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Investing in the New Energy Economy

Patrick R. GillardEEI-ICF Transmission & Wholesale Markets School

Washington, DC July 2, 2009

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Impact of Credit Crunch on Financing

• The financial and banking crisis of 2008 was debilitating for developers and tax investors– All sources of capital shut off– No private equity capital, no lenders, no tax equity

• Following election, industry participants quickly organized

• Unprecedented bipartisan support for the industry

• Immediate industry reaction is very positive

• The “devil is in the details”

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Private Equity Firms

• Private equity firm is generally a group of investors referred to as equity partners

• Includes the general partner (who has responsibility for managing the investment, e.g., determining how the acquired firm will be operated), plus other partners (called limited partners) who contribute capital, but are otherwise passive owners

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Private Equity Investment Overview

• Following record growth in investment in 2007, private equity investment in energy declined dramatically late in 2008 and in 1Q 2009

• May 2009 KMPG survey indicates that 35% of 200 private equity firms said energy would be the most appealing sector for private equity as the economy recovers; financial services and technology tied for second place with 15% each, followed by healthcare and business services, both of which were cited by 12% of respondents

• Public policy initiatives, such as ARRA implementation, cap-and-trade, a national renewable energy portfolio standard, and increased public funding for R&D in clean energy technologies, expected to stimulate private equity investments in energy

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Private Equity Investment in Utilities

• The Energy Policy Act of 2005 (EPACT) repealed Public Utilities Holding Company Act of 1935 (PUHCA)

• Federal Energy Regulatory Commission (FERC) now the primary regulatory authority for public utility holding companies.

• FERC has implemented policies set forth in the EPACT that have had the effect of encouraging investment in the electric utility industry, such as: – removing barriers to ownership of utility assets– allowing higher rates of return for transmission assets– streamlining FERC merger review process (e.g., approving

Exelon’s hostile bid for NRG within 6 months)

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• Private equity funds have traditionally invested in unregulated electric generation plants, but recently have been investing in regulated utility operations

• 2007 acquisition of the Texas utility TXU Corp. by a private equity consortium led by Kohlberg Kravis Roberts & Co., Texas Pacific Group, and Goldman Sachs for $45 billion was the largest private buyout in U.S. corporate history

• Also in 2007, Duquesne Light Holdings completed its merger with a consortium led by Macquarie Infrastructure Partners and The DUET Group

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• More recently, in September 2008, MidAmerican, a unit of Berkshire Hathaway, was bidding against Electricite de France, then working with two private-equity firms, Kohlberg Kravis Roberts and TPG for Constellation Energy

• In December, a solo EdF agreed to buy half of Constellation’s nuclear business for $4.5 billion

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Key Considerations

• Impacts from use of debt to finance transaction

• Buyer inexperience with regulated utilities

• Legal authority of regulators to review private equity buyouts

• Regulator access to information about subsidiary and parent

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Key Considerations

• Ring-fencing– Corporate separation of utility and nonutility

businesses– Separation of corporate reporting– Prohibition on access to utility cash– Single purpose entity with a single independent

director– Separate utility credit rating– No debt guarantees by the utility– Single purpose entity to prevent parent-induced

bankruptcy of the utility

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Private Equity Investment in Generation Assets

• PE firms target (i) acquisitions of assets in operation, (ii) development and construction of potential assets, (iii) funding of mature technologies/manufacturing and (iv) funding of new technologies

• PE firms have recently focused on asset-based opportunities in renewable energy technologies such as biomass, geothermal hydro, landfill gas, solar and wind

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Key Considerations

• Long-term off-take arrangement

• Financeable project with debt as well as equity

• Substantial equity investment by sponsor in the transaction

• EPC agreement with favorable terms

• Transaction structure allows for monetization of tax benefits to increase returns

• Pretax vs. after-tax returns

• Sufficient size to justify time and expense

• Return on investment

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REITs

• A REIT is a corporation, trust or association that primarily invests in real estate assets and elects to be treated as a REIT under Section 856 of the Internal Revenue Code

• An entity classified as a REIT is generally not subject to federal income tax at the entity level, provided that it distributes all of its taxable income to its shareholders on an annual basis

