EnergyCents- Ep 32 - Green deals - Financial sector increases commitments to corporate renewables

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Hill Vaden:  Alright, welcome back to EnergyCents, an S&P Global podcast that covers all things on the intersection of energy and finance. This is Hill Vaden and I'm here today with Peter Gardett, our lead research director of the energy view climate and clean tech team, which is focused on specifically the intersection of finance and the clean tech sector. So, Peter, how are you?

Peter Gardett:  Good. Thanks, Hill. How are you doing?

Hill Vaden:  I'm doing well. I guess we're here on a Monday during a short week. Hope you had a nice weekend.

Peter Gardett:  Yeah, it was good. It’s very nice weather in New York. So, I will take it.

Hill Vaden:  Good. Good. Well, the big news today I think is the, I think the name of the barge is the Ever Given which is now floating again in the Suez Canal after that had been constructed. So, as a New York resident, as I was looking at that, I couldn't help to think about my difficulties parallel parking. How are you as a parallel parker in New York?

Peter Gardett:  So, fortunately, like most New Yorkers, I don't own a car. But for a number of years, what I did, I ended up biting the bullet and paying a small fortune for parking just because I was too paranoid about parking in the street. That’s from my own parallel parking, and just everyone. I'm not counting, I'm counting myself here, drives kind of crazy, and I just couldn't trust that my windshield like the side mirrors were going to be safe.

Hill Vaden:  We did the, my wife and I lived in Chicago for a while, and we did the same thing where we paid to park in a garage in large part because we didn't, we moved there in January, and we got a huge snowstorm. And we were parked on the street and the snowplow nothing melts in January in Chicago, and we could not get our car out for weeks. And so we were that was the best money maybe that we've ever spent was all street parking in Chicago. I very much sympathize with this pilot or captain or whatever one calls a ship not barge driver. Yeah, because I feel like this guy is just or this person is under all sorts of a microscope for parallel parking.

Peter Gardett:  I mean the way they design new ships now, I was in Panama a few years ago with the Panama Canal, and they really do design the exact, an exact fit. They leave an astonishingly tiny amount of space on either side of the vessel as compared to ours. So, there’s not much room for error.

Hill Vaden:  Clearly, clearly. So, all right, well, we’re in another conversation. We're here today to talk about a topic that that you recently published on, and I'll read the full name of the report, but Financial Firms Take Counterparty Role in Corporate Renewable Energy Buying. And this is really looking at the role of the financial sector in renewable procurement. Can you maybe summarize some of the big takeaways from the report and why we chose to publish it when we did?

Peter Gardett:  Yeah, absolutely. So, traditionally, in energy markets, I think a lot of people are familiar with the old sort of hub and spoke model where a utility a power company owns a big power plant, and they also operate the transmission grid or do so with a partner, and those that either that single firm or those two firms simply deliver power to an end customer who pays a power bill. And that holds true for everything from a household to a manufacturing plant. Increasingly, as renewables become more and more cost competitive, this sort of in between market structure has emerged where companies will directly contract with power providers, so either solar manufacturers and have operating arms or literally independent power providers, IPPs, who will build a solar array or wind farm and sell that power directly to a manufacturing plant. Sometimes they'll do it by selling into the grid and sort of reallocating that power, if you like, to the end consumers, sometimes they'll do it by literally placing the solar array near the manufacturing facility.

The thing is that's been done sort of through this somewhat complicated process using tax equity and tax incentives. But increasingly, there have been some shifts in the market where the large financial players, the asset managers, and big institutional investors have been building these power plants, selling directly to utilities and creating structures so that they can garner the benefits of the cash flow, the benefits of the tax equity, the benefit of the emissions offsets all at once, rather than going through that kind of complex intermediary phase.

Hill Vaden:  And describe tax equity, please.

Peter Gardett:  So, tax equity, word of warning, it can get really complicated, like everything to do with taxes, but in concept, it's pretty simple. You can take tax incentives, production tax and current tax incentives or investment tax credits, and apply them to your profits to the taxes that you would ordinarily pay. And so if you build a solar array and you get a 20% tax credit on that, you can take 20% of what you earn and apply that against your profits from some other part of your company. The issue is that a lot of energy companies and particularly these independent energy companies, or solar companies, just didn't make enough money to use those tax credits on their own balance sheet.

So, they would enter into these somewhat complex transactions where they would sell the tax equity to a bank, which would then sell it on to a company that could use that a Google, Disney, any number of household name companies use tax credits and tax equity markets in this way. And they've worked for a long time, the economics of the business just changed as it's grown more mature, as the size of these projects have gotten a lot larger, companies themselves become more profitable. So, in some ways, the tax equity market is a victim of its own success. It's designed to kind of accelerate the growth of a new technology. It did that. Now it's gotten to a scale where it's kind of lived out its purpose on wind and solar. I do think it's going to be very valuable for other technologies, but in some ways, we're seeing the market move past it a little here.

