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Renewable Energy

The Truth about Renewable Energy

By Roger S. Conrad on May. 5, 2015

The world can’t run on wind and solar power alone, at least not yet—that’s the inconvenient truth renewable-energy developers rarely acknowledge in their press releases and investor presentations.

Their hesitation is understandable. Since President Jimmy Carter launched the US government’s first major push to develop clean energy in the 1970s, critics have dismissed these solutions as “flower power,” a political choice that would collapse under the weight of faulty economics when public support waned.

This scenario played out in the 1980s, when a sharp drop in crude-oil prices chopped the legs out from under Carter’s push for US energy independence. His successor, President Ronald Reagan, responded to this new environment by pulling the plug on government support for green-energy research and development.

Of course, renewable-energy technologies have progressed significantly since the 1970s; for example, the US Dept of Energy estimates that wind-energy costs declined by two-thirds over a 20-year period starting in the early 1980s.

The installed base of wind-power capacity has also grown from 6 million kilowatt-hours in 1985 to about 185 billion kilowatt-hours last year. And check out this graph comparing the current US electricity mix to what the Energy Information Administration projects the landscape will look like in 10 years.

(Click graph to enlarge.)US Electricity Mix Current vs EIA Projection for 2025

The data presented in our graph reflects the Energy Information Administration’s base case, a scenario that’s based on developers’ current plans and suggests natural gas and renewable energy will continue to win market share from coal.

Rooftop solar panels and other forms of distributed generation, meanwhile, will remain a relatively insignificant slice of the pie. Nevertheless, the implementation of distributed solutions will grow rapidly from a small base, creating a huge investment opportunity.

Our next graph breaks down the planned and expected capacity additions that underpin the Energy Information Administration’s base projection for the US electricity mix in 2025.

(Click graph to enlarge.)Projected Capacity Additions by Fuel throigh 2025

The Energy Information Administration projects that gas-fired power plants will account for about 66 percent of the generation capacity that the US builds over the next decade. In this scenario, renewable energy makes up 24 percent of new capacity. However, the construction of new nuclear power plants and coal-fired facilities likely will occur at a subdued pace.

Politically Dependent

Renewable energy has made major inroads since the 1970s, and the Tea Party’s embrace of distributed solar power in some regions gives some credence to the argument that political support may not evaporate to the extent that it did in the 1980s.

At the same time, the rollout of renewable-energy capacity still depends heavily on government’s helping hand at the federal, state and local level. And although political reversals won’t squelch the push for green energy, such a development would require some painful adjustments on the part of industry participants.

A glance at the risk factors listed in SolarCity Corp’s (NSDQ: SCTY) recent 10-K filing underscores the industry’s dependence on government support. More than 20 pages in length, this section underscores the damage that changes to favorable government policies could inflict upon SolarCity’s business. These risk factors include:

  • Regulatory changes in California and other key states that would allow electric utilities to charge rates based on their actual costs. The Golden State currently imposes higher prices during peak hours to encourage conservation and switching to distributed energy.
  • Applying to rooftop solar owners the same disconnection and backup power fees to ensure grid reliability that are levied on industrial customers.
  • Allowing utilities to assess a charge for grid maintenance to distributed-generation users.
  • Cutting the price utilities must pay for electricity from distributed sources.
  • Governments not raising the caps on net-metering payments for distributed power that flows back into the grid.
  • Regulators’ failure to compel utilities to spend on grid upgrades to facilitate greater use of distributed generation.
  • Cutbacks in the existing system of tax rebates and subsidies, such as the likely sunset of the 30 percent federal solar tax credit on Dec. 31, 2016.
  • Closing the loophole allowing SolarCity and others to circumvent ownership rules by leasing equipment to homeowners.
  • Adverse developments in a current Internal Revenue Service investigation/audit of company use of government money and valuations of solar systems for tax purposes.
  • Changes in US and Chinese trade practices and retaliatory tariffs that could boost the price of imported solar-power components.
  • Changes in US and Chinese trade practices that inhibit the domestic manufacture of solar-power components at SolarCity’s planned production facility in Buffalo, New York.
  • Any change to the agreement with the state of New York for a proposed solar components factory in Buffalo. The current deal requires SolarCity to put up a fraction of the estimated $5 billion cost.

You get the point. SolarCity would not stay in business without aggressive government support for solar energy. And the same is true for many other participants in this rapidly growing industry.

These companies’ prospects hinge on whether the government remains supportive of green energy. Unfortunately for their shareholders, there’s no clear answer.

Over the past decade, the biggest gains in renewable-energy adoption have come from utility-scale projects. Renewable portfolio standards enacted by 29 states and the District of Columbia have contributed to the boom in clean-energy capacity. These rules require utilities to generate a predetermined percentage of their electricity from renewable sources by a set date.

In the 35 states where utilities operate in regulated markets, power producers usually buy an ownership interest in green-energy capacity from developers and recover this investment in their rate base.

In other states, developers operate the facilities and sell power to utilities under long-term contracts (often 20 years) that include rate escalators. Utilities pass on the cost of this electricity to customers.

