Financing investments in renewable energy : the impacts of policy design

Abstract

The costs of electric power projects utilizing renewable energy technologies (RETs) are highly sensitive to financing terms. Consequently, as the electricity industry is restructured and new renewables policies are created, it is important for policymakers to consider the impacts of renewables policy design on RET financing. This paper reviews the power plant financing process for renewable energy projects, estimates the impact of financing terms on levelized energy costs, and provides insights to policymakers on the important nexus between renewables policy design and financing. We review five case studies of renewable energy policies, and find that one of the key reasons that RET policies are not more effective is that project development and financing processes are frequently ignored or misunderstood when designing and implementing renewable energy policies. The case studies specifically show that policies that do not provide long-term stability or that have negative secondary impacts on investment decisions will increase financing costs, sometimes dramatically reducing the effectiveness of the program. Within U.S. electricity restructuring proceedings, new renewable energy policies are being created, and restructuring itself is changing the way RETs are financed. As these new policies are created and implemented, it is essential that policymakers acknowledge the financing difficulties faced by renewables developers and pay special attention to the impacts of renewables policy design on financing. As shown in this paper, a renewables policy that is carefully designed can reduce renewable energy costs dramatically by providing revenue certainty that will, in turn, reduce financing risk premiums.

Introduction

As part of the international trend toward electricity industry restructuring, a number of countries and several U.S. states are establishing new forms of public policy support for renewable energy. Depending on their design, policies to encourage the development and use of renewables, such as solar, wind, biomass, and geothermal, can have positive or negative impacts on project financing costs. This paper reviews the financing process for renewable energy projects and identifies important relationships between policy design and finance. We emphasize five policy case studies, each of which provides critical lessons for the design of future renewable energy support programs. The paper combines qualitative assessments of the interactions between policy design and power plant financing with quantitative analysis of some of these interactions.

Although the cost of renewable energy has fallen dramatically over the past 20 years and some renewable energy projects are now economic on a private-cost basis, renewables are frequently more costly than other forms of electricity generation [1]. Renewables provide social benefits that are not fully internalized in investment decisions, however, including pollution reduction and the mitigation of electricity price variability 2, 3. To overcome this market failure and reduce institutional barriers, policies have been enacted in the U.S. and abroad to encourage renewable energy technology and project development. These policies have included tax incentives, cash payments, renewables set-asides, standardized power sales contracts, and low-interest loans.

Yet past experience with these and other renewable energy commercialization policies has been mixed, and renewables still make up only a small fraction of worldwide electricity production. Ideally, policy design should link incentive mechanisms to policy goals, subject to technical, market, and financial constraints. This criterion is not always met, however, and political considerations and⧹or lack of information often impact policy development, frequently resulting in mismatches between a policys incentive mechanism and technical, market, or financial constraints [4].Because of this dynamic, a number of renewables policies have not been as cost-effective as they could have been if they were designed differently.

Depending on their design, programs to support renewables can have positive or negative impacts on project financing and financing costs. This paper emphasizes power plant financing as an integral consideration in the design of cost-effective renewable energy policies. We argue that one key reason that renewables policies have not been more effective is that project development and financing processes are frequently ignored or misunderstood when designing and implementing support programs. As discussed in Section 2.3, financing is particularly important for renewables developers because their projects are often disadvantaged in the financing process relative to other sources of electricity generation 5, 6, 7.

By increasing project risks and decreasing the availability of long-term power sales contracts, electric industry restructuring may further handicap renewables in the financing process. But restructuring has also brought renewed attention to renewable energy policies. Existing forms of public support, many of which have been funded and administered by regulated electric utilities, will not all be appropriate in a restructured electric industry [8]. New approaches for supporting renewables are being sought 9, 10, 11and, given the likelihood that new policies will emerge out of the restructuring process, it is important for policymakers to understand the problems that can arise if policies are not designed with consideration given to financing. Moreover, at a time when the emphasis appears to be on shorter and more market-driven renewable energy policies than those used in the past, reviewing and highlighting the financing implications of policy design is all the more essential. Armed with a better understanding of the relationships between policy design and financing and with concrete lessons from past policies, policymakers should be better prepared to design and implement new renewable energy programs within electricity restructuring efforts.

We begin this paper by providing a background to the financing process for power projects generally, and renewable energy specifically. A cash-flow model is used to briefly illustrate the effects of key financing variables on renewable energy project costs. Next, we review a series of five case studies to demonstrate that many renewables policies have not fulfilled expectations, due, in large part, to their impacts on financing. The case studies highlight important relationships and lessons that must be understood in order to improve and refine prospective renewables policies. The paper concludes by discussing some of the specific ways that restructuring will impact the financing of renewable energy projects, and by briefly reviewing new renewables policies in light of our case study findings.