Lesson 8 Overview

Low-carbon energy in many regions has started to become competitive with fossil-fuel generation on an LCOE basis when including certain incentives we will discuss in this section. The social costs of some harmful pollutants emitted when fossil fuels are burned for useful energy are not reflected in the price of the fuel itself or the price of the final energy output. It is also important to consider that while subsidies are given to renewable sources of energy, certain in-kind subsidies to fossil fuels such as low cost mineral rights and the ability to socialize environmental clean-up do not make it into the LCOEs of these sources.

One solution to this problem is to place a price on pollution, which would make non-polluting alternatives look more economically attractive. The United States and many other countries actually do this with some types of pollutants - sulfur dioxide and oxides of nitrogen, for example. The European Union (and some areas of the U.S.) impose a price on carbon dioxide emissions through a system of tradeable emissions permits. Whether those prices are sufficiently high as to reflect the true social cost of pollution is subject to a lot of debate, some of it quite heated. But in concept, it is possible to level the playing field by taxing or pricing pollution.

We'll talk a bit about taxes in this lesson, but will spend more time on the other alternative, which is to subsidize or incentivize energy sources that don't pollute. Many jurisdictions actually do a bit of both. The motivation for these subsidies can be as much about politics as environmental quality - in many cases renewable energy subsidies are a form of industrial policy, meant to promote growth in a specific sector (like wind or solar), rather than about reducing pollution per se. These subsidies and incentives can take several different forms, from providing payments for each unit of energy generated to lowering capital or financing costs for new investments.

Our focus here is really on how these subsidies and incentives affect the financial analysis of power plants. We won't go too deeply into the mechanisms behind each specific type of incentive program, nor will we talk too much about how effective the incentive programs might be. (Another course offered through the RESS program, EME 803, touches on these issues.) We'll also limit ourselves to those types of incentives that directly affect project financing or financial analysis. There are a very wide variety of policy options, apart from direct taxes, subsidies or incentives, that can have the effect of shifting investment decisions towards renewable energy.

Learning Outcomes

By the end of this lesson, you should be able to:

• Discuss topics related to taxes, subsidies, and incentives for renewable energy resources
• Describe the mechanisms by which tax credits, feed-in tariffs, rebates and loan guarantees all lower the cost of low-carbon energy resources as compared to fossil resources;
• Illustrate the impact of different types of subsidies and incentives on the pro forma financial statements for a renewable energy project;
• Use the DSIRE website (dsireusa.org) to gather information on available subsidies and incentives for use in a pro forma financial analysis;
• Build a financial model for your project;
• Construct the financial metrics for your project.

Reading Materials

• Database of State Incentives for Renewable Energy (DSIRE) [1]. This is a fairly comprehensive online resource for information on renewable energy incentives.
• One focus of this lesson is on the markets for Renewable Energy Credits, which are tradeable certificates generated by renewable and alternative energy projects constructed under state renewable portfolio standards, which set quotas for electricity generation from alternative energy sources. The National Renewable Energy Laboratory publishes an annual summary of the REC market, which is very well done: NREL: Status and Trends in the US Voluntary Green Power Market [2].
• Section III of The Cost of the Alternative Energy Portfolio Standard in Pennsylvania [3] by S. Blumsack, A. Kleit, and B. Idrisu, which contains a good description of how renewable portfolio standards work in a number of different states.
• Wind Pro Forma Example (no PTC) [4]
• Wind Pro Forma Example (with PTC) [5]
• Discussion with Nicolle Natali on the recent implications of the Inflation Reduction Act on Renewable Energy (specifically the solar market). This video is embedded in the lesson content.

What is due for Lesson 8?

This lesson will take us one week to complete. Please refer to the Course Calendar for specific due dates. See the specific directions for the assignments below.

• Complete the Lesson 8 readings, including the lesson content
• Participate in the Zoom discussion
• Complete Quiz 6
• Project work: Financial Model
• Project work: Financial Metrics

Questions?

