I am reposting an article by a friend, Ricardo "Ric" Barcelona, published in the Inquirer last November 27, 2017. I attended the book launching
of Ric's book, “Energy
Investment: An Adaptive Approach to Profiting from Uncertainties” last November 22, 2017 at Shangrila Hotel Makati. Good work and congrats again, Ric.
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In writing my new book, I came face to face with three
energy investment paradoxes. All trace their roots to generous subsidies.
Counter-intuitively, generous subsidies did not result in
wide scale deployment of renewables, more so with solar as subsidies’ poster
kid.
Innovation is the second paradox. Advocates argue that as
increasing renewables capacity is installed, their costs would fall.
Ironically, when subsidies are too generous, the costs
decline more slowly than in markets without subsidies.
The third paradox blasted the notion that growth and
profitability go hand in hand.
With solar installation’s “frenzied” growth, albeit from
a low base, I struggled to find beneficiaries of this boom that profited
financially, much less achieving value-creating returns.
Perhaps, not surprisingly, we come across contradictory
reports on renewables’ progress from the business press.
One sunny morning in 2013, leading journalists herald the
dawn of renewables’ new era. Solar is sold at a price lower than coal, so the
headline says. As analysts scramble to validate their financial models, most
could only scratch their heads and were at a loss for answers. The next batch
of headlines came to their rescue. Investors and advocates of “competitive”
solar power were up in arms. The cause? Governments in Europe cut renewables’
subsidies drastically. Within weeks, “high growth” solar companies filed for
bankruptcies, with wind struggling to make ends meet while barely remaining
afloat albeit financially moribund.
In The Atlantic’s November 2015 issue, which I quoted
William Gates, Microsoft’s founder, provided an answer as to where the problem
lies.
By succinctly arguing how costs comparisons become a
disservice to the environmental cause, Gates observed: “Photovoltaic solar is
not economical. Its intermittency is a major problem. When environmental
enthusiasts point to photovoltaic solar as having a similar cost to
hydrocarbons, what they mean is that at noon in Arizona that may be the case.
However, solar does not come at night. So the fact that at one moment you reach
parity, so what? Distinguishing a real solution from a false one is actually
very complicated”.
Economics of subsidies
The economic cost of energy equates to their life cycle
cost of energy. This is a simple addition of the recovery of its normalized
fixed assets costs, variable operating expenses, and fuel costs. Embedded
within the fixed costs are its implied return on assets and a depreciation
expense, while variable and fuel costs are inflation adjusted, with fuel prices
accounting for most of the volatilities. Renewables tend to have stable costs.
Philippine coal-fired power’s economic costs would be
about P7.29/kWh, while PV Solar would be about P9.09/kWh. Financial costs based
on acquisition prices would be about P3.00/kWh to P4.50/kWh. This compares with
PV Solar’s feed-in tariff (FiT) of P8.50/kWh. With PV Solar equipment costs
having fallen sharply, its economic cost is below the feed-in tariffs. While
the learning curves effects favor PV Solar’s improved costs competitiveness,
fuel and power prices from coal-fired and gas-fired power fell from peak of
P8.00/kWh to its present levels of P2.00 to P3.00/kWh. The FiT subsidies
actually widened to P5.50 to P6.50/kWh, or up to two thirds of revenues.
The lessons are stark. When subsidies are set as the
costs differences, the “correct” level is indeterminate. As power prices
increase, renewables need lesser subsidies but nevertheless continue to
collect. When this happens, consumers would coax regulators to claw back the
subsidies because renewables are raking it in at consumers’ expense.
Paradox One: Generous subsidies do not result in wide
scale renewables deployment. Highly dependent on subsidies, changing government
priorities that cut subsidies turn secure revenues, into the very source of
uncertainty that bankrupt the venture.
Innovation paradox
Learning curves suggest that with each doubling of
renewables’ capacity, its costs would decline by about 20 percent. Enthusiasts
present this as evidence that success is a fait accompli.
