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The Importance of Long-Term Contracting for Facilitating Renewable Energy Project Development

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The Importance of Long-Term Contracting for Facilitating Renewable Energy Project Development The importance of long-term contracting for facilitating renewable energy project development May 7, 2013 Dr. Jurgen Weiss Dr. Mark Sarro Copyright © 2013 The Brattle Group, Inc. This report was prepared for Ridgeline Energy LLC, a wholly owned indirect subsidiary of Atlantic Power Corporation. The authors are Principals of The Brattle Group. All results and any errors are the responsibility of the authors and do not represent the opinion of The Brattle Group. ACKNOWLEDGEMENTS We acknowledge the valuable contributions of many individuals to this report and to the underlying analysis, including members of The Brattle Group for peer review. www.brattle.com TABLE OF CONTENTS I. Executive Summary ........................................................................................................... 1 II. Public Policy is Key to Renewable Energy Investment ..................................................... 5 A. New York has a Renewable Energy Commitment ..................................................... 5 B. But the Wholesale Energy Market is Separate ........................................................... 7 III. Advantages of Long-Term Contracts for Renewables ....................................................... 8 A. Less Development Risk and Revenue Uncertainty ..................................................... 8 B. Lower Project Cost of Capital .................................................................................. 11 C. More Renewable Projects Get Built ......................................................................... 18 D. Lower Cost to Ratepayers of Meeting the RPS ........................................................ 21 IV. Evidence of the Impact of Long-Term Contracts on Renewable Energy Development .................................................................................................................... 23 A. California .................................................................................................................. 24 B. Massachusetts ........................................................................................................... 26 V. Benefits to New York of Long-Term Contracts for Full Renewable Output .................. 28 VI. Conclusions ...................................................................................................................... 33 i www.brattle.com I. EXECUTIVE SUMMARY Ridgeline Energy LLC (“Ridgeline”), a wholly owned indirect subsidiary of Atlantic Power Corporation, asked The Brattle Group to consider the extent to which long-term contracting can help facilitate the financing and construction of renewable energy projects. In particular, Brattle was asked to examine the potential effect of long-term contracting on the development of renewable energy generation facilities in the State of New York. The evidence shows that for the past several years the vast majority of power plants have been built either by vertically integrated utilities or with the support of long-term contracts. This is even more the case for renewable energy projects. At first glance, this observation may seem at odds with the underlying reasons for creating competitive markets for electric power, capacity and renewable attributes over the past two decades. A closer look, however, reveals that there are important theoretical and practical reasons long-term contracts and utility ownership have been the dominant approaches to support the development of renewable energy projects. One of the primary reasons is the well-understood concept that projects with large sunk and irreversible initial investments are subject to the “hold-up” problem in the absence of liquid spot and secondary markets.1 Large infrastructure projects such as those for renewable energy usually involve correspondingly large upfront investments. Once the investment is made, the cost of providing services from the infrastructure typically is relatively modest. Power generation is a classic example of such projects. If a power plant had just a single potential user, this user would have an incentive to offer to pay only the marginal cost of producing the power (or a tiny bit more) rather than to also paying for initial capital outlays once the plant is built. This is because once the investment is made, the cost of the investment is sunk and cannot be recovered (for example by “un-building” the plant and selling the material), and the owner of the plant will be willing to accept any price that at least covers the plant’s variable cost. When there are liquid spot and forward markets, a potential investor can ensure that enough revenues will be collected to pay for the initial investment by entering into forward contracts. In the absence of sufficiently liquid forward markets, such as in New York for energy and renewable energy certificates (“RECs”), however, potential investors will be reluctant to invest in such projects, primarily because of the risks associated with hold-up. This problem is particularly relevant for projects with long lives such as renewable energy projects. 1 Since most of the financial and economic details related to renewable energy projects are confidential, it is difficult to assess the extent to which there is evidence of the actual impact of this hold-up problem, apart from the prediction that it will lower the number of projects that can be financed/built. However, Invenergy’s 10-year REC contract with NYSERDA for High Sheldon Wind Farm is indicative. Given that the REC contract was signed more than a year after the project’s commercial operating date, Invenergy likely would have been willing to accept a relatively low price for RECs, since the revenues were no longer needed to get the project built and any revenue would be incremental. Likewise, NYSERDA had an incentive to offer a low price. For more details, see http://www.prnewswire.com/news-releases/invenergy-and-nyserda-enter-into- renewable-energy-credit-purchase-agreement-113344714.html. 1 www.brattle.com Energy markets are subject to substantial regulation. For example, regulators have shown a tendency to impose price caps once wholesale markets rise to levels deemed unacceptably high. The market for renewable power is even more regulated, often still relying on regulatory requirements. For instance, without mechanisms like Renewable Portfolio Standards (“RPS”), the environmental attributes of renewable power would have little market value (beyond anyone willing to pay a voluntary premium for such power). Since the forward market for RECs post- 2015 is illiquid, the risk of regulatory hold-up, i.e. of changes in regulation that effectively reduce the value of renewable attributes after projects have been built, is substantial. Experience has shown that forward markets for energy, capacity and RECs, where they exist at all, are liquid often only for relatively short periods of time. There is some evidence that this problem has become worse after the financial crisis of 2008 and the structural reforms and restrictions on commodity trading by the Dodd-Frank Act.2 Consequently, potential funders of renewable projects usually cannot ensure recovery of their fixed and sunk investment cost through contracting in secondary forward markets for energy, capacity and RECs. In the absence of such hedging possibilities, it is likely that renewable energy projects simply will not be financed without a long-term revenue guarantee.3 This explains the predominant use of long-term contracts in the restructured U.S. power markets, coupled with direct ownership by regulated vertically-integrated utilities where direct utility ownership is still permitted. Even if it is theoretically possible to enter long-term contracts for energy, capacity and RECs separately, as is potentially the case in New York, the interaction between the separate pricing of the various products, including the potentially differing length of contracts, makes the financing of renewable projects difficult. This is because a project developer will need to contract in a way such that the sum of the separate revenue streams from energy, capacity and RECs is sufficient to recover the initial fixed outlay. Until renewable technologies become competitive with existing fossil technologies without consideration of renewable attributes, signing long-term contracts for energy and capacity alone will not provide sufficient revenues.4 Hence, a renewable project developer could only sign such contracts once a long-term contract for RECs has been obtained and thus the REC revenue stream is known. However, the contract price a project developer would be willing to accept for RECs, in turn, depends on the incremental revenue stream needed to generate sufficient overall revenues to recover the initial investment, an amount that is known only after contracting for energy and 2 While the Act clearly affects traditional hedging activities of the electric power industry, its ultimate long- term effect is unclear. For a discussion, see Grant Thornton, “Financial reform: How the Dodd-Frank Act affects the energy industry.” There is some evidence that markets may be providing some longer-term hedges. However, there is ongoing uncertainty about their treatment under the Act, and whether or not the market for such hedges is liquid and its tenor is sufficient to provide enough mark risk mitigation to have a material impact on financing costs. 3 The absence of a liquid forward market is particularly problematic for RECs, the prices of which are characterized by boom-bust
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