promoting wind energy development in an era of restructuring

34

© 2000, Elsevier Science Inc., 1040-6190/00/$–see front matter PII S1040-6190(99)00103-7

The Electricity Journal

Promoting Wind Energy Development in an Era of Restructuring

Carefully targeted loan programs and “buy green” programs are efficient means of promoting wind energy projects, but investment tax credits should be avoided because of the perverse incentives they create.

Frank Harris and Peter Navarro

ind power represents an abundant, renewable, non-

depletable energy resource. It ranks second only to hydroelectric-ity as the cheapest source of renewable electricity generation and is significantly less expensive than other renewables, ranging from solar and biomass to geo-thermal resources.

In at least eleven states, it is eco-nomically feasible to significantly increase wind power generation. These states are California, Colo-rado, Hawaii, Iowa, Massachu-setts, Minnesota, Montana, Ore-gon, Texas, Washington, and Wyoming. With such an increase would come important environ-mental and economic benefits.

At the state level, increased use of wind power results in cleaner air and water while generating income- and property-tax reve-nues and creating well-paying jobs. At the national level, wind power helps cut our trade deficit and improve national security by reducing our dependence on for-eign petroleum imports. At the global level, this energy source helps reduce greenhouse gas emissions and the attendant threat of global warming. In this regard, emissions offsets from an increasing reliance on wind power would contribute to the broader federal policy of reduc-ing greenhouse gases—a policy dictated by the Kyoto Treaty

Frank Harris

is a doctoral student ineconomics at the University of

California at Irvine. He specializes inindustrial organization and public

choice, and currently teaches healtheconomics and operations research at

California State Universityat Long Beach.

Peter Navarro

is an AssociateProfessor of Economics and PublicPolicy at UCI’s Graduate School ofManagement. He holds a Ph.D. in

economics from Harvard Universityand a Master’s in public

administration from Harvard’sKennedy School of Government.

This article is based on the report,

Policy Options for Promoting WindDevelopment in California: A

Report to the Governor and StateLegislature

, available on the Internet

at http://gsm.uci.edu/~navarro.

W

January/February 2000


35

on Global Warming signed by President Clinton.

1

Despite the potential role wind power can play in the nation’s energy and environmental pic-ture, its future is unclear. This is because of a complex confluence of regulatory, legislative, and politi-cal events.

At the state level, utility restructuring has made it much more difficult for regulators and legislators to directly mandate a price or quantity for renewables such as wind. At the federal level, amid intense partisan bickering over the budget, Congress allowed the wind industry’s “production tax credit” (PTC) to expire, and only recently restored it—but for a very limited time.

2

Further complicating matters are several types of discriminatory pricing practices. For example, at the state level, the California Inde-pendent System Operator (Cal-ISO), which administers the state’s power grid, has included among its protocols one on “uninstructed deviations” that levies a significant financial penalty on generators deviating from their schedules by producing either too much or too little power for the grid. For inter-mittent resources such as wind, this protocol basically shifts risk from the ISO to the generator, thus acting to discourage the develop-ment of intermittent sources.

ore broadly, at the federal level, rules for transmis-

sion pricing that were included in Order 888 issued by the Federal Energy Regulatory Commission (FERC) in 1996 essentially rein-force the industry practice of take-

or-pay, capacity-based charges, also penalizing wind projects. In order to be assured of available transmission capacity, a wind project operator must reserve transmission services in advance and pay for the capacity reserved—regardless of whether the capacity is actually used. This reliance on capacity-based charges, in turn, causes intermit-tent technologies like wind and solar to have a high transmission

first useful to understand project financing in the industry.

I. Project Financing

Because wind turbine projects are highly capital-intensive, the cost of wind energy is largely determined by the project financ-ing terms, specifically, the cost of debt, the loan maturity, the cost of equity, and the project’s ratio of debt and equity to total capital.

s a practical matter, the most important constraint on the

amount of debt used is the debt service coverage ratio (DSCR). The DSCR is defined as the minimum ratio of operating cash flow to total yearly debt service required by a lender, where operating cash flow equals total revenues less cash expenses, and total yearly debt ser-vice includes both principal and interest payments. Thus, if the debt service is $1 million in a given year and the DSCR is 1.4, a project developer must generate $1.4 mil-lion of operating cash flow to ser-vice the debt, with the extra $400,000 providing a cushion in the event of operating underper-formance. As for loan maturity, that is important because as the term of the loan increases, the price of energy will fall.

