Recent Washington packages include:
- The $780 billion stimulus package offers incentives, with $94.1 billion worth of programs targeting renewable energy over 10 years. They include a 30% manufacturing tax credit for companies building renewable energy production facilities in the U.S., $8 billion in loan guarantees for renewable energy projects, $4.5 billion in grants for smart-grid electric transmission systems and $2 billion for carbon-capture and -storage technology, among others.
AND
A cap-and-trade bill, which mandates that electric utilities to meet 20 percent of their electricity demand through renewable energy sources and energy efficiency by 2020. According to the Congressional Budget Office (CBO), the U.S. cap-and-trade program will cost $22 billion annually, or about $175 per household, by 2020, including:
- Invests $190 billion in new clean energy technologies and energy efficiency, including energy efficiency and renewable energy ($90 billion in new investments by 2025), carbon capture and sequestration ($60 billion), electric and other advanced technology vehicles ($20 billion), and basic scientific research and development ($20 billion).
- Mandates new energy-saving standards for buildings, appliances, and industry.
- Reduces carbon emissions from major U.S. sources by 17 percent by 2020 and over 80 percent by 2050 compared to 2005 levels. Complementary measures in the legislation, such as investments in preventing tropical deforestation, will achieve significant additional reductions in carbon emissions.
Yet the simple fact is that for renewables to survive long term, they must be able to compete with fossil fuels, primarily natural gas and coal economically without government assistance. Estimates of the potential contribution to US energy supply of renewables vary from 10 per cent to 20 per cent in 20 years. These targets remain just that, targets on paper.
It seems like almost every utility and power producer in America is jumping on the renewable energy bandwagon. So what could be wrong with that? Well, one thought is that the current valuations across the entire renewable and green energy sector are not justified by realistic or realizable forecasted cash flows or current enterprise Values measured by hard assets which generate actual electricity or create some other form of tangible value.
This should remind one of the internet boom, in which hundreds of billions of dollars changed hands on the back of a paper napkin essentially, and was the domain for high risk venture capital, distressed investor capital and hot money, which ran the sector from 0 to 100 almost overnight, only to abandon the technology sector as quickly as they entered in what became one of the largest boom and bust cycles the U.S. has ever seen.
Now, the fact is that the venture capital remains substantially underinvested in the Renewable Energy Sector, which is by definition a sector that is designed for their type of capital. It is characterized by high technology and implementation risk, and plagued by substantial government involvement, regulation and environmental constraints, and long term developmental requirements.
Simply put, the renewable and green energy sector has not developed to a point in time where it is appropriate for pension, insurance, endowment, family office or retail investors at any meaningful investment levels at this point in time.
Additionally, a majority of the renewable and green energy projects being developed and contracted or purchased by regulated utilities and other power producers in North America are either in developmental stage or are substantially disadvantaged by lack of transmission or other environmental or permit restraints, thus the net realizable gain in usable renewable generation continues to be negligible.
Does this sound familiar, perhaps similar to the recent "Ethanol boom and bust", or the "Dash to Natural Gas" fired generation in the mid 1990's. Hold that thought, as we will revisit these failures and potential lessons not learned in a moment.
What about t the substantial "hidden pass through" cost of the current Renewable and Green Energy initiative which is fast becoming a liability to regulated utilities, and has not been fully realized by the retail consumer through substantial regulated rate increases, which will be required to the tune of billions of dollars across the U.S..
While some of these regulated rate increases are pending in almost every State in the U.S. and involve almost every major and mid cap regulated utility holding company, the majority of the required pass through remain hidden in what we will refer to as a combination of "Phantom Contracts" and "credible contracts". Others would refer to this simply as window dressing.
What is a Phantom Contract you might ask? Well these are also commonly referred to as "Frame Contracts" in the energy sector, whereby a utility might sign a contract with a Renewable Developer, for say 100 MW of generation to be built and delivered under a long term contract. So what's the problem, after all, the frame contract has all of the bells, whistles, headline numbers and statistics Utilities like to make public, for example: "Utility XYZ Today announced that they have signed a contract with Developer ABC for 100MW of Renewable Generation to be brought on line by some future date".
What is the catch? Well what is not disclosed is that commonly in frame contracts, the developer has not fully permitted the energy projects, or not secured the land, has not purchased turbines, has environmental problems, transmission constraints, financing constraints, or all of these issues and many more. To be clear, there is nothing illegal or nor visible rule violations with such contracts, with the exception that they greatly distort the true generation metrics of the market when they are made public by utilities.
