The Gillard Government in Australia has introduced its carbon tax, and there is to be a Clean Energy Finance Corporation to subsidize renewal energy projects and technology. A few months ago I proposed a market driven structure under which such subsidies might be granted, and it is timely to revisit that now.
I am no free-market ideologue, but if there is one role to which government is least suited it is funding the development and commercialization of technology. Simply handing out large-scale research funding might easily create a bureaucracy that, far from enhancing development of the implementable technology, actually crowded out real commercially driven development.
The alternative is to directly subsidize individual renewable generation projects that might not otherwise, even with the effect of the tax, be competitive with carbon-emitting generation. The subsidy would meet the difference between a project’s actual capital cost and the amount of capital it could raise on purely commercial terms.
The problem with this, of course, is that government would again be in the business of picking winners, but with the further problem that private project developers could make excessive returns from the scheme without contributing to the objective of maximizing the renewable energy base.
The purpose of this note is to propose a general framework for capital subsidies that draws on the lessons of project finance to ensure that maximum societal benefit, in terms of increased renewable generating capacity, is gained from that investment.
Proposed capital subsidy framework
I suggest that there should be two requirements for renewable generation projects to receive government capital subsidies.
First, the rate of return to the project’s commercial capital should capped but with excess returns allowed to be reinvested as private equity in expanding the existing project or in new, eligible, renewable generation projects.
Second, that at least 70% of the project’s commercial capital (excluding the subsidy) should be in the form of non-recourse commercial bank debt.
First, the rate of return to the project’s commercial capital should capped but with excess returns allowed to be reinvested as private equity in expanding the existing project or in new, eligible, renewable generation projects.
Second, that at least 70% of the project’s commercial capital (excluding the subsidy) should be in the form of non-recourse commercial bank debt.
Capped rate of return
One very interesting development in infrastructure finance over the last few years has been the privatization by some governments of monopoly infrastructure assets. Control is maintained over these "regulated" assets by various means, one of which is that the rate of return to the private owners is capped.
The allowed return is calculated by applying the capped rate of return to the "regulatory asset base", which is value of the assets assessed for the purpose. What is interesting is the behaviour this has encouraged.
With a capped rate of return the incentive for the private owners of the regulated assets is to expand the regulatory asset base on which their return is calculated. If the rate of return on assets is capped, the absolute return can only be increased by increasing the value of assets. Thus the incentive is for the private owners of regulated assets to expand those assets, and this has been observed.
I would suggest that similarly capping the rate of return on renewable projects that receive government subsidy, but allowing the private owners to reinvest any excess returns in expanding the asset base on which the capped rate of return is applied, would perfectly align the incentives of the private project owners and society. Say, for example, that the owners of a subsidized renewable project were only allowed to take home a return from their investment in the project of 15%. However any excess return in that particular project could be reinvested by them as new equity into project expansion or into a new project or projects, which would themselves be subject to a capped return of 15%.
The private investors could then maximize the returns on their initial investment almost without limit, creating proper market incentives, but only by creating and reinvesting in project expansions or in new projects. They could not benefit from excess returns on a single subsidized project, which would discourage the gaming of the subsidy system.
Recall that society's objective is to maximize renewable generating capacity. Under this scheme the initial government subsidy to a project might be leveraged into an increase in renewable generating capacity which is much larger than the increase represented by the original project.
In fact the growth in the renewable asset base would be further multiplied by the compulsory use of debt finance for the projects. Each $1 in excess return applied as new equity in project expansion or new projects would also support several times that amount in new commercial bank debt. This is also consistent with the observed behaviour of the owners of regulated infrastructure assets. And so this leads to the second criteria.
Minimum 70% commercial bank non-recourse debt
It is well known in the project finance industry that where the challenge is maximizing the amount of capital available to finance a project or sector, the mobilization of debt capital is key. Unlike in the world of finance theory, real capital does indeed care about the form of its investment. The vast amounts of capital controlled by commercial banks can, effectively, only be invested in the form of debt. If it is not utilized in that form, substantially all of that commercial bank capital would be wasted to the renewable sector.
Projects that are funded only or substantially by equity will be limited in size or will be inefficiently using scarce equity capital - including subsidies - that, from the societal perspective, could otherwise be leveraged into much larger base of renewable assets. It is true that the equity in projects would now be leveraged, and higher risk. Experience again shows us, however, that this will not lead to any material difference in the amount of equity capital available. Again contrary to finance theory, the providers of project equity are not just comfortable with leverage but they seek it almost without limit, and are constrained ultimately by the risk tolerance of the lenders.