Hill Vaden:  And so and then, I guess, with that it sounds like we're seeing a doubling down of commitment from the financial sector into these less complex arrangements.

Peter Gardett:  Yeah, I mean, on the face of it less complexity. I think financials like to add complexity at the backend, and they understand the risk. So, what really appeals to both of the parties in any one of these arrangements for the utility, they're paying less for super reliable supply, for that's for the end customers, or for the manufacturer, for the financing company, asset manager or the investor, you're getting a very reliable return at an above rate of Treasury return. So, even if it's only earning 5% or 6%, every year, you're still making substantially more than you would make in treasuries or really a lot of the other equally safe investments.

Hill Vaden:  Sure. And how long are they…? I mean, these are multi-decade agreements.

Peter Gardett:  Yeah, they often run up to 20 years. Customarily, they have sort of reopener agreements arrangements in them so that the cost power remains competitive takes into account any operational changes, but they will be multi-decade agreements often.

Hill Vaden:  And are there any regions that were in, are these, I suppose most advantage in the higher priced power markets or…?

Peter Gardett:  Not necessarily. A lot of it is about regulation. So, there's kind of two ways of approaching this. You can either take that direct sale approach in which you are building renewable energy facility and selling directly to a customer. Anything that's left over, you can kind of sell into the transmission grid. That it tends to be in less regulated markets, generally speaking, that's the southern half of the United States. Generally speaking, the northern half of the United States has more structure around its reliability requirements. And so it will require any independent power producing facility to sell into the broader transmission grid in order to kind of maintain that transmission grid and contribute to its operations. So, in that case, they'll use something called a green tariff. Financially speaking, it has many of the same benefits, the same reliability on both sides, often very cost competitive. But it essentially uses the power transmission market in the middle that's regulated as a mechanism for delivering and often the actual electrons.

Hill Vaden:  Okay. Well, so you and I were talking last week, there was an article that we both read in the Financial Times looking at, I think it said Clean Tech 2.0 or something like that, that was showing a real maturation of the clean that the low carbon business. And I think there was at least one speaker in the article saying this time it's different. Does this give more confidence around that Clean Tech 2.0 idea that things are more mature and that this time it’s “different”.

Peter Gardett:  So, this time is different, but it also doesn't necessarily mean that it's a 2.0 of what happened before. I kind of am a veteran of clean tech 1.0 and I remember the rush to it very well. At the time, a lot of the same themes that we're seeing now around the kind of intersection between digitalization and clean energy were already beginning to emerge. But the venture capital structures that Silicon Valley relied on really didn't work well with a manufacturing model which is what solar, wind energy, so much of energy infrastructure still is. So, this second round, clean tech 2.0, if you like, still has that fundamental tension within it where which parts of the value chain link really well with digitalization platforms and automation, AI, all those things, those still work really well for Silicon Valley financing structures of these companies, the manufacturing component, that is always going to be a challenge for them.

One of the things I noticed in that article is that they brought a corporate venture capital. So, a lot of the Shells, BPs, so on of the world have been launching these corporate venture capital arms, CVC. And this has been kind of a big trend and they're putting big dollars behind it. Those have a very mixed history. So, I think it's yet to be proven whether a corporate venture capital arm can really generate the kind of innovation that a normal VC would and then translate that into a manufacturing scale, so still to be determined. A lot of this has been driven by specs, frankly, that allows public equity investors to participate in a venture capital style firm. And so you have a number of Silicon Valley companies attracting public equity level investing. And that's it's hard to tell to what degree that's a trend. Clearly, it's very hot right now, so we'll see how that goes in the next year, I would say.

Hill Vaden:  It sounds like these are different things, though, that I guess both are showing a real commitment from large, sophisticated financial players, but this procurement piece is, I suppose, more certain returns all in a low carbon mindset, but not necessarily the 2.0 idea that what we're seeing on the specs in some of these other mom and pap companies.

Peter Gardett:  Those are much more junior technologies much earlier in their development phase. Wind and solar at this point are cost competitive on their own merits in many places and in many instances, and are only going to get more so as the supply chains continue to build out, as the operational history is there. This is it. At this point, it's no longer really an innovation business often in wind and solar because utility scale solutions are already at the level where you're talking about cash flow rather than a sort of startup level hockey stick growth curve. Whereas you look at electric vehicles and batteries and those kinds of technologies, which count as clean tech, those things are still earlier in their technology development cycle and there's still a lot of room for those gigantic returns that Silicon Valley structures need.

Hill Vaden:  Okay. But are the same types of financial firms, I think the report you mentioned Sha de Sha, NextEnergy, Brookfield, Copenhagen Infrastructure Partners, and I'm going to mispronounce it but Caisse de Depot Quebec.

