Since 2004, several U.S. states have designed and implemented markets for Solar Renewable Energy Certificates (SRECs). These markets are intended to serve several purposes in supporting the growth of solar energy within the state. 2010 was a banner year for the SREC concept as solar growth in these seven markets outpaced the rest of the U.S., turning the East Coast into a focal point for solar companies in California and across the world. No two SREC programs are the same and some markets will fair better than others. Understanding why some markets are successful while others faulter will become increasingly important as other states look to SRECs as the way to incentivize solar.

In 2007, SRECTrade conceived an online marketplace powered by competitive monthly auctions for SRECs. Since launching in New Jersey, the transaction platform has expanded to all seven key SREC markets, adding Massachusetts, Maryland, Ohio, Delaware, Pennsylvania, and Washington, DC. Through the experience gained developing SREC markets and aggregation services, SRECTrade takes a look at the components of an effective SREC market, the challenges that they face and some recommendations for how to avoid some of the design flaws found in existing SREC programs.

The key benefits of an SREC market include:

1. Efficient Subsidy: With an effectively designed SREC market, the value of the SRECs will equal the difference between the cost of solar energy and alternative energy sources. This value will decline over time as solar technology becomes more efficient and costs come down. When an SREC market is used to drive solar growth, the value of the subsidy will be market-based. Therefore, the state is able to promote the growth of solar energy with the least burden on society.

2. Minimal Taxpayer Impact: Unlike other programs designed to promote solar energy, the burden of an SREC market falls primarily on the electricity ratepayers, not taxpayers. Electricity suppliers that sell non-renewable electricity in a state are required to purchase the SRECs. The additional cost will be diffused across the large ratepayer base that consumes the non-renewable electricity. This shows up as a minimal increase in non-renewable electricity prices on ratepayer bills. Meanwhile, the state government no longer needs to allocate significant state budgets towards paying grants or rebates to solar owners. The only cost to the state is in implementing and maintaining the program.

3. Industry Stability: The SREC market has a stabilizing effect for the solar industry in a state. Historically, solar companies have thrived because of state-sponsored grant and rebate programs. The reliance on these programs has lead to cyclical boom and bust periods for the industry. Shortly after the upfront subsidies are announced, they are oversubscribed and quickly disappear. This is primarily due to the fact that states must allocate a limited source of tax-payer dollars to fund these programs. SRECs offer a market-based subsidy post-installation that will not disappear from one year to the next. The costs are diffused across the rate payer base and a long-term schedule is defined that acts as a stabilizing force for the industry.

There are three conditions that must be present in order for a state to implement an effective SREC market:

1. RPS Solar Carve-Out: The RPS solar requirement distinguishes solar from other renewable energy resources and in most cases will value solar electricity at a higher rate than other renewables. Most states will set a target for solar, either as a percentage of the total electricity sold into the state, as a fixed capacity target in megawatts (MW) or as a solar energy target measured in megawatt hours (MWh) or SRECs produced in a year.

Some states will have generic Renewable Energy Certificate (REC) markets that ineffectively promote solar. Unlike wind or hydro, solar is implemented on a smaller scale and therefore will produce fewer RECs. These facilities are unable to access generic REC markets that consist of fewer large-scale transactions. In addition, solar is still more expensive than other renewable technologies and unable to compete in generic REC markets. Several wind farms would produce significant numbers of RECs at a far cheaper price. Some states have addressed this by assigning a 2x-3x multiplier to RECs from solar facilities, but these programs have been ineffective as the transaction costs of procuring wind or hydro RECs continues to be significantly lower.

Other states have created carve-outs for distributed generation facilities. The definition of distributed generation is a key issue with these programs. Distributed generation for wind and hydro may be defined as anything below 20 megawatts, but in the solar industry, a 5-20 megawatt facility is utility-scale. The distributed generation carve-outs may be effective in promoting some solar, but the majority of projects that will benefit from such a market are significant in scale relative to the rest of the solar industry. Residential and commercial solar projects will not be able to access these markets. Because of transaction costs, the distributed generation REC markets will consist of wind and solar projects above a megawatt, where wind still has a significant cost advantage.

For these reasons a separate SREC market must be created in order to effectively promote solar.

2. Unbundled, Tradeable RECs: A state must allow the SRECs to be owned and traded by the generating facility. In some states, your utility company owns your SRECs. This is a common stipulation in state solar grant or rebate programs. Other states have a budget for solar. For example, California historically has not been a viable SREC market because the state required that utilities purchase the SRECs bundled with the electricity that the system produces. In that case, the SRECs cannot be unbundled and sold separately. The benefit of unbundled SRECs is that it sets the foundation for a competitive market. Suppliers cannot simply set SREC prices for the facilities that fall into their territory. When the SREC is unbundled and able to be sold across distribution territories, or even state lines, the market for the SRECs becomes competitive.

