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Financing of Emerging New-Energy

Temporary but strategic financing of emerging new-energy technologies is an absolute necessity. If we want clean-energy alternatives, if we want energy diversity, we need to pry open toeholds for their emergence and scale-up.

Why is this? The reason is that the U.S. energy market is riven with barriers to entry for clear new sources—barriers that won’t by themselves be overcome. Fossil fuels, with the help of their own government subsidies over the years, are thoroughly entrenched, with trillions of dollars’ worth of infrastructure in place. At the same time, utilities tend to favor established business models and are required by regulators to provide the lowest-cost power, all of which steers them toward fossil fuels. Against this background focused research, demonstration and even in some cases deployment supports are necessary tools for helping clean new-energy technologies gain the level of scale and efficiency they need to compete.

Without such temporary financing it won’t happen. With it true energy diversity may arrive sooner than people think.

Yes, but it needs to do that in smarter ways than it has in the past. Increased support for R&D shouldn’t be controversial—the government has a long track record of profitable R&D investment. The trickier decisions involve technologies that are closer to mass commercialization. There is little question that private investment in innovation beyond R&D can fall short without government support—for example, new private models for financing energy deployment, operating clean-coal power plants, or servicing solar installations require large-scale deployment to be developed; they aren’t going to be invented by people designing new widgets in a lab. In a recent essayfor Issues in Science and Technology, I laid out some of the risks of spending too much government money on energy innovation, but also flagged some of the pitfalls of being overly stingy. I’d like to see policy makers take seriously the advice of Joe Aldy, a former adviser to President Obama, who argued in arecent paperin favor of simple government incentives that remove a lot of the bureaucratic discretion that has plagued some past efforts. They would also be wise to take a serious look at a proposalmade by John Deutch, former head of the CIA, for a new energy investment authority that would also aim to insulate government energy financing from politics.

New energy technologies will help move the economy to a low-carbon future. However, the most important first step to bring these technologies to market isn’t direct government financing but a carbon price. The appropriate price signal will lead to “induced innovation”—technological breakthroughs brought about by changes in the relative prices of factors of production. As carbon-intensive fossil fuels become more expensive, private industry will have a strong incentive to search for new low-cost alternatives. And as consumers demand more efficient products to lower their energy costs, industry will have incentives to provide them.

This applied research needs to be supplemented with more basic scientific research, however, and here government has a more direct role to play. Because basic scientific knowledge is a public good, private markets tend to underinvest in it. The more basic and long-term the research, the worse this problem is. Thus, there is an argument for well-targeted and well-designed government R&D policy. Of course, what constitutes well-targeted and well-designed is an open question. The government has made mistakes in the past: the Synthetic Fuels Corp., the breeder reactor, and most recently, Solyndra, the solar-power company that received a federal loan guarantee in 2009 only to declare bankruptcy in 2011. But careful studies by economists have shown that government R&D dollars have, on the whole, had a positive impact on innovation.

Another open question is how the government should go about financing R&D. Government traditionally has relied on grants and in some cases, low-interest loans or loan guarantees; also tax credits and public-private partnerships have been used. And of course, there are patents. But one approach that is garnering favor of late is the use of prizes. The idea is to offer financial rewards for achievement of innovation objectives that are specified in advance. Competition for the prize and the use of a precisely specified goal are important aspects of this approach that may do a better job of bringing about change in certain settings. Prizes aren’t perfect—they lead to some duplication of effort, for one thing—but it might be time for the government to experiment with this approach to financing energy R&D.

Richard Newell of Duke University has published widely on the topic of energy markets, innovation, and technological change and has several survey papers on the topic. His collected works can be found here.

Governments have a poor track record when it comes to pushing new energy technologies because they are generally unqualified to conduct due diligence on companies seeking government funding. A better approach would be for governments to stop trying to pick technology winners, and instead set a consistent framework within which companies could compete. Governments can certainly play a role in incentivizing new technologies that are deemed in the national interest, but this should be done in a way that avoids preferentially funding companies with political connections or those that can convincingly exaggerate the promise of their technology.

A fairly straightforward way to achieve this would be to offer financial incentives for product that is actually delivered, instead of providing grants and loan guarantees to companies that promise to deliver. The government could offer an initially generous, but gradually declining direct per gallon subsidy for qualifying fuels. For example, offer a direct $2/gallon subsidy for the first 250 million gallons of qualifying fuel produced and sold as transportation fuel from a facility, and then $1/gallon for the next 250 million gallons of qualifying fuel produced. Allow any company capable of delivering the fuel to receive the subsidy, but stipulate a phaseout schedule for the subsidy in advance.