The rules differ slightly in the deregulated states and the District of Columbia, where renewable-energy developers receive preferential treatment and subsidies that aren’t available to conventional power plants.

The Environmental Protection Agency’s (EPA) proposed rules to limit greenhouse-gas emissions from existing power plants effectively amount to a federal renewable portfolio standard.

In the unlikely event that the EPA enacts these rules as proposed and Congress doesn’t overturn them, construction of wind- and solar-power capacity would receive another boost.

Fraying Support at the Federal Level

The Aug. 12, 2014, issue of Energy & Income Advisor highlights some of the government policies that support renewable energy. (See Renewable Energy: Policy Matters.) As long as these policies remain in effect, renewable-energy capacity and generation will continue to grow.

However, evidence suggests that the popularity of these government policies has dropped sharply in areas where higher electricity rates have increased consumers’ bills.

Thus far, US policy reversals haven’t been as dramatic as in Australia, where the Liberal Party recently ended the tax on carbon emissions and has threatened to nix subsidies for renewable energy and do away with renewable portfolio standards.

This sea change in government policy has retarded development of clean energy in Australia, a country that boasts some of the most salutary conditions for solar power in the world.

US policymakers remain divided on renewable energy. President Barack Obama’s administration continues to make moves to support renewable energy, in part by applying tougher environmental standards to oil and gas production and coal-fired power plants.

The Republican majority in both houses of Congress remains vehemently opposed to these efforts. Expect the party’s presidential candidates to take a similar stance on this issue.

Investors should expect the EPA’s final rules to move forward—at least until 2017. However, the Republican majority would almost certainly block any Congressional appropriations needed to implement these regulations.

This political environment suggests that Congress won’t extend tax credits for solar power that sunset on Dec. 31, 2016. Although the upcoming presidential and Congressional elections could resolve this impasse, renewable-energy supporters would need to control both houses in the legislative branch and the White House to prolong these tax benefits.

State Politics: A Mixed Bag

Investors should pay closer attention to activity at the state level. Renewable portfolio standards have held up in most jurisdictions, though the push for more of a reliance on renewable energy appears to have run out of steam. In fact, several states have rolled back their targets for the proportion of electricity generated from green sources.

Ohio Gov. John Kasich last year froze the state’s renewable portfolio standards amid an influx of customer complaints about higher electricity bills and a November 2014 election that strengthened the Republicans’ hand in the legislature.

This spring, Idaho cut the required length of contracts to purchase renewable energy to five years from 20 years. Officials also continue to study a proposal that would reduce this term to two years, ratcheting up the competition for sales and likely driving down prices for customers. These policy shifts have occurred because Idaho has more than enough renewable-energy capacity to meet state requirements.

Meanwhile, an alliance between the Kansas Farm Bureau and the oil and gas industry has sought to overturn the state’s renewable portfolio standards for the fourth consecutive year. But even if this effort finally succeeds, the state’s utilities are already on track to generate 20 percent of their electricity sales from clean energy by 2020; repealing these rules would be somewhat of a moot point.

More worrisome is the push to eliminate tax credits afforded to operating wind- and solar-power facilities, a move that could stymie the development of additional capacity and reduce the value of existing plants.

Greater adoption of rooftop solar panels and other forms of distributed power generation have led to pressure on net-metering rates, or the price that utilities credit owners of solar-energy systems when they contribute electricity to the grid.

For example, Wisconsin regulators last year imposed an annual fee of $182 on operators of rooftop solar-energy systems and slashed the prices that utilities pay for electricity from distributed sources to $0.03 per kilowatt-hour from $0.14 per kilowatt-hour.

And Arizona changed the rules stipulating which entities can market and install rooftop solar-power systems, allowing Arizona Public Service Company, the regulated electric utility owned by Pinnacle West Capital Corp (NYSE: PNW), to enter this business and compete with incumbents such as SolarCity.

Arizona Public Service Company’s scale, existing customer relationships and access to low-cost capital give the utility a huge leg up on the competition and enable the firm to offer deals to residential and commercial customers that SolarCity can’t match. In a price war, the electric utility has all the advantages, despite Elon Musk’s talent as a stock promoter.

Beware the Duck Belly

Ironically, California and other states that historically have supported renewable energy pose the biggest risks to green-energy developers and their ongoing government support.

The wind doesn’t always blow and the sun doesn’t always shine; these sources of renewable energy generate electricity intermittently.

Government policies that promote clean energy undermine the economics of conventional power plants that run 24-hours a day and provide baseload power to the grid. These facilities represent the cheapest, most reliable means of generating electricity.

Replacing these baseload power plants with intermittent sources means that grid operators must rely on flexible generation, peaker units that fire up when consumption exceeds baseload capacity. These frequent start-ups and shutdowns entail much greater expense than power plants that run constantly, while constantly flipping the on and off switch on these facilities makes them less reliable and prone to breakdowns.