Table 1

illustrates representative values for the key financial parame-ters of a typical wind project and compares these parameters to those available to wind’s chief competitor in the generation market—natural gas combustion turbines.

3

At present, natural gas projects enjoy significantly more favorable financing terms because of the

At the state level, utility restructuring has made it much more difficult to directly mandate a price of

quantity for renewables.

cost per kWh generated, further disadvantaging them relative to competitors like natural gas. Despite proposals from wind and solar energy advocates to move to an “energy-based” transmission pricing structure tied to the actual utilization of transmission ser-vices, FERC has refused to speak further on this issue.

Faced with these state and federal obstacles, the rate of growth of wind energy development in the nation has begun to wane. The pol-icy question this article poses is this: How might wind development be encouraged in a fiscally responsible way? To answer this question, it is

A

M

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greater

perceived

financial risks of a wind energy project. These risks include cost over-runs and con-struction or operation delays, wind turbine failure or underperfor-mance, and less available wind than forecast. While these risks represent a legitimate concern to investors, much of today’s perceived financial risk is nonetheless overstated.

New turbine designs have cut operating costs by as much as 80 percent from levels of only fifteen years ago. These turbines start pro-ducing power at lower wind speeds, keep operating at higher wind speeds, and generate more energy from all velocities in between. Addi-tionally, this new technology is highly reliable and utilizes wind resources with capacity factors that have exceeded 40 percent.

nfortunately, despite a dra-matic reduction in the

real

financial risk of building a wind project, there remains a significant gap between this real risk and the

perceived

risk of such a project by the capital markets. This perceived risk manifests itself in the capital mar-kets as a substantial “risk premium” that wind developers must pay rela-tive to natural gas turbine project developers, as illustrated in

Table 2

.From the table, we start out with

a benchmark levelized cost of

cost by 3 percent to 6.62 cents/kWh, as seen in Row 4, while the biggest impact of all, lowering the cost of equity by 600 basis points, reduces the generating costs by 11 percent to 6.06 cents/kWh (Row 5). Finally, in the last row of the table, we see that if all four parameters are changed to reflect all the favor-able financing terms of a gas project, the cost would fall by 22 percent to 5.29 cents/kWh. This clearly indicates that financing terms are critical in determining the cost of wind energy.

II. Cost-Side Policy Options

As a practical matter, policymakers have three main categories of cost-side policy options to improve these financing terms. These include: (1) loan options such as loan guarantees and low interest government loans, (2) tax credits and exemptions such as a state sales or property tax exemption or an investment tax credit, and (3) direct production subsidies.

able 3

examines the impact of each of these options on the

levelized cost of wind energy from a typical 40 megawatt wind farm

wind energy of 6.81 cents/kWh. It is perhaps useful to note here that while a levelized cost of 6.81 cents/kWh may seem high relative to other estimates that informed readers may have seen for the cost of wind power, it is important to remember that we are assuming

no

federal production tax credit in this analysis, since that credit, as noted above, has expired.

In Row 2, if the interest rate were reduced by 150 basis points to that paid by gas projects, the cost per kilowatt hour of wind energy would fall by 6 percent to 6.43 cents/kWh. Extending the loan maturity from fifteen to eighteen years, as indicated in Row 3, reduces the cost by 7 percent to 6.31 cents/kWh. Similarly, lowering the debt service coverage ratio, holding other things constant, reduces the

Table 1:

Key Financial Parameters for Wind and Natural Gas

Natural Gas Combustion Turbines Wind Project

Interest rate on debt LIBOR

1

25 basis points LIBOR

1

175 basis points

Loan maturity 15–18 years 12–15 years

Minimum DSCR 1.25 1.4

Post-tax equity return

8%

14%

Table 2:

Financial Risk and the Cost of Wind Energy

Change Financial Parameters to Those Of Gas Projects

Levelized Cost of Wind Project

(cents/kWh)

Impact onLevelized

Costs

Benchmark “base case” — 6.81 —

Interest rate on debt Reduce by 150 basis points 6.43

2

6%

Increase loan maturity Increase from 15 to 18 years 6.31

2

7%

Lower minimum DSCR Lower from 1.40 to 1.25 6.62

2

3%

Reduce equity cost Reduce from 14% to 8% 6.06

2

11%

Total impact

Change all

5.29

2

22%

TU



37

in California using a simulation currently in use in the wind indus-try.