• A REIT must satisfy a variety of complex requirements, including rules regarding the REIT’s beneficial owners, asset composition, sources of income and required distributions

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REITs

• REIT must derive at least 75 percent of its gross income on an annual basis from real estate sources (such as rents from real property, mortgage interest, and real property gains) and must derive at least 95 percent of its gross income from a combination of real estate sources, dividends, interest and certain other specified sources

• At least 75 percent of the value of a REIT’s assets must represented by real estate assets, cash and cash items, and government securities

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Recent IRS Ruling

• In 2007, in a Private Letter Ruling, the IRS found that that a transmission and distribution system is a real estate asset qualifying under the 75 percent asset test

• Ruling also holds that rental payments received by the REIT for a lease of the system qualifies as “rents from real property” under the 75 percent income test

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Impact of IRS Ruling

• REIT structure may be attractive to potential investment in transmission and distribution infrastructure, as well as to utilities that are considering the transfer of existing systems to a more tax-advantaged structure

• Potential tax benefits of a REIT must be weighed against the burdens of compliance with complex REIT tax rules

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The ARRA Commitment is a Down Payment

“The country that harnesses the power of clean, renewable energy will lead the 21st century.”

-President Barack Obama, Speech to Congress, Feb. 24, 2009

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Basic Energy Governmental Incentives

• State Renewable Portfolio Standards (in 28+ states)– RPS require utilities to purchase a fixed percentage of

their electricity from renewables– Many states allow for trading of Renewable Energy

Credits (RECs)– Some states allow energy efficiency improvements to

qualify

• State Rebates

• Federal tax provisions & other stimulus bill incentives

• Sustainable Energy Utilities

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How Big Is the ARRA Commitment to Energy?

• Energy-related direct appropriations = $35 billion; with additional funds available for energy from other baskets

• Stimulus impact of certain tax credit changes falls outside the dollar totals

• The appropriation for the Loan Guaranty program is $6 billion but that translates into capacity to guarantee $60 billion in loans

• Clean Renewable Energy Bonds and Energy Conservation Bonds provide $4 billion for energy projects

• The Treasury grant in lieu of tax credits program is unlimited, and while not perfect, could be very widely used

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What Else Does ARRA Do for Renewables and Sustainable Energy?

• Energy efficiency programs flow mostly through existing state programs

• Clean Tech research gets a boost

• Utilities are pushed towards efficiency and renewables

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Utilities and the Section 48 Investment Tax Credit

• In October 2008, as part of the Emergency Economic Stabilization Act of 2008:– The definition of energy property in Internal Revenue

Code section 48 was modified to allow renewable energy property owned by utilities to qualify for the energy investment tax credit (ITC)

– Eligible property includes solar (electric and hot water), fuel cells, microturbines, small wind property, geothermal heat pumps, and combined heat and power systems

– The extensions of the ITC and the Treasury grant program in lieu of ITC and PTC are thus relevant for utilities

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Election to Claim Energy Investment Tax Credit

• Project investors in projects previously qualifying for section 45 production tax credits may elect to take section 48 investment tax credits– Current law allows section 45 PTC to be taken over a 5 or 10

year period (10 years for wind).– Current law allows section 48 ITC to be taken in the year the

project is placed in service (30% credit for solar, fuel cell, small wind property; 10% credit for other qualifying technologies).

– ARRA provides that technologies previously qualifying for the PTC (including wind, biomass, geothermal, landfill gas, waste-to-energy, hydropower, and marine facilities) may now claim a credit equivalent to the 30% ITC.

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Treasury Grant in Lieu of Tax Credit

• Treasury will provide grants in lieu of section 48 investment tax credits.

• Projects eligible for section 45 production tax credits can be converted to ITC to qualify for grant program.– Construction must begin prior to 12/31/2010– Projects must be placed in service before:

• 2013 for wind (30% credit)• 2014 for biomass, geothermal, landfill gas, waste-to-

energy, hydropower & marine renewables (30% credit)• 2017 for fuel cell, solar, small wind (30% credit)• 2017 for geothermal, microturbine, combined heat &

power and geothermal heat pump property (10% credit)

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Extension of Bonus Depreciation

• Extension of 50% first-year Bonus Depreciation– In 2008, Congress allowed businesses to recover the

cost of capital expenditures faster than the ordinary depreciation schedule.