PV Solar exceeded what the theory prescribes. The
learning curves, however, could stall or even reverse its decline. For example,
US wind turbines costs declined from about $4,500/kW in 1997 to $1,200/kW in
2001. When subsidies were made more generous in 2004, the rush to build wind
farms clogged the production lines that saw wind turbine prices spiked to
$2,400/kW in 2010 before settling at $1,500/kW in 2015.
Rapid declines in renewables’ costs impact producers’
revenues, where exponential volume expansion is subdued by accelerated price
declines. In effect, innovations that lead to rapid costs decline may be
curtailed when subsidies buffer the need for aggressive costs competition.
Project proponents act as mechanisms to channel subsidies
from the state to producers. A quick mental calculation would convince
proponents that the cost of postponing investments has its value.
If it becomes certain that tomorrow’s equipment costs
would be substantially lower, and the technological cycle is shortened significantly,
the cost of waiting in terms of foregone revenues could be lower than the
equipment costs savings.
This is where PV Solar’s fate is sealed. Unlike hydro or
geothermal power’s utilization rate of up to 95 percent, PV Solar at best is 22
percent. The foregone revenues are a fifth of those lost from alternative
technologies. Worse, after five years of operation, PV Solar’s utilization
rates could fall to 12 percent to 15 percent. This comparison makes developers
more inclined to wait rather than to rush in to invest—unless of course the
subsidies are generous.
What happened to the early movers—an advantage that
strategy would suggest they reap the benefits for being decisive? Ironically,
as future equipment costs fall farther, the early movers are stuck with
obsolescing assets that are stranded as they lose competitiveness. Worse, their
valor and decisiveness to be the first to invest leaves them to do the heavy
lifting to lower costs that ultimately benefit the latecomers to profit from
their labor.
Paradox Two: Subsidies blunt the need to accelerate costs
reduction. Waiting to invest could prove lucrative where the latecomers profit
from “early movers” follies.
High growth, expanding losses
Simple arithmetic tells us that for as long as revenues
falls lag the rate of costs reductions, firms could expand cash operating
margins. Solar equipment and panel producers are trapped in vicious cycles.
To remain competitive, they continually innovate that
costs money while reducing costs (and prices). Competitors push the technology
frontier that renders obsolete any incumbents’ offerings. As competition
intensifies, rising costs and falling revenues or market shares could only lead
to bankruptcies.
Within the PV Solar waiting game, in bypassing one
generation of technology, and wait the more cost effective innovation, the
shorter waiting period could prove lucrative for developers. However, for PV
Solar producers, the waiting game could only exacerbate the pressure on
operating margins.
Paradox Three: Accelerated volume expansion and rapidly
declining prices erode cash operating margins, where the firm loses more the
more it grows.
In my academic sojourn, what was presented as simple and
readily understood formulation for calculating the “correct” subsidies turns
out to be nuanced and complex. Under dynamic markets, where energy prices vary
daily, fixing the subsidies becomes an indeterminate exercise. There are many
possible answers for a given time that does not hold true once the prices
change.
When PV Solar rely on up to 67 percent of revenues from
subsidies, the state becomes a counter-party that is critical to sustaining the
firm’s financial viability.
Vagaries of politics imply constantly changing
priorities, making for a fickle advocate.
Contrary to popular belief, subsidies are far from a
source of secure income. As governments renege, subsidies (or its loss) become
a major credit risk.
My short prescription: Treat renewables, coal and gas as
one supply portfolio. Their different costs structures provide physical hedges
against rising energy prices, potentially increasing portfolio returns.
We may take William “Bill” Gates’ advice to heart:
“Distinguishing a real solution from a false one is actually very complicated.”
Understanding how business work, and applying the same rigor to renewables and
our energy supply portfolios may just lead us to offering a real solution to
meeting our future energy needs.
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See also:
