Despite challenging conditions, alternative energy has momentum

EDITOR’S NOTE: Don Warlick wrote a two-part series on the alternative energy business in the January 2008 and February 2008 issues of OGFJ. We asked him to provide an update on this sector of the energy industry for 2009. To access his previous articles, go to www.ogfj.com and click on “archives” for those months.

Business sectors worldwide are being impacted by the economic chaos that began early in 2008 and reached a crescendo in the fall and winter months. That is certainly true for the solar, wind, and biofuels sectors within the alternative energy area. But it gets even more complicated when one takes into account the upheavals of the oil and gas markets and what has also taken place in the commodities markets.

Certainly energy has come into focus given the price run-up in 2008, and the US Presidential campaigns made it a centerpiece as well. From reports, energy will remain an important issue with the new administration in Washington, so it is timely to address the alternative energy space, if only to assess what we think may be happening in this area in 2009.

This article moves quickly through the three principal AE sectors to explain, as we see it, what may be ahead of us in each. But to summarize (hopefully without oversimplifying), we submit the following exhibit that shows sector-specific perspectives. No doubt about it, 2009 will be challenging. But we believe that the solar and wind sectors — and to a less extent the biofuels sector — will each have sufficient market momentum to move through the year with reasonably good performance.

Solar energy

This alternative energy sector may have the best opportunity for growth in the short term and could gain traction for several reasons:

1. The cost of producing solar power continues to fall, probably faster now with the imposition of improved technology. The goal for solar has always been to move as fast as possible to grid parity (the cost of conventional electric power generation). That might take place within the next four to five years. It will not be easy, since solar power has been at least twice as expensive as conventional electric power, even when factoring government subsidies into the equation. Accordingly, a recently-released report from the Royal Bank of Canada, the average cost for installed photovoltaic solar power could drop to $4.40 per kilowatt by 2011 compared to $7.37 this year. That could allow solar to be near-competitive with grid power at $3.50 per kilowatt, predicted to be attained between 2012 and 2014.

2. Solar technology is viewed as a main contributor in reducing greenhouse gases. During the recent discussion at the UN Climate Change Conference in Poland, solar has taken a front seat in the push for global reductions. This issue is growing in importance and will continue to do so in the years to come.

3. The incoming US Presidential Administration is quite supportive to solar. This was an important topic of discussion throughout the Presidential campaign, and also serves as a job-expansion opportunity. It helps also that the greenhouse gases reduction issue is in line with the new administration’s goals for the environment.

4. The most important support is restoration of the Investment Tax Credit. As a part of the Emergency Economic Stabilization Act of 2008 (also known as the “Bailout Bill”) the US House and Senate gave the solar industry a huge boost with a new solar investment tax credit (ITC) provision that extends the 30% tax credit for commercial and residential solar installations for eight years, eliminates the $2,000 monetary cap for residential solar electric installations, eliminates the prohibition on utilities from benefiting from the credit, allows Alternative Minimum Tax filers to take the credit, and authorizes $800 million for clean energy bonds for renewable energy generating facilities (including solar). A recent economic study assessing the impact of the ITC extension indicates it could generate $325 billion in solar private investment and possibly create in excess of 400,000 jobs.

There are two main types of solar installations, those using photovoltaic (PV) technology and those utilizing solar thermal systems technology. PV is the leader for broad applications around the world, including electric utility installations. Thermal systems are constructed in reflective mirror fields that concentrate sunlight into a receiver where resulting high temperatures produce steam for electric power generation (identified as CST).

Beginning in early 2008 there have been significant project announcements by electric power generation entities in the US thanks to solar adoption among leading utilities like Florida Power and Light, Arizona Public Service, Pacific Gas and Electric, and others. By late November, utility scale project backlog was about 5.5 megawatts (about 75% CST and 25% PV), lending momentum to solar’s progress in the US.

A crucial supporter for utility-scale solar growth potential is the new eight-year Investment Tax Credit, previously available for commercial and residential projects only. This is a big plus since it provides policy-certainty to the utilities in committing to these huge investments. Add to that a second driver, the Renewable Portfolio Standards which are now in force in 27 of 50 states, obligating utilities to invest in renewable projects.

Taking into account these utility projects as well as off-grid solar projects, there is an excellent opportunity for broad-scale job creation in the near future — these manufacturing and installation jobs will be spread among all states. This fits nicely with the new administration’s plans for employment growth across the US.

But with the credit crisis in full bloom in the US, how will solar projects be financed? We believe the utility-scale projects will go forward given the creditworthiness of the large electric utilities. Commercial and residential projects may slow, due to difficulties in securing funding.

