Falling Energy Prices and Tightening Credit- Double Whammy on Clean Energy Investments, #1

This is the first of two posts that describe how two recent trends- falling energy prices and the global tightening of credit- are affecting the market for investments in clean energy. This post will examine falling energy prices, while the next post will examine tighter credit.

Falling Energy Prices
Several recent articles in major publications (WSJ and NYT) have pointed to the negative affect that falling fossil fuel prices are having on alternative energy.

As the graph to the left shows, crude prices have dropped significantly since their record highs earlier this summer. The NYT article mentions that natural gas prices have followed suit, dropping from $13.58 per thousand cubic feet in July to $6.79 in October. Coal has also dropped in price (EIA).


Project Finance Framework
The upshot of lower energy prices is that they make investing in clean energy look a lot less attractive financially. The standard method of underwriting and valuing investments in clean energy projects is as follows:

1) Calculate the upfront capital cost
2) Calculate the future savings from avoided energy use- this is the income stream of the investment
3) Compute an internal rate of return and decide if it meets some hurdle rate. If so, invest. If not, throw it out.

Using this framework, tightening credit and falling energy prices are a double whammy for clean energy investments. First, tighter credit means that the "price" for capital goes up, i.e. interest rates and hurdle rates are set to rise. At the same time, lower energy prices mean the savings from avoided energy use are smaller, reducing the future income stream, thereby making investments less likely to meet the already higher hurdle rate.

This new found financial math has resulted in a flood of capital leaving the sector. As quoted in the NYT article:

"Worldwide project financings for new construction of wind, solar, biofuels and other alternative energy projects this year fell to $17.8 billion in the third quarter, from $23.2 billion in the second quarter, according to New Energy Finance, a research firm in London. The slide is expected to be sharper in the fourth quarter
and next year."

Traditional Project Finance and Energy Volatility
This exodus of capital makes sense using the project finance framework. But taking a step back, why should an investment in clean energy, a stable investment that will generally have a lifetime of at least 10 years, be compared to a short-term, highly volatile price signal like oil? The massive volatility of oil, natural gas and coal makes their price almost worthless in long term planning. Oil, after up being up about 40% on the year during the summer, has since swung to being down about 30% year-to-date. Making long-term, sober investment decisions based on a commodity subject to such whipsaw effects seems like no way to manage money.

Opportunities
I believe this volatility in the savings stream is not only a serious problem with relying on traditional project finance to value investments in clean energy. Several potential fixes come to mind.

First, and easiest, is policy. Enact what Thomas Friedman has been calling for the past year: a gas tax that puts a floor on the price of oil. This would ensure that clean energy investors need not worry about extreme downside risk of falling energy prices.

Second, is to rethink the provision of energy. Currently, energy is provided as a commodity, something that everyone can buy and use freely. Instead, why couldn't power utilities - and their investors - rethink the model? Instead of selling energy by the killowatt-hour, why don't utilities start selling the service of power? This is a way to strip the volatility out of energy provision. Consumers could enter into fixed price long-term contracts with energy providers to ensure for the service of power regardless of the source, insulating themselves from energy price risk. Providers, on the other hand, would be able to enter into long-term agreements and know they have a market for their power at a specific price. They could then use this price for energy to investigate whether investment in clean energies is attractive or not, and strip fossil fuels out of the equation.

Third, is to use scenario planning to imagine what will happen to a clean energy investment under different future energy scenarios. In this paragraph, I essentially adapt Nassim Taleb's Black Swan framework to energy prices. From a clean energy investors perspective, in the worst case scenario the price of oil will go to zero, and the investment's income stream will go away. However, I believe this is extremely unlikely as oil R&D and exploration has been going on for centuries, making the possibility of a disruptive game-changer slim. On the other hand, let's assume we didn't make the investment in clean energy, but instead invested in fossil fuels, because it had a better internal rate of return based on our projections. Then, strife in the Middle East, a hurricane in the Gulf Coast, strict new carbon taxes or one of a handful of other plausible scenarios occur, and drives the price of oil through the roof. In this case, the price of oil can rise indefinitely. It can easily pass the highs it set earlier this summer and head above $200 and theoretically just keep on rising. It seems clear to me, then, that the much bigger risk is that oil prices go through the roof, not that they collapse. From a risk management perspective, going the clean route is clearly the best choice.

Although the recent drop fossil fuel prices has hurt investment in clean energy, I think going forward fossil fuel volatility will actually become one of the key drivers for further investment. Yet again, it looks like clean tech has the potential to help the world turn a serious problem into an opportunity for a greener, more prosperous future.