Then there is what we will call "credible contracts" for renewable energy projects being signed by Utilities across the U.S., which have some realistic hope of being built and brought on line to generate actual electricity. The full "pass through" cost of these renewable contracts to the retail consumer has yet to be fully comprehended by the marketplace and regulators and thus the true value of the entire renewable and green energy sector remains unquantifiable and I must thus conclude as previously mentioned that current inflated valuations across the entire renewable and green energy sector are not justified.
The measurement I use is realistic forecasted realizable cash flows or current enterprise values measured by hard assets which generate actual electricity or create some other form of quantifiable tangible value.
To be clear, this has not stopped regulated Utilities from continuing to sign phantom contracts and credible contracts for renewable and green energy generated electricity. Alternatively, it has not stopped the capital markets from financing renewable energy and the various developer and power producers who are sponsoring the projects.
Recent examples of renewable transactions just to name a few include:
Source: The Daily Deal 2009
- FPL Group Inc., the parent company of Florida Power & Light Co., through its unit NextEra Energy Resources LLC, FPL has become the country's top producer of renewable energy from wind, with 65 projects in 16 states with a capacity of nearly 6,400 megawatts of electricity, or enough to power more than 1.5 million homes and businesses. It's also the country's top producer of solar energy, with the largest solar thermal plant in the world in California's Mojave Desert, the 310-megawatt Solar Electric Generating Systems. In February, it broke ground on its DeSoto Next Generation Solar Energy Center, which will bring commercial-scale solar photovoltaic power to Florida for the very first time at the end of this year.
- NRG Energy Inc. said in February it was investing $10 million in closely held eSolar Inc., which designs modular power plants using solar-tower technology. NRG has the rights to build three plants with eSolar technology in the southwestern U.S., including a 240-megawatt development for Edison International's Southern California Edison unit.
- Duke Energy Corp. bought wind project developer Catamount Energy Corp. from Diamond Castle Holdings LLC for $240 million in cash and $80 million in assumed debt - a year after buying Austin, Texas, wind developer Tierra Energy LLC for an undisclosed sum. Catamount generates 300 megawatts of wind and has a pipeline of nearly 2,000 megawatts under development in the U.S. and U.K., including the Sweetwater project in Nolan County, Texas, one of the largest wind projects in the world.
- PacifiCorp, controlled by MidAmerican Energy Holdings Co., a unit of Warren Buffett's Berkshire Hathaway Inc., is also expanding into renewable energy. Last September it began generating electricity from the 100-megawatt Leaning Juniper 1 wind project it bought from PPM Energy in 2006. And in August it acquired the 140-megawatt Marengo wind project under construction near Dayton, Wash., from Renewable Energy Systems Americas Inc., with plans to expand it by more than 70 megawatts.
- AES Corp. participated in a $50 million funding round in Nanosolar Inc., a maker of solar panels for utility-scale plants, along with Carlyle Group, French electric utility Electricite de France SA and Energy Capital Partners. NV Energy Inc., parent of Nevada Power Co., recently signed a joint venture with Solar Millennium LLC to develop solar power plants in southern Nevada.
- Public Service Enterprise Group Inc. in New Jersey has said that it's interested in investing more in the renewable sector, particularly in solar energy, and its CEO Ralph Izzo has gone to Capitol Hill to push for a national renewable portfolio standard.
- Gamesa Corp. Tecnologica SA is auctioning off its portfolio of wind power projects, with Citigroup Inc. advising it. It has three projects with signed interconnection agreements that have completed the permitting process, 11 others in medium to advance d stages of development and 45 in early-stage development.
- Babcock & Brown Ltd. put up for sale its entire six-gigawatt wind development pipeline, hiring Marathon Capital LLC to advise it. The pipeline consists mostly of North American wind projects but includes a few international ones. The auction didn't come soon enough: In mid-March, the group filed for bankruptcy.
- Noble Environmental Power Inc. and First Wind Holdings Inc. also have individual projects up for sale. NRG is shopping its Padoma Wind Power LLC unit in La Jolla, Calif., which it bought in 2006 for an undisclosed sum, and AES might sell some of its wind plants - most of which are in the U.S. but also in China and France - if the price were right.