If you have any questions, please post them to our Questions? discussion forum (not email). I will not be reviewing these. I encourage you to work as a cohort in that space. If you do require assistance, please reach out to me directly after you have worked with your cohort --- I am always happy to get on a one-on-one call, or even better, with a group of you.

Types of Subsidies and Incentive Programs

Before you get too deeply into this lesson, have a look at the Glossary page from the DSIRE website [6]. Focus on the first section of the page, which defines a number of types of financial incentives. The definitions here aren't too in-depth, but reviewing them will get you familiar with the language of different types of incentives. If you are interested, the section of the page on "Rules, Regulations and Policies" is also worth a look to give you some appreciation for the truly dizzying array of ways that governments at various levels (state, federal, and local) are trying to encourage the use of renewable energy resources, particularly for the production of electricity.

In general, DSIRE is a very good resource for learning about renewable energy and energy-efficiency incentives in the United States. The following video provides a quick tour of some of the most useful information on the DSIRE website. (Note: as of this writing the DSIRE website was undergoing some major revisions, but the structure of the website itself does not appear to have changed that much. It is worth some time wandering around that website to see what information is available.)

Video: DSIRE Video (4:20)

We'll categorize subsidies and incentives into a few broad categories:

• Tax incentives
  Tax incentives include credits, deductions and exemptions. Understanding the difference between the three is important. A "credit" represents a rebate on your tax bill, while a "deduction" represents a reduction in your taxable income. An "exemption" is simply an excusal from paying a certain category of tax (you could look at an exemption as a credit or deduction equal to 100%). There are relatively few tax exemptions for renewable energy as compared to the number of different tax credits or deductions. So, the difference between a credit and deduction comes down to whether the subsidy is applied pre-tax or post-tax. Recall our discussion of the pro forma profit and loss statement from Lesson 8. The depreciation allowance for invested capital is a good example of a deduction, since depreciation is subtracted from pre-tax net income. A credit is really no different than a direct payment since it is applied as a reduction to taxes paid, or as an adder to after-tax income (the two are mathematically equivalent).
  
  As a simple example, suppose that a project had a pre-tax income of $100 in some year, and faced a 35% tax rate. Without any subsidies, the tax bill for the project would be $35, and its after-tax income would be $65. Now, suppose that the project could take advantage of a tax deduction or a tax credit, both of which were equal to 20%. If the subsidy were structured as a credit, the 20% would be subtracted from the 35% tax rate, for a net tax rate of 15%. The tax bill for the project would fall to $15 (15% of $100) and after-tax income would rise to $85.
  
  Now, if the subsidy were structured as a deduction, the tax analysis would go like this:
  • The subsidy would reduce taxable income by 20%, so taxable income in this case would fall to $80.
  • The 35% tax rate would be applied to the reduced taxable income. So total taxes for our hypothetical project would be 35% × $80 = $28.
  • After-tax income would be $100 - $28 = $72.

  Because the credit is applied either to the tax rate itself or post-tax, tax credits are often more generous than tax deductions. In some circumstances, a company or project may even claim a tax credit if the income for the project during the relevant year was negative (so the project owner would get paid in the form of the tax credit, even if her project did not make any money and would not have paid any taxes in the first place).

  Video: Interview with Nicolle Natali (18:37) from AE 878

  If this video is slow to load here on this page, you can always access it and all course videos in the Media Gallery in Canvas.
  Once the video begins to play, you can access the transcript for this video by choosing the transcript icon, to the right of the magnifying glass icon, in the upper right corner of the video player. 