So what is the overall (and perhaps oversimplified) picture for US markets in the solar space? We foresee steady progress for the larger projects throughout most of 2009 and on into 2010, with small or off-grid construction picking up in the second half of 2009.

Wind energy

This sector has been a success story for several years. Beginning in Europe years ago, wind power has been on a fast track, especially after coming to the US in recent years.

During 2008 US wind energy installations will surpass the 2007 total of 5,249 installed megawatts with approximately 7,500 MW (enough electricity to power 2.2 million homes). It’s a growing business with international manufacturers expanding the US manufacturing base and creating jobs, resulting in a positive situation, especially in view of the job-expansion plans of the new administration.

A total of eight new wind turbine component manufacturing plants opened during 2008 with 19 new facilities announced. We must also remember there is significant component manufacturing and supply in this sector. Although much of the technology and history for wind generation equipment emanated from Europe, it is estimated that today about 50% of all components for US wind turbine installations are manufactured in this country. At the beginning of 2008 there were more than 15 large wind turbine manufacturers supplying units into the US market. Wind farm developers are critically important too. In 2005 nine such developers accounted for about three-fourths of installations in the US, while today there are slightly more than 15, which account for 80% of the total installations.

Europe leads the globe in total electricity produced from wind power. The European leader is Germany with approximately 20,000 wind turbine installations that generate 8% of that country’s electricity. But there is growth offshore as well with the largest wind farm in the world being located offshore UK in the North Sea. This is a $2.7 billion project involving 341 wind turbines. There’s more to the south where Spain, the fastest-growing producer of wind power in the world, produces about 28% of that country’s electricity from their wind farms.

But back to the US where this article is focused. In 2002 only 1% of new electricity generating capacity was wind power; in 2007 approximately 30% of new electricity generating capacity was wind power. The 5,244 MW added in the US during 2007 provided power for 1.5 million households.

New installation growth has allowed the US to lead the world in new wind energy installations for three years running. The fastest growth is occurring in Texas where 1,618 MW were added in 2007. Texas is the leader in wind turbine installations due to significant wind power resources in the western part of the state. “Resources” mean that the wind is strong and predictable (as opposed to being intermittent and unpredictable). The fast growth of wind power in the US, and more so in Texas, has been helped by experienced developers, typically from Europe like Iberdrola (Spain), Windkraft Nord (Germany), or Energias de Portugal. In fact, about two-thirds of wind projects under construction in Texas are owned/operated by foreign companies like these.

Besides having significant wind resources, the state of Texas is better suited to handling transmission issues with sparsely-populated areas and also a single state agency to operate the electrical grid and manage the deregulated utility market in most of the state.

Leasing acreage to newly-developing wind farms in Texas can be a boon to long-suffering ranchers and landowners. The operator of a 154-turbine wind farm near Sweetwater, Texas, is paying a local rancher $500 per turbine per month to operate the system on his property — income that totally eclipses that of the farming and ranching business.

The most significant impediment to growth in wind energy is in transmitting power from remote locations over long distances to the highly-populated eastern markets and population centers where there is high demand. The US electrical grid is in need of expansion for a fast-growing market with demands for more power and reliability. It’s expensive to build these systems. For example, two recent projects for power transmission approved by FERC, the Tallgrass and Prairie Wind transmission projects, will cost up to $3 million per mile to construct. Apply those numbers to the thousands of miles of transmission projects that are needed right away and it’s evident what the industry is facing.

Then there are other economic and financial considerations that apply. There are 27 states in the US where Renewable Portfolio Standards (RPS) require the power generation sector to have a share of their power generation portfolio to be in renewable energy. California calls for 20%, other states can range downward to 10%. In May 2008 the US Department of Energy released a significant report entitled: “20% Wind Energy by 2030”, which outlined the potential for wind energy to supply at least 20% of total electricity nationwide by the year 2030. A hugely ambitious goal, if executed, the industry would add 12.5 gigawatts per year until 2030 (compared to 5.2 gigawatts added in 2007). A huge stretch, but an interesting plan…and just in time to be considered by the incoming administration.

Then there is Production Tax Credit or PTC that was authorized by the Energy Policy Act of 1990 to help boost renewable energy sources by providing the generator 2.1 cents per kilowatt-hour as incentive for wind energy. But Congress has provided only one-year or two-year extensions for PTC, a nettlesome problem in managing program continuities for an industry that must plan 30 to 50 years in advance.

The wind farm systems, as they have been developed and operated in this era of growth, are created with special financing vehicles that address federal tax incentives. A wind farm is typically a project partnership involving investors, a general partner and operating management, so it’s important to have sophisticated, experienced developers. These developers will evaluate projects and choose equipment from manufacturers such as Vestas, GE, Gamesa, and others in assembling a complete package for these wind farms within a long-term operating and financial template.