ESCOs and Building Retrofits in China

The opportunity for building energy efficiency retrofits in China is massive. Currently, 95% of buildings in China are classified by the government as "high-consuming", meaning they use 2-3 times more energy per square foot than buildings in the US and Europe. The China State Development Council Research Centre estimates that if done properly, energy efficiency could provide a quarter of China's new power needs by 2020. At current rates of power plant construction in China, this is about 25 500MW new coal plants avoided every year.

It's also cheaper to invest in energy efficiency. According to the Asia Business Council's recent report on building energy efficiency, gaining a new MW by building new power sources is 4 to 6 times more expensive than gaining the same MW by investing in energy efficiency.

The problem is that investing in these energy efficient solutions takes capital and financing. Wang Hong, technical director for Maunsell AECOM Beijing, thinks one of the problems plaguing energy efficiency investment and financing in China is that banks up to this point have not been very interested in existing buildings. Historically, more of the focus has been on lending to finance new construction and development, limiting funds available for retrofits. Hopefully as the development market cools, banks will start expanding credit to the many promising retrofit projects available. In a positive sign, the Asian Development Bank announced last week that it will invest 800 million yuan ($117 million) in energy efficiency retrofits in mainland China.

Energy service companies (ESCOs) have also started to take advantage of these opportunities to invest in energy efficiency in China and help fill the financing gap. ESCOs identify and finance building energy efficiency retrofits and use the energy savings to pay back the initial investment (more background on ESCOs). The first Chinese ESCOs sprang up in 1998 with help from the Chinese government, World Bank and several other governmental organizations. Since then, the ESCO industry has seen rapid growth. In 2006, about 100 ESCOs financed over 400 energy conservation projects in 16 provinces totaling US$280 million in investment. For comparison, American ESCO's invested about $2.5 billion in energy efficiency retrofits in 2006. Taking into account the higher level of ineffeciency in Chinese buildings along with the sheer amount of floor space in China, the ESCO business has a lot of room for growth in China.

Several large American ESCOs are moving rapidly into the market. At a presentation at a McGraw Hill green building conference in Shanghai in October, Shane Tedjarati, President of Honeywell India and China, described a project that Honeywell had done in collaboration with the Tsingtao Asahi beer factory in Shenzhen. Honeywell did an energy audit and upgrade that included heat recovery, optimization of the cooling and HVAC system, and a centralized control system, which ultimately resulted in 17% annual energy savings. Honeywell provided the financing on a 5-year contract, which meant that Tsingtao didn't have to put any capital into the project. The Asian Development Bank has also partnered with Johnson Controls for its new investment in energy efficiency, which will be a good foray into the market for Johnson.

Given the China-sized opportunity to both make money and reduce carbon emissions, I expect to see much more ESCO activity in China.

Fire Retardants and Indoor Environmental Quality

Today I attended an interesting lecture by Dr. Arlene Blum, the Executive Director of the Green Science Policy Institute, a new think tank that brings together scientists to advocate for green public policy and serve as a credible counterforce to industry lobbyists. She was also the first woman to attempt Everest, as described in her book Breaking Trail: A Climber’s Life. The lecture was held at the Tsinghua University Department of Building Sciences.

Dr. Blum’s lecture focused on a topic I hadn’t thought about much: the effect of fire retardants on building indoor environmental quality (IEQ).

Fire Retardants and IEQ
Fire retardant (FR) chemicals are typically halogenated chemicals that contain bromine or chlorine, are added to many products in order to improve fire safety. Halogenated FR chemicals are most commonly used in electronics, building insulation, and furniture, and are therefore of great importance to professionals thinking about the built environment.

The problem with these halogenated FR chemicals is that they are extremely toxic. These chemicals have been proven to cause significant health problems in wild animals and are likely to cause significant health problems in humans, particularly in young and newborn children. Despite these potentially dangerous side effects, the use of FR chemicals has proliferated in recent years as more and more governments are beginning to require fire retardants as a fire safety measure, particularly in California thanks to stringent fire codes.

Woods Center at Stanford
The scary thing is these halogenated FR chemicals are even being found in green buildings. For example, the new Jerry Yang & Akiko Yamazaki Environment & Energy Building at Stanford University "sets sustainability standards for Stanford" and is built to LEED Platinum standards, although not certified by the USGBC. However, when Dr. Blum took samples from the building, she found that both the insulation and the furniture had extremely high levels of bromide. Needless to say, this did not make the Stanford people very happy.

