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United States

Investors still uneasy with credit markets

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Interest is growing in the potential role for sales of renewable energy credits in wind project financing structures, but investors and lenders remain uncomfortable with markets that have yet to be awarded long term security by regulators. That could be changing

Issues of liquidity, lack of uniform standards and long term regulatory uncertainty are still major barriers to the United States market for renewable energy credits (RECs). The RECs market is growing, but it is not sufficiently developed to play a role in project financing structures. While REC sales can provide an additional revenue stream for wind power producers, says Lenny Hochschild of Evolution Markets, they are not yet something developers can take to the bank."

RECs are intended to represent the environmental attributes of renewable energy generation and can be traded separately from the underlying electricity or bundled with it and sold as green power. "Perhaps the single biggest obstacle to being able to finance wind projects with REC sales is basically the disconnect between the time horizons of the developers and those of REC buyers," Hochschild told delegates attending a REC trading workshop at Infocast's recent Wind Power Finance and Investment conference in San Diego. While developers need long term contracts to arrange project financing, most buyers are only willing to go out a couple of years. Nowhere is the problem so obvious than in the New England Power Pool (NEPOOL), particularly the state of Massachusetts, where tight supplies pushed REC prices as high as $51.05/MWh in 2004.

"When you look at the prices you think projects should be going up left, right and centre," says Anna Giovinetto of Evolution Markets. "But they just can't, because developers can't get the long term contracts they need." Buyers in Massachusetts, she explains, determine their need for RECs based on their load obligations, which extend only a year in advance. With prices so high, nobody is ready to enter into multi-year contracts for credits they are not sure they will need.

What Hochschild calls the "great fear of the unknown" is also a factor, not just in NEPOOL but in other US markets too. "Because RECs and renewables portfolio standards and all this stuff is fairly new to all of us, there are certain folks who are basically saying, this is a great idea, but let's wait and see what it all costs," he says.

Uncontrollable risk

Michael Freeman of Exelon Power Team, a wholesale power marketing company, says regulatory uncertainty is a big issue for his company. "The thing we struggle with the most internally is the concept of the RECs as a viable concept over a long period of time," he told conference delegates. "Will the concept of the REC stay intact or will it be obliterated by some regulatory body or bodies at some point during a ten year or 15 year agreement? That's a very difficult, and I would say somewhat uncontrollable, risk to mitigate from an offtaker perspective."

For the same reason, Freeman is not interested in buying RECs without the underlying energy. "Even though that is the way they are sold now, the regulatory risk embedded in that concept of just going along for 20 years buying unbundled RECs scares the hell out of me."

Of the 18 US states, plus the District of Columbia, that have some form of minimum standard for renewable energy supply, "only a handful" are actually trading unbundled RECs to comply with mandates for green credits in the so-called compliance markets, says Hochschild. Others allow for trading but have yet to see it happen. Still others make no provision for tradable RECs at all. Of those that do trade, most have only a limited number of market participants.

Program design can also have an impact on how effectively those markets will operate. Although Maine has a 30% green power requirement, it already gets half of its electricity supply from hydro, which qualifies. With REC prices coming in at about $0.30/MWh, says Giovinetto, the state's renewables portfolio standard, which sets the requirement, is "really just an exercise in pushing paper around."

In California, which has a renewables target of 20% by 2017 (one of the most aggressive in the nation), unbundled wind RECs are currently selling for a mere $1.50/MWh. That is because utilities are required to buy green power, not RECs, to meet the target. "There are many different reasons why," explains Hochschild. "I personally think the biggest reason is because of the California power crisis, regulators didn't quite feel comfortable immediately establishing an unbundled REC trading system." But with a move underway to establish a credit tracking system across the western states, he expects policymakers to get more comfortable with the concept. "We think that at some point, perhaps as early as this year, there may be some legislative action that will allow some form of unbundled REC trading to occur."

Lack of liquidity

The lack of uniformity, regulatory uncertainty and limited market size all contribute to a lack of liquidity in the REC compliance markets in the US. But as markets mature, says Hochschild, that should start to change. He says he fields calls weekly from investment banks, funds and speculators interested in learning more.

"Just like any market -- whether it is Wall Street or a mature commodity market -- has large percentages of speculative capital in there which helps transparency and helps liquidity, obviously if some speculative capital starts coming into the REC market it could increase the size of the market," he says. "I'm not saying it will this year or next year but I think a lot of people are looking at it. It will help price discovery, it will help term, it will help a lot of developers finance their projects."

The use of futures options are not yet widespread in REC markets, although it is something Hochschild expects will grow as buyers and sellers try to get a better sense of the forward curve for REC prices. "It just seems to us that using options, maybe setting a floor for developers who need to go to the bank or setting a ceiling for the buyers, would make economic sense."

Exploring different deal structures many also help provide more certainty for buyers and sellers. Buyers in the high priced Massachusetts market may be ready to take more regulatory risk in exchange for lower REC prices over a longer term. High prices may also allow developers to go forward with projects on a partial merchant basis -- selling the power directly into the market at spot prices rather than under a long term power purchase agreement (PPA).

"From conversations we are having with various folks on the equity and debt side, it appears they are starting to get more comfortable with where REC markets are going and are able to look slightly more towards merchant risk," says Hochschild. "We're not saying they are going to build without any sort of a PPA. All we are suggesting is that perhaps if there is a PPA that is very close to their ratios and they don't have quite that ten year REC sale, but they have a two year REC sale, they are starting to get more comfortable."

Meantime, Hochschild expects more states to develop renewable energy standards -- and more to base their programs on REC trading. Voluntary green electricity markets, where prices are very low compared to compliance markets, will help the evolution. "The voluntary market is nothing that is going to enable wind companies to develop and finance projects. What the voluntary market does, which is a fantastic thing for the industry, is help the public become very aware of renewable energy and helps the public make politicians aware that this is something that is important to communities," he says. "From our perspective, the voluntary market plays a huge role forming community support that ends up resulting in compliance law."

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