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The Future of Tax-Advantaged Energy Production

By Roger Conrad on September 14, 2012

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Exelon Corp (NYSE: EXC) was kicked out of the American Wind Energy Association (AWEA) this week. Despite being one of the country’s biggest wind generators, with 1,003 megawatts (MW) of operating capacity and 696 MW of projects under construction, management committed an unforgivable sin: It made public comments that it does not support an extension of the wind energy production tax credit.

With expiration looming Jan. 1, 2013, the AWEA is fighting tooth and nail to win more time for the credit and continue the sector’s recent building boom. Imminent expiration has in fact made wind a campaign issue in many parts of the country, including key swing states where the sector has become a major employer.

Less publicized are looming expirations of tax credits now providing an advantage to other forms of energy. Some geothermal power credits, for example, will sunset on Jan. 1, 2014. So will credits for biomass, landfill gas and qualified hydropower facilities. Finally, tax credits for solar energy, fuel cells, microturbines and geothermal heat pumps are slated to end on Jan. 1, 2017.

Those are the dates by which new projects must be in service in order to qualify for credits, according to a study released this week by Allison Woodbury Leppert of the law firm Leonard, Street and Deinard. Ms. Leppert also notes some companies will lose their tax advantages as soon as Sept. 30, unless they make proper filings for the 1603 Grant in Lieu of Tax Credit.

How essential are these credits for renewable energy projects and those who develop them? And will ending them choke off America’s renewable energy industry, just as the sunset of similar tax credits did in the 1980s?

Tax credits have clearly spurred activity to date. Since 2006, US energy generation from wind power turbines has quadrupled from less than 30 terawatt hours (TWH) to more than 120 TWH. Output rose 27 percent in 2011, as wind power rose to 61 percent of total US renewable energy output. Wind’s total share of US electricity is still only about 3 percent, according to the US Energy Information Administration (EIA). But that’s more than triple its contribution of less than 1 percent just a few years ago. And wind’s share will rise again in 2012.

The requirements in more than three-dozen states that utilities use renewable energy have driven much of the infrastructure buildout. Such mandates are still quite popular in many states, notably California, which has a requirement that 33 percent of energy be generated via renewable sources by 2020. But as EIA data shows, regulations only provide so much incentive. In fact, plans for new wind power facilities will fall sharply after this year, when credits expire.

Again according to the EIA, roughly half of the 23.5 gigawatts of electric generating capacity slated to come on line in the US this year is some form of renewable energy. The percentage in 2013 is nearly as high, though it’s almost all solar and other non-wind resources. By 2014, however, renewables’ share of projects in the development stage falls to barely 30 percent, and by 2015 it’s scarcely 10 percent. By contrast, nearly 90 percent of the US generating capacity that’s on track to start up by 2015 is from natural gas.

Advantage: Gas (for Now)

At its current spot price of less than $3 per million British Thermal Units, nothing can compete with natural gas for generating electricity. And with more gas from the Marcellus and Utica Shale plays flowing up and down the eastern seaboard in coming years, gas is likely to stay cheap for a while.

That means gas–not wind, coal, nuclear, solar or anything else–will be utilities’ first choice for new generating capacity. Of course, utility executives are well aware that natural gas has historically been a very volatile commodity.

Prices are at rock bottom now because energy producers have cracked the code on shale gas, unlocking vast new reserves that are not currently exportable. Sooner or later, however, power generators, heavy industry and export facilities for liquefied natural gas will soak up the supply glut, and pricing for the fuel will be based on global demand rather than purely on North American demand.

Given that prices in Europe and Asia are several times what they are here, North American gas prices can’t help but rise. That means companies burning gas to generate electricity will see costs rise. And those that put all their eggs in that basket run the risk of winding up like Calpine Corp (NYSE: CPN).

That company was forced to file Chapter 11 bankruptcy in 2005 in the face of soaring gas prices. It’s doing quite well in the current environment. But those who owned the stock pre-bankruptcy were basically wiped out by Calpine’s extreme leverage to gas at the wrong time.

Calpine is an unregulated generator selling its power wholesale at market prices. Virtually all regulated utilities, by contrast, automatically pass through energy costs in rates. Revenue rises when energy prices do, but there’s no impact on earnings, at least so long as regulators allow those prices to pass through.

Soaring rates due to rising energy costs, however, will invariably invite criticism based on hindsight. And as many utilities found out from the retroactive ratemaking of the 1980s and ‘90s, regulators can lay waste to profits and shareholder returns when they’re in a punishing mood.

That’s a big reason today’s utility executives continue to advocate generation diversification. Jim Rogers, CEO of Duke Energy Corp (NYSE: DUK) is no doubt a pariah in some circles after speaking at this month’s Democratic convention in Charlotte, N.C. And he’s probably less than popular in the Carolinas, due to the continuing drama over the ouster of Duke’s presumptive CEO following the merger with the former Progress Energy.

But Rogers definitely speaks for his fellow utility CEOs–as well as most other industry professionals–when he argued for a long-term and non-partisan approach to energy. And most would likely support his contention that investment is needed in “zero emission” power sources like wind and nuclear.

Building nuclear now is hardly a cinch, however. For one thing, based on current natural gas prices, it’s not competitive. Steady operating and fuel costs are the keys to long-term profitability for a nuclear plant. That’s the clear record of the 100-plus nukes that have operated in the US since the 1950s.