If a project cannot achieve 70% commercial bank leverage then this requirement will also have served another purpose, to certify properly structured projects. Electricity generation projects have a whole suite of risks; construction/completion risk, financing risk, market price risk and operating risk are the major categories of risk in addition to technology risk.
It would be a very inefficient use of the available funds to subsidize projects that are taking on material non-technology risks. If so the subsidy would provide, in effect, a free option on these risks to project equity holders. Risk seekers would develop projects as a way to gain cheap exposure to market or completion risks, not to expand the renewable generation base. The 70% minimum commercial bank leverage requirement should ensure that these risks are hedged or otherwise allocated away from the project, as they would be in any properly structured project financing.
Conclusion
The compounding returns from reinvestment and leverage would mean that the approach I have suggested could lead to a geometric rate of increase in the renewable-generation asset base. Exactly the result we are seeking as a society and, under this structure, it would be one pursued by project equity-holders in their own self-interest.
I have only outlined the general principles here, and obviously there would be much work to be done in implementing it. Nevertheless, I think it would be a good basis for starting a discussion about the most effective means of providing capital subsidies to renewable projects.
The allowed return is calculated by applying the capped rate of return to the "regulatory asset base", which is value of the assets assessed for the purpose. What is interesting is the behaviour this has encouraged.
With a capped rate of return the incentive for the private owners of the regulated assets is to expand the regulatory asset base on which their return is calculated. If the rate of return on assets is capped, the absolute return can only be increased by increasing the value of assets. Thus the incentive is for the private owners of regulated assets to expand those assets, and this has been observed.
I would suggest that similarly capping the rate of return on renewable projects that receive government subsidy, but allowing the private owners to reinvest any excess returns in expanding the asset base on which the capped rate of return is applied, would perfectly align the incentives of the private project owners and society. Say, for example, that the owners of a subsidized renewable project were only allowed to take home a return from their investment in the project of 15%. However any excess return in that particular project could be reinvested by them as new equity into project expansion or into a new project or projects, which would themselves be subject to a capped return of 15%.
The private investors could then maximize the returns on their initial investment almost without limit, creating proper market incentives, but only by creating and reinvesting in project expansions or in new projects. They could not benefit from excess returns on a single subsidized project, which would discourage the gaming of the subsidy system.
Recall that society's objective is to maximize renewable generating capacity. Under this scheme the initial government subsidy to a project might be leveraged into an increase in renewable generating capacity which is much larger than the increase represented by the original project.
In fact the growth in the renewable asset base would be further multiplied by the compulsory use of debt finance for the projects. Each $1 in excess return applied as new equity in project expansion or new projects would also support several times that amount in new commercial bank debt. This is also consistent with the observed behaviour of the owners of regulated infrastructure assets. And so this leads to the second criteria.
Minimum 70% commercial bank non-recourse debt
It is well known in the project finance industry that where the challenge is maximizing the amount of capital available to finance a project or sector, the mobilization of debt capital is key. Unlike in the world of finance theory, real capital does indeed care about the form of its investment. The vast amounts of capital controlled by commercial banks can, effectively, only be invested in the form of debt. If it is not utilized in that form, substantially all of that commercial bank capital would be wasted to the renewable sector.
Projects that are funded only or substantially by equity will be limited in size or will be inefficiently using scarce equity capital - including subsidies - that, from the societal perspective, could otherwise be leveraged into much larger base of renewable assets. It is true that the equity in projects would now be leveraged, and higher risk. Experience again shows us, however, that this will not lead to any material difference in the amount of equity capital available. Again contrary to finance theory, the providers of project equity are not just comfortable with leverage but they seek it almost without limit, and are constrained ultimately by the risk tolerance of the lenders.
If a project cannot achieve 70% commercial bank leverage then this requirement will also have served another purpose, to certify properly structured projects. Electricity generation projects have a whole suite of risks; construction/completion risk, financing risk, market price risk and operating risk are the major categories of risk in addition to technology risk.
It would be a very inefficient use of the available funds to subsidize projects that are taking on material non-technology risks. If so the subsidy would provide, in effect, a free option on these risks to project equity holders. Risk seekers would develop projects as a way to gain cheap exposure to market or completion risks, not to expand the renewable generation base. The 70% minimum commercial bank leverage requirement should ensure that these risks are hedged or otherwise allocated away from the project, as they would be in any properly structured project financing.
Conclusion
The compounding returns from reinvestment and leverage would mean that the approach I have suggested could lead to a geometric rate of increase in the renewable-generation asset base. Exactly the result we are seeking as a society and, under this structure, it would be one pursued by project equity-holders in their own self-interest.
I have only outlined the general principles here, and obviously there would be much work to be done in implementing it. Nevertheless, I think it would be a good basis for starting a discussion about the most effective means of providing capital subsidies to renewable projects.
