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XIV. Renewable Energy Finance and Feed-In Tariffs

(originally published March 17, 2008)

In the last couple posts in this series, we’ve established that in industrial economies, price expectations for energy are low for fundamental economic reasons (mechanical work must displace human labor or animal work) but that in the US and Canada, these expectations are further depressed by low population densities, in many locations extreme ambient temperatures and temperature swings, and a preference for “big” vehicles and buildings. All of the latter mean that more mechanical or thermodynamic work needs to be done by energy-consuming machines to reach a desired outcome. As petroleum prices soar, we are starting to feel the pinch of an economy based on exhaustible fossil fuels, priced well below their actual costs for too many years. The direct and indirect subsidies to fossil fuel extraction and overuse were part of the now somewhat outdated Cheap Energy Contract that holds governments and energy regulators responsible for keeping energy prices much cheaper than actual costs, especially if we take into consideration the environmental and climate costs of fossil fuel combustion.

The expectation that energy be cheap and our heavy reliance on these massively subsidized but polluting forms of energy, present special challenges for the building of a new clean energy system. Transforming the energy business involves building large amounts of infrastructure that must be financed either through tax revenues (thereby subsidized by other parts of the economy) or private investment that is paid back through consumer payments for energy or energy-related goods or services. If the prices of the latter must be low, private investment will not be commensurate to the task as investors will have few chances to see their money again with a reasonable return. If additionally there is an anti-tax bias in the country, there will be few funds available from public coffers to finance infrastructure.

The major costs of renewable energy, especially renewable electric generators, are the initial capital costs of the generators, transmission lines, and the clean energy storage devices we will eventually need to balance energy flow on the grid. The fuel is free renewable energy flux but as we have learned, that flux is, in the case of the most plentiful forms (wind and sun) not of such a high power density, so renewable energy technologies must take in a wide cross section of that flux to come close to matching the output of conventional generators using more compact fuels. This means building many capture devices and large storage devices. “Many”, “large”, and “new” mean a greater initial capital investment to match our current power needs, front-loaded costs that must be paid over time.

The critical importance of increased energy efficiency in this equation is reducing at some point in the future the overall societal need for capital investment in future clean generators as well as being able to throttle back now on existing fossil generators and the development of new polluting generators.

Existing Clean Energy Finance Mechanisms

If the Cheap Energy Contract is becoming difficult to sustain for a whole host of reasons, alternative society-wide economic agreements about energy finance are still in flux. There are a number of contenders, none of which have fully established themselves in an era of dwindling fossil resources and increasing carbon constraint. Many are “end runs” around existing social agreements about energy pricing and the building of new infrastructure.

No (Energy) Social Contract, No Subsidies

Some players on the energy market (many of whom believe they represent the lowest cost producers) claim that regulations and government subsidies raise the cost of energy. These energy free marketeers echo sentiments of libertarian (a.k.a. neo-liberal) economists who believe that less regulation automatically leads to markets determining the least expensive price for energy by competition. A totally unregulated market in energy would not price in the cost of pollution including carbon emissions. Some green-inspired market advocates then would allow a cap and trade system to assign a cost to carbon emissions without other new regulation or government subsidy.

Carbon Pricing

After Kyoto, groups of regulators and activists worldwide have been working towards assigning a price to carbon emissions that may have the effect of driving energy markets towards cleaner solutions. Within this general model there are two contending groups: one that believes the carbon price should be set by a cap-and-trade system that determines the carbon price by the balance of supply and demand for pollution permits and the other that believes that a carbon tax or fee set by regulators is more efficient. In either case, the price on carbon will at least start driving energy users towards more efficient use of expensive energy. It is doubtful that at this point in time, regulators will set or engineer the carbon price to be so high as to advantage some of the currently more expensive renewable energy solutions in a purely economic comparison. At very high carbon prices, great economic pain would be inflicted for a number of years as low carbon alternatives to our current energy conversion system would take a while to develop and represent singly and together large capital investments. Those who hope to rely solely on carbon pricing tend to downplay the historical benefits that fossil energy producers and fossil electric generators enjoy representing and benefiting from as they do decades of sunk costs and subsidies that most carbon pricing systems are not designed to account for; therefore they can act as a catalyst but only at very high levels will switching to renewable fuels appear high on the agenda.

Tax Credits

The American renewable energy industry has some large wind, geothermal and solar projects on the ground because of tax breaks that large institutional energy investors have benefited from on and off over the past couple decades. The ITC or Investment Tax Credit allows investors to write off 30% of their investment from their taxes while the PTC or Production Tax Credit provides investors in certain mostly renewable generators a few cents tax credit that adds up to a substantial incentive. The ITC and PTC were cut out of the Energy Bill of 2007 and are now again up for a vote and potential veto by President Bush. As a form of renewable energy finance, the ITC and PTC have been effective for those renewable energy projects that have won power contracts with utilities and can otherwise compete on cost inside US utilities’ generation portfolios. The tax subsidies have worked best as supplements to other forms of subsidy and pro-renewable regulation.

