Inevitably, forward outlooks for renewable energy have been based on the question: How will the industry compete in an era of tax-credit uncertainty? For an industry focused on long-lived assets plagued by short-term tax policies, this has been a sensible question to ask. The uncertainty resulting from tax policy remains today.
While not diminishing these concerns, however, this article is centered on a different question: How do renewable projects compete, long term, in an era of low power prices and reduced demand for electricity?
If we accept the premise that tax credits will not be available as a long-term incentive and that a material decline in the price of equipment is unlikely, the future growth of the industry will require a new catalyst. It is our view that the key to growth in the industry is to unlock a cheaper source of capital. This new capital will come from the public equity markets, which are materially cheaper than today's alternatives.
Crunching the numbers
Before looking too far ahead into the future, it is helpful to step back and take a broader look at the U.S. electric power industry. As a whole, the U.S. power market has not experienced meaningful growth in recent years. From 2008 to 2011, the power market has experienced a 1% compounded annual increase in installed capacity. Electricity sales statistics have been flat over the same period, which suggests that declining reserve margins will not result in a construction boom, although declining reserve margins may spur construction in certain regions of the country.
By contrast, wind installations have increased by 21%, and solar installations have increased by 73% over the same time frame. This is despite the fact that the levelized cost of energy (inclusive of tax benefits) for renewable technologies is dramatically above that of conventional combined- cycle natural gas plants. In July 2012, the U.S. Energy Information Administration estimated the levelized cost of a conventional combined cycle at $66.10/MWh, wind at $96.00/MWh and solar photovoltaics at $152.70/MWh.
The current state of power markets is not any more encouraging. In 2012, average wholesale prices at PJM West were $40.18/MWh, a decrease of 22% from 2011. The situation in other pricing hubs in the country was not much better:
– MISO Illinois: $32.06/MWh – down 17%
– ERCOT Houston: $35.91/MWh – down 43%
– Palo Verde: $30.03/MWh – down 18%
This decline in prices is highly correlated to declining natural gas prices, due to the shale gas phenomenon. In 2011, the average Henry Hub was $4.02/MMBtu, while in 2012, it was $2.75/ MMBtu, a decline of 31.5%.
These statistics raise an obvious question: What has been driving the development of renewable generation? There have been two primary drivers. The first are state renewable portfolio standards (RPS). According to SNL Financial, the average 2012 RPS target of the 31 states with RPS was 7.6%. As of November 2012, these RPS targets had been met, with 8.0% of eligible generation being renewable. In contrast to the broader market fundamentals, these standards should continue to be a driver of growth, as the 2015 average target is 10.6% and the 2020 average target is 16.4%.
The second driver is the success of the U.S. Department of the Treasury's cash-grant program, which as of Dec. 5, 2012, had disbursed approximately $16 billion in proceeds. It will be interesting to see whether the traditional tax equity market can absorb the expected increase in demand this year, as this program is not available to projects that entered commercial operations after Dec. 31, 2012.
Taking these issues as a whole, the question remains: In an era of marginal increases in required capacity, with the price of wholesale power across the country declining, when tax equity is increasingly constrained, how can the renewable energy industry sustain its growth?
We believe the key lies in unlocking a cheaper source of equity. Fortunately, there is a large source of capital that is currently untapped. For more than a decade, the public equity markets have been a tremendous source of capital for master limited partnerships (MLPs) and real estate investment trusts (REITs). MLPs and REITs are established, tax-advantaged holding companies for long-lived, capital-intensive, hard assets. These assets typically generate significant cashflow from long-term revenue contracts. MLPs and REITs pay the majority of this cashflow out to investors as dividends.
Investors have flocked to MLPs and REITs in recent years for two key reasons: dividend sustainability and dividend growth. Since 2008, MLP and REIT stocks have dramatically outperformed the broader market. Compared to other yield investments, MLPs and REITs are generally simple to understand, making dividend sustainability and growth easier to predict. Investors place serious value on these characteristics. Based on current market yields, public equity investors value these assets at 7% to 8% distributable cashflow yield, which is the equivalent of a levered equity discount rate.
Renewable power assets are not only similar to the long-lived, capital-intensive assets owned by MLPs and REITs; they are, in many ways, higher quality. The majority of commercial real estate assets typically have leases of 10 years or less with non-investment-grade tenants. Commercial real estate also tends to be moderately to highly cyclical in nature, adding risk to long-term dividend sustainability.
Renewable assets, by contrast, are non-cyclical and typically have revenue contracts of 15 to 20 years with investment-grade counterparties. If investors value MLP and REIT assets at 7% to 8% distributable cashflow yield, there is good reason to believe they will value renewable assets at similar, if not lower, yields. As the low- to mid-teen returns required by most renewable developers are becoming increasingly unattainable at today's power prices (even with outstanding RPS in many states), the public markets represent a game-changing opportunity to drive industry growth.
Year of the YieldCo
Due to current Internal Revenue Service rules, renewable assets are not eligible for the tax-advantaged status enjoyed by MLPs and REITs. The intent of this outlook is not to make a case for renewable energy assets to be REIT or MLP eligible. While this could provide for a potential long-term solution, the legislative path to achieve that status is, at best, uncertain. Regardless of future legislative changes, we believe a vehicle for accessing this low-cost equity capital exists today. Our company calls this vehicle a ‘YieldCo.’
A YieldCo is simply a C corporation that acts as a holding company for renewable assets. Due to the myriad of tax benefits available to renewable energy assets – such as bonus or MACRS depreciation, investment tax credits, and production tax credits – the YieldCo vehicle can carry forward net operating losses and shield taxes for extended periods of time. As additional assets are developed and/or acquired, the tax shield period is extended even further.
We believe that 2013 will be the year of the YieldCo. Based on the fundamentals outlined above, it is difficult to make the case that the status quo will be sufficient to maintain the renewable industry's outperformance in the power sector. While RPS will provide some growth prospects, power market fundamentals are not conducive to robust growth unless the cost of capital decreases. By allowing renewable energy projects to access mid- to high-single-digit costs of capital, YieldCos can enable the renewable energy industry to sustain the momentum it has been building.
Andrew Redinger is managing director and group head and Daniel Brown is vice president of KeyBanc Capital Markets' utility, power and renewable energy group. Redinger can be reached at email@example.com, and Brown can be reached at firstname.lastname@example.org.
The authors wish to add the following note: KeyBanc Capital Markets is a trade name under which corporate and investment banking products and services of KeyCorp and its subsidiaries, KeyBanc Capital Markets Inc., Member NYSE/FINRA/SIPC and KeyBank National Association (KeyBank N.A.), are marketed. Securities products and services are offered by KeyBanc Capital Markets Inc. and its licensed securities representatives, who may also be employees of KeyBank N.A. Banking products and services are offered by KeyBank N.A.