The Problem- Short-Sighted Public Policy Encourages Use of Toxic Fire Retardants
Now, this is not necessarily Stanford's fault. I just use the example to illustrate the unintended consequences of California's laws that require the use of FR chemicals in insulation and furniture. Currently, no non-toxic substitutes exist for such chemicals, and if Stanford wants to buy a chair, it must buy the chair coated in a toxic FR chemical.

Clearly, the intent of such laws is noble: to promote fire safety. However, Dr Blum makes the point that the data cannot show that these FR chemicals even contribute to fire safety. According to the National Fire Protection Association, the data is not complete enough to show that FR chemicals have had any impact on fire deaths in the US. What is clear though is that these chemicals are toxic.

So how can we eliminate the dangerous chemicals while also preventing fires? Dr Blum suggests we focus on the root causes of fires: primarily candles and cigarettes. Fire-safe candles (fat base, shorter wicks) have become the standard in America, and self-extinguishing cigarettes have also become the norm. Both of these steps help reduce fire deaths and don't rely on the introduction of hazardous chemicals into the built environment.

The US Green Building Council Role
I believe the US Green Building Council should take a strong role in advocating for good public policy on fire retardant chemicals. The USGBC has made significant progress in spreading awareness on volatile organic compounds (VOCs) and the associated negative health affects, which has resulted in many manufacturers removing VOCs from their products. The USGBC should consider incorporating credits into LEED that reward builders who eliminate halogenated FR chemicals from their buildings. Ideally, this will help push manufacturers of furniture and insulation, as well as public policy makers, in the right direction on balancing fire risk with chemical toxicity risk.

The USGBC's advocacy is also incredibly important because the chemical companies spend lots of money to push legislators toward mandating these toxic chemicals. A strong counter lobbying force needs to put forward by green organizations in order to keep these toxic chemicals out of homes and offices.

The China Connection
The question of how to deal with fire retardant chemicals will be an important one for China, particularly as they continue to scale their chemicals industry and improve their building codes. Toxic fire retardants are not currently widely used in China, but the chemicals industry is hoping for rapid growth.

I hope rather than mandating the use of these toxic chemicals, the Chinese government will focus on the root causes of fires. Given that China has 350 million+ cigarette smokers, it is critical that the Chinese cigarette industry moves to fire safe cigarettes. This will keep the Chinese safe both from fires and also toxic chemicals.

Prosper Center, Beijing

I met recently with Tianji Xu, development manager for the Prosper Center, a newly completed 1.6 million square foot office development in Beijing's CBD. Prosper is the first LEED-CS Gold certified building in Beijing and is still the only rentable LEED office space available in the capital.

Why LEED?
Tianji said the decision to pursue certification under the US Green Building Council's LEED rating system was a no-brainer for two reasons.
First, he sees LEED as the emerging world-class green building standard. LEED was used in order to attract multinational tenants, since many of them are already familiar with the system from their home markets. Second, he felt the scorecard system provided the development team with the most flexibility in pursuing the Gold rating. I've heard similar things from other developers and green building professionals in China, and suspect that LEED will quickly solidify itself as the leading (no pun intended) rating system for green buildings in China and internationally.

How Much Did it Cost?
Tianji estimated that Prosper cost 8% more than a standard office building due to its green features. He attributed most of this premium to the increased cost for the high-efficiency systems (low-e glass, HVAC, etc) that had to be imported from America and Europe. Interestingly, he said he didn't think they could have brought it in any cheaper without sacrificing quality. Hopefully, as more local Chinese building product manufacturers see the potential in the green building market, they will begin to mass produce high efficiency systems, lowering the costs for green both in China and internationally.

Who Are the Tenants?
Prosper Center is super-premium Class A space and charges some of the highest rents in Beijing. At this point, the building is about 75% leased up. Tenants include CB Richard Ellis and East Asia Bank. I think CBRE is an interesting case study; since they have an internal commitment to only occupy green space, they essentially had no choice but to occupy the Prosper Center. As more and more multinational tenants adopt this type of internal policy for their international operations, demand for green buildings in China will boom. Given the severe lack of supply (again, Prosper Center is the only leasable LEED space in Beijing), this will be a huge opportunity for developers who can get ahead of the curve.

Tianji agreed, and thinks green building in China will take off within the next 5 years. He also mentioned that they chose to build green not just to appeal to tenants, but also to investors. Might this mean that investors already recognize how the growing demand for green buildings will affect the real estate market? Stay tuned.