The risk in a full throttle clean energy race

The drive to get much needed renewable energy technology to market may be seeing some funding needlessly wasted. It could be time for equity to play a stronger role in the funding mix.

National governments increasingly see themselves locked in a ‘race’ to support the development and deployment of clean energy technology to cut emissions and capture a competitive advantage by offering a range of financial incentives to support the commercialisation of innovative technologies.

"When it comes to the clean energy race, America faces a simple choice: compete or accept defeat," US Energy Secretary Steven Chu told Congress in November 2011. "In the coming decades, the clean energy sector is expected to grow by hundreds of billions of dollars. We are in a fierce global race to capture this market."

Raising the specter of falling behind, Chu warned: "In the past year and a half, the China Development Bank has offered more than $34 billion in credit lines to China's solar companies. China is not alone: to strengthen their countries' competitiveness, governments around the world are providing strong support to their clean energy industries" (statement to the House Energy and Commerce Committee, November 17, 2011).

The executive director of the Energy Department's Loan Programs Office (LPO) had earlier told the Senate what was at stake. "Clean energy has an important role to play in America's future. The extent to which we can successfully deploy new, innovative clean technologies will have enormous implications for our future global competitiveness, energy security, economic recovery, and environment" (Report on the Clean Energy Financing Act, Senate Report 112-47, August 30, 2011).

The race analogy is not restricted to the United States. In the United Kingdom, SmartGridGB, a lobbying organization of energy suppliers, technology companies, consumer organizations and grid operators, launched a report Tuesday asking "Smart Grid: a race worth winning?" and came to a clear conclusion the answer is Yes.

"Smart grid development will deliver more secure, sustainable and affordable generations of British consumers; and the development of smart grid globally represents a major growth opportunity for Britain," according to the report written by consultants Ernst and Young (smartgridgb.org/news/35.html).

But in rushing to win, the clean technology community and policymakers are leaving taxpayers with some very unattractive investment options.

Crossing the valley

Competitive pressure to develop and deploy clean technology, build a clean energy manufacturing base, and even start exporting clean tech products and expertise to the rest of the world, has led governments to offer an unusual range of non-market measures to support clean tech companies and projects.

Financial support ranges from guaranteed prices and rates of return (using feed-in-tariffs) to the provision of loan guarantees for early-stage technologies to help them reach commercial scale and subsidies through tax breaks and outright grants.

Advocates point to the various forms of support fossil fuels have received in the past, including technology programs and subsidies that supported the commercialization of the fracking technology which is not revolutionizing North America's gas and oil production.

Particularly for early stage technologies, there may be a "valley of death" obstructing the transition from the laboratory and pilot stage to full-scale commercial deployment of even promising new technologies.

"The primary impediment to commercial deployment of earlier-stage energy technologies is the difficulty in obtaining financing, which results from the high capital cost of commercial-scale energy projects and technological and commercial risk inherent in new technologies," according to the Senate Energy Committee.

"Tens or hundreds of millions of dollars are required to build even moderate-sized electricity generation or to achieve economies of scale in manufacturing products like solar voltaics or advanced batteries. These sums are unavailable from even the more risk-tolerant investors, leaving borrowing as the only option," the committee reported. Yet financing on this scale is typically unavailable to borrowers.

Citing Bloomberg New Energy Finance, the committee wrote "venture capital firms or corporate research and development departments will back initial research through pilot-scale installations" but "rarely have the financial resources to deploy a 20 MW solar thermal electric generation demonstration project".

Infant industries and risk

In the context of developing countries or industrial policy, the commercialisation valley of death would be called the "infant industry" argument and should put both governments and taxpayers on their guard.

The standard criticism is that governments are poor at picking winners, and it can be difficult to wean industries off early-stage support and force them to grow up and become competitive. Attempts to scale back support via reductions in feed-in-tariffs in the United Kingdom, Germany and Spain have already provoked howls of outrage.

But the bigger concern centers around risk-sharing and the distribution of downside risks (losses) and upside risks (profits) between commercial investors and the taxpayer.

Support is usually structured as debt (cheap loans and loan guarantees) or subsidies (direct cash grants and tax breaks) rather than equity (shares, options or venture capital funding).

Structuring support in this way makes sense for clean tech companies and investors since it avoids diluting their share of potential returns. But it makes no sense for taxpayers. In too many instances, taxpayers shoulder losses but fail to reap gains from investing alongside the industry.

Estimating the credit subsidy cost

In 2005, the US Congress passed the Energy Policy Act Section 1703 established the Innovative Technology Loan Guarantee Program to guarantee commercial lending for projects that "avoid, reduce or sequester" emissions of greenhouse gases and "employ new or significantly improved technologies."

But the program required "a reasonable prospect of repayment" and insisted no guarantees could be extended unless the borrower "paid in full" for the cost of providing the obligation, or the credit subsidy cost (CSC) (expectation of loss and benefit of cheaper borrowing using the full faith and credit of the United States) was covered by budgetary appropriations approved by Congress.

In practice, Congress declined to provide appropriations, and the program operated on a "self-pay" basis. Between 2005 and 2009, the Energy Department did not issue a single loan or loan guarantee. Clean energy companies considered the self-pay credit subsidy cost requirement prohibitive, according to the Department.

The 2009 American Recovery and Reinvestment Act expanded the program by creating temporary new authority under Section 1705, lasting until September 2011. Section 1705 broadened the type of projects which could receive guarantees. But crucially, Congress appropriated billions of dollars to cover credit subsidy costs.

The Loan Programs Office has now issued final or conditional guarantees covering over $10 billion worth of (nuclear) projects under Section 1703, around $16 billion of projects under Section 1705, and $8 billion of direct loans under a separate program to support advanced technology vehicles.

"Congress appropriated nearly $10 billion to cover potential losses in our total loan portfolio," Chu told the House Energy Committee, "thereby acknowledging and ensuring that the inherent risks of funding new and innovative technologies were recognized and accounted for in the budget."

In practice, the amount of recognized credit support subsidy is smaller. Of $6 billion appropriated for Section 1705 under the stimulus act, only $2.435 billion remained after recissions and transfers, according to the Congressional Research Service ("Loan Guarantees for Clean Energy Technologies: Goals, Concerns and Policy Options" January 2012).

However they are calculated, these modest appropriations are backing loans worth $35 billion. It is an open question whether Congress has fully budgeted for likely losses and the amount of subsidy conferred.

It is clear guarantees are not being offered on an actuarially fair basis (when they were offered on a self-pay basis under Section 1703 there were no takers). The Department is not really making loans, with an expectation of being repaid in full, but injecting equity, with an expectation of losses on at least some projects.

To protect taxpayer interests, in future the government should take equity or equity-linked positions alongside private investors, so winning projects help pay for losses on the rest.

It would not be popular with the clean finance community. But there is no reason why taxpayers should not seek a proper return on their investment to reflect the risks they are taking.

This article was originally published by Reuters. Republished with permission.

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