- Exelon Corp. recently executed power purchase agreements for three wind farms in Pennsylvania and one in West Virginia, Exelon has become the largest provider of wind power east of the Mississippi River. And last October, it bought the rights to purchase 198 megawatts of output from the 396-megawatt Twin Groves Wind Farm near Bloomington, Ill., from Constellation Energy Commodities Group Inc. Horizon Wind Energy LLC, owned by EDP Renovaveis SA, will continue to own and operate the plant.
- American Electric Power Co. has mixed contracts with ownership. It has signed long-term power purchase agreements with wind-power-plant developers, including Majestic Wind Power LLC, a unit of Babcock & Brown, this past January. But it also owns 310 megawatts of wind generation in Texas, including the Trent Mesa Wind Farm, which sells its output to TXU Corp., and the Desert Sky Wind Farm, which sells its output to CPS Energy of San Antonio. Around 3% of its generating capacity comes from renewable sources. Its plan is to add 1,000 megawatts of new wind energy by 2011.
- Entergy Corp., a New Orleans utility and big nuclear power producer, might be another buyer. It has acquired 50% stakes in two 80-megawatt wind farms in Texas and Iowa. But the company may be more interested in developing clean coal technology, having partnered with researchers at the Massachusetts Institute of Technology on several demonstration projects.
Regulatory Morass
The regulatory structure of the electricity industry remains a patchwork among the states. Transmission remains highly regional and fragmented and this has had a tremendously negative impact on the unregulated power generation industry. In an environment where more government regulation is looked upon with favor by Washington, the industry will continue to struggle to find its economic footing and continue to be constrained.
The federal Department of Energy was established in 1977 in response to the failure of supply during the oil embargoes that shocked oil-dependent America during that decade. Created at the same time was the independent Federal Energy Regulatory Commission (FERC) to regulate interstate electric and gas issues. The Public Utility Regulatory Policies Act of 1978 (PURPA) was created soon after. Among other requirements, PURPA required utilities to purchase power from PURPA qualifying facilities and pay the utilities' avoided cost to the qualifying facility.
PURPA was the first step in encouraging the formation of an independent power generation industry and a major step towards deregulation. The anticipated benefits and outcomes over time were modernization of the power generation fleet, higher efficiencies, and smaller power generation units closer to demand centers and potentially lower costs to end use consumers.
The new market entrants required more participation from the capital markets to finance their new projects. In addition, power generation was initially valued differently. Under the traditional regulatory environment, utilities were allowed to earn a return based on the original cost of their investment (regulated rate of return). With the enactment of PURPA, the value of a facility came to be much more closely associated with income generated by the facility, the discounted cash flow value (DCF).
The natural result of these and subsequent regulatory changes was a desegregation of utility asset ownership. Unregulated power generators were typically either associated with utilities or, beginning from the early days of deregulation, with Independent Power Producers (IPP's) or power marketers.
Unregulated power generators, who came to control nearly 25 percent of all power plants in the U.S. by 2002, up from less than 5 percent a decade before, found their plans, strategies, and actions replicated throughout the market as competition became fierce.
Unlike regulated utilities, which were guaranteed a regulated rate of return on their investments, which led to over-engineered plants, over billing to customers, and cost overruns, unregulated power generators and developers initially had more discipline on cost control. The unregulated power generation industry, along a number of parameters, became an example of market capitalism stripped almost to its essence. The power the results and the exacting price associated with market forces were in full swing as the industry moved further into the era of the 1990s.
Prior Self-Inflicted Crisis - The Dash for Natural Gas
Many times during the past 10 years, the US electric and gas industry has achieved the distinction of generating bad news on a daily basis. The highlights, which are not limited to the unregulated energy companies but extend to traditional integrated regulated utilities, include: tremendous plunges in market capitalization (in some cases over 90%), credit downgrades to "junk" status for many firms, multiple bankruptcies and threats of more, federal and state probes of company trading practices, retreats from foreign markets, and billions of dollars in write offs of bad investments.
As the single largest cost of a power plant, every component of the fuel of choice was of great importance. The ability to control or manage the cost of the fuel and the reliability of the fuel supply were key elements of power plant development. Due to several factors, including availability, price, and deliverability, and reliability, natural gas became the prevailing fuel for merchant power plants. Over 90 percent of new plants were fueled by natural gas.
Why did this happen? Who is to blame? As with any crisis, the origins of the past energy credit and investor crisis have deep roots. Some are more important and correctable than others. As Enron was the beacon for all that was going to be good about deregulation-innovation, intense competition, customer choice-so it is a lightening rod for all that went wrong-over promising results, over leveraging and lack of management expertise. At bottom, the energy credit and investor crisis is like the Enron debacle, was a failure of risk management and a lack of credible trained management.
