ALTERNATIVE ENERGY OUTLOOK

The Alternative Energy industry is going through a recovery after absorbing the global recession and the cascading fall in global crude oil prices. Earlier this year, quite a few alternative energy companies were in the trough. Though these alternative energy companies have recovered from their lows, their valuations are still extensively lower than their 52-week highs.

The growth of alternative energy companies is closely tied to the fortunes of the economy. In its latest release, the Energy Information Administration (EIA) predicted that total U.S. electricity usage will decline by 3.3% in 2009 before growing by 1.3% in 2010 as the improving economy coaxes a gradual recovery in electricity sales. In fiscal 2008, annual U.S. photovoltaic (PV) installed capacity grew by 63% year-over-year, bringing the cumulative installed capacity to 792MW.

According to the Solar Energy Industries Association (SEIA) — the U.S. trade association on behalf of close to 500 companies in the solar energy industry — Germany ranked first followed by Spain, Japan and U.S. in terms of cumulative installed solar electric power as of year-end fiscal 2008. However in fiscal 2008, Spain (2.46GW in 2008) beat Germany (1.86GW) in terms of new installations. World solar PV installations reached a record high of 5.95GW in 2008, representing growth of 110% over 2007.

According to the European Photovoltaic Industry Association (EPIA) — the world industry association for solar photovoltaic electricity market — the cumulative global installed PV capacity stood at almost 15GW, compared to only 9GW in 2007.

ALTERNATIVE ENERGY OPPORTUNITIES

Alternative Energy Environmental Advantage: Solar power is one of the most benign electric generation resources. Solar cells make electricity without air or water emissions, noise, vibration, habitat impact or waste generation.

Fuel Risk Advantage: Unlike fossil and nuclear fuels, solar energy has no risk of fuel price instability or delivery risk. Although there is variability in the amount and timing of sunlight in the day, season and year, a properly sized and configured alternative energy system can be designed to be highly reliable while providing a long-term, fixed-price electric supply.

Locational Advantage: Unlike other renewable resources such as hydroelectric and wind power, solar power is generally located at a customer’s site due to the general availability of sunlight. As a result, solar power limits the expense and energy losses related with the transmission and distribution from large-scale electric plants to the end users. For most residential consumers in quest of an environment-friendly power alternative, solar power is currently the only viable choice as it can be sourced in urban and rural environments.

Subsidy Programs: Governments, most notably that of China, have augmented their financial support for alternative energy and solar projects. China is aiming at increasing its installed solar power capacity to 2GW by 2011 from 140MW capacity at the end of fiscal 2008. To satisfy this objective, the Chinese government offers 50% of the cost of investment of solar power projects. For solar projects in remote areas, the government subsidizes 70% of the project cost. A company under our coverage benefiting from this move includes Solarfun Power Holdings Co. Ltd. (SOLF – Snapshot Report).

Through the American Reinvestment and Recovery Act (ARRA) passed in February 2009, the U.S. Treasury Department has implemented a alternative energy program to hand out cash grants in lieu of the investment tax credit for renewable energy projects. Recent focus on renewable sources will greatly benefit green crusader companies like Rentech Inc. (RTK – Snapshot Report). Also, the Department of Energy (DOE) in the U.S. has implemented a loan guarantee program to help developers obtain financing for solar power projects.

ALTERNATIVE ENERGY WEAKNESSES

Recent Start-ups: A large number of alternative energy companies are recent start-ups with limited resources. As such, quite a few depend on their customers’ ability to finance solar projects.

Global Recession: The global economic crisis has affected alternative energy sales and earnings growth. Weakness in the debt and equity markets, for as long as it lasts, will raise costs of capital for firms in this emerging sector and may hinder project financing, working capital requirements and new research and development.

Fortune Tied to Crude: Alternative energy stock prices generally rise and fall in direct proportion to the price of crude oil. While in times of high oil prices this may present an opportunity, it also increases volatility in the sector.

