Despite the election of President Obama potentially heralding a new era in alternative energy investment in the US, a worsening financial crisis and falling oil prices mean that project finance bankers are taking a more cautious approach when selecting deals, writes Theodore Kim.
Green energy had been a buzz phrase throughout the final weeks of last year’s US presidential campaign. Both Senator Obama and his Republican rival Senator McCain eagerly promoted their determination to lead the US economy towards energy independence. This was largely due to a massive government campaign of tax incentives and government investment to fund development of alternative energy generation.
Yet, the risk aversion from the ongoing credit crunch, a steep drop in world energy prices, and a shake out in the nascent US alternative energy industry, with many once-promising start-ups and IPOs now trading at or near penny stock levels, have put an entire new spin on just how brave – or foolish – the enthusiasm for alternative energy investments really is. The long-term outlook for alternative energy will heavily depend on the usual factors that drive the banking sector – namely lending rates, the credit curve, default levels and operating cashflow. For the short term, investors are looking at far more mundane issues, such as the price at the gasoline pump and an unfreezing of the financing deal flow pipeline.
With gasoline prices hitting US$4 per gallon, a record high in the US, the voting public was crying out for relief. Both Obama and McCain promised ambitious plans to combat global warming and achieve energy independence.
Specifically, Senator Obama’s official campaign platform and oft-repeated pledge was to invest “US$15bn a year in renewable sources of energy. To create 5 million new green jobs … put 2 million more Americans to work rebuilding roads and bridges, setting up a new electricity grid so renewable energy can get to people. If America can spend US$10bn a month rebuilding Iraq, we can spend some money rebuilding America.”
Even McCain went out of his way to run television footage of himself standing alongside wind turbines and promising to make the US a ”leader in a new international green economy”. Nonetheless, political analysts pointed out that McCain’s steadfast support for the oil and gas industry probably cost him votes in crucial battleground states such as Ohio, Florida and Missouri, where few consumers are big fans of ExxonMobil’s record breaking profits, or of the US$200mn-plus package given to its retiring CEO during the presidential campaign.
Crashing crude and credit crunch
Much of that politicking was during a period when world oil prices hovered around US$150 per barrel with widespread predictions of a march to US$200. Interest and enthusiasm towards all things green peaked before Lehman Brothers collapsed. After that, the crunch truly took hold, bringing the energy deal pipeline to a complete halt.
Most shares of the few alternative energy companies traded have fallen to levels below their IPO pricings. This is partly due to the fact that as oil and natural gas prices fall, there is a substitution away from demand for alternatives. Additionally, with bankers increasingly reluctant to take on riskier lending projects, there has been widespread concern that much-needed investment capital for big renewable energy projects will likely become even more difficult to secure.
Initial and secondary stock offerings by clean energy companies have slowed to a crawl. For all of 2008, new equity investment for alternative energy-related deals amounted to less than half of the record US$25.4bn raised for 2007. Worldwide project financings for new construction of wind, solar, biofuels and other alternative energy projects fell to US$17.8bn in the third quarter of 2008, from US$23.2bn in the second quarter, according to New Energy Finance, a London-based research firm.
“Alternative energy investors are in shock,” says John White, executive director of the Centre for Energy Efficiency and Renewable Technology, a California advocacy group. ”Renewable energy projects and new technologies are now at risk because of their capital intensity.”
Several US wind energy companies have been forced to delay new projects because of trouble raising capital. Additionally, a number of ethanol projects have been delayed for lack of financing in Iowa and Oklahoma, and one plant operator in Ohio filed for bankruptcy protection in December. Tesla Motors, a high-profile maker of battery-powered sports cars with near Formula One racing performance, recently announced it had to delay production of its electric Model S sedan, close two offices and lay off workers.
Despite political sentiment to march ahead in developing alternative energy, public funding alone will not change the basic economics of energy production and the tight credit environment. The central questions facing renewables are: how long will credit be tight and how low will oil and natural gas prices fall?
