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Energizing Minnesota's Economy

February 20, 2009 By Nathan Paine

Minnesota's Renewable Energy Standard (RES) requires 25 percent of the state's electricity to come from renewable sources by 2025. The RES is an aggressive wind standard and will produce significant regional economic benefits in Greater Minnesota. However, wind power's rapid expansion in Minnesota will require an enormous amount of capital to finance project costs. It is estimated that the Minnesota will need between 5,500 MW and 6,300 MW in new wind projects if the RES is achieved solely through wind power. Wind project developers will need access to more than $12 billion dollars of capital in order to finance this expansion.

Accessing capital to finance wind projects has been a challenge for wind developers because of the importance of federal tax incentives to return on investment from a wind project.  The credit crunch and economic recession has reduced the number of potential investors with the capital to invest in the wind industry and a sufficient tax base to make efficient use of the federal tax incentives.  In addition, the credit crunch has made financing for wind projects more costly.  However, there are a number of potential alternatives that may enable the wind industry to still expand.  One such alternative is a feed-in tariff that obligates utilities to purchase electricity generated from wind at set rates.  Another is the use of investment funds that would own the tax equity in multiple wind farms.  Investment fund use is promising because it would allow for a diversified portfolio of wind farms and would attract new sources of capital.

Federal tax incentives include the production tax credit (PTC) and the Modified Accelerated Cost Recovery System (MACRS).  The PTC is a per kilowatt-hour federal tax credit for wind generated electricity and provides an inflation-adjusted 1.5 cents/KWh during the first ten years of a wind project.  For 2008, the inflation-adjusted PTC provides a 2.1 cents/KWh tax credit.  The MACRS allows depreciation deductions over an accelerated five year schedule.  

Investor returns can derive as much from these incentives as they do from cash flow generated from power sales.  However, most wind developers and owners do not have a sufficient tax base to fully utilize the production tax credit.  There's need to attract tax motivated investors to the table.  But the economic slowdown has reduced the number of companies with a sufficient tax base to efficiently utilize these tax incentives.  As a result, it is a challenge for wind developers to access capital. 

Tax incentives have important implications for how wind projects are financed.  The principal financing structures used in the wind sector require equity investments from outside investors with a sufficient tax base to efficiently utilize the tax incentives.  These financing structures reduce the wind project's local economic impact because the revenues flowing to the outside investor do not enter the local spending stream. 

As a result, wind farm ownership is usually transferred to a partnership.  Typically, the partnership allocates the cash distributions and the tax incentives disproportionately to the tax-motivated investor until it receives a predetermined internal rate return at which point the allocation flips to the developer.  A typical wind project is decommissioned after 20 years, and it is common for it to take 10 - 12 years to reach the internal rate of return threshold.  Moreover, added risk is introduced in the later stages of the project because of uncertainties over O & M costs and turbine performance.  This flip structure is also used for projects in Minnesota qualifying for full Community-Based Energy Development (CBED) payments.  This means that for most of the project's lifetime (including CBED projects) a significant portion of the monetary benefits flow to an outside investor.

The reality is that wind projects require a significant amount of capital and risk tolerance beyond what most local investors are prepared to shoulder, thus necessitating the participation of an outside investor.  However, Minnesota should further explore the feed-in tariff both as an option for making it easier to get access to capital and as a tool to promote community wind development.  The feed-in tariff would require local utilities to pay premium rates for wind-generated electricity, a tool successfully used in Europe.  The payments do not require a tax base.  In addition, because the payments are guaranteed and stable, feed-in tariffs remove the need to engage in costly contract negotiations with utilities and have the potential to reduce risk.  Although uncertainty can be reduced with long-term power purchase agreements, feed-in tariffs open doors to new sources of capital because all the returns derive from cash flow revenue.  Wind developers would not need to find tax motivated investors and so this would allow local economies to benefit more from wind development.  A feed-in tariff also gives the investor access to cheaper capital (i.e. larger cash flows reduce the amount of equity an investor needs to put into the project and enables to the investor to take on additional debt and still meet the required debt-service coverage ratio). 

The financial risk to the ratepayer can be minimized by some sort of regional cost sharing plan.  In addition, local and regional economic benefits from community based wind development may partially offset higher electricity prices in the region. 

Whatever direction public policy takes, it is critical that the wind industry have stable public policy.  The pattern of expiration of the PTC followed by short-term renewal of the PTC has been detrimental to investment in the wind industry.  It has deterred long-term investments and resulted in significant additional costs associated with the ramping up and ramping down of investments in wind projects (e.g. the disruption and destabilization of supply chains for turbine equipment).

Minnesota should consider a feed-in tariff mechanism to promote local ownership of wind farms and give wind developers access to new sources of capital.  This would promote more efficient development of the wind industry and would promote community based wind development.  There are several peer-reviewed studies that find wind projects produce significant regional economic benefits in comparison to other fuel types.  Community based wind development maximizes these regional economic benefits.  Another benefit of community wind development is the greater distributed generation that places less of a burden on the transmission grid.


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