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Capitalism Administers a Harsh Lesson: How to Finance Green Projects

 

My wife and I attended a party Saturday night in Washington, DC. So, we used some credit card points to stay at a plush hotel near the White House. Over a leisurely breakfast, I read the weekend edition of The Financial Times – yes, I am that much of a geek. An article on the PG&E financial crisis and possible implications for financing “green” energy projects caught my attention. It suggests possible lessons, not just for California, but all states that wish to promote renewable power.

The premise of the article is that leveraged long-term green power contracts signed with investment grade utilities became very popular for investment by pension funds starved for yield. Since regulators in many states would approve these things that did not have to compete in a market, the price became somewhat immaterial. This lack of competition allowed for these projects to deliver what often seemed “absurdly high” rate of return targets which made them magnets for those offering finance.

As I said in my last blog post, I am not a climate denier. I believe that carbon reduction is important across the economy, including the power sector. However, I have long been troubled by the “command and control” (Soviet) approach to green energy procurement. While most Americans want more renewable energy to help address climate change, economically efficient procurement decisions are key.

Fundamentally, efficient procurement decisions hinge on establishing the cost of emissions, and then requiring the producer to pay to offset the cost of any emissions they do not mitigate. The cost of emissions can be assessed as an outright tax or by trading credits for emissions up to an agreed-upon cap. In this latter approach, those who do not emit have credits to trade to those that do – a stream of revenue for the clean producer and a stream of costs to the emitting producer. This serves as an economic incentive for the emitting producer to reduce costs by investing in cleaner production.

As I noted in my last blog, there was broad consensus in the US political sphere prior to the 2008 financial crisis about the favorability of a national cap-and-trade program for the power industry. The concept had worked wonderfully in reducing acid rain in the 1990s but there were technological solutions (“scrubbing”) that could be attached to a plant to deal with NOx and SO2. The technological solutions to cutting carbon from thermal generation are – to this point – quite expensive (see Southern Company’s travails with the Kemper IGCC plant in Mississippi). This makes carbon cap-and-trade a bit harder.

When the consensus on developing a cap-and-trade program to deal with carbon broke down after the financial crisis – and whatever else poisoned our collective political environment – states began a “feel good” frenzy of renewable portfolio standards for their regulated utilities. The motivations behind the standards were doubtless varied, but for most regulators and legislators this must have seemed an expedient way of driving renewable procurement without the messiness of explicit cost increases to customers. This “command” from the gods of state policies (images of Mount Olympus come to mind) came even in areas where a cap-and-trade policy was being implemented, such as in California and in the states in the Northeast (see https://www.rggi.org/).

Why take this duplicative approach? Well, it may have “felt good” and besides cap-and-trade market mechanisms require tinkering to make sure the cap is low enough to cause the proper economic response without causing too much disruption. This can be a very transparent process that can be politically uncomfortable. Practically speaking, the media and most voters have an easier time understanding and accepting a simple “order” to procure clean energy.

So now we are back to the article sited at the top of this blog. The ordering of green projects through regulated utilities which then either build or contract for them is dependent on financial viability of the utility. This means that if anything threatens that economic viability – like a large liability – then the regulator or state must step in to keep the utility whole to creditors.

What happens if regulators or the state government refuse to make the contracting utility whole? This increases the risks that the green projects would hold in a bankruptcy proceeding as “out of market” in terms of costs and open to being eliminated in a workout. If this happens, the costs for financing the next round of renewable resources then goes up because the perception that the utility contract is ironclad is in doubt. If that perception is allowed, then capital can go elsewhere or be attracted back to the utility contracts by higher returns on the capital. Higher returns on the capital mean higher costs to customers.

Let’s be clear: Any attempt to achieve meaningful reductions of carbon in the power sector will cost money. That is why I wish my friends in the environmental community would stop with the Messianic messaging on carbon reduction which seeks to vilify and enrage skeptics (did I mention our poisoned political environment?) but rather embrace carbon reduction as a “risk management” tool. “Risk management” is a market term that implies hedging or things that might involve a “cost”, but that help insure against the possibility of a worse outcome. Thus, we have insurance or agree to participate in a market that has costs for collateral, etc. to provide collective security against a bad event like a big default.

Those who say an efficient way to manage climate risk is infeasible and expensive need to pay attention to the hidden costs and problems associated with the way we are pursuing our environmental goals now. Capitalism has administered a stern lesson on the “feel good” approach. Time to try something different.

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