Tax subsidies have proven to be politically vulnerable because they are a form of indirect subsidy that are difficult to understand or empathize with for the average voter. Furthermore the benefit of these subsidies has accrued in the US disproportionately to larger renewable projects. The current funding plan to reinstate the ITC/PTC pits the renewable energy industry and its Congressional supporters directly against fossil fuel companies and their allies that has led to the current political fight over reinstating the tax credits, the outcome of which will be decided soon.

Direct Subsidies

US, Japanese and European governments have long funded research into renewable energy through various national labs and grant programs. In addition, some demonstration or early commercialization stage power plants have received grants as a way to reduce risk and help obtain additional private funding. While the US has not under the current administration directly funded the building of new power plants, the European Commission has issued grants to help build new solar power stations in Spain.

As I noted in my post introducing the Cheap Energy Contract concept, there are green energy supporters who believe that massive pre-commercialization subsidies either from the side of government or grants/investments from private sources will create revolutionary cheap renewable energy technologies. Shellenberger and Nordhaus see government investment in renewable energy research as key to what they have named their book and think tank, a “breakthrough” in clean energy generation costs. Google’s RE<C strategy sees private investment as a partial or complete replacement for government subsidy to the same end.

Both direct and indirect subsidy by government requires at some point tapping into revenue from taxes, either revenue diverted from existing budgetary items or revenue from new taxes.

Rebates

Some financial subsidy to renewable energy takes the form of upfront payments upon the purchase of a renewable generator, mostly small generators for homes or businesses. The California Solar Initiative is the largest example of a rebate program but other US states have had similar rebates. Funds for these payments usually come from the electric rates paid by all ratepayers within a region or they could also be paid through tax dollars. While these programs in combination with tax breaks have been able to stimulate solar development, there are reports that these programs are overly bureaucratic and are not stimulating enough renewable energy development. The advantage of a rebate program for residential customers and small businesses is that it lowers the upfront payment and lessens “sticker shock”.

Renewable Energy Quota Systems

Certain states in the US and various European countries have adopted requirements that utilities generate a certain percentage of the electricity they sell from renewable sources by defined target dates. Renewable Portfolio Standards or RPS laws assess fines to utilities that do not achieve these goals. With the RPS, a utility is supposed to find the “least-cost” renewables though there are some RPS laws that stipulate carve-outs for particular local resources, requiring that a certain percentage of the RPS be wind, solar, etc. By arrangement with regulators, utilities should be able to recover any disparity in cost between the renewable resources and regulated generation rates though this is not necessarily a part of the RPS law’s intention: the notion being that in the requisitioning and bargaining process the cost of the renewable generator will be brought down in price to levels close to the (mostly fossil) market rate. RPS laws are present in some US states, varying from levels such as California’s 33% by 2020 to as low as 5% in some states. Some states are allowed to fulfill their RPS requirements by buying green energy certificates from outside the state.

Without carve-outs for particular resources or technologies, RPS statutes drive utilities to buy energy from the currently most mature, least expensive technologies, usually onshore wind. The quota does not place the positive motivation for achievement within the actors who make the crucial decisions, the utilities, who are put in the position to avoid a penalty rather than gain a reward. Some leaders of utilities with a better regional energy mix, with a keener business sense, or with ethical motivations have taken a somewhat more inspired and creative approach to the RPS mandates than others. As RPS’s are based on achieving a standard level, overcompliance is not necessarily rewarded.

Renewable Energy Certificates/Green Power Marketing

RPS’s and voluntary carbon offset programs are often backed by “green tags” or REC’s (renewable energy certificates). These certificates are a way for investors in renewable energy to make additional money in excess of the wholesale electric rate they earn by selling the green “attribute” of generated power to third parties not involved in the power sales transaction. RPS standards that allow the purchase of RECs are big stimuli to what is called sometimes “Green Power Marketing”, i.e. the selling of RECs. These tradable certificates are the closest thing to a “free” market in renewable energy; notably they are a derivative of the energy itself, traded on an auxiliary market rather than a payment for energy delivered.

Feed-in Tariffs: A New Energy Contract?

With the exception of carbon pricing, in the US system some combination of the above are currently operative, yet there is growing interest in feed-in tariffs, a system that operates on different principles than each of the above. The reason for this interest is that for most concerned policy makers and renewable energy activists who take the threat of global warming seriously, transition to a Renewable Electron Economy is not happening fast enough. Many states are lagging in achieving RPS goals. The general agreement that a move to renewable energy is advisable has not been backed up with policies that enable effective action. Because of rapid rates of installation of renewable generators, people are looking to the example of Germany and Spain, where feed in tariffs have been most successfully established. Germany more than doubled the amount of renewably generated electricity on its grid from 2000 to 2007 (6% to 14%) while Spain has moved up to become the number two producer of wind electricity and is leading the fast growing solar thermal electric industry.