4

Before describing the results, it is useful to first briefly discuss some of the complex interactions of this model.

For example, under a low-interest loan or loan guarantee program, a lower interest rate would not only lower the cost of debt but would allow wind developers to increase the debt-to-equity ratio and thereby indirectly further lower costs. At the same time, a loan program might also be structured to include a lower DSCR and a longer debt maturity. These provisions likewise would allow for the model to increase debt relative to equity in the capital structure and similarly lower costs. Accordingly, these assumptions can be entered into the model and a new levelized cost relative to a “base case” can be calculated.

From Table 3, it should be clear

achieved by implementing a one-cent-per-kWh subsidy program.

Perhaps most importantly, it is also clear from the table that no

one

policy—even re-imposition of the federal PTC—is sufficient to reduce the levelized cost of wind power near to the point (about 3.5 cents/kWh) where it is competitive with natural gas. Note, however, that when several policy options are combined into “packages,” the levelized cost approaches that of the cost of natural gas, falling to as low as 3.77 cents/kWh.

III. Weighing the Policy Options

In considering these various pol-icy options, each must be weighed by regulators and legislators based on both economic and political considerations. But clearly, the most important step that a coali-

that for the loan options, the big-gest benefit will come not from a lower interest rate per se but rather from a reduced DSCR and a longer debt maturity. For example, with the low-interest loan program, lev-elized costs fall only 8.4 percent to 6.24 cents. However, if such a pro-gram also includes a reduced DSCR of 1.25 and an additional three years to debt maturity, we get a 21.1 percent reduction.

rom the table, it should be equally clear that some policy

options have a much smaller impact than other policies. For example, a state sales tax exemp-tion reduces levelized costs by only 4.5 percent, while a local property tax exemption would reduce costs by only 3.7 percent. On the other hand, re-imposition of the federal PTC clearly reduces levelized costs by a massive 24.1 percent, while a similar impact is

Table 3:

Policy Simulations

Simulation AssumptionsCents/kWh

PercentChange

Base case assumptions 6.81 0

Loan options• Low-interest government loans 200-basis-point interest rate reduction only 6.24

2

8.4Plus lower DSCR and longer debt maturity 5.37

2

21.1

• Tax-free bonds Reduced interest rate according to formula 6.03

2


2

24.5

• Government loan guarantees 150-basis-point interest rate deduction 6.43

2


2

18.9

Tax credits and exemptions• State sales tax exemption “Zero out” sales tax 6.50

2

4.5• Local property tax exemption “Zero out” property tax 6.56

2

3.7

Production subsidies• Direct subsidy 1 cent/kWh 5.14

2

24.5• Re-imposition of Federal production tax credit (PTC) 1.5 cents/kWh PTC 5.17

2

24.1

Policy Packages• Loan guarantee, federal PTC, sales tax exemption 4.05

2

40.5

• Low-interest loan, sales/property tax exemptions, federal PTC

3.77

2

44.6

F

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tion of governors from the “windy states” can take is to lobby the fed-eral government for a reinstitution of the PTC. In this regard the U.S. Congress allowed the PTC to expire in July 1999 amid intense partisan bickering over the budget. In December 1999, the PTC was finally reinstituted but only for the relatively short time of 30 months (retroactive to July 1999).

5

Given that the PTC has the single largest effect on the economic cost of wind power of any of the poli-cies examined, it is essential that the governors of those states endowed with abundant wind resources wrk together to lobby both Congress and the Clinton Administration for a longer time frame for the PTC (such as the five

years advocated by the American Wind Energy Association). As part of this lobbying effort, it likewise will be useful for this coalition to send a clear signal to the Clinton administration and FERC that a transmission pricing policy based on energy usage rather than capacity would be a useful step in promoting wind power.

From a state point of view, such lobbying has virtually no political or economic risk. From the federal point of view, such a subsidy does entail some modest costs to the treasury and, as various academics have rightly pointed out, it also skews investment in the industry toward more costly equity financ-ing. Nonetheless, this subsidy has proved to be highly effective.

