Expanding the Investor Base and Lowering the Cost of Capital for Renewable Energy through Master Limited Partnerships by Sean Flannery and Wilson Rickerson Meister Consultants Group, Inc. Prepared for the Union of Concerned Scientists April 2014 Key Findings We believe institutional investors would be interested in investing in renewable energy through MLPs as an attractive way to diversify portfolios while responding to green priorities. MLP asset managers would conduct due diligence on renewable energy deals and lower the transaction costs hurdles for institutional investors to invest in renewables. We estimate that the pool of capital interested in renewable energy MLP deals could easily provide the projected investment of $50-$70 billion per year over the next 5-10 years to increase non-hydro renewables to 30 percent of U.S. electricity generation by 2025. The size of this pool would create competition to supply capital if a correspondingly large pipeline of renewable energy deals were not identified. We estimate that cost of capital for renewable energy in MLPs given potential institutional investor interest would converge with the recent cost of capital for natural gas pipelines in MLPs (i.e. 4.9%). This would represent a significant decrease relative to current costs of capital under tax equity deals and is slightly lower than the current cost of debt financing. UCS analysis shows that reducing the cost of capital by 3 percent through MLPs could lower the levelized cost of electricity (LCOE) from a typical wind project by 17 percent and would be worth about 40 percent of the value of the production tax credit (PTC). Overview of Current Investment Climate for Renewable Energy The cost of capital for renewable energy is an important factor in determining the levelized cost of energy (LCOE) because wind and solar projects require high levels of upfront capital investment and relatively low operating costs over the project lifespan. While U.S. policy incentives for renewable energy have been inconsistent from year to year, available incentives have been primarily focused on production or investment tax credits and accelerated depreciation.
As a result, capital formation has been largely driven by a pool of tax equity investors - largely investment banks and insurance companies. The tax equity investors are typically highly-rated and highly-levered entities with substantial and persistent taxable income. The total pool of tax equity financing was estimated at approximately $6.5 billion in 2013, after having fallen to about $1 billion in the aftermath of the financial crisis of 2008. Tax equity investors generally will not invest in projects less than $25 million and typically target $75-100 million deals. The equity investments are structured to capture the majority of cashflows and incentives until the tax-related incentives are exhausted generally 7-10 years after which the structure flips and the investor can exit the deal. These tax equity structures differ significantly from typical equity investments and include features more consistent with debt than with equity. The base of $3-6 billion per year in tax equity investors is modest relative to the investment required to meet current and projected levels of renewable energy development in the U.S. In 2012, U.S. investment in renewable energy (primarily wind and solar) was approximately $40 billion. 1 According to a 2012 study by the National Renewable Energy Laboratory (NREL), steadily increasing renewable energy to provide 30 percent of total U.S. electricity generation by 2025 and 80 percent by 2050 will require investing roughly $50-70 billion per year over the next decade, increasing to $85-125 billion per year over the longer-term. 2 The combination of a small number of investors and complex, opaque and heterogeneous deals creates barriers to entry, limits capital formation for renewables, and results in higher cost of capital than we would expect for assets generating the duration and magnitude of cashflows typically found in renewable energy deals. Approaching Master Limited Partnerships (MLPs) for Renewable Energy The Master Limited Partnership Parity Act, introduced by Sen. Coons(D-Delaware) in April 2013, seeks to expand the potential pool of investors by allowing renewable energy to qualify for master limited partnerships (MLPs). The MLP structure avoids double taxation (corporate and shareholder) by passing through income and gains to the investor. The MLP market has grown from $155 billion in 2007 to over $400 billion in 2013, with more than $60 billion in annual capital raised in this segment over the past two years and exceeding tax equity by a factor of ten or more. The main driver of growth in demand for MLPs has been new natural gas infrastructure. Investors are attracted to the high current income, generally high asset quality and ease of transacting these exchange-listed funds. Our analysis indicates that the MLP market could be an important bridge to dramatically increasing renewable energy funding and lowering the associated cost of capital. We reviewed relevant literature and interviewed twelve investors, attorneys, analysts and operators in the MLP and renewable energy project arenas to assess the level of potential interest in investing in renewable energy projects though listed MLP structures. We found that much of the existing literature provided fairly limited analysis of the potential impact of 1 Based on data from the American Wind Energy Association, Solar Energy Industry Association and Bloomberg New Energy Finance. Investment in wind and solar was approximately $36.5 billion. 2 National Renewable Energy Laboratory (NREL) 2012. Renewable Electricity Futures study, NREL/TP-6A20-52409. Golden, CO. Online at: http://www.nrel.gov/analysis/re_futures/. 2