Feed-in tariffs represent a “New Energy Contract” in that they are a social agreement that re-prices energy to allow a transition to a higher proportion of renewables in the electric system. Feed-in tariffs are performance-based incentives that pay premium per kilowatt-hour rates to renewable generators to compensate them for early adoption of new cleaner technologies. Feed-in tariffs in their most successful forms are priced to reflect the cost of generation plus a reasonable profit. The point is to help jump-start the renewable energy industry by rapidly creating economies of scale in the manufacture of technologies like solar panels, wind turbines, solar thermal collectors or geothermal exploration and well-drilling. Furthermore the stable return on investment for generators reduces the finance costs for projects, which ordinarily are very high for new riskier ventures. FITs are a form of open 10 to 20 year power purchase agreement for qualified generators in distinct categories. Grid access and payment are guaranteed for generators that meet whatever the qualifying criteria that are set in the feed in tariff law. The costs of the feed-in tariffs are borne by all ratepayers in proportion to their electricity use and in Germany currently account for 3% of electricity expenditures by consumers. A rate-pooling mechanism across the widest possible rate-base is desirable to spread the costs among the beneficiaries as we all benefit from increased use of renewable generation.

As an example of a FIT menu of tariffs, in Germany the 2009 onshore wind tariff is 8 eurocents/kWh, offshore wind 14 eurocents, large solar PV farm 35 eurocents, small roof-mounted PV 45 eurocents, hydroelectric 4 to 7.5 eurocents depending on size, biomass 8 to 10 eurocents with a 2 eurocent bonus for innovativeness or district heating, geothermal ranging from 7 to 15 eurocents depending on size. Tariffs can vary depending on the strength of the renewable resource as well as on the size of the generator itself. A full menu of feed-in tariffs can extend one or two pages at most, detailing distinct classes of generator by size or location.

One difference between feed-in tariffs and other policy instruments is that feed-in tariffs can operate almost entirely as a standalone policy alternative, depending on a few social institutions for their effective growth. Feed-in tariffs benefit from a financial system that recognizes feed-in tariffs, is prepared to offer low interest loans based on the security of the tariff, and also allows mutual fund-style joint investment in renewable generators, allowing small and large investors to participate. Unlike tax based systems in the US, the funding for feed in tariffs runs largely through the private economy; emphasis is placed on the bankability of a project under the tariff system. Funding for a solar installation on a home or apartment building can become as simple as getting a car loan, while funding a large renewable installation will after financial due diligence enjoy the interest rates usually accorded the lowest risk business loans. Feed-in tariffs are successful because when priced right they are a strong incentive and design the electricity market to prioritize increasing the proportion of renewable generators. They also incentivize the project builders and owners themselves, those who make the decisions to site and buy renewable generation technologies. Yet they also put pressure on plant developers to efficiently design, situate and maintain their generators as payment is contingent upon producing electricity.

Historically feed-in tariffs of any sort were actually first formulated in the United States in 1978 with PURPA which required utilities to buy energy from renewable generators at the “avoided cost” of fossil generators. PURPA was implemented differently state by state and had a mixed history of success in helping the US renewable energy grow. PURPA also was criticized by some as expensive in an era of low natural gas prices as well as lack of acknowledgement of the cost/benefit ratio of renewable generators. In California, the first generations of wind turbines and some early solar installations have their roots in California’s implementation of PURPA.

German legislators from Left and Right in the 1990’s arrived upon feed-in tariffs as a way to promote local and regionally produced green energy and protect it from lowball pricing by the German utility industry. A product of the collaboration between the very conservative CSU and the Greens, the original tariff was a guaranteed per kilowatt hour wholesale price to small hydroelectric plants, wind generators and solar installations. In the year 2000, the pricing formula of cost plus a reasonable profit was instituted in the first German Renewable Energy Law (EEG) to further promote the development of economies of scale in a wider range renewable technologies. The new law introduced the concept of “degression” which means that future manufacturing efficiencies are forced by reductions in the per/kWh cost each successive “class year” of generators. The German law is considered an unqualified success for the German renewable energy industry that now employs approximately 210,000 people in a country of 82 million people. In a country without the traditional large hydroelectric resources of its more mountainous neighbors in the EU, Germany now generates 14% of its electricity from renewable sources with the goal to reach 25-30% by the year 2020.