Excess Capacity: Industry-wide excess solar cell and module capacity have led to stockpiling across the board. As a result, we think the performance of alternative energy companies such as Evergreen Solar Inc. (ESLR – Analyst Report), JA Solar Holdings Co Ltd. (JASO – Analyst Report), A-Power Energy Generation System (APWR – Snapshot Report) and LDK Solar Company Ltd. (LDK – Snapshot Report) — weighed down as they are with high inventory levels — will remain under pressure in the near term.

German Roll-back: Germany, one of the prime solar markets with a lucrative subsidy alternative energy program, is considering a roll-back of its grants. This will affect companies such as First Solar Inc. (FSLR – Analyst Report) and SunPower Corporation (SPWRA – Snapshot Report), who cause a substantial portion of their sales from Germany.

In 1859, Charles Dickens famously penned the opening lines to “A Tale of Two Cities”: It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair…

Dickens was not, of course, referring to the outlook for the renewables sector in 2009, but he easily could have been. The outlook for the renewables sector is a remarkable juxtaposition of a rosy future and a grim present. On the one hand, the growing public and political consensus around the dangers of climate change coupled with the rousing endorsement from Congress in the broad renewables tax package enacted in October 2008 all bode well for the sector. On the other, the dramatic downturn in the financial sector suggests that obtaining project-level financing is going to be tough sledding throughout 2009.

This “best of times, worst of times” dynamic suggests the coming year may well be the year that the renewables sector proves its mettle to the market, showing remarkable resilience in the face of extreme financial uncertainty. To do so, it will need a little help from Capitol Hill— and Congress may well deliver.

Prospects for Climate Change Legislation in 2009

During the 2008 presidential campaign, President-Elect Obama endorsed a cap-and-trade program as the preferred approach to reduce global greenhouse gas emissions. Likewise, both the House and the Senate are poised to resume consideration of various cap-and-trade proposals early in 2009. While many economists, including the Congressional Budget Office, prefer the simplicity of a carbon tax, most observers believe that a cap-and-trade system is the most likely political outcome.

If a cap-and-trade regime is inevitable, the next question to ask is when it might be enacted. The answer to this question depends largely on the health of the economy. Many believe that the Obama Administration will be reluctant to burden an already soft economy with the higher energy prices that a cap-and-trade program would almost certainly bring. If the economy remains mired in recession throughout 2009 and 2010, comprehensive climate change legislation could be shelved until a possible Obama second term.

Renewable Energy & Energy Efficiency

If comprehensive climate change legislation is tabled for the short term, it seems likely that Congress and the Obama Administration will redouble efforts on more narrow policy goals or regulatory reforms that have long been at the forefront of environmental policy in the United States. Indeed, the appointment of Ken Salazar as Secretary of the Interior; Carol Browner as head of the newly formed National Energy Council; and appointments at the Environmental Protection Agency, the Department of Energy (DOE), and other agencies all point to a determined effort to chart an aggressive course on environmental policy. In particular, the likelihood for a federal renewable energy standard (RES) is enhanced by the convergence of large Democratic majorities in both chambers of Congress and a Democrat in the White House. President-Elect Obama was supportive of a federal Renewable Portfolio Standard throughout the presidential campaign, and the House of Representatives passed a similar RES on several occasions. The Senate, long a stumbling block to this legislation, will have a decidedly greener point of view in the incoming Congress.

The most recent House version of an RES, in H.R. 6899 from the 110th Congress, likely represents the jumping- off point for legislative efforts in the 111th Congress. Interestingly, that version allows for energy efficiency measures to be treated as qualifying under the RES standard. This would bode well for energy efficiency technologies, particularly in the Southeast where other renewable resources appear to be less abundant.

Likely, other areas to be considered will be modified Corporate Average Fuel Economy standards for the automobile industry and new and more flexible tax credits for clean and alternative energy. Likewise, the incoming Obama Administration had pledged to invest billions of dollars in infrastructure including areas such as smart grid, biofuels pipelines, and mass transit. This infrastructure spending could be authorized quickly in 2009 in the promised economic stimulus bill currently under consideration by House and Senate leadership. The stimulus bill could also include large grants, tax incentives, and other authorizations for renewable energy and energy efficiency projects and technology.

