American Power Act

Fresh off of a financial crisis that risked throwing the US into a depression, my hope was that lessons would be learned.  Nothing dramatic, perhaps, but at least the basics on incentive structures in financial deals.  Like when you let people bet only with somebody else's money, they are far less careful about what they bet on, and how much they put at risk.  And the related issue that if you let investors take their own cash out of the game too quickly, the probability of project failure rises sharply.  And finally, if the one left fronting (or guaranteeing) all the cash is you, it is time to worry.

Worrying does not seem to be the strong suit of Senators Kerry and Lieberman (K-L) in their American Power Act (APA) proposal issued in May.  They have joined a line of political backers for nuclear power who want to give reactors a pass on the market test, adding to the already rich pot of subsidies that nuclear investors would receive.

I've just completed a detailed analysis of three of the nuclear tax subsidies within the APA for Friends of the Earth:  5 year accelerated depreciation for nuclear investments; a 10% investment tax credit; and an expansion of the nuclear production tax credit.  The full memo is available here; a summary by Friends of the Earth is here.

Keep in mind that the scope of this analysis was quite limited:  many other subsidies to nuclear in APA were not quantified; and the large set of existing subsidies to nukes also ignored.  But even so, it appears that through the 5 year depreciation and ITC alone, K-L have kicked in the final 20 percent to the "policy-enhanced  investing" that the industry seems increasingly to be relying on. 

This "20 percent" was the equity required to be at risk for nuclear projects that were getting the remaining 80 percent guaranteed by the feds under the Title 17 advanced energy loan program.  While the investors woudl still need to put in the equity at the beginning, the generous tax breaks effectively allow them to take most of it off the table within three years of reactor operation; and the full capital at risk (or nearly all in our low estimate using more favorable capital cost assumptions) within five.  After that, gentle taxpayer, it is you and I who bear the financial risk from projects going bad.  And no, we don't get to share in the upside if the project turns out well.

The main findings from the memo include:

• K-L subsidies worth billions per reactor.  The new subsidies will be worth between $1.3 and nearly $3.0 billion per new reactor on a net present value basis.  This is equivalent to between 15 and 20 percent of the total all-in cost of the reactors, as projected by industry.

• New subsidies will undermine equity requirements of the nuclear loan guarantee program.  Despite significant structural weaknesses in DOE's Title 17 loan guarantee program, the rules at least required investors to hold a 20 percent equity stake in the new project.  A key goal of this requirement is to ensure investors have a strong interest in the long-term success of the venture and feel substantial pain from its failure.  However, the K-L bill would in effect allow investors to recover funds equal to this equity share within the first few years of plant operation.  Financial risks from project failure would then rest almost entirely with taxpayers.

• New nuclear subsidies on offer under K-L are worth 15 to more than 50 percent of the expected market value of power the plants will produce.  This is in addition to the many other subsidies the nuclear projects would already receive.

• K-L “progress payments” allow ITCs to be claimed before reactor opens, greatly increasing taxpayer risks.  Bill language to recapture these credits is unlikely to be effective in a situation where a reactor project goes into bankruptcy.

• Aggregate tax subsidies to new reactors could reach tens of billions of dollars (net present value) from K-L's two main tax breaks alone. The national cost of K-L's tax provisions can be benchmarked by evaluating two build-out scenarios:  6 reactors, matching the number likely to be supported under K-L's expanded nuclear loan guarantee pool; and 22 reactors, matching the number going through NRC licensing as of May 2010.  As not all reactors will be the same type, the calculations assume half are AP1000s and half Areva EPRs.  Under a 6 reactor scenario, K-L will add $9.7 to $15.6 billion in tax subsidies to nuclear power on a net present value basis.  Under a 22 reactor scenario, the net present value of subsidies on offer just through 5-year depreciation and ITCs reaches $35.7-$57.3 billion.  Unlike the PTC, neither of these other subsidies have any national caps, so the taxpayer cost scales linearly with reactor count.  
  

Check out these links for more on subsidies in APA; and for an assessment of APA's loan guarantee retention fee.

This is the first of what will hopefully be a series of posts looking at specific aspects of The American Power Act (APA) proposed by Senators John Kerry and Joe Lieberman. 

This one deals with the nuclear “loan guarantee retention fee” (section 1102), as an item I’d flagged an needing additional information in my initial review of  the Bill’s summary. 

