Bioenergy, Geothermal, Solar, Wind Power

Estimating Forward REC Price Curves

Issue 4 and Volume 13.

Almost all of today’s renewable energy projects rely on regulatory financial incentives in order to make investment returns sufficiently attractive. Some incentives, such as rebates and tax credits, have known monetary value and are therefore rather easily incorporated in financial pro formas. Other incentives, namely renewable energy certificates (commonly known as “RECs”) used for compliance with renewable portfolio standards (RPS), are inherently variable and therefore require exogenous methods to determine their value. Because RECs can be unbundled from the underlying renewable power and sold to utilities with renewable energy obligations, they are commodities subject to a variety of market forces that impact their value.

Valuing RECs without consideration of the factors influencing their supply and demand increases the risk of mispricing RECs in both REC-only and bundled power purchase agreements. This can result in unnecessary RPS compliance costs for utilities, or conversely, lost revenue opportunities for renewable energy project developers.

We see forward REC price curves as an important element of any REC transaction for three key reasons. First, and perhaps most obviously, forward price curves allow sellers to value RECs on a ”willingness to pay” basis, as opposed to being price takers in the market. Second, forward price curves help identify future inflection points that can inform a seller’s or buyer’s REC strategy. In other words, locking in REC prices under long-term contracts limits flexibility to re-price the REC asset should market fundamentals change dramatically. Third, utilities increasingly need adequate price benchmarking information to calibrate their procurement decisions in order to meet the expectations of their regulators.

REC market structure, energy market fundamentals and incentive mechanisms will impact future supply and demand of RECs, which in turn will considerably influence future REC prices.

Because RECs are a product of regulation (or sometimes transacted in voluntary markets), supply of and demand for RECs are primarily functions of the underlying structure of the market (a policy decision). For example, RPS regulations typically specify the technology type and capacity thresholds that qualify a renewable energy project – and therefore the subsequent RECs – to count towards the RPS target. Some regulations stipulate the geographical or power delivery location of a renewable installation, while other markets restrict RECs imported from other states (although the legal validity of such restrictions has recently been challenged in court).

For the most part, policy decisions affect demand for RECs through the annual procurement requirements codified in the regulations, typically a percentage of electricity sales. Less obvious is the fact that energy efficiency requirements can also impact REC demand insofar as these policies reduce electricity sales, therefore reducing the megawatt-hours required to meet the RPS obligation.

REC supply and demand is also predicated on underlying market fundamentals. REC demand–a function of electricity consumption–is impacted by overall economic output in a given region. REC supply, driven primarily by the availability of renewable resources, is also driven by project development factors in a given region, including the timing of interconnection and overall project lead times. In the case of solar RECs from distributed photovoltaics, supply is also dependant on customer adoption rates of rooftop applications.

Importantly, REC supply is also dictated by the availability of other state and federal renewable energy incentives. State solar rebate programs and federal tax incentives among other mechanisms can have direct implications for renewable energy project development, and therefore, REC supply. For example, in one recent study of solar REC (SREC) prices in New Jersey, the expiration of the investment tax credit resulted in a significant decline in supply and a 70 percent increase in projected SREC prices. Moreover, market circumstances relating to these incentives (such as the dearth of tax equity investment following the onset of the economic recession) can impact REC supply insofar as they inhibit the use of given incentive mechanisms and lead to less renewable energy project development.

REC pricing risk can be mitigated, to some extent, by analyzing forward REC price curves. REC markets are an important tool to achieving higher levels of renewable energy generation. As commodities, the value of RECs is driven by market fundamentals in addition to project-specific factors. Buyers and sellers will increasingly need more sophisticated REC pricing models to ensure that REC transactions reflect an appropriate valuation.