by Roger Feldman -- Bingham, Dana L.L.P.
U.S. energy availability and price issues are back in the news. The environmental costs of alternative energy policies and alternative means to deal with them have returned to focus. Innovative approaches to renewable energy incentives could and should be a by-product.
As recently reported by the Energy Information Authority ("EIA"), despite increased exports in 2002, the U.S. is still the largest importer of petroleum products because it is the largest consumer. The U.S. has the most emissions of carbon dioxide from fossil fuel in the world – nearly twice that of the second largest emitter. Petroleum consumption is the primary source of carbon dioxide emissions, followed closely by coal; the U.S. is the largest producer of carbon dioxide from petroleum consumption. And what is slated to help pay for Iraqi reconstruction and possibly U.S. war costs? Increased petroleum production and, presumably, U.S. as well as global use.
The U.S. has developed the world’s most effective model for pollution control methodology through its cap-and-trade program relative to sulfur dioxide (SO2) and nitrogen oxide (Nox) emissions. It is expected that by 2010, businesses will meet the Clean Air Act’s reduced emissions targets. While the Federal government has rejected this approach in the CO2 context, favoring some form of voluntary program to achieve national goals, the EU is moving ahead in this area.
The U.S. led the world in geothermal, solar, wind, wood and waste electric power generation in 2001, while proposed selected tax credits are up for reauthorization – and there clearly has been a surge in wind project development – these are certainly not times when increased tax incentives or other subsidies for renewables are to be expected on an ongoing basis. A modest return to mandatory standards and limited production incentives are in the offing.
Consequently, response to excess oil dependence and concern with excess CO2 emissions by stimulating renewables development, using the emerging successful environmental market techniques, would be a development of historic proportions.
How realistic is that? Two questions require evaluation. How well is the U.S. experiment on market trading of conventional pollutants working? Do any other experiments in the U.S. or overseas point the way to innovative means of stimulating renewables?
For these limited purposes, it is sufficient to note that while great progress has been made in trading programs to date, the Bush Administration’s efforts to push trading solutions – arguably at the expense of improved environmental standards – coupled with defects in existing program implementation, has led to lawsuits crippling several key state programs. There has been pushback by environmentalists on the entire concept, as exemplified by the following reported comment:
"The Bush Administration is trying to move away from command and control, but [trading] is fraught with miscalculations… Banking and trading is a nice long shot, but a scheme based on market forces takes so much oversight that it is almost impossible to predict success."
This should not be understood as the last word on this subject from the green community. Nor has it prevented further progress in improved trading regimes in Texas as well as other states, particularly where local use of the offsets is anticipated.
Evaluation of the application of "green commodity" experiments must begin with a recognition of their relationship to the project finance characteristics of renewable energy projects. Put briefly, these are that technological uncertainties, vulnerability to market trends, variable character of resources, constraints on ability to use conventional risk mitigation tools arising out of project size represent barriers to project development. Consequently, returns on equity in special purpose entities, cash flow firmness to secure project debt, and availability of credit enhancement to close the project credit gap all are impaired. Historically, mandatory purchase price offtakes, production incentives, subsidies and tax credits, and accelerated depreciation have been the primary responses. They can only be sustained as long as governmental funds hold out.
With the technological improvement of renewable energy sources – wind being a primary example – and the possibility of additional credit support through payment for the emissions reduction credits resulting from their use or resource portfolio standard power purchase requirements, which they help to meet, the opportunities for overcoming these constraints has become clearer.
In the conventional SO2 control market, pollution control firms already have been able to create a basis for equity return by accepting, as compensation, payment for "overscrubbing" by accepting the rights to sell reductions in emissions in excess of project requirements into the existing emissions trading markets.
In the global environment, there has been an effort to create markets for certified emission reductions for greenhouse gases (both in domestic and certified emerging markets arising under the terms of the Kyoto Protocol. The Prototype Carbon Fund of the World Bank is a closed-end fund for purchase of "high quality" carbon credits, measured in terms of its multiple defined baselines and under standardized contract documents. Its pricing methodology still involves a case-by-case evaluation of the credits (which may include social and environmental benefits). It is the foundation for market creation.
Implementing the impending obligations of the Netherlands government to acquire Kyoto emissions reductions, the International Finance Corporation ("IFC") has been engaged to serve as its purchasing agent, to screen, validate and contractually acquire emissions reduction credits. Like traditional PPAs, payment for carbon credits is on delivery. Conventional lenders are still concerned about the efficacy of the marketplace. IFC is exploring whether, as the market matures, the ERC market may be compatible with its traditional guarantee mechanisms. As of now, its purchases are a project revenue enhancement, rather than a "greenstream." This can change as private financial institution comfort with the market changes.
In the renewable portfolio standards markets – where "Renewable Energy Credits" (RECs) for use of green power have become, in certain European countries and a large number of U.S. states, a legally-defined commodity – programs to create "greenstreams" are being initiated by affording green developers markets or floor price guarantees for their RECs, as well as fostering private competitive auction markets for RECs.
These are milestones for referral to facilitate additional structured finance of renewable energy projects. The principles are clear. Use of potential financial mechanisms depend on the strength of markets, trading protocols, and the strengths of counterparties engaged in markets, because they have confidence in their robustness and transparency. Government or multilateral programs to facilitate the transition to such markets is essential.
Depending on which private mechanisms emerge from the profile of that market, conventional transactions may come to include:
• Tranched debt – some portions of which are backed in whole or in part by greenstream credit;
• Greenstream-funded or credit-backed debt reserves;
• Additional greenstream-backed credit enhancement by third party guarantors, equity risk assumption or development of derivatives.
Consequently, new market-based programs may represent more sustainable options for a larger number of projects developed on a structured finance basis, than do implicit subsidies through a finite number of dollars of available tax credits.
The current global energy-environment situation can be read as a clear indication of the need for enhanced development of renewable energy. Lessons as to how to do so can be learned from the greenstream" developments arising from market-based environmental and energy credit-based trading of the past decade. Public policy and project finance can be linked through carefully crafted programs leading to the creation of sustainable markets.
ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years. In particular, he has analyzed and executed a wide variety and substantial value of project financings. He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration. He is a graduate of Brown University, Yale Law School and Harvard Business School.