A Folly in US Energy Financing

Ever wonder why gas prices at the pump have held steady around the $4 per gallon mark for the past two years, despite the global economic slowdown? The last time prices reached $4 was just after Katrina. Consumers then underwent sticker shock. Lately prices have pulled back a bit but come 2013, consumers may see $5 to $6 per gallon gas as the US economy rebounds. What is keeping fuel prices so high? Aside from the traditional market forces, there are many other factors that affect fuel prices too.

Certainly the conflicts in the Middle East (i.e. Syria, Egypt, Palestine) and the nuclear threats from Iran play a part. With the slightest inkling of a possible supply interruption, fuel buyers and speculators will jump into a buying or selling frenzy. Wars, threats of war, OPEC news or lack thereof are all likely triggers to set fuel buyers on edge creating havoc for companies and consumers alike. These erratic fuel price swings do more damage to an economy by spawning uncertainty and instability.

An important stabilizer for these lopsided market forces has been improved fuel efficient engine designs that presently deliver up to 40 miles per gallon (mpg). Already some designs are boasting 100mpg with their pilot models! – (ecomotors.com).  But, even if 100mpg cars were introduced to the US market today, fuel prices would most likely continue to rise because in addition to geo-political uncertainties, there are domestic ones as well.

MIT Energy Finance Forum
At a recent energy finance forum last month organized by MIT’s student run energy club (mitenergyclub.org), CEOs, thought-leaders, and entrepreneurs representing various facets of the energy industry discussed the many opportunities and challenges created by higher energy prices. Everyone agreed that moderate price increases backed by sound government policies could help boost a stagnant economy. They go hand in hand such that one could not exist without the other. Higher fuel prices stimulate new research for alternative fuel sources, encourage design engineers to do what they do best, and create public awareness on the importance of conserving energy. On the other hand, comprehensive government policies help companies and investors align their business strategies with US national interests as well as with each other. Having both in synch attracts new investors.

So when I heard panel members at the forum blame the high cost of energy on the Obama Administration’s lack of a national energy policy, I wondered if the Secretary of Energy, Dr. Steven Chu, had lost his way.  In 2012 Chu’s Department of Energy (DOE) invested in over 180 projects with ARPA-E, a new R&D agency for basic renewable energy projects. Chu’s ‘hit or miss’ approach to unveil the ultimate breakthrough without announcing a definitive national energy strategy has overshadowed the rest of the industry. Energy-sector CEOs have had to navigate rudderless relying on politically motivated investment tax credits and subsidy schemes (i.e. Renewable Energy Certificate or RECs) to make ends meet. The following are a few examples of how some have coped with the current situation.

PSEG
According to Ralph Izzo, the Chairman and CEO of PSEG, a New Jersey based utility company, DOE’s meddling with energy infrastructure projects  and the Obama administration’s lack of producing a national energy strategy have created such a high level of anxiety and uncertainty among investors, that no investor in their right mind would agree to finance the expansion or conversion of an energy plant today without insisting on a list of unfeasible assurances. In fact government subsidies and their tax credit schemes are never included in the financial proformas used to evaluate deals, since investors never know if the laws will survive the next political elections. Elections occur every four years and energy plant deals normally require a 20 year investment horizon. Izzo shared an insightful example of how the price of building a similar nuclear plant had jumped from $450m in 1989 to $10billion today. In his opinion the 20x price escalation was primarily due to the unwillingness of Congress to commit to a national energy strategy.

The uncertainties caused by the US Government’s indecisiveness is affecting not just fuel buyers but their capital investors too. Since renewable investments are so new and have yet to be securitized (packaged into tradable securities), cash-rich pension fund managers who invest for the long term have been barred from participating in non-traditional energy investments. Without more historic data from a broad range of similar investments and the availability of affordable financial tools to hedge against risks of loss, securitization of renewable energy projects has been challenging. Unfortunately, large cash reserves that would otherwise be used to finance infrastructure energy projects currently remain on the sidelines with dim chances of being deployed any time soon.

Siemens
Ironically, the more the DOE offers incentives to entice private investors to invest in large energy projects, the less likely private funds will participate in a deal. This very issue became part of a fascinating panel discussion with representatives from Siemens, Bechtel, CEIFA, Zanbato, and the DOE itself. The panel suggested the presence of a greater problem where investor expectations needed to be updated in favor of equity investments over debt. They highlighted that the risk profile of an energy-related project is significantly less from that of a bridge and hence should be structured differently. To them, bridges can ‘lead to no where’, while energy sources will always be in demand somewhere on the planet.

While it awaits for more favorable winds from Congress, the energy sector growth in the US has had to rely on internal financing along with many clever and unconventional energy financing partnerships.

Public-Private Partnerships in Energy
One way long term projects such as city metros and highways are financed is through the formation of a Public-Private Partnership or PPPs. How successful have PPP’s been with large energy projects? The truth is that not all PPPs are the same. In fact the lack of a reliable template that is easily transferable from one project to another was deemed ‘very difficult’.  Each deal had to be tailor-made from scratch to satisfy a long list of specific requirements. When compared to each other, PPP’s were no more than a name plate suggesting some form of a collaborative involvement among large players including the government.

A ‘public green bank’ operated in Connecticut under CEIFA (Clean Energy, Investment and Finance Authority) uses public funds to attract private investors into jump-starting small renewable energy projects. Directors of this new bank hope to show small success stories where their combined investments will eventually be pooled into a bond product and securitized for sale to larger players, possibly even to pension funds. Citing the Solyndra debacle, the CEIFA representative recommended that the US Government avoid large projects and instead focus on smaller ones that can be aggregated into securitized debt instruments.

A panel member from Siemens offered another PPP example involving three partners, an equipment manufacture, which in this case was Siemens, a methane gas buyer, which was Kimberly-Clark, and a client who produces methane gas (3-Rivers Solid Waste). To close the deal, Siemens had to front the equipment to the methane gas producer and agree to absorb 100% of the project risk. In turn Kimberly-Clark agreed to a floor price in the event the market of natural gas were to collapse. 3-Rivers Solid Waste leveraged tax exempt financing rates and loaded back end debt payments to Siemens during periods of maximum production. As you can see, each partner had to give up a little to make this deal work. (Additional details are listed at http://1.usa.gov/12FKdaS.)

Siemens impressed the audience further with another example of unconventional energy financing for a proposal to build 100 train coaches for Amtrak. In this deal Siemens agreed to underwrite the entire amount, if Amtrak, a US government owned entity, would agree to partially by-pass the open-bidding requirements and automatically award Siemens with one-quarter of the order. Government officials cited a possible violation to the fair bidding process, which according to the VP of Government Affairs, David McIntosh, has kept the deal tabled for now. Clearly Siemens is not happy with these and other similarly unconventional and risky arrangements, but noted that there are no better alternatives in the energy financing environment today. The Company hopes that its aggressive sales approach and patience will eventually pay off in the ‘very’ long run, while, it waits with the rest of the industry for the DOE to reassess its myopic R&D focus and introduce a comprehensive national energy strategy.

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