• Credit: Interview with N. Natali by M. Kleinginna © Penn State is licensed under CC BY-NC-SA 4.0 [8]
• Loan programs
  Loan programs are generally advantageous because they can lower the cost of debt faced by an energy project or investor, which in turn will lower the WACC, sometimes dramatically. There are basically two flavors of loan programs. Many governmental entities offer low-interest or zero-interest loans for renewable energy projects. There are also loan guarantees, which reduce the cost of debt by providing a sort of insurance in case the project does not perform as anticipated or if the project owner defaults on her debts. Loan guarantees are often used by governments to convince private investors to purchase debt being offered by companies promoting technologies that have not yet been market tested. Ultimately the loan guarantee has the same effect as the low-interest or zero-interest loan - it can lower the cost of debt and thus the WACC.
• Rebates and Grants
  Rebates and Grants, although technically different, work much the same way. Both act to offset the capital cost of renewable energy technologies. There are some technical differences - for example in some jurisdictions a rebate is actually considered income that could be taxed, whereas a grant is exempt from any income tax.
• Feed-in Tariffs
  Feed-in Tariffs (or what DSIRE calls "performance-based incentives") are payments to the owners of qualifying energy projects for each unit of energy produced from those projects. Feed-in tariffs actually have much the same effect on a project's financial position as a tax credit. Feed-in tariffs are not used very often in the United States, but have become quite common in Europe. Germany, for example, had for years set a very high feed-in tariff for solar photovoltaics. As a result, Germany became one of the world's largest markets for solar energy despite having a climate that, compared especially to hot desert climates, was not all that advantageous for solar.

The Renewable Portfolio Standard (RPS, sometimes called Clean Energy Standards) also deserves some mention, since it has been a popular mechanism to support renewable energy development in the United States in particular. Please have a look at Section III of "The Cost of the Alternative Energy Portfolio Standard in Pennsylvania" (reading on Canvas), which describes the RPS in one particular U.S. state, Pennsylvania. Pennsylvania's RPS is typical of how many such portfolio standards work. The reading also provides an overview of RPS policies in some other states. (You might notice that Pennsylvania qualifies some fossil fuels as "alternative energy sources" under its RPS, which demonstrates that RPS policies are not always equivalent to low-carbon policies.)

Figure 8.1: Renewable and Clean Energy Standards, 2020.

Credit: DSIRE Wesbite [7]

The RPS is basically a quota system for renewable energy and has been applied mostly to electricity. More than half of U.S. states have adopted some form of RPS, as shown in Figure 8.1, taken from the DSIRE website (note: look on the DSIRE web site for the most up to date version of this picture, as state programs change structure rapidly). Some countries have adopted policies for blending petroleum-based transportation fuels with biomass-based fuels (such as the Renewable Fuels Standard [9] in the U.S., which you can read about through the U.S. Environmental Protection Agency, but our discussion here will focus on portfolio standards for alternative electricity generation technologies. Rather than subsidizing renewables through financial mechanisms as we have already discussed, RPS sets quantity targets for market penetration by designated alternative electricity generation resources within some geographic territory, like a state or sometimes an entire country. Typical technologies targeted under RPS include wind, solar, biomass, and so forth. The way that RPS systems typically work in practice is that electric utilities can either build the required amount of alternative power generation technologies themselves, or they can contract with a separate company to make those investments. Companies that build renewable energy projects can register those projects in a jurisdiction with the RPS to generate tradeable renewable energy credits (RECs). The RECs can then be sold to electric utilities who can use those credits to meet their renewable energy targets.

You can find more information on REC prices through the NREL REC report assigned as part of this week's reading [2]. The data in the report makes a distinction between "voluntary" REC prices and "compliance" prices. Some states or areas have RPS targets that are not mandated by law, while in other states utilities face penalties if they do not comply with meeting their RPS targets.

Impacts on the LCOE for Energy Projects

Incentives and subsidies, if structured correctly, should act to make the technologies that qualify for those subsidies more competitive (compared to technologies that do not qualify). One mechanism that we can use to measure how this works, and whether the subsidy or incentive is likely to be effective, is by looking at how the incentive measure affects the levelized cost of energy (LCOE) for different projects.

Incentives and subsidies can affect the LCOE in one of two basic ways: they can reduce the LCOE directly through tax credits or feed-in tariff type structures, or they can reduce the WACC faced by the project developer (i.e., through loan guarantees or low/zero-interest loans).