3. Penalty for Non-Compliance: Finally, in order to have a robust SREC market, your state must implement some sort of fine or penalty for non-compliance. This is commonly known as a solar alternative compliance payment (SACP). The SACP is what drives the values of SRECs above any other type of REC. Without the SACP, it is difficult to incentivize buyers to pay prices that promote solar growth.

Every state has implemented the SACP in a different way. Massachusetts and Washington, D.C. have fixed the SACP at $600 and $500 respectively. New Jersey has an SACP of $711 starting in 2009 that diminishes 2.5% annually through 2018. Other states like Ohio and Maryland have started the SACP at $450 and set it to decrease by $50 every two years. Finally, Pennsylvania has taken a different approach by setting the SACP at two times the average SREC price in the region, initially designed to keep that market in check with neighboring states – though, due to faulty implementation, the SACP is set at two times the price paid by electricity suppliers in the state.

The SREC markets face some challenges that need to be considered:

1. Regulatory Risk: SRECs are environmental commodities created by state regulation. Any entity that plans to create and sell SRECs will run the risk that the political environment changes. These concerns will be very evident in the early stages of the market, but tend to subside over time as the state’s commitment to the program grows. In New Jersey, the SREC market has been strengthened twice since it was first created in 2004. In the 2010 reiteration, the state added a provision requiring a legislative mandate to lower the SACP. Massachusetts has set a 10-year commitment to the program. Other states like Maryland and Delaware have increased their requirements and fines since implementing SREC programs. This tends to be common as most states passing SREC legislation for the first time will start with unaggressive objectives that are easier to get consensus on and are later strengthened once the markets have seen early success. Despite these positive signs, there is little that can be done to completely mitigate the regulatory risk that an investor faces. At any time, the government will have the authority to dismantle or materially affect the program. The key to a successful SREC market from the regulatory standpoint is that there are no indications coming from the legislative bodies that would negatively impact the existing stakeholders in the program.

2. Market Risk: Unlike feed-in tariffs, rebates or grants, the SRECs carry a value that is determined by market forces. As supply increases relative to the growing demand, the value of SRECs will decrease over time. This creates a significant challenge both in the retail (self-financed residential and commercial) and the institutional solar markets. Any solar developer would prefer a fixed feed-in tariff or upfront cash grant to the complexity inherent in SREC markets. The potential fluctuations in SREC values create a tremendous amount of uncertainty for investors in solar.

The demand is set by the state RPS solar requirements either in the form of a set number of SRECs required by each electricity supplier or based on a percentage of the electricity sold into the state by each supplier. Each year, the demand is set to increase until the state has met its overall solar target. In most cases, demand can be easily calculated, though it is occasionally impacted by the non-participation of some electricity suppliers. For a variety of reasons, companies may choose not to participate in the SREC market and opt to simply pay the SACP instead of purchasing SRECs from the market. To address this, some states, like Delaware, have provisions that will increase the SACP in future years for any particular supplier who opts to pay the SACP instead of procuring SRECs. Pennsylvania, meanwhile, uses an SACP that is twice the implied market price to incentivize suppliers. Finally, states can affect a supplier’s willingness to opt for the SACP by distinguishing the tax treatment of the expense incurred. An SREC purchase can be treated as a deductible expense, while the SACP may not.

The more significant force that impacts demand is the available supply. The relationship between supply and demand is one of the most crucial aspects of a successful SREC market. A market that is unable to attract the supply to meet the demand will have above market SREC prices until the supply increases. A market that attracts too much supply too quickly could face a collapse in SREC pricing. This is especially challenging in nascent SREC markets that accept out-of-state SRECs and have relatively small requirements. For these reasons, both the Pennsylvania and Washington, D.C. markets have recently seen price collapses. As of April 2010, there was a 4.3 megawatt requirement in Washington, D.C. and a total of 38 megawatts enrolled for the program. In Pennsylvania, there was an 18 megawatt requirement and over 85 megawatts enrolled from across the region.