More resolution on other nuclear subsidies from detailed bill language

Before delving in to that specific item, the detailed APA brought a few other nuclear-related subsidies into greater focus than could be discerned from the summary alone.  Clearly, Kerry and Lieberman have some broader strategy behind their strong desire to shift more and more of the investment risk for an ever larger number of new reactors from investors to taxpayers.  Maybe it is pure politics (MA has MIT, a strong backer of nuclear; CT is the headquarters of General Electric); maybe it is some downpayment on a future climate deal; maybe they really do believe that nuclear power should be the anointed winner of the post-carbon energy world, without even having to compete. 

Whatever it is, however, the risk-reward balance is worrying (with taxpayers on the hook for so much of the investment risk, K-L don’t even give us any of the upside), as are the potential impacts on inter-fuel competition.

• Nuclear delay insurance subsidy expansion is larger than was evident in the summary.  This is because the fixed number of contracts role to new facilities if no claims made.  Rather than "just" tripling the face value of the policies from $2 billion to $6 billion, and eligible reactors from 4 to 12, K-L also took allows all 12 available policies to be reused and reassigned to new projects if claims are not made on the inital plant.  This change greatly increases the likelihood of the government incurring losses under the program; and practically means that coverage will be available to any reactor that wants it during the period of delay insurance operation.

• Near-current deduction of investment tax credits by counting them as “progress payments.”  The bill summary made it clear that K-L thought production tax credits for new nukes weren’t enough, and that they wanted investment tax credits as well.  ITCs in general dramatically shift performance risks from plant owners to taxpayers relative to production tax credits (which can’t be earned until a plant is actually producing).  The progress payments allow more rapid deductions on partially complete investments. 
• Increased nuclear production tax credits (section 1124) – national cap is increased by 33%, from 6,000 MW to 8,000 MW.

A detailed look at nuclear loan guarantee retention fees

Including a retention fee is a de facto admission by K-L that federal loan guarantees for nukes will be among the cheapest money in the project.  I don't see this admission as a bad thing.  Quite to the contrary:  in any 12-step program, recognition is step 1.  Only by acknowledging the enormous value of the guarantees can K-L or others in Congress more directly assess their impact on the competitive dynamics of the energy industry.

For too long, the entire focus on the loan guarantees has been on whether or not they will default, not on the enormous distortions they will cause in energy investment patterns even if they don’t.  Look at the industry’s own cost models (which do not predict default and bankruptcy) and the loan guarantees top the list for most valuable “incentives”.  NEI also holds the guarantees at the top of their long and growing wish list of support.  This subsidy is what I refer to as the intermediation value of government loan guarantees – basically, the difference between what a true market transaction would price the risk at and the US Treasury’s cost of borrowing.

Loan guarantees generate subsidies even without default in two main ways.  First, they reduce the cost of debt substantially.  The higher the market risk of your project, the larger the cost savings from replacing “debt investor” with “taxpayer” as your funding source.  Second, because title 17 of the Energy Policy Act now allows 100% of the debt to be federally guaranteed (up to 80% of the total project cost), nuclear investors get to use far more debt than any true merchant structure would have ever allowed.  Debt is cheaper than equity, so the weighted average cost of capital on the new reactor goes down further.

This creates some uncomfortable facts for K-L, however.  The first is that less risky projects – even if they also get federal guarantees – will end up relatively worse off vis-à-vis nuclear than without the guarantees.  If these other projects are also less politically powerful, they may end up far worse off – an unfortunate outcome if they also happen to be quicker, more scalable, less expensive, and lower risk to the taxpayer-investors than a new reactor.  The second issue is that if the feds are the cheapest source of funding, there’s no reason for the nuclear borrowers to pay it off any sooner than they have to (potentially 30 years out). 

The retention fee attempts to deal with this second issue.  It partially calls industry's bluff that they need financing only during the construction phase -- though even with the retention fee, low cost credit lasts well into the plant's operating life -- and possibly for the full duration of the loan.

Retention fee mechanics

Assuming a 4 year construction period (admittedly ambitious), you have the following schedule of retention fees (longer construction times would delay the year in which the retention fee kicks in) that escalate the cost of borrowing over time:

• Years 1-4: no retention fee due to construction period
• Years 5-9: no retention fee due to 5 year grace period
• Year 10: 0.5% fee added to whatever base rate the borrower is paying
• Year 11: 1.0% fee added (escalating 0.5%/year through year 14)
• Year 12: 1.5% fee added
• Year 13: 2.0% fee added
• Year 14: 2.5% fee added
• Year 15: Rate jumps to 5.0% above original note interest rate; this occurs no more than 10 years after operations begin, and stays there until the normal expiration of the note.

Will the retention fee accelerate repayment of government guaranteed debt?