Then let the technologies battle it out for supremacy in the marketplace just like other products breaking into new markets. We will have simply tilted the playing field toward a wide range of qualifying energy technologies without putting the government in the position of competently carrying out due diligence on supposedly promising options.

Such a system would have huge advantages over the current system. First, private investors would assume the technology risk, and therefore would be responsible for conducting a high level of due diligence. This takes the technology risk assessment out of the hands of the government so taxpayers won’t end up financing plants that never deliver—which has too often been the case in recent years.

The system I am proposing would be an effective way to filter out those who are essentially just hyping their technologies in order to receive tax dollars from those that have more realistic expectations that can be delivered upon. Producers will be paid for what they deliver instead of receiving taxpayer funds for what they claim they can deliver, and it isn’t taxpayers who are on the hook for their hype should these companies fail.

Throughout U.S. history, the government has helped defray the cost of developing new energy sources. It happened with coal; it happened with oil; now it’s happening with renewable energy. The salient question isn’t whether government should be involved in financing new energy sources; it’s how the government should do so smartly. Today, as a wide variety of new energy technologies are growing up, it is time for the government’s and the market’s approach to them to grow up too. As government and investors alike help these technologies, they should do so in a more sophisticated and more economically efficient way.

The government, most fundamentally, should be clear about its goal in spurring new energy technologies. Does it want to birth new manufacturing jobs? Does it want to maximize domestic energy output? Does it want to slash carbon emissions? The answer is important. Each goal suggests a different strategy of investment.

Broadly, the government should structure its approach toward energy finance to encourage the globalization of new energy technologies. If the goal is cheap, clean energy, then—as with cheap T-shirts or cheap laptops—the strategy should be to encourage the growth of a global industry that brings prices down. The long-term question for the U.S. is where in that globalizing industry it can play to maximum financial benefit.

More specifically, when the U.S. subsidizes new energy technologies, it should do so in a way that’s ruthlessly economically efficient. The federal tax breaks that have helped finance wind and solar power in the U.S. haven’t passed that test; by some estimates, as much as 30% of the taxpayer money spent through those subsidies has gone not to build wind farms or solar projects but to pay the financial institutions that act as middlemen in these tax-credit deals. Today in Washington, lawmakers are debating various ideas to reform these tax credits in ways that might generate more new-energy bang for the buck.

The real challenge associated with having government subsidize “new” energy technologies is that once the process begins, it tends to never end. The federal government should get out of the business of picking energy technology (or resource) winners and losers and focus instead on developing an equitable, uniform and simple tax code that facilities capital formation in the energy industry. Let markets decide the best energy technologies to promote, since doing otherwise begs for inefficient market outcomes and unintended policy consequences. Consider, as an example, the case of the federal wind Production Tax Credit or “PTC”—a subsidy developed by Congress in 1992 to help “jump-start” a “new” and promising industry. To date, this tax incentive has been extended eight different times—the most infamous of which was included in the 11th-hour tax deal rushed through at the close of the last Congress. The federal wind PTC extension, included as part of the “tax expenditures” portion of this bill, will likely cost American taxpayers some $12 billion.

While the wind industry may arguably have been a “new” and “infant” industry in 1992, no such claim can be made today, more than two decades later. Today, the wind industry is one that is comprised of over 50,000 megawatts of nameplate capacity—that’s equivalent to 50 nuclear power plants worth of capacity—assuming that wind had availability factors remotely close to most operational reactors. Further yet, wind-capacity development has increased fivefold since 2006, a huge portion of which includes a large share of very risky, speculative “merchant” (or non-contracted), wind capacity.

This federal tax subsidy is simply unneeded to finance renewable technologies since over 30 states, including the District of Columbia, now have in-state renewable-energy requirements called “renewable portfolio standards” that set a (renewable) resource-neutral annual generation requirement. Renewable generation now has a mandated market in these various states: you don’t need a tax subsidy or other form of federal finance. Including federal tax subsidies on top of these renewable requirements leads to a free rider problem that facilities the worst kinds of incentives for “rent seeking” as was evident in late 2012 when the federal wind PTC was set to permanently expire.

From an economic perspective, the “one-size-fits-all” wind PTC, like many federal energy subsidies (including those for other energy resources like oil and gas, coal and nuclear), is an exceptionally inefficient and expensive means of supporting wind generation since these big per-unit tax subsidies fail to recognize the industry’s heterogeneity and operational differences. While the media likes to harp on the Solyndra-type failures associated with big federal government handouts, the real outcome that arises from these policies isn’t a boatload of business failures so much as it is a huge degree of overcapitalization, overdevelopment, and oversupply. Look at wind and solar as great examples of how overly generous government subsidies (in the U.S. and Europe) help plant at least a few seeds that have resulted in these industries’ recent cyclical downturn.