The production tax credit (PTC) is one of the most well-known incentive programs for renewable energy in the United States. The structure of the PTC has changed over time, but it currently provides a tax credit equal to $22 per MWh for each MWh of electricity generated by a qualifying wind facility. The PTC does not actually extend over the entire life of the wind facility but, for the purposes of this example, we'll ignore that detail.

Suppose that we had a single 1 MW wind turbine that cost $1,200 per kW (or $1.2 million total) to construct. The wind turbine produces 3,000 MWh of electricity each year and the developer faces a WACC of 15% per year. The operations cost for the wind turbine is $5 per MWh. The lifetime of the project is assumed to be ten years. Remember our formula for the LCOE:

Here the LVC is $5/MWh. Looking back to the formula from Lesson 9, verify for yourself that the LFC for our hypothetical wind turbine is $79.70 per MWh, so the LCOE is $79.70 + $5 = $84.70 per MWh.

Recall that the way the production tax credit works is that it acts like a rebate to the owner of the project receiving the credit, for each MWh of electricity generated (note that not all tax credits work like this - some tax credits are based on capacity or on the amount invested). That rebate is functionally like a discount on the LCOE. So, to incorporate the impact of the PTC, we just subtract it from the LCOE. Thus, the impact of the PTC on our hypothetical wind turbine is:

Recall from the introduction to the lesson that there is some equivalence, in terms of encouraging low-carbon energy resources, between providing subsidies or incentives for those resources and imposing a tax or a price on emissions from polluting resources. You can see how this might work using the LCOE equation. If we were to take a hypothetical 1 MW coal plant with a capital cost of $2,000 and a marginal operations cost of $20 per MWh, assuming that the coal plant produced 7,000 MWh each year under the same financial terms (WACC and time horizon) as the wind plant, you would get the LCOE for that power plant to be $76.93 per MWh (try it yourself). Without any taxes, subsidies or incentives, the coal plant would look cheaper than the wind plant. But with the PTC, the LCOE for the wind plant would fall below that of the coal plant.

Now, let's see what happens if we were to impose a carbon tax of $10 per MWh on the coal plant (one MWh of coal-fired electricity has about one tonne of embedded CO₂, so a tax of $10 per MWh is roughly equivalent to a carbon tax of $10 per tonne of CO₂). The carbon tax is just a variable cost of operation, so it increases the LVC for the coal plant from $20 per MWh to $30 per MWh. The LCOE rises by $10 per MWH to $86.93 per MWh. With the carbon tax, the coal plant now looks to be more expensive than the wind plant without the PTC. (The wind plant looks a lot better if it happened to get the PTC at the same time that the coal plant was being taxed for its carbon emissions.)

Next, we'll take a look at the impact that a loan guarantee or low-interest loan might have on the LCOE for our hypothetical wind project. Suppose that we got to our 15% WACC for the wind plant through the following calculation: the wind plant is financed 50% by debt and equity, with costs of 15% and 20%, respectively. If the tax rate is 35%, then we would get a WACC of approximately 15% (try it yourself).

Now, suppose that the wind project is able to obtain a loan guarantee that lowers its cost of debt to 3% (assume for the purposes of this example that the share of debt and equity financing stays constant). This would lower the WACC to 11.2% and would lower the LCOE to $73.49 per MWh (again, you should try these calculations yourself). In this case, comparing the impact of the loan guarantee to the impact of the PTC, we can see that the PTC is more advantageous (i.e., it yields a greater reduction in LCOE).

Subsidies and Incentives in the Pro Forma

In this section, we'll take our hypothetical wind project and look more closely at how subsidies and incentives can be incorporated into the pro forma financial statements. We'll focus on the PTC for this example. The project parameters for the wind turbine will remain the same, except that we'll extend the operational time horizon to 15 years from 10 years and assume fixed operations and maintenance costs of $10,000 per year. We'll also assume a sales price of $60 per MWh over the entire life of the wind project. The project parameters are shown in Table 8.1.

The analysis that we are describing here is included in an Excel file posted on the Lesson 8 Overview page, called "Wind Pro Forma.xlsx (no PTC)." The tables below will show some excerpts from the full P&L and Cash Flow tables.