For the borrower to want to pay off the federal debt earlier, the cost of that funding must rise higher than alternative sources of debt.  This is possible – if, for example, the reactor comes in on-time and below budget, and interest rates stay low, the jump to a 5% retention fee might trigger refinancing in year 15 instead of year 30. 

But there are also many scenarios where the refinancing is unlikely:

• Default.  The risk of default is highest during the construction phase.  With no fee until at least year 9, the majority of defaults will kick in prior to any impact from the retention fee.

• Financial stress.  If the reactor is under financial stress due to construction delays, cost over-runs, or an expectation that break-even power rates will not be achievable when the plant goes live, there will likely be no capacity to repay any of the debt lines early. If there is, the government debtor is likely to be more easily lobbyed for relaxed repayment terms than is a bank.  This would especially be true in a situation of systematic financial stress across the nuclear sector, as would occur following a reactor accident somewhere in the world; or from structural changes in electricity markets that alter the economic benefits of large scale, centralized power generation.

• Federal credit is still cheaper.  Even with the retention fee premium at 5%, it is quite possible that the alternative sources of credit will be more expensive.  This outcome could arise in two situations.  If the market situation is not great for nuclear, industry promises about take-out financing once the plant is built may not materialize inexpensively.  Second, replacing the Federal Financing Bank with a private lender, even if the initial interest rate seems lower, could well be far more expensive if the 80% debt structure of the project needs to be ramped down to 40 or 50% to meet private lender debt covenants. 

Unknowns

There are also a variety of unknowns in how the sketchy language on the retention fees would be deployed.  These include:

• Impact on existing $18.5 billion nuclear pool.  Though K-L want to amend the title 17 statutory language, it seems unlikely that they could retroactively institute this fee on guarantee applicants for the first $18.5 billion.  What is unknown is whether there would be any restrictions in modifying the terms of a program to which $122 billion in applications have already been submitted under the old rules.
  
• Retention fees versus credit subsidy and administrative fees.  While it is rational to assume that retention fees are in addition to, rather than in partial lieu of, credit subsidy and administrative fees, this is not explicit in the proposed language.  In the high stakes world of nuclear lobbying, nothing should be taken as a given.
  
• Cash cow for DOE?  Under title 17, the interest and principal goes directly back to Treasury.  Fees, on the other hand, appear to go to Treasury but remain available to DOE for subsequent use.  This is a very interesting potential wrinkle.  Consider that were this this interpretation is correct, the retention fees would create a return of up to $5 billion per year (5% of $100 billion in total authorizations) that would flow to DOE rather than to the general taxpayer.  If we further assume that DOE pools the money to support additional guarantees, this might create a revolving-fund like structure similar to what the CEDA legislation would have done, without the need to pass CEDA.  Any lawyers out there who can evaluate whether this type of an outcome would be possible?

Just last week, the Economist magazine noted in an editorial that:

However you measure the full cost of a gallon of gas, pollution and all, Americans are nowhere close to paying it. Indeed, their whole energy industry—from subsidies for corn ethanol to limited liability for nuclear power—is a slick of preferences and restrictions, without peer. The tinkering that will follow this spill will merely further complicate it.

As if on cue, out comes "The American Power Act."  For some reason, idle hands in Congress always find particular comfort in working on energy bills, and an early summary of the latest of a long line of government energy initiatives has just been released.  A short summary of that summary can be accessed here.  The American Power Act will dole out all sorts of goodies, with some huge potential gains to coal and nuclear power.

Before going into what the bill contains in giveaways, it is useful to note some of the key things it does not do.  It does not remove the government from the role of choosing technology winners and losers, and it does not build a neutral policy platform on which all energy technologies must compete for whatever public support is offered.  In fact, the bill summary views this not as a bug, but as a feature, noting that the bill is "investing in innovation across all energy sources."  Investing in everything is not a very good theory of change, as I've examined in detail previously.  Finally, it does not work to quickly establish greenhouse gas price signals for key energy and industrial sectors, but rather seeks to shelter them from these prices for many years.

