A Properly Designed Feed-in Tariff Can Lower the Cost of Capital and Keep Electric Rates Down

by Richard W. Caperton

Conversations about building new renewable energy almost always come back to the electricity from these projects being more expensive than fossil fuel energy.  This may be the case (although it’s almost certainly overstated), but this shouldn’t lead to the conclusion that the way to minimize rate impacts is simply to use less renewable energy.  In fact, there are policy tools that can help lower the cost of renewable energy, letting us meet renewables goals at a lower price.

One of these policies is a feed-in tariff, also known as “CLEAN Contracts.”  Perhaps most famous for its successful implementation in Germany, a feed-in tariff is a policy tool that guarantees a fixed price at which renewable generators can sell the electricity they produce.  The tool works by requiring that utilities offer a standardized, long-term contract to clean energy developers, with a price determined by a public body or regulatory authority.  Feed-in tariffs provide the transparency, longevity, and certainty that banks need to finance projects, which leads to significant investment.  Indeed, feed-in tariffs are responsible for 75 percent of the solar photovoltaic power installed worldwide, as well as 45 percent of the wind energy.

The key element of a feed-in tariff is to set a price that reflects the cost of generating the energy, including a reasonable rate of return that is fair and equitable to both investors and ratepayers.  This is generally the same way that regulators set electricity rates, by looking at a utility’s costs – including investments in new generation – and setting rates at a level to recover those costs plus a reasonable rate of return to their investors.  The rate of return is critical, because there is evidence that the necessary rate of return under a feed-in tariff program can be lower than the typical rate of return that utilities require.  This means that renewable energy is cheaper with a feed-in tariff than without.

Publicly-available data on utility rates of return, feed-in tariff policies, and costs of renewable energy can give important insights into just how big this difference can be.

[JR:  Warning -- This is a wonky post, which is why I like it!]

To start, we need to determine what rate of return utilities generally get on their investments.  There are some exceptions, but theorists generally agree that the rate of return a utility should get is the same as their cost of capital (that is, how much their investors expect to earn on their investment). According to data compiled by the Edison Electric Institute, investor-owned electric utilities can expect to earn a return on equity of just over ten percent.  Of course, this can vary by utility, with some utilities earning rates of return of closer to eleven percent.  (Non-profit electric companies, such as electric cooperatives and municipal utilities, likely have a different cost of capital, so this analysis is specific to investor-owned utilities.)

The average investor owned utility has a capital structure that is roughly 50 percent equity and 50 percent debt, and faces an effective tax rate of about 33 percent.  If we assume that their cost of equity is ten percent and cost of debt is five percent, then the “weighted average cost of capital” for a utility is 6.7 percent.  Ultimately, this is the cost of capital that will be passed on to ratepayers on every investment.

Now, let’s consider two ways that a feed-in tariff can lower this cost of capital.  First, the capital structure can change, because a feed-in tariff adds certainty to a project that makes it desirable to banks.  Second, some investors will require a lower return on equity, because they have non-financial reasons to make the investment.

Under the first example, we can simply change the expected capital structure to 70 percent debt and 30 percent equity.  In fact, this is the capital structure that the province of Ontario used in calculating their feed-in tariff rates.  Keeping the cost of equity, cost of debt, and tax rate the same as above, this has the effect of lowering the weighted average cost of capital to 5.4 percent.  The only thing that has changed is that the project is being built in a policy environment that includes a feed-in tariff, which has allowed the project developer to attract more debt.

With this information on rates of return, we can use Dr. James White’s“Renewable Energy Payment/Feed-In Tariff Calculator” to estimate what price this implies for a hypothetical feed-in tariff.  Dr. White’s model only covers the United States, but we can use it to calculate the required feed-in tariffs just across the Great Lakes, in Michigan.  There, a utility installing a large wind turbine would require 10.72 cents per kilowatt-hour (kWh) to make the appropriate return on their investment.  However, if Michigan had a feed-in tariff, the exact same project would only require a rate of 9.8 cents per kWh, due to the change in capital structure.  (These rates are purely hypothetical and are meant to serve as examples.  Any feed-in tariff rate setting procedure should involve a careful analysis of the cost of owning and operating a renewable generation system, which has not been done in this paper.)

This difference of .92 cents may seem like a little, but it adds up fairly quickly.  As of June, Michigan had generated 157 million kilowatt-hours of electricity from wind.  If Michigan had had a feed-in tariff in place for the first half of 2010, Michigan’s ratepayers could have saved over $1.4 million.

The other way that a feed-in tariff can save ratepayers money is by encouraging renewable development by investors who will be satisfied with a lower return on equity than traditional electricity infrastructure investors.  The primary reason why someone would accept a lower return is that utilities see investments primarily as financial investments, whereas small developers – such as a homeowner installing rooftop solar – have some non-financial motivations, including the desire to take personal action against climate change.

Now, we can calculate the cost of capital for a small investor.  Gainesville, Florida, has implemented a feed-in tariff through their municipal utility and will attract rooftop solar installations.  Depending on the project specifications, Gainesville projects that renewable developers will earn returns of up to 4.99 percent.  For simplicity’s sake, let’s say that the return on equity in Gainesville is five percent.  Financing structures for small installations tend to be more complicated than a simple debt/equity mix, such as financing models involving leases.  Rather than trying to account for these effects on the cost of capital, let’s just assume that the project is paid for entirely with cash by the homeowner.  (Effectively, this is a 100 percent equity capital structure, so the weighted average cost of capital is the same as the cost of equity.

For a small solar project in Florida, Dr. White’s calculator suggests that a utility with a 6.7 percent cost of capital would need to receive about 34.72 cents per kilowatt-hour on their investment.  An investor who only expected a rate of return of five percent, however, would need to receive just 30.40 cents per kWh to make the same investment.  (Again, these rates are only intended to serve as examples.)

This difference of 4.3 cents per kwh can turn into significant savings for ratepayers.  Suppose this hypothetical utility sold 2.1 million megawatt-hours of electricity (as Gainesville Regional Utilities did in 2009).  If half of a percent of their power was generated from solar, that would be 10,500,000 kWh of solar power sales.  With a feed-in tariff system that saves 4.3 cents per kWh, this utility would have saved $450,000, savings which can be passed on to their consumers.

In both of these scenarios, the only thing that’s changed is the existence of a feed-in tariff.  With this tool in place, some renewable energy will be built by people who demand a smaller financial return on their investment, because they benefit from non-financial returns.  Even the traditional infrastructure investors – who demand the same return on equity as investor-owned utilities – will be able to sell power more cheaply, because a feed-in tariff allows them to leverage their investment with more debt.  This means that the exact same amount of renewable generation can get built, but consumers will pay less for it.  Building clean energy and saving money: this is the optimal solution.

Richard Caperton is the director of clean energy finance at the Center for American Progress