by Andrew Schifrin and Larry Eisenstat, Dickstein Shapiro LLP
While renewable power generation has been the belle of the ball in federal and state energy policy, many renewable projects have stalled because of their inability to secure financing.
Assuming a renewable project’s technology is proven, whether its economics will support standalone project financing depends on one thing: predictable, long-term cash flows. The surest, most well-developed vehicle for establishing project cash flows is the long-term power purchase agreement (PPA). Encouraging prospective purchasers to offer renewable projects long-term PPAs with robust pricing would be the most direct way of attracting capital—debt and equity—needed to finance renewable generation.
Energy policymakers have been sidetracked by indirect means of cash flow enhancement, such as tax credits, depreciation and loan guarantees. These subsidies, however, do not compensate for the lack of a PPA. There have been only one or two utility-scale renewable generation facilities built in recent years that operate entirely on a merchant basis, i.e., that do not have a long-term PPA, even though such projects would have been eligible for substantial tax incentives. Conversely, virtually every utility-scale renewable project that entered into commercial operation during this same time has had a long-term PPA.
For decades, long-term PPAs have been a key component of power project development. As industry participants know, the Public Utility Regulatory Policies Act (PURPA) led to the development of hundreds of power projects. The primary reason for PURPA’s success in getting power plants built can be attributed to long-term PPAs with robust pricing, which many states required utilities to offer to qualifying facilities.
Why do long-term PPAs work? The answer is cash flow, a reliable and predictable revenue stream that can be financed. Lenders and investors can get comfortable with technology risk associated with renewable generation when a track record demonstrates the technology works. Lenders and investors can get comfortable with construction risk if a developer uses a proven turnkey engineering, procurement and construction (EPC) contractor. And lenders and investors can get comfortable with operational risk by considering resource adequacy studies and knowing that a qualified operator has been retained. Lenders and investors, however, cannot get comfortable with electric commodity price risk and do not want to commit the significant money required to finance a power plant without certainty concerning a project’s future revenue stream.
A long-term PPA from a creditworthy counterparty can eliminate commodity price risk and provide comfort that a project will have sufficient revenues for debt service, capital improvements and variable operations and maintenance expenses.
There are ways to encourage utilities and others to offer long-term PPAs. The PURPA-style approach of a state mandate requiring utilities to offer long-term PPAs would be effective.
As we saw with PURPA, however, this approach can lead to an acrimonious and confrontational relationship among contracting parties.
A better approach would incentivize utilities to enter into long-term PPAs at prices generally reflective of the then-current costs of the renewable project’s construction and future production, inclusive of a reasonable return on equity. By far the best way would be to assure utilities that should they enter into such agreements, they would be able to rate base all of their PPA-related costs (including pass-through of purchased power costs) and earn a return on those costs exactly as if they were capital expenditures.
Moreover, utilities’ shareholders and ratepayers should benefit from rate base treatment because it should improve credit ratings, and that would lower utilities’ cost of capital. Another approach would be to give purchasers (utilities and other large end users) under long-term PPAs a renewable purchaser’s tax credit, called an RPTC. Such an approach would be more efficient than the current PTC because it would provide tax credits to entities that could use them.
As we have witnessed from the government’s cash-for-clunkers program, direct payment incentives work. To accelerate renewable power development, policymakers should focus on incentives that would lead to market-priced, long-term PPAs and would allow renewable projects to secure financing.
Andrew Schifrin is a partner in Dickstein Shapiro LLP’s Energy Practice. Reach him at 212-277-6534 or [email protected]
Larry Eisenstat is the head of Dickstein Shapiro’s Energy Practice. E-mail him at [email protected] or call 202-420-2224.