Global energy prices are a crucial factor in determining the viability of alternative energy investment.
For example, bankers estimate that most utilities and other builders can profitably choose big wind projects over natural gas-fired plants only when gas prices are US$8 per thousand cubic feet or higher.
During 2008, spot gas prices at one point hit a record US$13 per thousand cubic feet, but since then have dropped to around US$5.6.
”Starting from the US$6 level and below, natural gas-fired electricity production makes wind power look like a questionable idea and solar power unfathomably expensive,” says Kevin Book at FBR Capital Markets.
Government mandates already in effect as legislation at a federal level last year, including state rules requiring renewable power generation and federal requirements for production of ethanol, will help ensure alternative energy markets continue to exist no matter how low oil and gas prices fall.
The agriculture lobby in Washington will fight to ensure that the US ethanol industry remains alive and kicking – if not highly profitable.
Nonetheless, the credit crunch and the reluctance of banks to extend too far out on the risk curve, means that companies that would like to build alternative energy production facilities will face severe financing challenges.
”Simply put, if you can’t borrow money on reasonable terms, you can’t develop renewable alternative energy projects,” adds FBR’s Book.
Adding to the shaky outlook for raising cost-effective investment financing is the small but growing threat of global protectionism in the face of a steadily worsening recession.
Alternative energy is a truly global business with many key industry players based in markets such as Europe, where several German firms are highly active in wind generation, as well as in Brazil, a global leader in ethanol production, marketing and distribution.
“Global protectionism is now a very real concern. There are always enormous pressures in a recessionary downturn to take steps to protect domestic producers and put up obstacles to free trade and investment. But, if all governments take protectionist policies, then there will be real tension,” explains Brad Setser, a fellow in geo-economics at the New York-based Council on Foreign Relations. “Moreover, if one government is doing a stimulus programme and then recipient companies take that stimulus to invest abroad, there might be some tricky political and economic issues – particularly as some of the benefits of a stimulus intended for the original country leak out to the rest of the world.”
The US Treasury: world’s largest institutional investor
Despite concerns about alternative energy deals, few bankers are willing to discount just how powerful an ally the government can be in restarting the investment pipeline. Obama’s goals include a specifically earmarked US$150bn fund for clean energy projects. This money will most likely be raised from increased taxes, such as a windfalls profit charge on the oil industry. The new administration is also likely to support congressional efforts to impose new regulations on energy production and energy markets. During one of many post-election news conferences, Obama clearly indicated that implementing a rigorous alternative energy policy would be his second objective after addressing the top priority of the financial crisis.
Among other targets mentioned, Obama called for an 80% reduction in carbon emissions by 2050 and wants to auction off 100% of emission allowances to raise money for clean energy projects and improved alternative energy technology.
Another example of the new administration’s steadfast march into alternatives is the creation of a new White House post, director of energy and climate policy. This position will be held by Carol Browner, the former director of the US environmental protection agency under President Clinton and former secretary of environmental regulation in her home state of Florida.
Quiet revolution in politics and prices
Key to the new Obama administration is that there has been a sea change in corporate, consumer and government thinking about alternative energy. “The stereotype had been that the corporate community opposes policies that would cap greenhouse gas emissions and move towards alternatives. That doesn’t exist anymore,” says Susan Glickman, the southern region director for the Climate Group, which works with Fortune 500 companies to build an economic case for taking action against greenhouse gases and developing green energy.
Political activity by alternative energy firms is already well underway. Solar and wind companies have forged powerful lobbies in states with strong renewable energy investment potential, like Texas, New Jersey and Colorado. Banks such as JP Morgan and Citigroup have established the first “carbon principles”, a new methodology to measure risks that companies face from climate change and climate legislation.
Instead of debating whether government should regulate greenhouse gases, debate now centres on how deep the cuts should be – not only in reducing permitted carbon emissions but also in eliminating subsidies and tax breaks for oil producers as well as increased investment and regulation in favour of alternative energy production.
