Renewable energy credits can help reduce risks associated with clean energy projects. Understanding the benefits, and potential drawbacks, of these credits will be important in deciding their broader role in the clean energy transition.
Right now, under the auspices of the Greenhouse Gas Protocol revision process, there is an ongoing debate about the importance of renewable energy credits, or “RECs.” As I discussed in an earlier blog post, RECs represent the attribute of clean energy, where a REC is considered a separate entity from the electricity itself. RECs are used by companies (and others) to reduce the amount of greenhouse gas emissions they associate with their electricity consumption. But electricity doesn’t flow from point to point, and the companies are not actually consuming clean electricity. Ultimately, a REC is just a piece of paper, so its connection to emissions reductions is unclear and a source of considerable controversy.
Part of that controversy lies in the value of a REC. To understand that value, one might start with how much a REC costs. When a buyer purchases a REC from a clean energy project, the purchase should improve the finances of the clean energy project. However, prices of RECs are quite low unless they are part of a long-term contract or are used to comply with state policies like a renewable portfolio standard. Given that there are transaction costs associated with RECs and considerable uncertainty about their future prices, it’s not clear how significant the revenue from these RECs could be to any given project.
But that isn’t the whole story. Looking solely at REC prices misses a significant way that RECs can be valuable: they encourage companies to enter into long-term bilateral contracts with clean energy developers.
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Companies want to receive RECs as part of these long-term contracts, because they can use RECs to reduce their claimed emissions and contribute to achieving their climate goals. In return, these long-term contracts provide additional value to a renewable energy project by reducing the amount of risk the developers and their financiers must take on. This risk is effectively assumed by the company entering into the long-term contract with the clean energy developer.
Over the past few months, I have spoken with renewable energy developers to better understand how this risk-reduction process works in practice. The remainder of this blog post discusses what I learned about risk, how renewable projects are financed, and the role RECs play in managing both. I will conclude by discussing what this all means for the relationship between RECs and emissions reductions.
Project Finance
Most renewable energy projects are not on the books of a large company. Instead, developers create a new company for each project, sometimes called a special purpose vehicle. This is called “project finance.” Creating a separate corporation has advantages. First, for developers, it means that if the project fails to make its loan payments, the only recourse the lender has is limited to the assets of the project itself. This is called “nonrecourse debt.”
The special purpose vehicle also has advantages for lenders. In particular, the cash flows of the special purpose vehicle can be contractually obligated to be spent in a specified manner to increase the likelihood of debt repayment. More broadly, the ability to contractually allocate the risk of the project is the major advantage to using a special purpose vehicle.
Projects are usually financed with two types of money: equity and debt. Equity is the money that investors directly put into the project, and debt is the loans. Generally, debt is going to be cheaper than equity, in part because the interest is tax deductible, so the more debt financing a project has, the less expensive it will be. Banks, however, don’t like risk, so the amount of debt they are willing to provide (and the associated interest rate) will depend on how risky the project is.
Debt Coverage Ratios
One of the most important questions for a lender is whether the project will have enough cash each year, after paying operating expenses, to cover the loan payments. The more debt, the higher the loan payments, so the higher the revenue must be. However, revenue for a renewable energy project is uncertain, which mostly arises from the uncertainty in power prices and the uncertainty in the amount of generation, the latter of which depends on how hard the wind is blowing or whether the sun is shining.
Lenders can deal with this uncertainty in multiple ways. One is to use a very conservative estimate of the revenue. For example, while an equity investor might look at the median revenue projection, banks instead will base their calculations on the 90th or even the 99th percentile projection. This means that, when looking at the distribution of projected revenues over a given year, the lender will make decisions based on a revenue projection low enough so that 90 percent (or 99 percent) of all projections will be higher than that projection.
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Lenders also require a buffer in calculating the cash flows to cover the loan payments. In other words, they don’t just ask that the 90th percentile revenue is enough to cover the loan payment; they require that the revenue must cover the loan payment multiplied by an extra factor called the debt service coverage ratio. (This is one of the most prominent coverage ratios used in project finance, but there are others.) The higher the level of the risk, the higher the ratio.
With the revenue projections and this ratio, one can calculate the maximum loan payment possible. This loan payment determines the size of the loan and (along with the interest rate) the cost of the debt. Lower risk means lower debt service coverage ratios, which means that a project can take on more debt, which in turn reduces costs.
Long-Term Contracts
A clean energy project developer has few avenues to reduce weather-related risks, but there are ways to reduce the risk associated with uncertain electricity prices. The most prominent option for a large electricity consumer, such as a company with a data center, is to enter into a long-term contract promising a fixed price for the electricity generated.
These contracts, called power purchase agreements, come in a few different forms (including so-called “virtual” purchase power agreements). Power purchase agreements create a fixed price for the power produced by the renewable generator, so the generator is not exposed to the variability of the current electricity price. Instead, that risk is taken on by the counterparty to the contract, such as the data center company. (Note that other types of derisking methods exist.)
By ensuring a fixed price for electricity, these contracts reduce the revenue risk for renewable generators. This derisking approach makes banks willing to accept lower debt coverage ratios, which enables a project to take on more debt and cheaper financing. Cheaper financing then translates into lower overall costs for the project. And lower costs mean more clean energy.
These long-term contracts are important for the electricity consumers, because the RECs transfer to the consumer under the contract. Without the REC, and the consequent ability to claim reduced emissions toward their climate goals, many potential electricity consumers would not necessarily be motivated to enter into these long-term contracts.
So, the importance of RECs is two-fold. RECs that are not part of long-term contracts and are sold on an open market are generally inexpensive, bringing less revenue to the project. However, the RECs associated with long-term contracts make clean energy cheaper by enabling more debt financing. The RECs associated with these long-term contracts have two types of implicit value: any price premium paid by the electricity consumer, and the reduction of financing costs.
Conclusion
Much of the controversy about the reductions in emissions associated with a REC focuses on the issue of additionality, or whether the renewable project would have occurred without the REC. This is an incredibly challenging question to answer because it involves understanding the counterfactual where the REC never existed. There are ways one could try to understand this counterfactual, but there will always be fundamental uncertainty in such a result.
It would go too far to say that all of the RECs associated with long-term contracts represent additional clean power, because at least some long-term clean power contracts would likely exist even in the absence of RECs. But if the presence of RECs means more people are willing to enter into long-term contracts, basic economics suggests that there will be more long-term contracts. These contracts reduce costs, and economics again says that cheaper clean energy means more clean energy. And, taking the syllogism to its conclusion, more clean energy means lower emissions. Even if we will never know how much exactly is due to the RECs.
