REFF Wall Street 2011 Conference was held recently in NY and brought together industry experts to discuss the challenges facing the renewable energy sector.
Conferences attendees were primarily focused on dealing with natural gas pricing impact on the renewable energy sector and the prospects for financing of renewable projects once the 1603 ITC Cash Grant expires this year. The clear message coming from the conference was that the sector needs a level field with the fossil fuel industry to compete effectively.
Oil and Gas investments through MLP offer an important source of development capital for the traditional energy sector. Following the energy crisis of the 1970’s, Congress looked to spur investment in the energy sector for oil and gas exploration and created the MLP structure that provided specific tax advantages to investors. Over the last 30+ years the legislation allowed for growth of publicly traded MLPs for the development of generating more energy resources. The qualifying areas included processing, transporting, storage, and refining.
Fast forward to 2011 and the US is faced with far broader issues relating to global warming and energy security. The price of fossil fuels is now starting to reflect the diminishing supplies and political instability as well as broader growth in the emerging economies.
As we continue to be challenged by current and future energy security, the need for alternative energy sources is at its greatest. The time has come for Congress to level the investment field for energy production and investment by allowing MLPs for renewable energy investments.
Current Policies Need To Be Enhanced
Industry participants expect that the 1603 ITC Cash Grant in lieu of Tax Credit will expire in 2011. The grant program has been a successful policy to spur investments, development and deployment of renewable energy projects. Future fossil fuel prices are expected to increase under various forward scenarios as shown in exhibit 1 from the EIA, US Energy Information Administration report on US Energy Outlook, 2011.
The need for additional capital to flow into renewable energy is compelling. Clearly policy is a key driver for the renewable energy sector as demonstrated by the success of the 1603 program to channel more capital to the sector. Without broad based policy regimes the sector will not attract the capital necessary to bring renewable energy to the tipping point – grid parity and mainstream adoption.
With the expiration of the 1603 Cash Grant set for the end of the year, the sector would have to turn to the tax-equity market for financing of projects. The tax-equity market depends on bank profits and can shut-down when the banks are not profitable. The renewable sector simply can’t rely only on the tax-equity appetite of commercial banks, which number at best to about twenty institutions. Renewable Energy public and private MLPs could be an important source of capital for the sector and an attractive asset class for a range of investors.
MLP Background – Defining Characteristic Of The MLP Model
Exhibit 2 shows the typical structure of an MLP modified to reflect Renewable Energy assets. The existing MLP investments are broken into Upstream (Oil & Gas Exploration), Midstream (Storage, Pipelines) and Downstream (Refining and Transport) assets. The publicly traded MLPs outstanding are close to $100 billion-plus in the infrastructure (Midstream) MLP sector and more than $200 billion in the Midstream sector. Industry participants expect that to increase by another $150 billion over the next few years.
Renewable Energy public and private MLPs would be attractive to all types of investors, as it would allow exposure to sectors that are not available efficiently as a pure-play exposure to clean energy assets. The underlying assets in energy infrastructure MLPs could include solar PV, solar CSP, wind, biomass and waste to fuel, energy storage, CCHP, energy efficiency deals and other emerging energies such as wave and tidal power and fuel cells.
Oil Prices – Exhibit 1:
Structure – Exhibit 2:
MLP have the following characteristics:
• Natural physical assets that are long tenured
• Fixed-Income like distributions
• Taxation is on a pass-through basis
o No corporate or other entity level tax
o Tax items flow through to the LP members, who pay tax at their own rates
• No double taxation
• Entity-level taxes leaves more cash available for distribution
• Public MLP can raise funds from broad class of investors
• Management had greater control than a corporate structure
Changes Needed For the Renewable Energy Sector
MLP structure provides the tax benefit of a limited partnership and at the same time provides liquidity of common stock since the PTP (Publicly Traded Partnership) units’ trade on exchange just like common stock. The tax code requires minimum 90% of the income to come from eligible investments which currently include natural resources, commodities, or real estate. This allows oil and gas production, refining facilities, and pipelines, etc to qualify for MLP. Since these are income producing assets, the resulting high dividend attracts a lot of investors.
Income earned from renewable energy projects, however, is not considered eligible for MLP. This is probably just because of historical reasons more than anything. When this law was passed in 80s, renewable energy sources were not in the same state as today. This historical factor favors the old energy over the newer renewable sources. Congress needs to pass a legislation to change this to level the playing field.
Benefits for the Renewable Energy Sector
Developing MLPs for the Renewable Energy sector could spur greater investment in the sector and provide an additional asset class for investors. Retail investors could participate in the sector with products that have a fixed-income like structure with lower overall volatility and correlation to equity assets in the clean-tech sectors.
Currently tax-equity based structures for renewables are not available to the retail investors. Structured MLPs could provide access to capital that would not be traditionally available for project finance or infrastructure development.
Exhibit 3 shows the investor base in the traditional listed MLPs currently available to investors.
Investor Base – Exhibit 3:
Renewable Energy MLPs – A Potential New Asset Class
Solar and Wind assets are usually structured with long-dated and structured PPA (Power Purchase Agreements) that allow for level distribution of income to the investors. Congress can append the existing code to include Renewable Energy assets as qualifying natural resources activities. Exhibit 4 highlights that traditional MLPs have had low correlation to traditional assets.
Historical Performance – Traditional MLPs – Exhibit 4:
Risks
The major risk for a Renewable Energy MLP would be a decrease in distributions from the production of energy deliverable from a PPA. Performance guarantee structures and insurance could help offset this risk. Equipment risk for invertors and other sub-systems can be offset by pre-funding reserve funds as well long term manufacturing warranties.
Conclusion
The Renewable Energy sector needs continued policy and investor support. MLPs in the traditional energy sector have led to great sourcing of capital for projects and infrastructure development and provided for non-correlated returns for investors. The development of Renewable Energy MLPs will provide investors, institutional and retail, with a unique asset class with exposure to real assets and an opportunity to generate sustainable returns in a liquid asset class. Congress needs to provide a level playing field for all energy investments.
The structural shift in the energy complex is real and permanent – the days of unlimited cheap energy are over. Climate change and energy security are key economic risks and the development of MLPs for the renewable energy sector can help hedge the risks and provide for economic growth.
John Joshi is a Managing Director at CapitalFusion Partners LLC, an advisory firm focused on renewable energy and infrastructure projects. He also runs the Carbon Finance & Securitization group on LinkedIn. Mr. Joshi can be reached at jjoshi@capitalfusionpartners.com
Malay Bansal is a Managing Director at CapitalFusion Partners LLC, where he focuses on financing for clean energy, infrastructure, and commercial real estate. Mr. Bansal can be reached at mbansal@capitalfusionpartners.com