In terms of the new subsidies in the bill, in depth analysis requires the specific legislative language.  However, some choice nuggets are already evident in the summary:

Nuclear

• 5 year depreciation on nuclear reactors expected to last 60 years.
• Formally increases Title 17 loan guarantees to nuclear by $36 billion, to $54 billion (there is an additional $2-4 billion above this total that is already in place for front-end facilities such as enrichment).
• Introduction of a "loan guarantee retention fee" on nuclear loan guarantees, supposedly to expedite repayment of the guarantees.  (The language here is strikingly weak:  "to ensure that money is returned to the program as expeditiously as practicable").  The actual form and meaning of these fees is not clear from the summary however.  It could be a withholding from the loan guarantee amount (in which case firms will overstate need to create a buffer).  Also not clear is how the retention fee will interact with the credit subsidy payments already required.
• A tripling of the coverage for nuclear delay insurance, from $2 billion to $6 billion in face value; covering 12 rather than 6 reactors.
• Accelerated licensing and review procedures for new reactors, and elimination of some review steps.  How these complex projects can be properly overseen with the expedited process remains to be seen.
• Increased research push on small reactors and fuel reprocessing.
• Since production tax credits can only be earned once a plant begins operation, the bill adds a 10% investment tax credit that can be captured earlier, and likely even if the plant is never completed.  A 10% federal grant would be available to non-taxable entities involved with reactor construction, as such entities can't use tax credits.  Detailed legislative language is needed to see whether these can be combined with other subsidies, such as production tax credits, or much be used instead of them.
• Allows nuclear to access Advanced Energy Project Credits, providing up to a 30 percent tax credit for manufacturing eligible project components (credits may be carried forward up to 20 years).  The credits have a national cap, so look for subsequent legislation to dramatically increase the available support.  The current cap of $2.3 billion is rounding error in nuclear projects, and remains low even after the APA's  additional $5 billion (Section 4003) in credits is included. 
• Expanded use of tax-exempt private activity bonds in the nuclear power sector.  Because nuclear projects are so big, this provision may not be popular with other users of private activity bonds.  Usage of Build American Bonds (BABs), another tax-advantaged financing tool, by the Vogtle reactors is among the largest BAB projects in the country.
• Allows existing production tax credit (PTCs) for nuclear to be entirely allocated to private participants on a project that includes both taxable and non-taxable entities.  This will increase the effective value of existing nuclear PTCs.
• Extends suspension of import duties on imported nuclear components.  Although nuclear is touted as a solution to energy security concerns, many of the most expensive reactor elements are manufactured outside of the United States.

Coal

• The bill provides some additional subsidies to advanced coal and carbon capture and storage.  However, the most valuable subsidies to the coal sector will likely come through the grants of emissions credits.  The impact of these schemes is difficult to gauge without more detailed language, but Section 1431 of the bill does indicate that where plants or utilities capture and store carbon, they will actually earn GHG allowances.  Under a strict cap and trade, such facilities would simply avoid the need to buy credits by reducing emissions. 
• Section 798 appears to buy off up to 35 GW of premature closure of merchant coal plants by allowing them to continue to receive emissions permits even if the plant has been closed or repowered.  There is no detail suggesting that the buyouts will go first to the dirtiest plants (whether merchant or not), or require high levels of operations in order to be eligible.  The risk of this subsidy being gamed seems high.

Clean Energy Funding

• Section 1801 establishes a "Clean Energy Technology Fund" to promote development of new energy technologies, though provides little additional details on eligibility, structure, or funding levels.  One concern is that the wording sounds like this could be an effort to implement some type of clean energy bank, along the lines of poorly structured earlier proposals for a Clean Energy Deployment Administration (critiqued here). 

Credit Offsets and Allocations

• Title II of the bill attempts to establish some centralized vetting of offset claims, both domestically and internationally, to ensure that offsets are awarded for behaviors that actually reduce emissions.  This is a useful element of the bill, though likely extremely difficult to do well.
• As with other climate bills, this one contains broad giveaways of carbon credits for a sizeable period at the inception of the new law.  As explained by Joe Romm, the bill also attempts to deal with credit price volatility through gradually increasing floors and caps.
• Title IV provides widespread rebates and allowances to industrial emitters of GHGs, suggesting that key industrial sectors will see little price incentive to curb emissions.

"Fast" Mitigation of Hydrofluorocarbons

• Though "extremely potent greenhouse gases," HFCs are to be reduced to 15 percent of baseline, but not for another 22 years.  Hard to imagine what "slow" mitigation looks like.

Oil and Gas

• Section 1204 allows state opt-out of oil and gas drilling within 75 miles of its coastline (otherwise federal laws pre-empt state wishes).  While this provision was introduced in response to the recent Gulf oil spill, its actual protection of coastal resources may be more symbolic than real.  As of May 11th, the Gulf spill oil slick was 130 miles long and 70 miles wide -- enough to have blown through the proposed buffer zone.
• Provides substantial subsidies to convert vehicles to natural gas (starting section 4121).  This is another example of government micro-managing technology selection.  The transport policies should be neutral with respect to any option (better engines, hybrids, electric vehicles, improved fleet management) that reduces oil demand.

Update:  The full bill, in all 987 pages of glory, has now been released.  It will obviously take some time to go through.