Peter Gardett:  The Quebec Pension Fund.

Hill Vaden:  That’s easy to.

Peter Gardett:  Yeah, so all of those are very similar firms. De Sha I would put maybe slightly in a different bucket, but the rest of them have very clear sort of investment remits. They need to produce returns above a certain index level for guaranteed payouts over time to pension funds. And those kinds of investors, these are not your early stage kind of looking for big spreads. And what they will do is they'll take those reliable sort of cash flow that is coming in at 4% or 5% and they will, in many cases, securitize that cash flow and then begin to trade it and that will create a separate revenue stream for them. One of the other things I mentioned in the paper is around additionality as far as it applies to carbon allowance, the carbon offset market. So, that's another potential cash flow sort of stream for them and a trading opportunity for them. But fundamentally, most of them are really looking at this as like an income producing asset rather than a technology player.

Hill Vaden:  Okay, and additionality is a new word for me. Can you go into a bit more detail on what additionality is and how it affects this motion?

Peter Gardett:  I mean, additionality is a super important concept for everyone in the clean tech market because it's the fundamental idea that whatever you're putting on the grid or putting out into the energy system, is something that would not necessarily be there under normal market circumstances. So, what climate policy is intended to do is to drive the energy transition forward. So, to do that requires a kind of constantly rising baseline. So, you have if you were going to, if wind and solar just become super cheap to the point that it's cheaper to build that than it is to build anything else, then on some level, you don't necessarily need to continue supporting them as the government. Whereas if we're talking about hydrogen or some other form of more advanced power, clean tech deployments, you do need to be able to support that. So, in either case, whatever is additionally added, should qualify for special treatment in a way because it's helping drive forward this energy transition that otherwise might not happen on its own.

So, in order to prove additionality is one of the big sort of fundamental driving elements of this market in part because many of these projects are able to garner carbon credits, carbon allowances by proving that they have not emitted produced emissions that produce pollution that would have been there anyway. So, it's so simple in that it just anything that is added has to be additional to kind of a natural market state. On the other hand, proving it can be quite a difficult sort of accounting exercise. The various parties to Paris Agreement continue to discuss this, but fundamentally, carbon allowances that are produced by projects that qualify for additionality are the accounting mechanism for meeting nationally determined contributions under the Paris Agreement. So, you have to produce them as an economy in order to meet your nationally determined contribution.

Hill Vaden:  Is conditionality redundant? Is it a redundancy in terms of the power supply demand?

Peter Gardett:  Will they overproduce power is that what you’re saying like it'll produce power twice?

Hill Vaden:  Well, are we bringing new power into the system? If I'm understanding correctly, the additionality concept of bringing something new into the system through a direct agreement, I suppose that customer would have normally just tapped into the grid, right?

Peter Gardett:  Correct.

Hill Vaden:  Could the grid not support that existing customer today or does that free up capacity within that existing grid because the additional piece is now meeting the needs of a very large consumer?

Peter Gardett:  The nice thing about these projects is they avoid that question entirely, because that is exactly the kind of subject matter that gets brought up at the Public Utility Commission hearings, then Federal Energy Regulatory Commission hearings and becomes very contemptuous. If you are directly contracting, in a way you managed to skip over this whole discussion. You can say instead of buying from the grid where that power could be coming from coal, natural gas wherever, I know I am buying from this dedicated power plant and therefore it is by definition, additional to the structure that exists in the previous year when I was buying off the grid. It's very easy to kind of prove that this is additional and then to take that and that can support the creation of carbon allowances carbon offsets for avoided pollution.

Hill Vaden:  Okay. And so how big, we mentioned some of those names who are on the financial side of it, is this group financing it relatively well defined or new entrants still coming in? And are those new entrants, traditional asset management, traditional investment banking, what’s the makeup of these guys?

Peter Gardett:  Yeah, they're much more traditional asset managers, and there are more and more of them all the time. This market is only beginning to take off, and you will see, I think, a lot more of the asset managers begin to step in to these kinds of structures. One, so the market is set to we’re predicting at S&P Global that this corporate renewable market will continue to grow over the coming decade. It was just shy of a billion dollars this year in contracted capacities, it's 2021 numbers so a little bit of…

Hill Vaden:  This is global?

Peter Gardett:  This is US.

Hill Vaden:  Okay.

Peter Gardett:  And then we're looking at $17 billion a decade from now. So, that's almost essentially doubling in the US project, renewable project contracting by US corporations. This is like a relatively small part of potentially the global structure. It's harder to forecast when you get outside of that because the structure of power markets gets kind of complex. There is definitely a global trend towards direct contracting across the board because it's proven to be super reliable, cheaper there's a lot of reasons to do it. There's a clear motivation for it in the US and in a way that works very well with the requirements of an asset manager. One of the things that will probably drive some of this growth is a move towards virtual power purchase agreements. So today, you've had that kind of we talked about that direct sale element where you have one counterparty on each side. Increasingly, smaller firms or firms that aren't able to take advantage of a whole large power installation will group together and sign a VPPA. And they will sign that VPPA with a single financial counterparty, creating a very similar kind of structure, a little bit more complexity in terms of the delivery mechanism, but fundamentally very similar. We have a single seller moving to multiple parties, but selling to them directly.

