One of the more prominent asset classes that U.S. pension funds invest in is electric utility stocks and bonds. This is because utilities are historically stable businesses, and as a result are suitable for retirement funds precisely because they are generally subject to virtually no market risks from competition. Thus their profits, while not literally guaranteed by a state’s utility governing agency, are nonetheless essentially guaranteed through approved rates of return and rate recovery.
In turn, dividends from electric utility stocks have historically been stable and reliable along with utility bond interest. However, a growing number of utility securities analysts are warning investors about utility company revenue erosion traced to the increased volume of distributed solar energy generation. This market development now adds greater systemic risk to the otherwise historically stable portfolio of pension fund investments in utility securities, both stocks and bonds.
As this trend continues, other logical questions are raised as more and more distributed renewable energy generation comes on line. Could a potential hedge be an offsetting investment in disruptive renewable energy assets? How will investments in investor owned utilities (IOUs) be affected when utility revenues start to materially decline due to increased absorption of distributed generation? How do you adjust pension fund investment best practices in an environment where formerly stable utility stock dividends and bond “coupons” become somewhat unpredictable or simply no longer attractive? How should one invest in the electrical power sector when the EPA MATS and CSAPR studies say that coal fired electric utilities cause as much as $360 billion in economic damage annually in America due to mercury toxins and particulate pollution? What happens if a utility industry gets sued like the tobacco companies did for human health damages?
It turns out there may actually be a pretty good solution to this Wall Street dilemma that explains why it has been utilized successfully since the financial collapse of 2008. Fortunately, this approach also dovetails with current renewable energy finance and existing U.S. tax law, though relatively few people know about it.
Back in 2008, pension funds were actively looking to invest the large amount of pension assets despite the foreboding economy. However, the volatile and risky stock market was not an attractive pension fund investment immediately following the 2008 financial collapse and considering all of the uncertainty and disruptions afflicting the bond market at that time, buying bonds had its own set of market and interest rate risks. These factors drastically reduced the number of securities market investment options for pension fund managers.
At the same time, commercial bank lending to U.S. business had significantly decreased. However, the one notable exception to this decreased bank lending activity was for companies building renewable energy projects. Regardless of the state of the financial markets, in 2008 and 2009, solar and wind projects were still being developed and a little known fact was that many renewable construction projects continued uninterrupted throughout the financial crisis. Net new jobs in the solar sector actually increased as the rest of the U.S. job sector crashed. In fact, renewable projects like wind and solar, were for this reason beginning to be seen as new and attractive investments, especially to debt financers, and thus we saw solar and wind become welcome and accepted additions to traditional fossil fuel-based energy investments. Through education and successful project history, pension funds started warming up to the idea of construction finance lending to renewable energy projects, and the not so distant future could yield positive and less-risky returns on initial investment.
Interestingly enough, the key to renewable energy lending success by pension funds from 2008-2009, and even today, is that such lending is actually facilitated by the federal income tax code. If governments were to actually own an equity interest in a renewable energy partnership, (state pension funds are usually technically governmental entities for tax purposes) it would negate the energy investment tax credit (ITC) and/or the value of the production tax credit (PTC), which would be wasteful of the economics. To prevent this, what is known as “tax exempt use” or ownership under existing tax rules from nullifying the economics in the transaction, the pension fund simply lends money as straight debt to the energy project, and avoids a host of tax problems for both parties simply by not being an owner and by not holding an equity interest in the project.
Given that pension funds are free to utilize this investment option, it is reasonable to speculate that if this were to become a more popular investment, this could possibly accelerate the a priori problem of utility stock dividend or bond coupon erosion. This could happen by simply shifting pension investments away from buying stock, and instead lending to the very distributed renewable energy generation projects that are the source of the utility sector disruption.
Thus, it would appear that as of today, not only can pension funds remain in the energy sector, and remain in the debt rather than equity markets, but they can do so as a backstop, or hedge against the negative impacts that distributed generation will continue to have on the current electrical utility business model. This shift toward the renewable energy debt market and away from IOU stocks and bonds would still allow utilities to purchase or lease distributed generation assets, and utilize renewable energy from those independent power producers to meet IOU customer demands, at least until the existing IOUs and other conventional utilities figure out how to work with, rather than compete against, distributed generation assets.
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