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By Elias Hinckley on Aug 16, 2012 with 6 responses

Introduction to Banking Energy

Welcome to “Banking Energy”. This is a new column and in it I will be writing and facilitating articles and discussions about the uniquely challenging world of finance for energy projects and technologies. The column will cover the spectrum of energy types and technologies, with some special attention paid to the challenges of financing new energy technologies and new applications of old energy sources.

The column will include some review of established aspects of energy finance, but I will focus primarily on emerging issues and how energy finance affects things like market development, project development and adoption of emerging technologies.

I plan to have regular guest contributors and co-authors who can help add relevance, expertise and context. Additionally please don’t hesitate to make suggestions for future topics.

My background (at least the relevant bits) is a mix of finance, law and policy, primarily helping companies and investors find innovative and efficient ways to put energy deals together. I currently lead the clean energy practice at a large international law firm, have held a similar role for another law firm as well as one of the Big 4 accounting firms, and have also taught international energy policy at Georgetown University.

The focus here will be energy finance, but I expect to incorporate many aspects of energy law and energy policy, for the simple reason that energy finance, energy policy, and energy law are inextricably linked. Successfully navigating energy deals requires an understanding of the intersection and intricacies of finance, law, and policy. Direct government financial supports, from tax credits for solar power, to special deductions for oil drilling, exist in some form across virtually every energy source and technology. Indirect supports also influence the competitive landscape. Whether direct or indirect, fully realizing the value of government-based economic support is vital in making project economics work for energy projects. Similarly, legal and policy issues how energy can be sold, the regulation of prices, and, of course the environmental aspects of energy production overlay every part of the industry. How these regulatory programs operate, when they apply, and how they come into and out of existence can be vital to the financial viability of a project.

Why I View All Forms of Energy as a Commodity

I view energy, whether in the form of fuel to be burned, or ready-to-use electricity, as a commodity. Financial decisions in commodity markets are based on price. I’ll use electricity as an example. When I turn on a light, there is no thought given to the quality of the electricity being converted to light based on where it came from (whether that was a coal plant, a solar panel or any other electricity generating source). When delivered, that unit of power performs the same work, regardless of its origin and is (for the purpose of use in my light-bulb) indistinguishable from any other unit of electricity. Because units of electricity are indistinguishable, unless there is some external factor added (like a renewable energy requirement adding value) the market, and the decision about which electricity to buy, is necessarily driven only by the price per unit of electricity.

When the decision about whether a project will make financial sense is scrubbed this bare it is easy to see that there are two fundamental variables that balance the decision of whether or not to build or invest in new electricity production – how much will it cost to produce a unit of electricity and how much money can the seller of that electricity get for each unit sold. If I can sell my kilowatt hours for more than it costs to generate those kilowatt hours my power project makes sense. If it doesn’t sell for more than it costs to produce, I don’t build the generation project.

Cost and Price – Integrating Variables

To be sure, each of those two basic numbers – cost and price – have a wide range of variables that need to be integrated into the calculation. To illustrate this, assume that I am investigating the development of a wind farm. My cost per unit of electricity (the levelized cost of energy or LCOE) is arrived at by assigning a portion of the capital cost to each unit produced over the life of the wind farm. First I need to determine the cost to build my wind farm. Choice of turbine size, height, manufacturer, and location all affect the price. Then I need to figure out how much money I will need to pay for the different forms of financing necessary to pay for the construction of my wind farm – the use of money is not free (in future discussions I’ll spend time unpacking how this number is calculated, and optimized).

Next I need to model how much electricity my wind farm will produce over its life (20 years is a good working assumption). The wind doesn’t blow all the time so I need to adjust output to match my projected capacity factor (a 20MW wind farm produces 20 megawatt hours only under the right set of operating conditions, in general a wind farm will produce 30 – 45% of the total potential units of electricity over a year). With this number I can calculate capital cost per kilowatt hour. To this I still need to add the operating cost per unit as well as any transmission costs to transport my electricity to a place where someone would like to buy it (and there are multiple components to each of these amounts as well). If I were building a plant that required fuel (and water) like a natural gas fired plant, I would also need to incorporate the costs of fuel (and water) per unit, which is, of course tricky, because fuel prices are variable (and often volatile).

There is a similarly complex set of factors in determining the price at which I can sell my power (questions like when, where, and to whom). So it’s easy to see that reaching the point where I can make that simple comparison of cost vs. price isn’t easy – but once I reach that point, the fundamental decision is very simple. This will seem obvious to many readers, but it’s a concept that gets lost, a lot. So I thought I would lay this concept out, right from the start, because it will be the baseline against which many complex and controversial topics can be measured and (hopefully) resolved.