Additionally as we are currently experiencing in the Renewable energy boom, more capital flowed into the energy sector during past crises than there were profitable opportunities. During the peak of the bull market in the late 1990's credit was plentiful. This was especially true for companies in the energy industry who could spin a good story about the economy's continued strong growth, deregulation's likely success in spreading across the country, and the economy's assumed insatiable appetite for electricity, especially natural gas fired electricity at that time.
For many of the new merchant energy companies and developers, the decision to fuel growth through high leverage was easy-the capital was readily available, the power plants developed would generate stable future cash flows thanks to attractive pro-forma project economics, and for energy traders, revenues from long-term deals could be booked immediately using favorable accounting models allowed under the marked to market guidelines (MTM).
With readily available capital, companies went on an unprecedented power plant development binge-over 140,000 MW of capacity (an almost 20% increase) was added in three years, and more followed. This resulted in one of the biggest capacity gluts the U.S. market has ever experienced and is severely depressed wholesale power prices across the country.
Developers, power producers and utilities cancelled and suspended projects in development, under construction and mothballed completed plants en masse. The market quickly became the domain of distressed investors and hedge funds and a few private equity firms willing to brave the carnage over the ownership and financial control for hundreds of distressed power assets.
Lack of Discipline and Expertise
Availability of low cost capital is not in itself sufficient to create a credit crisis or push companies into bankruptcy. A series of bad business decisions is also necessary to get in the position of not making promised payments to lenders and destroying shareholder value.
As it has for other industries, deregulating the US power and gas sector offered the promise of significant value creation opportunities for shareholders and end use customers. The problem was that while management was given greater discretion to take on exponential risk, the boards of these companies were not sufficiently strengthened to guard against greater execution and credit risks.
This was especially the case energy companies moving from the insulated environment of monopoly utility franchises and guaranteed returns to the more competitive and volatile marketplace. Sound familiar.
Past energy crises were driven by a combination of too much available capital, the appearance of boundless investment opportunities, and weak governance systems. Management was further mismatched between their prior regulated expertise and experience and the high risk unregulated market they entered.
Despite clear evidence on the coming glut of power plants (e.g., falling forward prices and the fact that power demand was only growing 2-3 percent per annum), management went on believing it could grow earnings over 20 percent per annum on a sustained basis.
Maintaining this position required a quantum leap, namely that the economy would dramatically increase the need for electricity and much of the older current power plant capacity would become exposed to competition and exit the marketplace-as not much more than a third of the installed generation capacity was outside the regulated rate base at that time.
Management's insistence on heading down the wrong strategic road was driven by a focus on the wrong metrics. Instead of focusing on creating sustainable cash flow, developing tangible net asset value, management focused on how many megawatts of power plant capacity it had developed and how many megawatt hours it had traded, a la the current renewable energy targets of hitting a 20 percent nameplate renewable energy portfolio.
The results were predictable to the experienced risk managers and investors; too many power plants, allegations of phantom contracts and assets and reporting of inaccurate data to regulatory authorities.
The more serious consequences were the severe destruction of shareholder value and industry credibility as well as the disintegration of the natural gas generation development market.
Summary Conclusions
- Government handouts and mandates won't work - never have and never will, in any industry.
- The energy market is currently experiencing an interim period, from which a new energy market enigma has emerged; the renewable energy boom and bust cycle.
- The timing, force, and breadth of this renewable energy boom and bust cycle will be driven by anticipation, greed, and by innovation.
- Companies will reinvent themselves, will exit the business or go under, or will re-form into more capable models.
- Energy supply and demand will not rationalize for many years in the future, and it is likely, for some of the reasons stated, that at that time demand will again significantly overshoot supply.
- There will again be shortages, increased price (and fuel price)volatility, and a marked need for new power generation, primarily natural gas due to its moderate construction time, proven efficiency and security of fuel supply.
- The length of time-between now and when the need will again become evident-corresponds roughly to the design and construction stages of nuclear and large coal fired plants. Those plants, once in place and with their lower generation costs, will be very well placed to participate profitably in the energy markets.
- This is the opportunity before the energy industry today: to face the boom and bust cycle head on, with considered and careful strategic planning, as the industry moves into yet another era.
- Given the poor state of the United States economy, flawed economics of the renewable energy sector, there will be a large heap of distressed energy projects and companies for disciplined investors to pursue, as history has demonstrated.