Growing demand for flexible generation—an unfortunate side effect of the growing reliance on intermittent wind and solar power—translates into much higher system costs, raising customers’ bills. This phenomenon goes a long way toward explaining why households and businesses in Germany pay almost five times as much for electricity as their counterparts in Louisiana.

This challenge highlights the appeal and promise of batteries and other technologies that can store excess energy generated during peak hours for wind and solar power to help smooth out electricity flows over a 24-hour period. At this point, no commercially feasible solutions exist.

Until technology catches up with demand, regulators in California and other states with heavy adoption of renewable energy must contend with the “duck belly” depicted in this familiar graph.

Developed by California’s Independent System Operator (CAISO), the duck curve tracks power draws on the state’s grid over the course of a single day.

Source: CAISO

Whereas the 2012 data reflects actual draws, the remaining lines represent projections that factor in the anticipated adoption of rooftop solar power by Californians.

The duck’s growing “belly” during the middle of the day reflects growing contributions from rooftop solar and reduced draws from these households on the grid. This portion of the duck swells when the sun is at its strongest and solar-power generation peaks.

But when the sun goes down and Californians return home to prepare dinner, watch television and switch on other electricity-sucking appliances, draws from the grid increase, forming the duck’s neck.

As long as the duck’s belly remains relatively small, these daily fluctuations in power flows won’t affect overall grid economics. In this scenario, baseload power plants that run constantly can still sell enough electricity at high enough prices to stay solvent.

However, the economics grow more challenging as the duck’s belly expands. The greater the installed base of rooftop solar units, the less demand for baseload power in the middle of the day, which translates into lower electricity prices.

If these projections and the existing pricing system holds, a significant portion of California’s baseload power will become uneconomic to run; if utilities shutter this capacity, power shortages will occur after the sun goes down.

Replacing baseload power plants with peaker units that can stop and resume operations with relative ease would help to address this issue, albeit at a significant cost.

With a target of generating one-third of its electricity from renewable sources by 2020 and some prominent politicians calling for this proportion to reach 50 percent over the subsequent decade, California remains a strong market for renewable-energy developers.

But these ambitious targets could compromise the grid’s reliability and lead to soaring electricity costs–developments that could damage business and prevent renewable energy from reaching its potential.

Renewable Energy: How to Make Green and Avoid Red

Although SolarCity Corp (NSDQ: SCTY) and other outfits with unsustainable business models pose the most risk to investors’ wealth, long-term contracts and the participation of utilities in the space should ensure that renewable energy won’t reprise its disappearing act from the 1980s.

SolarCity’s backers trot out the tired argument that distributed solar power represents a paradigm shift that will erode utilities’ earnings power and loosen their stranglehold on the market.

Never mind that utilities’ investments continue to spur development of wind- and solar-power generation, as well as other forms of renewable energy.

Unlike standalone developers, utilities recoup these capital expenditures in their regulated rate bases and long-term contracts, which help to guarantee a reasonable rate of return and provide a high level of visibility to cash flow. These companies can also enjoy an extraordinarily low cost of capital, enabling them to finance any capacity that they build or acquire under favorable terms.

Moreover, utilities continue to lead the way in the development of storage solutions and improvements to grid infrastructure that will be critical to supporting wide adoption of renewable energy.

The greatest hope for effective energy storage technologies, for example, resides with Hawaiian Electric Industries (NYSE: HE) and its would-be acquirer, NextEra Energy (NYSE: NEE). AES Corp (NYSE: AES), another utility, owns the world’s largest energy storage facility—excluding notoriously inefficient pumped-storage solutions.

Even utilities that traditionally have relied on thermal- and nuclear-power plants have also made a push into green energy, including Southern Company (NYSE: SO), which emits the most carbon dioxide of any US utility.

The stocks may lack the sex appeal of SolarCity and other popular names that continue to champion the death of the utility sector at the hands of distributed generation. But with government support for renewable energy looking increasingly tenuous, utilities’ investments and balance sheets will become even more important to green energy’s future.

Solar-power developers will survive, but only if they help to serve utilities’ primary goals:

  • Meeting standards for grid reliability;
  • Reducing the environmental impact from primary resource extraction and the generation, transmission and distribution of electricity; and
  • Keeping costs and customer rates as low as possible to encourage consumption and economic growth.

Upstarts that don’t toe this line will find themselves in trouble, especially if their valuations reflect hype instead of fundamentals. SolarCity, the poster child for these problems, trades at an astronomical 18 times sales even though the company lost $1.47 for every dollar of revenue it generated in 2014.

Don’t be surprised if SolarCity tumbles to less than $10 per share when the going gets tough.

An Exclusive Report

I’ve written an exhaustive special report on the risks and opportunities in renewable-energy, highlighting investors’ best bets and the money pits that you should avoid at all costs. This 20-page report is available exclusively to Conrad’s Utility Investor subscribers.

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Roger S. Conrad needs no introduction to individual and professional investors, many of whom have profited from his decades of experience uncovering the best dividend-paying stocks for accumulating sustainable wealth. Roger b