The article below is an excerpt from our Q4 2022 commentary.
Analysts constantly state that renewable energy competes favorably against natural gas and coal-fired electricity generation on an unsubsidized basis. Although we disagree with this assessment, particularly once you adjust for intermittency, reporters repeat it headline after headline. Given the alleged cost benefits, we cannot help but wonder why policymakers continue to announce hundreds of billions of dollars in new renewable subsidies. Presumably, given ever-growing budget deficits and concerns around debt ceilings, we should be lessening the subsidies on wind and solar if they are cheaper than traditional power sources.
Instead, the Inflation Reduction Act of 2022 includes the most significant renewable power subsidies in history:
- An investment tax credit refunds up to 50% of the capital costs of wind and solar power. This tax credit is in effect until 2032 or until the US reduces its carbon emissions from electricity by 75% -- a herculean goal that guarantees the subsidies will persist for decades.
- The tax credit is uncapped: if power producers install new renewable capacity faster than expected, the impact of the Act will be more significant than budgeted.
- A production tax credit of 2.6 cents per kilowatt hour (kwh).
The Energy Information Agency (EIA) claims incremental onshore wind costs between 2-6 cents per kWh on a levelized cost of electricity basis, while solar’s LCOE is 3-5 cents per kWh. Therefore, the production tax credit equates to 30-100% of the total cost.
Combining the investment tax credit with the production tax credit, the cost of renewable power can turn negative.
Our research tells us these credits may represent the largest mal-investment of capital in history.
Pundits argue these subsidies will help accelerate the transition from hydrocarbons; we remain skeptical. Throughout human history, society has willingly shifted away from one form of energy towards another only when it has been economically advantageous. Before Colonel Drake drilled the first oil well in 1859, whale oil was a dominant fuel source. In 1840, the US consumed 1.6 PJ of whale oil, equivalent to 710 barrels of crude oil equivalent per day. By 1870, whale oil consumption had fallen 75% to only 175 barrels of oil equivalent per day, while crude demand surged from nothing to 14,000 barrels per day. The economics of drilling and burning crude oil justified the transition. Society did not rely upon subsidies. Instead, economics and energy return on investment (EROI) drove the adoption. Our research shows that fully buffered renewable power has a much lower EROI than natural gas. By massively incentivizing the widespread installation of such an inferior energy source, the Inflation Reduction Act will ultimately usher in an energy crisis of unprecedented magnitude.
Many analysts quickly point out that the cost of wind and solar have fallen by 80-90% over the past decade. They argue that these massive cost reductions are evidence of a sharp “learning curve.” As the industry installs more renewable power, they claim, efficiencies grow, and costs fall. According to this logic, governments should heavily subsidize early renewable capacity to reduce costs and fast-track adoption.
Unfortunately, our research suggests that this strategy relies upon a faulty assumption.
Over the past decade, most of the cost savings have come from cheap capital and energy costs and not dramatically improved manufacturing efficiency.
The 2010s were unique for two reasons: most primary energy sources fell by 90% from peak to trough, and the cost of capital turned negative for the first time in human history. Renewables are much more energy and capital-intensive than coal and natural gas-fired electricity generation. Is it any wonder their costs fell dramatically over the same period?
An efficient natural gas plant achieves an EROI of 30:1 after accounting for the energy needed to drill, lay pipelines, build the plant, and burn the gas. On the other hand, a top-performing onshore wind turbine is lucky to achieve an EROI of 12:1, while high-quality solar’s EROI is 8:1. These figures are on an “unbuffered” basis, meaning they do not adjust for renewable power’s intermittency. Utilities must install massive battery backups if they use wind and solar for base-load power. These batteries are very energy intensive to manufacture, lowering the buffered EROI to 6:1 and 2:1 for wind and solar, respectively. Therefore, it requires between 4 and 14 times more energy to generate a kwh of electricity on a buffered basis with renewables than with natural gas.
How do interest rates impact renewables?
The levelized cost of electricity -- the most widely used energy cost metric – is calculated by dividing the present value of all capital and operating expenses by the present value of all electricity output in kWh. While applying a time value of money to the electrical output might sound strange, this is how analysts calculate LCOE.