The Future of Renewable Energy Tax Incentives

To date, the principal approach to encouraging renewables development in the United States has been through the tax code. The production tax credit (PTC) has helped fuel remarkable increases in U.S. wind generation in recent years. Likewise, the energy investment tax credit (ITC) is largely responsible for the current boom in the solar sector. The same can be said of renewable energy tax credits for biofuels, biomass, geothermal, fuel cells, hybrid automobiles, and so on.

This approach has worked well… until now. The rapid decline of the financial sector throughout 2008 has all but eliminated the erstwhile renewables financiers from the marketplace. Even those financial institutions that still have cash on hand often have current financial and tax losses, making tax credits all but useless. Without these traditional sources of project-level financing, many planned wind, solar, and other renewables projects may never get beyond the planning phase.

It is against this backdrop that Congress is considering a revision of renewables tax incentives to make them more effective in the current financial climate. Congress will likely revisit energy tax legislation in 2009 to, at a minimum, extend the production tax credit for wind that expires on December 31 of that year. While considering that extension, Congress has indicated that it will consider making the PTC and possibly the ITC refundable. Unlike the current-law tax credits, the holder of a refundable tax credit need not have a tax liability to capture the value of the tax credit. Rather, the holder of the tax credit can apply for a refund from the federal government in an amount equal to the credit.

This approach would allow developers and project investors who do not have sufficient tax liability to capture the value of the tax credits to nevertheless do so in the form of refunds from the federal government. This change could significantly expand the universe of potential project investors from the handful (that have both the capital on hand and the tax liability to utilize the project tax credits) that exist today. Such an approach, if enacted, would push the United States a step closer to the feed-in tariff approach so common in Europe. One lingering complexity to be resolved is whether the accelerated tax depreciation (five years for wind and solar projects) would be refundable as well. On the one hand, this accelerated cost recovery represents a sizeable portion of the tax benefits that attract investors. On the other hand, Congress may be reluctant to set a precedent for other industries that depreciation and cost recovery can be a refundable item.

An alternative proposal put forward by the incoming Obama Administration would allow claimants of renewable energy tax credits to carry them back to the preceding five tax years. This would allow these project developers and investors to wipe out taxes paid in earlier years and claim a tax refund from the federal government. While this approach is likely to be helpful to many potential investors, it is unlikely to have the broader stimulus effect of a generally refundable credit.

Meanwhile, it seems likely that other industries will enter into the renewables tax financing market. In particular, public utilities appear to be a good choice to take up some of the slack. As regulated companies, utilities tend to have both cash and tax liability. In addition, the renewable energy sector is a natural fit for the core competency of these entities. Utilities know project development, power purchase agreements, transmission interconnects, and other fundamentals around power production (even if the underlying technology is new to most traditional utilities).

Conclusions

Despite momentum in public opinion, political circles, and discussions among strategic investors, the renewables sector faces a challenging year like most sectors of the economy. While comprehensive climate change legislation may have to wait for firmer economic footing, other help may be on the way. A federal RES would create demand for renewables on a national basis. This coupled with revamped refundable tax credits could shake loose project-level investment that has been lacking in recent months. These legislative changes could change the outlook from “A Tale of Two Cities” to another great Dickens book: “Great Expectations.”

This article was first published by the KPMG Global Energy Institute in 2009 prior to the enactment of the American Recovery and Reinvestment Act of 2009. It is reprinted here with permission of the publisher.

About the KPMG Global Energy Institute This article is provided by the KPMG Global Energy Institute. The Institute’s goal is to provide an open forum where industry financial executives can share knowledge, gain insights and access thought leadership about global energy industry issues and emerging trends. To access a regularly updated library of thought leadership, video and audio Web casts, podcasts and conferences and events, please visit http://www.kpmgglobalenergyinstitute.com/.