At the state level, the most attrac-tive policy option from both a polit-ical and economic perspective would be a loan program. This can significantly impact levelized costs at minimum cost to the taxpayers, provided that it is structured in a way to minimize the incidence of default. Accordingly, only well-qualified developers should be allowed to participate.

At the other end of the scale of desirability is investment tax credits (ITCs). Besides entailing a significant cost to the treasury, the bigger problem is the per-verse incentives they create. While ITCs provide strong incen-tives to

build

projects, they offer no incentives to

run

projects well—or at all. In fact, the ITCs of

Both entail moderate to significant costs to the treasury.



39

the 1980s can be rightly blamed for many of the failed wind farms that at one time littered the Cali-fornia landscape and tarnished the industry’s name.

In between these two poles of loans and ITCs, there are sales- and property-tax exemptions to con-sider. Both entail moderate to sig-nificant costs to the treasury. Such exemptions also introduce com-plex political interactions with local government authorities. Accordingly, while such exemp-tions can help the industry, policy-makers must use caution in any proposed implementation.

IV. Demand-Side Policy Options

One of the most direct and effec-tive ways to boost demand for renewable energy would be for both state governments and the federal government to commit to buying a minimum percentage of its electricity needs from

new

renewable sources.

In considering such a “buy green” policy, it may be useful to note that a recent poll conducted by the American Solar Energy Society revealed that fully three-fourths of Americans favor increasing govern-ment purchases of renewable energy such as wind and solar power to help reduce pollution.

6

It is important to emphasize here that unless only new sources are considered in any “buy green” state program, a net increase in renewable energy is unlikely to be achieved. Instead, existing renew-able generators might simply ben-efit from a fiscally undesirable and unnecessary windfall.

A second major policy option involves an expansion of existing green pricing, certification, and marketing programs. At the most general level, green power critics argue that such programs are doomed to chronically underpro-vide renewable energy because of “free rider” problems.

To date, these critics appear to be more right than wrong, as such programs have yielded only modest benefits in promoting

sulfur-dioxide allowance trading program. At the federal level, the Clinton Administration has pro-posed an RPS as part of its compre-hensive electricity restructuring bill. At least six states have already adopted an RPS as part of their restructuring plans, including New Jersey, Maine, Nevada, Mas-sachusetts, Connecticut, and (by regulatory order) Arizona.

Note, however, that of all the pol-icy options to assist renewables, an RPS is the one most likely to face sig-nificant opposition, suggesting that a more effective short-term strategy might be to focus on loan programs on the cost side and “buy green” programs on the demand side.

j

Endnotes:

1.

The treaty specifies that the U.S. must reduce its emissions to 7 percent below 1990 levels within the next decade.

2.

The Production Tax Credit (PTC) was established by the National Energy Act of 1992 as a means to stimulate wind development. It was initially set at 1.5 cents/kWh and indexed to inflation. It allows any wind developer to take this PTC for the first ten years of operation of its plant. This credit has a very signifi-cant impact on the price of wind power.

3.

This analysis was suggested by R. Wiser and E. Kahn,

Alternative Windpower Owner-ship Structures: Financing Terms and Project Costs

(Lawrence Berkeley National Labo-ratory, May 1996). Note that both the nom-inal cost of debt and equity are sensitive to the prevailing rate of inflation and level of interest rates in the economy at a given time. Wiser and Kahn assume higher nom-inal capital costs in their report for both types of projects, but in real terms the two analyses are comparable.

4.

Wiser and Kahn,

supra

note 3.

5.

Clinton Extends Tax Break for Renewable Energies

,

Elec. Daily

, Dec. 1, 1999.

6.

PR Newswire, Nov. 2, 1998. The sur-vey reflects interviews with 1,003 regis-tered voters, Sept. 22–28, 1998; it has a margin of error of

6

3.1%.

increased renewable energy devel-opment. It remains an open ques-tion as to whether such programs can work over the longer term once consumers acclimate to the new electricity market environ-ment. Nonetheless, unless support is continued for green marketing, that open question may never be answered. Accordingly, within prudent fiscal constraints, it may be useful for the “windy states” to support such programs.

As a third demand-side option, a renewables portfolio standard (RPS) has been proposed by the American Wind Energy Associa-tion, modeled after the federal

A second option involves expansion of existing green pricing, certification, and marketing

programs.

promoting wind energy development in an era of restructuring

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