renewable energy MLPs (REMLPs), was lacking in theoretical grounding and cited mostly secondary sources. Our analytic approach was to 1) estimate the magnitude of the potential pool of investment that might be tapped through allowing renewables to be financed through REMLPs, and 2) evaluate the extent to which we could identify similar asset classes and their pricing to estimate the resulting cost of capital. The cost of capital for REMLPs could then be integrated into future UCS modeling. Estimating the potential incremental investment through REMLPs We identified two segments to analyze as possible investors in REMLPs: the US mutual fund market ($15 trillion) and the US defined benefit pension market ($11 trillion). We found in our research that in recent years a number of public pension funds have made substantial allocations to the MLP market, despite the fact that these tax-exempt pension plans are not able to take full advantage of the tax benefits associated with these deals. MLP managers report a substantial increase in institutional investors in their funds. They indicate that the institutions are drawn by the prospects of high income generation compared to very low rates in bonds and disappointing returns in alternative asset classes. We calculated current 5-year annual growth rates (based on growth rates for the 5 years ending in 2013) for the defined benefit pension funds and mutual fund markets as a baseline for estimating total available capital, and then looked for asset classes within these markets that might be reduced (i.e. substituted) in favor of REMLP investments. We did not include the defined contribution (401k) market to avoid double-counting in mutual funds. We concluded that mutual fund investors would be most likely to reduce traditional bond investments to fund REMLP allocations and pension funds would be apt to use their alternative investment category as the source. We then calculated what percentage of assets in each segment would have to be reallocated to REMLPs over each of the next five years, using the 5-year historical growth rate of the MLP market, in both the $50 billion and $70 billion per year renewable investment scenarios. Our analysis indicates that the portfolio shift to fund the $50 billion per year scenario would require a transfer of 0.7% of portfolio assets; the $70 billion scenario would be 1% of assets at the end of the 5 years under these assumptions. REMLPs would represent just under 20% of the overall MLP market at the end of 2019. The plausibility of such a shift was enhanced by a number of additional factors, including evidence of rapid adaption of the MLP market in recent years to fund the massive increases in natural gas-related funding, changes in fund legal structures to accommodate needs and preferences of different investor segments, and evidence of growing investment in the MLP markets by institutional investors. Estimating the cost of capital for incremental investment through REMLPs Tax equity investors currently target a return of, on average, 11% for renewable energy deals, with the understanding that targets may be higher or lower depending on the individual merits of the investment. For MLP pricing, other studies tend to cite generic figures from 3
cents/kwh sources such as the National Association of Publicly Traded Partnerships. 3 We identified three asset types with similar characteristics and varying credit quality, and found that the best proxy for REMLPs would be lower quality investment grade (BBB-) natural gas pipeline deals, which currently trade at about 4.9%. Our analysis indicates that REMLPs may reasonably be expected to converge from the current level of 11% equity, or 8% weighted average cost of capital based on a mix of equity and debt financing to something approaching 4.9% over 5 years. This would represent a significant drop in cost of capital compared to current tax equity financing and slightly lower than the current cost of debt. Estimating the impact of REMLPs on the levelized cost of electricity (LCOE) UCS used this information to estimate the impact of MLPs on the LCOE of wind projects using NREL s Cost of Renewable Energy Spreadsheet Tool (CREST). 4 Assuming MLPs would lower the cost of capital by 3 percent, UCS found that MLPs could lower the LCOE for a typical wind project by 17 percent (1.2 cents/kilowatt-hour) compared to a traditional financing structure without the PTC. This finding is consistent with a 2012 NREL analysis of MLPs and other alternative renewable energy financing structures. 5 UCS also found that this level of cost reduction due to MLPs was worth just over 40 percent of the value of the PTC. Potential Impact of MLPs on Wind Power Costs 20 Year Levelized Cost of Electricity (LCOE) 8 7 6 7.25 6.75 6.05 5 4.35 4 3 2 1 0 Traditional FinancingTraditional Financing without PTC with PTC MLP without PTC (with 6.5% return) MLP without PTC (with 5% return) Key Assumptions Wind cost and performance: $1,900/kW capital cost, $50/kW-year fixed O&M, 40% capacity factor. PTC: 2.3 c/kwh for 10 years (after-tax value). Traditional Financing: 60% equity @ 11% after-tax return, 40% debt @ 5.5% interest and 15 year term, resulting in a weighted average cost of capital of 7.9%, and 2% lenders fee, (DSCR). For PTC scenario, debt/equity ratio changed to 35/65 to achieve 1.45 debt service coverage ratio (DSCR). MLP financing: 100% equity @ 5% and 6.5%, 1% general partners fee. Source: Union of Concerned Scientists (UCS) analysis using NREL's CREST model. 3 See, for example, Mendelsohn, M. & Feldman, D. (2013). Financing U.S. renewable energy projects through public capital vehicles: Qualitative and quantitative benefits. Golden, CO. National Renewable Energy Laboratory. 4 NREL s CREST model is available online at: https://financere.nrel.gov/finance/content/crest-cost-energy-models. 5 Mendelsohn and Feldman, 2013. 4
Conclusion Renewable energy finance is hindered by unstable incentive policy and a narrow investor base. Current renewable energy financing deals are complex to evaluate and require a substantial and persistent need to shelter income in order to take full advantage of the current tax incentives, which creates a barrier to potential capital flows to the sector. The standing prohibition of renewable energy assets in MLP structures, in which most energy structures are financed, further impedes capital formation for the sector. The nature of renewable energy projects, however, is inherently attractive to investors whether individual (mutual funds) or institutional (pensions) since they produce long term, high quality income streams that are substantially higher than those that can be found in traditional bond markets. Opening the MLP market to renewables could mobilize required additional investment in renewable energy, lower the cost of capital and lower the levelized cost of energy. 5