Two factors contribute to the oversupply in these markets. Neither market has a cap on the size of eligible projects – a crucial misstep in the early stages of a program. With an 18 megawatt requirement in 2010 and no cap on the size of the eligible projects in Pennsylvania, one large project coming from Ohio, West Virginia, Maryland or any other state in the region could collapse the entire market. The other factor affecting these two markets is the fact that both markets accept SRECs from out-of-state facilities. Not only does this contribute to the available supply that could feed into the state, but it also creates a larger disconnect in the relationship between supply and demand, leading to irrational behavior. Facilities from out-of-state that may benefit from other local incentives are more likely to build in a gold rush with little regard for the impact that it may have on another state’s SREC market. In addition, there is a significant gap between what the market looks like when a solar project is first conceived and what the market may be when that project finally comes online. This creates a significant lag time between the prices available in the SREC markets at the time the decision is made and the actual state of the market when the facility begins creating SRECs.

New Jersey and Massachusetts have taken thoughtful approaches to addressing the risk inherent in the SREC market. Both states are closed to in-state facilities only and have mechanisms to protect the market from severe oversupplies like those seen in Pennsylvania and DC. New Jersey pioneered the SREC program launched in 2005. In the early years, in addition to closing its borders to out-of-state facilities, New Jersey placed a cap on the size of project eligible for the SREC market. That cap was 2 megawatts. This meant that when New Jersey’s requirement was 20 megawatts, any one facility could not overwhelm the market. In addition, the state combined the SREC pilot program with other upfront incentives that promoted the growth of the retail residential and commercial industry in the state. This created an opportunity for small and medium-sized businesses that have become the foundation of the solar industry in New Jersey. Contrast this to North Carolina or Ohio where large facilities have dominated the SREC landscape in the early years of the program. Neither state is effectively building a foundation for a burgeoning solar industry. Instead, they have created an opportunity for big businesses that out-compete local companies to build the largest projects at the cheapest cost. In 2010, New Jersey lifted the cap of 2 megawatts on solar facilities at a time when its requirement was growing from 160 megawatts to 255 megawatts. This was a necessary move to help the state keep pace with its aggressive growth targets. Meanwhile, Massachusetts started with a 2 megawatt cap that was increased to 6 megawatts in 2010. This increase was also designed so that the state could keep pace with an already aggressive growth target.

In addition to the cap on system size, both New Jersey and Massachusetts have implemented additional safety nets to protect their respective SREC markets from collapse. In New Jersey, if the demand is met in three consecutive years and prices decrease in each of those years, then a 20% increase in the requirement will automatically be triggered to increase demand and support pricing. In Massachusetts, the state has set a floor price of $300 that can be achieved at the end of each trading year in a last-chance auction. If there is an oversupply, the remaining SRECs will be auctioned at the fixed-price of $300. Any SRECs left unsold after the auction will be given an additional year of eligibility and the buyers will see their requirements increase to compensate for the oversupply. Meanwhile, instead of an increasing solar requirement schedule, like those seen in most other states, Massachusetts uses a formula to determine the requirement in each year. Though this creates challenges for developers who prefer to know the requirement in future years, it is effective because the formula is designed to support SREC values, while helping the state achieve its solar targets.

3. Long-Term Financing: The vast majority of institutional projects backed by regional or national investment firms and banks will require “bankable” long-term SREC contracts. These outside investors and banks will value the environmental commodities at zero unless a contract is in place with a creditable counterparty. Credit requirements are significant given the perceived risks of selling SRECs and most institutional projects will require an A credit rating or higher from the buyer. At the moment, the SREC markets are too small for large institutions with the necessary credit. Since many compliance buyers are relatively small electricity suppliers, credit worthiness is hard to come by in the early stages of a market. Meanwhile, the buyers that are credit-worthy tend to avoid long-term contracts for various reasons relating to electricity supply contracts and general avoidance of long-term agreements. As a result, access to long-term SREC contracts is a key bottleneck in the uptake of an SREC program. Despite these challenges, markets like New Jersey and Maryland have been successful. Institutions are learning to operate within the SREC markets. Although there could be regulatory designs created to address these issues, most proponents of the market-based SREC would agree that these problems are best addressed by the market.

Recommendations for a successful SREC market:

1. Solar Requirements: A solar carve-out needs to be created for any state looking to implement a successful SREC market. This is a separate set-aside for the amount of solar energy that the state will require from year-to-year. Compliance with this set-aside must be possible through the procurement of tradable SRECs. Most states will implement a set-aside with an annual requirement based on a percentage of electricity supplied into the state. New Jersey recently shifted from a percentage requirement to a fixed requirement for the benefit of forecasting. The requirement should increase each year and should be established for at least 15-years or until the stated goal is achieved. Other states may opt to use a formula method similar to Massachusetts. This method warrants consideration as it builds in a mechanism to protect from severe over- or under-supply.