It’s an extremely stark contrast with the wide variation in the cost of operating natural gas power plants over that time. When gas plants were built in the 1990s in expectation of stable prices, they actually found themselves unprofitable just a few years later, as gas hit double digits.

Regulators in some states get it. Georgia, for example, remains in strong support of Southern Company’s (NYSE: SO) efforts to build two new nuclear reactors at its Vogtle site. And South Carolina is supportive of a similar effort by SCANA (NYSE: SCG).

These are the first nukes to be built in decades in the US, and they’re also the first using the Toshiba/Westinghouse’s AP1000 design. By agreeing to the project and allowing the utility to recover some costs before startup, Georgia officials are taking a chance that the company can deliver on cost targets.

Thus far, that bet is paying off: Southern announced in late August that costs are still running well below the $6.4 billion it initially approved back in 2009. That’s despite delays in final Nuclear Regulatory Commission approval this year, very likely due to stalling by the commission’s former chairman.

Southern’s still got a ways to go to meet its current target of late 2016 for startup. And how it and SCANA fare with their projects will no doubt be critical for whether any other AP1000 will be built in the US. But for now at least, there’s a commitment to develop a balanced power supply, rather than bet the whole farm on natural gas.

Unfortunately, regulatory support is less certain in other states. In Florida, for example, Duke Energy and NextEra Energy (NYSE: NEE) have proposed new nuclear plants under a rate plan that, like Georgia’s, would allow cost recovery as they’re built. However, opponents of these plants have expressed concern about uncertain costs and are using loaded terms like “scheme,” “fleecing” and “nuclear tax” to describe the plans.

Florida regulators are now considering the proposals. Failure to garner approval may not permanently doom these projects. But it’s hard to imagine they’ll proceed without rate recovery. And the alternative is moving toward increased dependence on natural gas in the Sunshine State.

Florida’s gas demand can certainly be sated by the construction of massive new pipelines into the state, which will benefit energy midstream companies like Energy Transfer Partners (NYSE: ETP). On the other hand, the state can look back to its experience with its earlier dependence on cheap oil for power generation, which made it difficult to endure the subsequent rise in fossil fuel prices. Decisions made based on the short term can do great damage later, though the people who were responsible for making those decisions are usually long gone by then.

Beyond Tax Credits

But my purpose here isn’t to muster policy arguments over whether it makes sense for the US government to maintain tax advantages for some forms of energy. Rather, I’m interested in whether the tax credits for renewable energy will be extended, and what the impact will be if they’re not.

Obviously, the answer to the first question will depend on who wins the White House this November. As soon as votes are in, Congress and whoever is president will have to hammer out a budget that makes progress on the federal deficit and prevents the dreaded fiscal cliff that was set up by last year’s compromise to raise the federal debt ceiling.

Since neither party is likely to win the White House as well as decisive control of both houses of Congress with 60 Senate votes, there will have to be a deal this time too. Whoever wins the most power in Washington will get more of what they want. That’s more likely to include wind and renewable energy tax credits if there are more Democrats in Congress, and less likely if there are more Republicans. And historically, newly elected (or re-elected) presidents do have a lot of influence on such negotiations.

Renewable energy stocks, however, are clearly not reflecting potential extension of the credits. Leading wind turbine maker Vestas Energy (OTC: VWSYF), for example, currently sells for less than USD6 a share, down from a high of USD142 in mid-2008.

That means we could expect some price recovery if credits were enacted. My view, however, is we’re better off investing in the sector as if there were no extension of the credits. And that means assessing what the damage will be if that’s the case.

During the 1970s, the Carter administration favored renewable energy and nuclear power as a way to wean the US off imported oil, the price of which had soared in the wake of the Arab Oil Embargo. In the 1980s, however, the Reagan administration reversed the actions of its predecessor, and the renewable energy industry practically vanished.

There are some factors this time around that suggest a somewhat less dire outcome. Technology has advanced enough to reduce costs substantially for renewable energy. The price of components for solar facilities has fallen hard in the face of mass production in China. State mandates for utilities to use renewable energy are still in place, and most companies still have a ways to go to meet required percentages.

Finally, most renewable energy in the US is being sold under long-term contract to regulated utilities, mostly with 15 years to 20 years left to run. Not one utility has ever defaulted on a power purchase contract to a non-utility power producer. Renewable energy producers can count on revenue from any plant now in operation, tax credits or no.

But there’s no doubt removing tax incentives will take a bite out of new development. In fact, EIA data clearly demonstrate that. And if there are no new tax credits and natural gas prices stay where they are now, development will almost certainly slump even more.

A handful of developers such as SunPower Corp (NSDQ: SPWR) enjoy the backing of much bigger and stronger companies–in SunPower’s case, its 66 percent owner Total (NYSE: TOT). But they’ll be among the very few survivors in a bloodletting that’s already taken SunPower’s share price to low-single digits from a high near $140 in the past five years.

Rather, if you want to bet on renewable energy, look for companies with long-term contracts to sell what they have. For example, Atlantic Power (TSX: ATP, NYSE: AT) is on track to bring a 300 MW capacity wind plant on line in Oklahoma by the end of the year. All of the plant’s output will be sold under a 20-year contract with the regulated utility unit of OGE Energy Corp (NYSE: OGE).

If wind power tax credits are allowed to expire and never come back, Atlantic probably won’t invest in another wind plant. But the cash will keep on flowing from Oklahoma. And that’s ultimately what will produce returns for its shareholders.

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