is equivalent to 85,000 automobiles in terms of its emissions and the equivalent of the absorption of 60,000 acres of trees.  Wind projects not only tap an inexhaustible fuel, they also reduce emissions.