The Important Role of Studies, Projections, and Assumptions

The LCOE is also a good comparative tool, although it is difficult to get real time comparisons as it takes time to build the necessary data. Here is a comparison of levelized cost projections for a plant placed in service in 2017 created by EIA using data from 2011. The multi-year spread is used to allow for a theoretically more even comparison, because for larger complex projects 2017 would be the earliest a facility could be operational.

A few important points are worth noting when reviewing these numbers. Assumptions have to be made for fuel prices, so significantly higher natural gas, coal, uranium, or biomass prices than used in the forecast will result in a significantly higher LCOE. These projections only include known external costs, so these do not include costs associated with carbon emissions, nor do these number consider a measurable increase in the price of water, which is necessary for several of these technologies. Finally, the rapid drop in solar PV pricing likely is not properly accounted for in this data (the 2010 data/2016 projections done one year earlier have solar PV costs 38% higher than in this projection).

Here is another set of projections (using 2010 data), in this case out to 2050, and including a reference price for operating base-load generating costs for a typical coal plant. This comes from the Google.org report The Impact of Clean Energy Innovation.

This second projection was created by the team at Google.org to illustrate that investment in technology can drive down the price of energy. These projections are based on EIA’s 2011 data – the same data used for the EIA projections. Obviously there are some striking differences. Some of this can be explained by Google’s numbers being based on the assumption that there are no transmission costs and that resources are only deployed in geographically preferenced locations (e.g., wind turbines only where the wind resources support consistent high outputs). Even with those adjustments taken into account it stands out dramatically how different the projections to 2020 by Google are from EIA’s projections to 2017.

The difference between EIA and Google projections (and there are other takes on this as well) illustrates another key interplay between energy finance and energy policy which I will be addressing in this column. Studies, projections and assumptions made regarding the basic financial case for various energy sources define an important part of the battleground over energy policy. I will make every effort to cut through bias in the many representations made about financing different energy sources and projects to help inform more honest policy discussions.

Next up: Why Good Projects Fail to Get Financed and Finding Value in the Emerging Water-Energy Nexus. In the meantime you can follow me on Twitter

  1. By Robert Rapier on August 16, 2012 at 3:52 pm

    Nice, comprehensive inaugural article. Welcome to the CER family. 

    RR

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  2. By Roy Toy on August 16, 2012 at 7:36 pm

    Thank you for this great Article I look forward to the next Installments.

    I am experiencing almost everything you mention in trying to bring a new technology to market. If I am successful in raising the Capital needed I will probably experience the rest. 

    The barriers to entry are high and wide.

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  3. By Russ Finley on August 16, 2012 at 11:59 pm

    I will make every effort to cut through bias in the many representations made about financing different energy sources and projects to help inform more honest policy discussions.

    Welcome. Every study is biased. That is the one thing you can count on.

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  4. By Andrew Holland on August 17, 2012 at 10:24 am

    Elias – welcome aboard. Great first article.

    If I can sell my kilowatt hours for more than it costs to generate those kilowatt hours my power project makes sense. If it doesn’t sell for more than it costs to produce, I don’t build the generation project.

    I’m sure this is the case for your projects, but I know that many utility companies are the most conservative (small c) businesses in the country – meaning that they would much prefer to build new electricity generation that is the same as the electricity they’ve already built and are familiar with. 

    Its important to note that not every business decision is a purely cost-benefit decision.

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    • By Elias Hinckley on August 21, 2012 at 11:43 am

      Thanks for all the nice welcomes. 

       

      Andrew, you are exactly right.  There are all kinds of things that influence how decisions on generation choice actually get made.  Perception, familiarity and all kinds of other biases become part of the decision making process.  Combined those biases with the inputs that can’t be easily given a dollar equivalent and there are times where good projects (or choices) just don’t happen.

       

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  5. By tadchem on August 17, 2012 at 1:51 pm

    Physicist Victor Yakovenko at the University of Maryland is developing the field of Econophysics, the main basis of which is the idea that money (currency) obeys natural laws strongly analogous to the Laws of Thermodynamics which govern the behavior of energy in physical systems: physics.umd.edu/~yakovenk/econophysics/

    The titles of his papers are very revealing: “Statistical mechanics of money”, “Evidence for the exponential distribution of income in the USA”, “Two-class structure of income distribution in the USA: Exponential bulk and power-law tail”, etc.

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