Hill Vaden:  Well in to kind of put that up there. So, it's going to double over the next 10 years, plus or minus. When was it $4 billion? When did it last double? What was this? Is this a 10-year process that got us to eight or was it 20 years that got us to eight?

Peter Gardett:  Oh, no, I mean, it doubled in the last, I don't know, four or five years. I mean, we're coming off a low base.

Hill Vaden:  All right.

Peter Gardett:  So, it's really only sort of 2017, 2018 that you saw this market start to really accelerate. And that just goes perfectly in line with the falling cost curve of solar and wind. Once solar panels and wind turbines got cheap enough to install, then it just became so easy to make that argument that corporate power buyer was better off doing direct contracting than they were necessarily buying power off the grid. I think you've had a couple of big events that have happened over the last few years, they've really raised the risk profile there as well. I mean, the California blackout, the Texas blackout we're seeing a number of sort of ramifications of climate change, broadly speaking, but also kind of long-term underinvestment in the public power sector that's driving people into these private structures.

Hill Vaden:  So, in the report, we look at, I don't know, 15 or 20 companies in terms of the largest and the customers of these procurement agreements. And there's a real bias to service firms Bank of America, Google Wells Fargo being the top three. In the middle, we've got, middle low, I'll say, three manufacturers, General Motors, Johnson Controls, and Owens Corning, each call it 20% to 30% of their total power needs being met in this way. If we're looking at an impact on climate, when do we need to see more or do we expect to see more participation in this type of things for the non-service companies where I assume Bank of America and Wells Fargo are contributing less to those own concerns than some of the manufacturing companies?

Peter Gardett:  Yes, for sure. I mean, so in some ways it's with the IT parts, it's good to remember that they do have bigger power difference than you might think. They operate server farms that consume pretty enormous amount of power. But having said that, yes, they're running out of power capacity against which they can contract. They were early adopters in this space because they have the cash flow, they have the profits and use the tax equity, they have conductance to kind of cleaning their business overall, so a lot of reasons that worked for them. The next generation, this next decade of double, doubling in size for that market is going to be driven by manufacturers, industrials who really will need the power and need the carbon allowances. They will need reliable power that they are going to have an increasingly amount of trouble getting from a public grid. They'll look at the operating history of these assets and say, “I was worried I couldn't rely on the sun being out.” But now that I've seen it, you combine a solar array with battery storage it actually could work for manufacturing facility. So, that will look much more realistic. And then as well, they'll also need as they continue to rely to some degree on emitting sources of power or products that come from the petrochemical sector, they'll need to offset their sort of sharing the emissions chain. And to do that, they'll need allowances and offsets, and they'll need to get those by contracting for them.

Hill Vaden:  Well, it sounds it'll reduce their costs, period.

Peter Gardett:  Yeah, sure.

Hill Vaden:  That you're going to there's a lot of good reasons to do this, but not least of which is going to improve your bottom line.

Peter Gardett:  Absolutely, absolutely.

Hill Vaden:  So, maybe this is a good place to wrap up, but what are the things we should be watching in this space in the immediate term to show momentum or to show, I suppose, increased commitment?

Peter Gardett:  Yeah, so I think everybody is just going to be looking at what happens to tax equity. I think the market is maturing, but maturation is a painful process for everybody. So, as we bridge from a time when we've been reliant on kind of complex tax equity structures to a more direct pay model, there's going to be a fair amount of shakeout there. Companies that traditionally use the tax equity route will probably exit the market, new companies, these asset managers necessarily need to worry about that as much will come in and do that. There is as part of the Biden infrastructure plan a proposal out there to make a number of these investment tax credits and production tax credits fully refundable, which essentially would allow the independent developers the solar grid farmers to directly take the cash out of that system. So, it would be it'd be a cash flow boon for them, but it would probably be short lived. So, medium term, we're definitely looking at more manufacturing plants becoming in more industrial capacity. A lot more use of VPPAs, probably a sustained use of green tariffs in the regulated markets, and a lot of interest from these asset managers and institutional investors in this space.

Hill Vaden:  All right, that was my dog scratching the door behind me, which may be a sign that we need to wrap up. But this is an incredibly interesting topic that sounds I think you did a great job simplifying a very complex operation system. Thank you for joining us on EnergyCents, and we look forward to having you back.

Peter Gardett:  Thanks. I look forward too.

Hill Vaden:  All right.

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