First, we'll take a look at the pro forma without the production tax credit. Tables 8.2 and 8.3 show excerpts from the P&L and Cash Flow statements (Years 0 through 3 for each statement). You could also try to reproduce these yourself as an exercise.

Based on the cash flow statement, we can calculate the net present value and IRR for this project. If you make the calculation yourself or look at the Excel sheet, you will find that the project has a 15-year NPV that is negative - over that time period the project loses $400,440 in present discounted value terms. The IRR is calculated to be 7%.

Here the IRR is itself useful information - it tells you how low the WACC would need to be in order for the project to break even. You can thus use the IRR in evaluating the usefulness of loan guarantees or low-interest loans in making renewable energy projects profitable. In this case, if the wind project has a 50% debt and 50% equity financing structure, then even if the cost of debt were driven down to 0%, the project would still face a WACC of around 10%. Since this is higher than the IRR, we can conclude that unless the mix of debt and equity financing can be adjusted (more debt, less equity) then a zero-interest loan will not be sufficient to make our wind project profitable.

Now, we'll incorporate the production tax credit for wind into our analysis. This section of the discussion will reference a different Excel file, "Wind Pro Forma.xlsx (with PTC)," which is also posted and can be downloaded from the Lesson 8 Overview page. Here we'll simply assume that our project is eligible for the PTC, and that the PTC is set at $23 per MWh.

To incorporate the PTC into the pro forma, we need to add an extra line to the P&L statement, which calculates the amount of the tax credit. Since the tax credit is calculated as a direct deduction from taxes paid, it is possible (and you'll see it happen in this example) that the Taxes line item in the P&L actually turns out to be negative. This indicates that the wind project receives a check from the IRS each year, because of the production tax credit. (The depreciation allowances also contribute here.) Table 8.4 shows Years 0 through 4 of the P&L statement with the PTC included. Please have a look at the Excel file in Canvas as well - you will notice that there is a line item for the tax credit only for years 1 through 10 (after which the project is no longer eligible for the PTC).

Table 8.5 shows the cash flow statement for Years 0 through 3. There is no real adjustment needed for the cash flow statement since the cash flow statement starts with the "Income Net of Taxes" line item from the P&L.

We can again go and calculate the net present value and IRR of the plant. The PTC in this case does not make the NPV positive - the project loses $54,145 in present discounted value terms - but the PTC does increase the NPV by close to $350,000 over the life of the plant. It also raises the IRR to 14%. In this case, if the PTC could be coupled with RECs for the project (even if those RECs were not worth very much individually), then the NPV would likely increase to positive territory.

Lesson 8 Summary and Final Tasks

Summary

Many renewable energy projects are currently at a cost disadvantage to conventional energy projects that do not account for in-kind subsidies to conventional projects for two reasons. First, many renewable energy technologies are not as mature as conventional technologies. Second, the social costs of pollution associated with fossil-fuel usage are not always fully incorporated into the prices charged in the marketplace. If the avoidance of those social costs could be monetized, then perhaps renewables would be more competitive with conventional energy resources. There are two basic ways to incorporate those social costs. First, polluting energy resources could be taxed (or a price put on their polluting emissions). Second, non-polluting energy resources could be given incentives or subsidies in some way, which lowers their costs compared to conventional energy resources. In this lesson, we discussed four basic mechanisms for providing subsidies and incentives. Tax credits and feed-in tariffs act as direct subsidies for each unit of energy produced. Rebates and grants can offset capital costs of new investments. Loan guarantees or low/zero-interest loans can substantially lower a project's WACC, increasing the present discounted value. Renewable portfolio standards or clean energy standards offer quota-based mechanisms for drawing alternative energy resources into the marketplace.

Reminder - Complete all of the Lesson 8 tasks!

You have reached the end of Lesson 8! Double-check the What is Due for Lesson 8? list on the first page of this lesson to make sure you have completed all of the activities listed there before we begin the next lesson.