Surcharge-Funded Renewable Energy Policies
6.4 Creating a Long-Term, Predictable Revenue Stream
As discussed in Chapter 5, project financing for RETs has traditionally required a full set of long-term power sales commitments that largely guarantee a revenue stream. At the very least, contracts have typically contained a fixed floor payment corresponding to the debt repayment period (EPRI, 1990). Given project financing, the creation of a long-term, predictable revenue stream is an essential component of a surcharge-funded policy that provides cash production incentives or long-term contracts. To meet this objective, three elements are essential: (1) a long-term payment period; (2) a funding mechanism that is secure; and (3) a contract that does not contain significant “out” clauses.
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LESSON: A long-term and predictable payment stream is essential for the development of RETs that use project financing. Legislatures and regulators should ensure, to the extent possible, that policies that promise long-term production incentives or above-market contract payments to RETs will continue to be funded throughout the payment period and that “out” clauses are minimized.
6.4.1 Long-Term Payment Period
In Section 4.5, we emphasized the need for a long-term payment period, especially for capital-intensive RETs, because the availability of lower-cost, non-recourse debt hinges on the existence of a stable revenue stream. Because of the short contract periods in the U.K.’s NFFO1 and NFFO2, financing costs increased dramatically resulting in high price premiums (Mitchell, 1995a). Contract periods of at least 10 years will allow a reasonable debt amortization period and provide equity investors a fixed revenue stream that can reduce risk premiums.
6.4.2 Secure Funding Mechanism
Even more critical than a long payment period is the security of the funding mechanism.
This issue is of fundamental importance for a range of policies designed to encourage renewables development, not just surcharge-based mechanisms. As noted in Chapter 4, the REPI provides an example of a poorly designed policy because funding security has not been forthcoming. Without some
assurance that funds will be available to make future incentive or contract payments, the policy support cannot be used as security for debt repayment.
In Section 4.4, we identified several ways to increase funding security for legislatively-directed renewables policies. Applied specifically to surcharge-funded programs, these strategies suggest several possibilities.
To the extent that surcharge funds are not treated formally as taxes and are not
routed through the legislature, surcharge-based programs may be somewhat immune to yearly funding changes. In these cases, legislatures need not appropriate the funds on a yearly basis and can create a renewables program with multi-year funding (through the surcharge) and spending authority. In contrast, where surcharge funds are treated directly as taxes, they must be appropriated yearly by a legislative body. In this case, stability may be best achieved through the creation of a standing or open appropriation, and/or through the creation of a “pool of capital” that is large enough to be pledged for current year and future payments (e.g., a trust fund).
Regardless of whether surcharges are treated formally as taxes, they will be perceived as an additional tax on electric service. Surcharge-funded renewables programs may therefore be particularly vulnerable to funding changes. Consequently, legislative
For example, in Michigan a 34-MW wood-waste-fired project, developed by Decker Energy International,
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was initially delayed because of a regulatory out clause in the contract that would have allowed Consumers Power to lower the power purchase rate if cost recovery was disallowed (NREL, 1994). In the U.K.’ s NFFO, uncertainty in the long-term funding prospects for the above-market renewables contracts led to the insertion of two “out” clauses in the Regional Electric Companies’ contracts with renewable generators.
To reduce “double-dipping,” some RETs are not allowed to take advantage of both grant programs an d
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federal and/or state tax credits, therefore reducing the effectiveness of capital support policies. For a thorough discussion of the “offset” issue, see Wiser (1996). In Chapter 9, an abbreviated description of this issue is provided.
language that demonstrates a strong commitment to continued surcharge funding is essential.
6.4.3 Contract Sanctity and “Out” Clauses
The sanctity of power sales contracts has become a key issue recently as utilities have attempted to withdraw from their PURPA obligations. As described by Michael Reddy of Toronto Dominion Bank, “If there is one issue, one hot button, in the industry right now that impedes potential development whether it’s renewables or otherwise, it is the assault on the sanctity of the contract. These non-recourse project financings rely on the predictability of cash flow and if you remove that predictability, you cast a significant cloud over it” (Brown and Yuen, 1994). Policies that force or encourage contract “out”
clauses can significantly impair the ability of developers to obtain project financing (Hamrin and Rader, 1993). For example, if the de-funding risk of a surcharge-based program is high, contract “out” clauses might be encouraged. In the future, financiers are likely to be very reticent of investments in projects whose revenues are uncertain because of “out” clauses. 40
6.5 Grants
In most circumstances, renewables policies should be designed so that subsidy levels are tied to project performance, not capital investment. However, if the conditions necessary for creating a long-term, predictable revenue stream cannot be met, policymakers may want to consider distributing surcharge funds as cash grants rather than production incentives or above-market contracts. Grants could be provided up-front or could be spread over several years contingent upon reaching performance or design objectives. A grant does not entail a long-term policy commitment to any individual project, however, therefore reducing one of the key risks of production incentives and above-market contract payment policies. 41
For small customer-sited projects (rooftop PV, for example), this form of capital support may be particularly useful because of the high initial costs of these facilities and the
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LESSON: If significant uncertainty exists on the duration and magnitude of the surcharge collection, or if legislative or regulatory action could eliminate funding at any time, long-term production incentives and above-market contract payments may not be viable. Grants, with appropriate project performance requirements, might be considered in these situations.
difficulties in obtaining financing. Moreover, because these facilities are often used to supply on-site electric use, production incentive policies may be more complex (due to metering requirements) than capital support. Up-front grants may also be especially helpful to projects that use new technologies and/or have particularly high performance risks. Capital support can partially insulate investors from these performance risks because, unlike production incentives, the subsidy level is not directly tied to uncertain electricity production forecasts.
Previous attempts to promote renewables via incentives tied to capital investment rather than production have not all been successful in encouraging project performance. For example, the investment tax credits and accelerated depreciation of the early to mid-1980s caused a California wind rush that resulted in large wind capacity additions, but provided wind power owners limited incentives for project performance (Cox et al., 1991). Lenders typically like to see project structures in which all
participants stand to benefit if the project does well, and would therefore generally prefer a subsidy tied to performance over one tied to capital investment. Consequently, up-front cash grants may need to be designed to give project developers incentives to install RETs capable of operating with reasonable performance. For example, funding could be contingent on state or federally imposed performance or operations requirements.