Friday, January 25, 2008

Renewable Energy and the Economy

Only a few weeks ago, 2008 promised to be a banner year for renewable energy, the companies that are developing it, and investors in those companies. Oil prices remain near historic highs, and the Energy Bill signed by the President in December boosted the country's ethanol mandate almost five-fold. Although the final legislation didn't include a national renewable electricity standard, 24 states plus the District of Columbia already have such standards in place. As a result, ethanol and wind and solar power have been expanding rapidly, with wind turbine installations in 2007 having grown at nearly double the rate for 2006. One might be forgiven for thinking this sector was essentially recession-proof, backed as it was by the happy alignment of fundamentals and regulations. But as the economy weakens, there are reasons to believe the story is not uniformly rosy, and the stock market seems to agree with that assessment.

At the end of 2007, the WilderHill New Energy Global Innovations Index (NEX), a composite of 86 new energy companies covering wind, solar, biofuels, efficiency, and hydrogen, was up by 58%, year-on-year. As of yesterday, however, it was off almost 20% for 2008 so far, compared to a drop of about 8% for the S&P 500. Why would a sector so favored by politicians, environmentalists, and socially-conscious investors suddenly appear to have diminished prospects, just when it seemed perfectly geared for growth? Unfortunately, renewables and the entire alternative energy sector are vulnerable to two of the same principal factors undermining confidence in the economy as a whole: the availability of credit and higher inflation at the wholesale level.

Ethanol and wind power provide two examples of these vulnerabilities. As I noted recently, the phase-in of the Renewable Portfolio Standard in the 2007 Energy Bill expands the domestic ethanol market from about 6.4 billion gallons per year (BGY) in 2007 to 9.0 BGY this year and 10.5 in 2009. But it also provides for refiners and blenders to receive waivers, if the required ethanol isn't available. If the companies building new distilleries cannot borrow enough to complete those facilities, then the capacity to meet the higher mandate may not exist. Meanwhile, rising corn prices, approaching $5 per bushel, will continue to squeeze the margins of new and existing producers. The final outcome of these trends, in a market created by regulations and subsidies, is uncertain.

Now consider wind power. Although developers had hoped the Energy Bill would extend the 2 cent/kWh Renewable Electricity Production Tax Credit (PTC) beyond the end of 2008, this benefit is at least available for projects completed this year. Its impending expiration might even accelerate some projects, as we've seen in previous years when the PTC was set to end. But a typical wind project receives financing in the range of 30-50%, and in recent years the sources of capital have grown more exotic, including Structured Investment Vehicles and "flip" structures. Wind power is thus vulnerable to some of the same credit risks affecting the entire economy, including the potential backwash from credit default swaps and institutional failures. These are hardly the problems you want to be dealing with, if you are scurrying to put steel on the ground before your tax break evaporates. Nor are wind turbine manufacturers immune to the escalating cost of raw materials, including commodities such as copper, which is at five-year highs. It also doesn't help that the price of natural gas, the fuel for wind power's main conventional competition, has recently uncoupled from the price of crude oil. While the oil futures price is 65% higher than one year ago, the same comparison for natural gas is only up by about 7%.

A weak economy has another, broader implication for green energy. As one of my readers mentioned recently, a deep or prolonged recession would very likely delay efforts to put a price on carbon emissions, whether through cap & trade or a carbon tax on fuel. Even if much of the revenue were redistributed to neutralize its regressive effects, anything that increased energy costs beyond their current levels would be a very tough sell. None of these specific or general concerns makes a meltdown in the renewable energy sector inevitable. But despite support from state and federal government, renewable energy companies could experience a disappointing 2008, particularly compared to the sector's performance last year.

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