For wind and solar, capital expenditures make up 90% of the total undiscounted cost, whereas operating expenses make up 95% of the total for a natural gas plant. In both cases, electricity output is flat over time. Therefore, with renewable energy, as interest rates fall, the present value of the capital cost remains unchanged while the present value of the output, discounted at a lower rate, grows. In the case of natural gas, the present value of the operating costs rises at the same rate as the present value of the output, leaving the ratio unchanged. A 600 bps fall in interest rates, experienced between 2010 and 2020, resulted in a 40% reduction in renewable LCOE but only a 4% reduction for natural gas. Conversely, renewable LCOE will grow much faster as interest rates rise.
We estimate that 65% of the reduction in wind and solar costs between 2010 and 2020 can be attributed to lower energy costs and falling interest rates. The “learning curve” explains only one-third of the observed decrease. If our models are correct, subsidizing wind and solar to help push costs further down the learning curve will be more than offset by rising energy and capital costs.
In Q4 2021, we predicted that rising energy and interest rates would drive renewable costs much higher. Less than two years later, we are already seeing the effects.
In early 2022, the Commonwealth Wind project (a 1,200 MW proposed wind farm off the coast of Massachusetts) signed an agreement with the Department of Public Utilities to provide electricity to the Boston area. Less than six months later, Avangrid Renewables (the project sponsor) announced that the “project [was] no longer viable and would not be able to move forward” without renegotiating their contract. The company blamed rising input and capital costs. In a matter-of-fact statement, in late January 2023, the company announced that the project “cannot be financed and built.”
In February, Duke Energy Corp. announced they would take a $1.3 bn impairment loss on selling their commercial renewables portfolio – a reduction of nearly 50%. When asked if they had overvalued their assets, the company replied: “I wouldn’t call it overvaluing. If you decide to sell these assets at any point in their life, you’re setting yourself up for an impairment.” Dominion Energy Inc. announced a $1.5 bn impairment charge on their 1,000 MW solar portfolio the same week.
Also, in February, BP announced it would slow its renewable transition pace after years of being the most vocal renewable supporter. On their Q4 earnings call, CEO Bernard Looney admitted that his renewable portfolio generated only a 6-8% margin compared with 20% for oil and gas investments. Shell made similar comments shortly after.
As energy prices and interest rates continue to climb, we believe many similar announcements will follow.
How can the industry explain all of these write-offs and about-faces if, as is widely stated, renewables are far more economical on an unsubsidized basis?
In our view, renewables can only work with abundant cheap energy and near-free capital. Unfortunately, a lack of upstream investment and persistent inflation means neither will be available. Nevertheless, policymakers insist on subsidizing more than 100% of the cost of renewable energy, a price tag of trillions of dollars. The result may be the largest mal-investment in human history. The vast energy disruptions and dislocations in Europe today provide a “road map” of what will happen here in the United States.
We estimate that over the next 15 years, the Inflation Reduction Act’s investment and production tax credits could total over $1.5 trillion. Unfortunately, we expect much less energy will be available in the US. Consider the following. If you believe we are now in an energy-insecure world, there are two available power technologies: natural gas or coal and renewables. The former enjoys an EROI of 30:1, while the latter has an EROI of ~5:1. The IRA has now guaranteed that investors will divert capital from traditional energy to renewable power. We believe the net result will, of course, be much less available energy, severely limiting economic growth.
Nor do we expect renewable subsidies will limit CO2 emissions. Germany has had the world’s most ambitious renewable subsidy program to date. Unfortunately, the renewable capacity has underperformed expectations over the past several years. As a result, Germany had to rely increasingly upon Russian gas imports. Following Russia’s invasion of Ukraine, Germany was forced to turn to coal to meet its power needs, completely undoing 20 years and trillions of dollars’ worth of renewable subsidies. We believe German coal-burning reached a record in 2022, resulting in CO2 emissions not seen for over a decade. While some might argue this was only due to the Russian invasion, poor energy policy played a determining role.
A viable solution exists today in the form of nuclear fission. Generation IV nuclear plants offer EROIs over 180:1 – far superior to renewables and traditional energy. Furthermore, nuclear fission emits no carbon at all. While the IRA offers some nuclear power credits, it does not go far enough.
The cost overruns and write-downs in the renewable space are just the beginning. Until policymakers can understand the issues in terms of EROI, they will continue to tilt at proverbial and literal windmills.
Intrigued? We invite you to download or revisit our entire Q4 2022 research letter, available below.
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