– As in 2008, businesses may immediately write-off 50% of the cost of depreciable property.

– Investment must be made by Dec. 31, 2009.

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Elimination of Subsidized Energy ITC Penalty

• Currently, section 48 investment tax credit (ITC) must be reduced if the property is financed with tax-exempt financing or other subsidized energy financing

• ARRA eliminates this limitation

• Broadens the possible public-private financing options

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DOE Loan Guarantees

• Renewable energy loan guarantees – $6 billion in appropriated funds should support at least $60

billion in loans – “Rapid Deployment” loan guarantees for renewable energy

power generation using current commercial technology, including:

• Renewable energy systems that generate electricity or thermal energy, and facilities that manufacture related components; and

• Demonstration or pilot projects using leading-edge biofuel technology that is likely to become commercialized and reduce life-cycle greenhouse gas emissions

• Transmission projects also covered– Loan guarantees for biofuel projects limited to $500 million– Construction must commence by Sept. 30, 2011

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Transmission Modernization

• Funding for transmission modernization and smart grid– $4.5 billion to DOE for expenses necessary for

electricity delivery and energy reliability activities:• Grid modernization, security and reliability• Energy storage R&D and demonstration• Energy efficiency measurement• Diversifying sources of ancillary services • Advancing use of wide-area smart grids

– Includes $80 million for DOE studies to facilitate regional transmission planning, and DOE technical assistance for Interconnection-wide transmission planning

– BPA and WAPA: large increase in borrowing authority

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Smart Grid Demonstration Grants

• DOE grants for smart grid demonstration projects, R&D – Financial assistance equal to 50% of the cost of

qualifying advanced grid technology investments made by qualifying entities to carry out a demonstration project

– Includes smart grid demonstration projects in urban, suburban, and rural areas, including areas where electric system assets are controlled by tax-exempt entities and areas where electric system assets are controlled by investor-owned utilities

– DOE anticipates making awards in three phases (October 2009, March 2010, and June 2010)

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DOE Fossil Energy R&D Grants

• Grants for fossil energy R&D – $3.4 billion for the Fossil Energy Research and

Development program, including: • (i) $800 million for selections under DOE’s clean coal

round III (which includes petroleum coke fuel input);

• (ii) $1.52 billion in competitive solicitation for a range of industrial carbon capture and energy efficiency improvement projects, including a small allocation for innovative concepts for beneficial CO2 reuse.

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Buy American / Davis-Bacon Requirements

• Generally, funds appropriated by the bill may not be used for a project for public infrastructure or public works unless all of the iron and steel used in the project is produced in the U.S.– Federal department and agency heads may approve

exemptions from this provision• The Davis-Bacon labor standards, generally

requiring that prevailing wages must be paid on public works projects, are applicable to projects financed by New CREBS, ECBs, or funded directly or indirectly by the Federal Government under ARRA

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Impact on Energy Project Developers

• Did ARRA address the problems and will it be effective? – Tax Benefits are clearly more valuable

• Does not increase the market for tax equity

• Individuals cannot use tax credits

• Complicated tax partnerships and leases remain the only means to monetize tax attributes

– Cash Grant and Government Guarantee program should increase capital availability

• Widespread concern that the programs will be difficult to implement

• Also concern about technical rules

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Impacts on Electric Utilities

• Utilities can benefit from the same incentives as other renewable energy developers

• Transmission and smart grid get a major boost ($11 billion)

• Fossil fuels not left out

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What’s Next?

• Are the programs and appropriations big enough to make a dent?

• Will transmission really get built under these incentives?

• Will state utility commissions permit utility pass-through of non-grant portion of utility smart grid costs?

• Will Congress move ahead with RPS legislation? With climate change?

• What happens when the stimulus money is used up?

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Questions?

Patrick R. GillardBallard Spahr Andrews & Ingersoll, LLP

[email protected]

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