“All of us who watched this election believe that we will have federal renewable energy legislation,” observes Stephen Smith, executive director of the Southern Alliance for Clean Energy, a Tennessee-based non-profit research institution. “I believe it will be one of the first things that will move in Congress and be part of a larger energy and economic stimulus package as it will promote green industry and green jobs.”
“Getting certainty in policy and certainty in carbon costs is a real positive for everybody,” adds David Parker, a utility analyst with Robert W Baird & Co, a Wisconsin-based asset management firm with a focus on small and mid-cap companies.
High tech leads to low costs
Apart from politics, increasing efficient technology and economies of scale have reduced production costs for many types of alternative energy to levels that are highly competitive with traditional energy sources – even at today’s depressed prices for coal and oil. According to The Smart Cube, a Chicago-based independent investment research firm, solar energy has fallen from a relatively expensive production cost of 9 cents per kilowatt-hour (kWh) for high wind speed sites in the early 1990s to a level today of around 3 cents.
For low wind speed sites, the fall in production costs over the same period was from 14 cents to 5 cents per kWh.
Electricity production using biomass fuels, a raw material that was hardly in commercial use a decade ago, has fallen to around 5 cents per kWh and is continuing to depreciate.
By comparison, the costs of tradition coal and oil-fired electricity production are around 4 cents/kWh.
Similarly, the cost of power from extracting landfill gas, a wholly non-existent energy source in the past, is now about 5 cents/kWh, depending on the size of landfill, financing available, and distance from the grid.
According to the US Department of Energy-funded National Renewable Energy Laboratory (NREL), the cost of energy from a 2MW landfill gas facility was estimated to be 6.4 cents/kWh in 2004 and, through increasingly widespread use and improved efficiency, will likely dip to around 3.7 cents/kWh by 2017.
The Smart Cube has also found that economics for geothermal energy production is structured in a way that the project pays back its entire capital costs in the first 15–20 years, during which time it delivers power at a highly competitive rate of 5 to 7 cents per kWh. After this initial payback period, costs fall by around 50% to well under 4 cents per kWh to merely cover operations and maintenance for the remaining 10–20 years that the facility can operate.
By comparison, the first commercial geothermal plants built in the 1980s racked up production costs as high as 16 cents per kWh.
“Looking at comparative world energy prices, notably crude oil and natural gas, and benchmarking those prices against alternative energy production is essential to determining the long term economics of any large-scale alternative energy investment project,” explains Omer Abdullah, managing director at The Smart Cube. “We can estimate to a fair degree of reliability what the unit production costs will be for alternative energy sources going out five years, 10 years or more, and see most all alternatives slowly dropping in unit costs. By contrast, estimating oil and gas price five years or 10 years out – or even five months from now – is far less reliable. This all adds to estimated volatility and risk.”
Much of the unit costs of alternative energy production are highly dependent of capital raising expenses and ongoing capex. While the massively larger oil and gas industry has enjoyed decades of tax breaks, subsidies and a highly developed and refined investment generation process on Wall Street, London, Frankfurt, Hong Kong and beyond, the relatively tiny alternative energy industry, by comparison, is just getting started.
As the US government increases the system of tax credits and green-friendly legislation and, at the same time, scales back its generosity towards big oil, the cost of alternative energy production should fall.
Furthermore, as investors become more and more comfortable with the economic viability of alternative energy financing deals, capital costs should fall.
No doubt, all of these green ideas for an Obama-lead Marshall Plan to build a national alternative energy infrastructure may seem highly revolutionary at best.
For many skeptics, alternative energy, even under a green-friendly White House, recalls the dot com internet and telecom hysteria that bankrupted less than a decade ago when then vice-president, Al Gore, called for a national campaign to develop the “information superhighway”. Nonetheless, there is nothing like massive government intervention to get investors to stand up, take notice and act – particularly in the area of tax credits and the creation of tax equity, which has been a key driver to financing a bulk of the existing US alternative energy infrastructure already in place.