Yet, in the wee hours of the last Congress, the great gnashing of teeth bemoaning the potential loss of “green jobs” in the wind industry appears to have served as adequate justification for continuing this very inefficient tax incentive. No one made the American taxpayer aware that this particular little tax extension, designed to save the wind industry’s “green jobs,” came at the price of some $300,000 per wind-energy job.

Allocative inefficiencies aren’t the only problem with federal government energy tax-and-finance programs: the distributional inefficiencies (i.e., who pays for this) can be just as bad. Consider that over 50% of wind capacity is located in only five states; over 75% is located in just 11 states. The federal wind PTC, which is paid for by taxpayers in all 50 states, unfairly shifts wind-energy development costs away from taxpayers in these large wind producing states, and onto those with little or no wind-development opportunities.

And, if this weren’t enough, the generous federal wind PTC adds insult to injury in many regional wholesale electricity markets by leading to distortionary “negative prices.” What does this mean? Well, when regional power markets post “negative prices,” it means that power generators have to pay the market (not get paid by the market) to take electricity. Not many markets work that way and neither do correctly functioning wholesale-power markets. These anomalies are wreaking havoc in some parts of the country, like Texas, and creating large uncertainties for those generators expected to build backup generators needed to provide electricity when wind energy isn’t available.

Thus, look at the federal wind PTC as a great example of why the federal government needs to get out of the business of picking energy-industry winners and losers, particularly through the use of tax and financing policies. This policy direction shouldn’t be directed simply at the wind-energy business or even renewables, but all energy resources: nuclear, oil and gas, coal and even energy efficiency. If there is a role for government in this process, then let those states that have the renewable (or energy) endowments (or interests) focus on making those subsidies and let’s stop forcing those in other parts of the country to subsidize resources to whom few, if any, direct benefits can be attributed.

The Obama administration’s penchant to back clean-tech investors with taxpayer money needs to be rethought. This isn’t to say that the U.S. government cannot intervene successfully in markets. But money isn’t well spent when public dollars are used to finance existing unprofitable businesses whose technologies could easily become obsolete. While the final payoff of billions of dollars in energy subsidies since the 1970s does seem unclear, we shouldn’t abandon government’s important role in fostering fundamental R&D. The shale gas boom finds its roots in a prior U.S. Department of Energy sponsored technological breakthrough, for example. Japan’s government support for R&D for its car industry similarly helped it dominate the hybrid tech sector.

Generally speaking, the energy business lacks the boundary conditions where venture capital can be effective in opening new economic spaces. Rather, steep incumbent competition and the daunting realities of large-scale fossil-fuel infrastructure already in place need to be taken into account. A recent UC Davis study argues that enormous loan guarantees may actually hinder the process of technological change by dwarfing potentially successful efforts the private sector may innovate on its own. A shift to the Small Business Innovation Research Program model (SBIR) could be a less expensive and more productive way to engage Clean Tech successes.

There are two good potential areas for increased U.S. government intervention in energy markets that could be expanded. First, the U.S. government, particularly the Defense Department, could strengthen the use of the enormous purchasing power of the federal government to procure promising new technologies, thereby helping to drive their maturation. Moreover, a more comprehensive approach that creates incentives for incumbent players in the energy space to invest in alternative fuels and efficiency innovation is sorely needed. A variation of California’s Low Carbon Fuel Standard is one option. Another would be a creative federal tax code mechanismthat rewards companies who engage in new energy technology investment instead of more typical massive capital flows to buy back their own stocks.

The government shouldn’t pick technological winners, as industry knows technologies and investment much better. The recent disasters in solar subsidies, where hundreds of millions of dollars of taxpayer money went down the tubes—both here in America and in Europe—are Exhibit One. The wind-turbine and corn-ethanol subsidies are also examples of what the governments are doing wrong. However, the federal government does have a significant role to play by funding defense and space research, and supporting basic science. Nuclear-energy research started as a military project and led to civilian nuclear-power generation. The Internet, which was also started as a military concept, has revolutionized our lives. There is also a big role for the private sector and private foundations to support science and academic research, especially in the fields of physics, chemistry and biology, which may lead to new energy technologies. It is up to the private sector, however, to take basic scientific discoveries and military and defense technologies and apply them for civilian uses, including energy generation, transportation, computerization, etc. Big breakthroughs and discoveries, of course, happen, but the incremental process of innovation and improvement funded by investors and companies is also hugely important.

Energy prices are fundamental to the competitiveness of the U.S. economy, and the oil, gas, power and renewable-energy sectors are very large U.S. employers. As for any industry of that importance, it is legitimate for the government to provide direct or indirect support for development of the energy sector. So the question isn’t whether the U.S. government should support new energy technologies. The question is what it should do and how.

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