2. Complying Entities: Most markets that have designed SREC programs to date are deregulated. The competitive electricity suppliers are typically required to procure SRECs based on the electricity that they sell into the state. Some states require that regulated utilities procure SRECs for compliance instead of the competitive suppliers. Although the regulated utilities are more willing to enter into long-term contracts, they do not operate in the same competitive environment as suppliers and place a significant burden on the SREC market given an oligopolistic nature and the transaction costs associated in dealing with regulated entities. For this reasons, competitive electricity suppliers should be held accountable for procuring SRECs for compliance in order to facilitate a fluid, competitive SREC market.

3. Compliance Mechanism: The SACP should be set at a fixed amount that is above $300 per megawatt hour. In most states, an SACP of $500 or more is needed to promote solar. This cannot be viewed simply as the cost per megawatt hour of the program. It serves only as a ceiling price for the market. The actual value of the SRECs purchased will be below this price. If there is a significant oversupply, the market price will drop significantly. If there is a shortage of SRECs, prices will be near the ceiling. Most state markets see SREC values in the $300-$400 range, unless there is a shortage or oversupply. SREC values need to be high enough to influence the project economics. Projects that don't need to factor SRECs into the ROI will be willing to sell SRECs at below market values, skewing the market.

4. Facility Size Restraints: In the early years of an SREC market when the requirement is under 100 megawatts, the state should enforce a cap on the size of the system. That cap could be a percentage of the requirement in any given year, i.e. no more than 5 percent of the requirement in that year, or it can be a fixed amount, like 2 megawatts. This is crucial in ensuring stability in the early years of the SREC markets. As the requirements increase, this cap can be increased or removed altogether. If every SREC market were overcome by the generation of a few behemoth solar farms, each state would be left with several solar projects and a few successful developers, instead of an industry. Meanwhile, the states that temper the growth of utility-scale solar and focus the SREC markets on residential and commercial solar will see electricians, general contractors, roofing companies and heating & air conditioning companies build sustainable businesses around solar. This will lead to jobs and job growth far more effectively than the influx in short-term construction jobs created by the occasional 50 MW solar project.

5. Safety Nets: The SREC market is not a completely transparent and real-time market. There is a significant lag from the time the input (a solar facility) is conceived and constructed, to the time the signal (SREC pricing) is affected by the input. This information delay will most certainly create situations where too much supply enters the market too quickly before SREC prices are able to indicate to the market that it needs to slow growth. As a result, an effective SREC market design will incorporate a price support feature. That price support should either come in the form of a floor price akin to that seen in the Massachusetts market, or a mechanism that triggers a requirement increase in the event of a price collapse. As more states create open SREC markets, the price support could come in the form of shifting supply from one state market to the next. If each facility is eligible in several states, the market becomes more diverse and subsequently more secure.

6. Certification and Tracking: There are several key aspects required for implementation of an SREC program. A state must first set up a process for certifying and approving facilities. This is the state certification process. Some states, such as Maryland, have onerous requirements for state certification that include, for example, mailing 14 hard copies of an application to a state public service commission or clean energy program. Other states have implemented this more effectively with online applications and approval. Obviously, the world would be a better place without the former and all states should implement the latter approach currently used by Pennsylvania. Once certified, the state must use a tracking registry. Most registries are powered by technology developed by APX and tend to be divided by region. Oversight of the registry is an important consideration. Some registries, such as the one operated by PJM Interconnection developed conflicting interests by engaging in the registry role (GATS) , while simultaneously operating as a competitor to the clients within the registry (formerly EnviroTrade). It is unclear whether the Public Utility Commissions at the state level have appropriate jurisdiction over the activities of the regional transmission operator. It is also unclear as to whether FERC will eventually regulate the activities of these organizations.

7. Reporting of Generation: Once, the registry is selected, the rules for reporting generation and receiving SRECs must be considered. Many states will allow facilities under 10 kilowatts to use production estimates derived from the PV Watts Calculator. This is effective in eliminating transactional costs for small producers that represent a minor portion of the market. Online monitoring is also available by approved vendors in many states. Some states require online monitoring for facilities above 10 kilowatts. This has been difficult to implement in a cost-effective way, however, as online monitoring technology improves and costs are reduced, it is very likely that the future SREC markets will all require online monitoring. Until then, states that implement programs should allow production estimates for facilities less than 10 kilowatts and allow self-reporting, with the threat of audit, to facilities above 10 kilowatts.