Some critics of feed-in tariffs claim that they are not competitive or market-based but analysts of these tariffs point out that they are just different market design mechanisms than other renewable promotion mechanisms. Feed-in tariffs shift competition from between merchant generators or project builders to competition within each technology type between technology companies. The lowest cost/highest return technology will get more business as projects built with that technology will be able to make more money.

The nomenclature “feed-in tariffs” is considered to be not very descriptive nor euphonious, so people have suggested a number of alternatives. A leading US feed-in tariff advocate and consultant, Paul Gipe prefers “advanced renewable tariffs” which distinguishes older “feed-in” arrangements to the grid from the second generation of tariffs. U.S. Representative Jay Inslee has called them “Clean Energy Buy Back” in his recently introduced national legislation.

Spanish Innovations

Both Germany and Spain have had a great deal of success with feed in tariffs but actually implement them differently. Germany have fixed tariffs that are determined using the formula average project cost plus reasonable profit and a fixed reduction of the tariffs for each generation of generators to pressure the industry to become more efficient. The Spanish have added to this a market option that can allow generators to make more or less money than a fixed tariff depending on the momentary demand for electricity and therefore its market price.

In many countries now with partially or completely deregulated electricity systems, wholesale electricity generation prices are determined either in anticipation of or by the minute-by-minute balance of supply and demand. There are also markets for additional services that help stabilize the grid. In Spain renewable generators are being encouraged to participate in these markets by being able to opt into these markets while still enjoying some bonus for their clean, renewable attributes.

In the Spanish system then, every year generators can choose whether they want to be compensated with a constant, German style tariff or operate by what they call the premium tariff system. In the premium tariff system, a generator can be compensated either a little less than or somewhat more than the fixed tariff for their technology depending on the market price of electricity at the time of generation. In the case of concentrating solar power or solar thermal electric, in Spain a generator can chose to be compensated at a fixed rate of 27 eurocents per kWh or be compensated somewhere at a rate between 25 and 31 eurocents depending on the market price of electricity at the time of generation. The latter scheme is more remunerative for a solar technology and may also incentivize the use of thermal energy storage to take advantage of late afternoon and evening peak demand. Most generators in Spain opt for the market option as it generally pays off. The Spanish system also allows the tariffs in existing agreements to be adjusted by as much as 2% a year to reflect inflation or changes in cost. Furthermore, in Spain, generators over a certain size are required to forecast their output to grid operators or be penalized.

The Spanish premium tariff system is then designed through successive generations of installations to gradually bring renewable generators into a wholesale electricity market where time of use and other services to the grid and electricity consumers will become the basis for payments in the future once cost parity between conventional and renewable generators has been reached.

Pre-conditions for a Successful Feed in Tariff System

If feed-in tariffs are the most successful system for accelerating renewable energy deployment, what conditions need to be present for these policy instruments to actually work?

1. Social acceptance and enthusiasm needs to be widespread for transitioning from fossil to renewable sources of energy, allowing marginal increases in electricity cost in exchange for cleaner energy. Some social and political patience will be essential in meeting inevitable challenges and adjustments required to work out the nuances of any new program.

2. The tariffs should be set at a price that compensates plant builders for their costs plus a reasonable profit

3. The tariffs need to be guaranteed for a period of time (10 to 20 year contracts) that assures return on investment and the law itself should be in effect for as much as a decade or longer to create a more stable investment climate for renewables. If some technologies no longer require this protection they can be phased out of the coverage of the tariff sooner than other technologies.

4. A tariff law that encompasses a wide variety of technologies helps balance the strengths and weaknesses of each generating technology. Including residential, community and wholesale generation technologies will help push renewable energy development on all fronts.

5. Tariffs should “degress”, go down in price, with each successive class-year of generators to encourage early action and increases in industry efficiency. A feed-in tariff system will become obsolete when costs are brought down and prices for fossil fueled generation inevitably rise.

6. A pooling mechanism for sharing costs of the tariffs should be instituted and spread across as wide rate base as possible. Within that rate base, costs need to be shared equitably.

7. Resolving physical or social barriers to energy development such as transmission or assessment of environmental impacts should be standardized, transparently negotiated with all stakeholders, and compressed in time given the urgency of increasing the proportion of renewably generated electricity in the generation mix.

8. Energy investment should be open to and remunerative for all types of investor through both cooperative and large corporate investment vehicles. In deregulated markets, barriers to utilities investing in generation directly need to be amended to allow utilities to profit from feed-in tariffs alongside other investors.

9. A financial system that recognizes the value of the tariff’s purchase agreement and loans money accordingly is key; sometimes public lending institutions can pioneer lending for early projects to demonstrate the viability of the system to private-sector banks.

If the above conditions are present or can be created, success with a feed-in tariff system is highly probable. If the groundswell in the US continues apace we may very well see successful feed-in laws on a local or national level within the next few years.

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