What will take place in 2009 and 2010? First we must remember that these wind farm projects are big-scope undertakings that call for huge investments and a long-term view. Even though there are many such projects underway, all are being affected to some degree by the seized-up credit markets, at least for the time being.

Even Boone Pickens’ Mesa Power LLC has slowed plans for its four-phase Pampa Wind Project, set to be the world’s largest wind farm. Mesa Power’s turbines from GE are set for delivery in late 2010, so there is time for the market to stabilize. But there are other big, well-financed players like BP, Shell, and very-experienced European developers already established in this market.

A simplistic assessment: We think wind energy will slow somewhat during 2009 and then begin to move with more speed by early-mid 2010.

Biofuels

This alternative energy sector consists primarily of corn-based ethanol and lesser volumes of biodiesel in US markets. Common biodiesel blends are 2%, 5%, and 20% (B2, B5, and B20) with soybean oil as the principal manufacturing feedstock. By far, corn-based ethanol dominates biofuels in the US.

The ethanol business is essentially driven by mandates. The ultimate encouragement of the 2007 Energy Law is to support and push the development of a cellulosic ethanol, biofuels that are produced from various non-food plants or biological materials, ideally switch grass.

Since 2002, ethanol production has grown at least 25% per year, reaching almost 7 billion gallons in 2007 and is anticipated to exceed 8 billion gallons in 2008. It could reach or exceed 15 billion gallons by 2015. Domestic production has not kept up with demand so there has been a rise in imports, recently supplying up to 12% of demand. More than half of imported ethanol comes from Brazil (from sugar cane-based production).

Biofuels are a farm-state product and are largely concentrated in about six Midwestern states where almost three-fourths of ethanol production takes place. At the beginning of 2003 there were 68 biofuel refineries operating in the US. At the beginning of 2008 that number doubled to 139.

There are multiple market drivers for ethanol with about five that are meaningful:

1. Mandated Production. According the earlier-enacted Energy Law.
2. Renewable Fuel Standard. Per RFS the gasoline refining sector, fuel blenders and gasoline importers are mandated to use increasing amounts of biofuels annually through 2022.
3. Clean Air Act. Oxygenated fuel mandates came via this act and required using fuel additives that increased oxygen content, replacing MTBE with ethanol.
4. Federal Blender Tax Credit. Those companies involved in ethanol blending receive 51 cents per gallon while biodiesel blenders receive $1 per gallon of produced product.
5. Tariff Protection. Fifty-four cents per gallon is applied to ethanol imports

Even with this “mandated” market with government-supported edicts to grow, biofuels have been tormented by a range of economic difficulties including higher input costs (high-priced corn), lower ethanol values, and difficulties in obtaining credit for plant construction.

Accordingly, this is a very tough business in which to participate. The principal problem has been the swings in the commodity market for corn. In June 2008 corn hit a record high of almost $8/bushel and then fell to near $3/bushel by early December. Ethanol prices will tend to follow corn and behave in similar fashion. But ethanol prices also will fall with the price of gasoline, given its blend requirements. Thus, the impact on both ends.

During 2008 ethanol producers were severely impacted by the wild swings in corn prices. Most entered multiple contracts to buy corn at preset prices. But when corn dropped precipitously, one of the largest producers, VeraSun Energy, was forced into buying at market rates and subsequently filed for bankruptcy protection in October. Another leading producer, Pacific Ethanol, has suffered as well and it is now cash-strapped with difficulties in servicing. In fact, the stocks of most of the leading ethanol manufacturers fell to 52-week lows in November, down more than 65% year to date.

Those with adequate financing and the ability to survive current conditions may be positioned when their hedging contracts reset and may be enabled to go forward thanks to lower-priced corn on one end, and mandated ethanol demand on the other. Also important, during the political campaign in the fall, both Presidential candidates traveled the Midwest and were supportive of farm state issues, with emphasis on ethanol production.

What can we expect in 2009 and 2010? The biofuels sector is in a weak condition and will continue to be adversely impacted if gasoline prices remain low. Depending on what takes place with worldwide crude pricing during 2009 as well as what happens in corn markets, we certainly expect the ethanol sector to continue to be challenged.

About the author

Don Warlick is president of Warlick International, a market and business consultancy established in 1977 that specializes in global energy business. Previously, Warlick served in marketing and corporate development roles with Getty Oil Co., PepsiCo Inc., and The Williams Companies. He has BS and MS degrees in engineering from the University of Tulsa.