Maximizing Returns – Strategies to leverage RE investment

Yasir Altaf and Pramod K Singh

15 October, 2010
One must grab an opportunity with both hands whenever it offers itself, or it may decide never to
knock your door again. Recent launch of Renewable Energy Certificate (REC) in India presents
itself as a similar opportunity which could lead to game changing events in the foreseeable
future. REC market can provide a greater push to Renewable Energy (RE) sector by way of
removing the current bottlenecks such as higher costs, uneven distribution of RE resources, and
increased procurement by utilities.
Around the globe, deregulation and privatization of power and gas has encouraged players to
seek innovative business models to maximize returns for stakeholders. Earlier, risks inherent to
these sectors had been subsumed in larger cost structures and/or paid for through excess
capacity and sub-optimal operation. Post deregulation, the emergence of new independent
entities has required new ways to manage and run an energy utility.
Taking a leaf out of the same book, the transition expected in RE sector in India is not too far.
This expected shift would be fuelled mainly by the upcoming REC markets which allow trading
of power and environmental attributes separately. Once REC markets are fully operational,
investors need to feel assured of higher returns on investment, while lenders need to ensure
that risks are limited. How the emergence of REC markets can help maximize value of
investment and mitigate risks would depend on the strategic assessment of selling energy and
REC attributes as bundled or separate products. The various options that could be available
before any new RE developer under the REC trading scheme unveiled by CERC are:
Option 1: Selling power to obligated entities at feed-in-tariff through PPA. Under this
option, associated renewable attributes will be deemed as purchased and no separate
selling of REC is permissible.
Option 2: Selling power through power exchanges or bilateral markets. Since, the power
price realization is uncertain, upsides could then be with REC sale through power
exchanges.
Option 3: Selling power within states at average pooled power purchase cost. RE
developer is free to sell REC through power exchange.
Option 1 is the conventional mode where Feed-in Tariffs are determined by various SERCs.
High tariffs allow for cost recovery of renewable projects and also include fiscal and financial
incentives, wherever applicable. However, from a developer’s perspective, there is an
opportunity loss which cannot be leveraged because of the involvement in PPA mainly for two
reasons:
No separate trading of REC will be allowed for RE generators selling power through
PPA. This would mean a loss in revenue as generators won’t get even the minimum
guaranteed REC price (floor price).
Secondly, the price of power being traded through exchange is currently higher than the
feed-in tariffs as illustrated in Exhibit 1. Moreover, the power prices are likely to remain
high in the next 5-6- years due to expected prevalence of demand-supply deficits.
 Exhibit 1: Feed-in-Tariff vs. Market Power Price (2009-10)
Source: MNRE, CERC, SERC and ICF Analysis

In contrast to Option 1, Options 2 and 3 allow RE generators to sell RECs at market determined
prices through power exchanges. Obligated entities not meeting their renewable obligation,
would necessarily buy RECs equivalent to the shortfalls from exchanges. The greater flexibility
in price determination in options 2 and 3 is encouraging for investors as it may result in
significant upsides based on deficits in both the power market and REC market as is illustrated
in Exhibit 2. RE developers which are more aggressive in their power sales strategy would get
compensated by selling RECs. However, under no circumstances price of RECs can exceed the
forbearance price (upper limit of selling REC).

10
Option 2
9
8 Option 3
7
Option 1
6
Rs/kWh

5
4
3
2
1
0
LRMC  Feed‐in‐Tariff Sale to open  Sale at Average 
market Power Cost

Price band Resource  Resource  Merchant  State Average

due to Type  Type  + REC 1 power cost + 
REC 1

Exhibit 2: Comparative returns for different options

(Source: CERC, ICF analysis using I-IPM®)

Additionally, having RE in the generation portfolio can hedge against decrease in value due to
structural uncertainties. Power prices may remain high till 2015-16 as constraints in capacity
addition, fuel supply and transmission availability are expected to persist. Investment in
renewable could be a strategy to diversify risk associated with loss of anticipated revenues due
to change in market conditions. e.g. any conventional fuel based merchant power plants may
not be able to sell power at Rs 4-5 per unit if sufficient capacity addition takes place or
transmission congestion is removed. On the other hand, obligation to purchase renewable will
result in necessary dispatch of renewable plants.. A possible decrease in value of merchant
conventional fuel based plants vis-à-vis renewable is illustrated in Exhibit 3

1,600
Value ($/kW)
1,200

800

400

-
Coal* Gas* Renewable*

Constrained (Business - as - Usual Baseline)

Un-constrained (Transmission Expansion and No Domestic Coal Limitations)

Exhibit 3: Valuation of generation portfolio under two scenarios

(*Value of illustrative plants in western region. lllustrative wind plant)

RE developers that take the risk to look beyond feed-in tariffs could leverage the benefits of
REC markets. CERC has determined band of price within which REC can be traded1. The REC
prices are expected to increase in future as the scheme progresses not only due to higher RE
targets, but also due to exhaustion of cheaper and easier to implement resources in the initial
years; non-solar REC market size is expected to be around USD 8-9 billion by 2020.
The REC cash-flow stream may determine whether or not a particular project is able to attract
financing. Although, the band for REC trading has been fixed by CERC, actual price would
depend on spot conditions. Different investors perceive price risks differently and decide which
option is most favorable to them. This would have impact on the financial structuring of a new
renewable project. Lenders would be more interested in financing a project that is under
contract (PPA) with certainty of revenue.
Equity investors on the other hand would usually be willing to take more risks and will
increasingly be willing to consider the REC revenues as probable in exchange for a significant
return on their investment. Even if RPO in one state is changed, a neighboring state with
comparable RPO could be a potential buyer for RECs and equity investors are likely to
recognize such opportunities. Overall, the difference between how banks value RECs versus
how equity investors value them and the emergence of a variety of equity investors could result
in more projects adopting an innovative mix of funding as well as sale options.
The impression fomented as a result of the prevailing market conditions is to participate in this
new RE race early and take the first mover advantage. This could be financially more rewarding
as:
1. Higher power prices in short term could promise increased revenue
2. Early investment in RE would allow developers to sell REC over a longer period. Floor
price for selling REC is guaranteed.
3. There are many states with high level of power deficits. Some of these states are
already purchasing power from expensive sources such as power exchanges.

1
CERC has determined band of price for trading non-solar REC at Rs 1500/MWh – 3900/MWh
 4. Sites with substantial generation potential are available and are less expensive today.
These sites will get exhausted later.
5. Current RE generation is about 4%; target to reach 5% by FY 2011 requires 8,000 MU
immediately. Annual increment in target by 1% would require huge year on year RE
generation
6. Currently, tax exemptions are available on purchase of renewable equipments.
Exemptions may not be guaranteed in future.
7. RE generators are least exposed to decrease in value against structural uncertainties
and even economic recession.
RECs can therefore represent a significant portion of a project’s economic return by selling
energy and RECs as separate products and therefore add another potential source of revenue
for RE developers. The value of RECs would be derived from mandatory RPO policies with
penalty clauses, and would be based on willingness of DISCOMs to pay for it and their ability to
recover cost of green power from consumers. The REC framework provides project investors an
option to take higher risk and get higher rewards. Adoption of merchant strategy can create
more value for stakeholders but would require higher appetite for risk. Yet, despite all the
seeming rush of RECs, much needs to be reviewed at the state regulatory and grid operational
side; however the feeling is that with REC scheme in place, RE sector is headed in the right
direction.
Yasir Altaf (yaltaf@icfi.com) and Pramod Kumar Singh (pramodsingh@icfi.com) are Consultants in Energy Sector with ICF
International (www.icfi.com) in New Delhi.