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A Financial Model For Geothermal Development
By Stuart D. Logan
Background
Escalating petroleum
prices have visited adversity on a world already struggling with the
financial hardships and physical threats associated with imported oil.
Such heightened concerns add urgency to the related conversation among
scientists regarding the effect of industrial CO2 on global warming. As
individuals and enterprises refocus their attention on the expedited
replacement of hydrocarbon power, governments continue to impose
carrot-and-stick systems designed to swing the balance away from fossil
fuel and toward other, endorsed means of producing energy.
We of course welcome the
scientific enhancement of, and the environmentally conscious use of,
traditional fuels. For instance, an abundant domestic resource like
coal presents fewer of the challenges posed by imported fuels, and also
creates far less pollution per kilowatt hour than in years past.
However, discussions in the board room, debates in the legislature, and
experiments in the lab now focus more and more on the existing and
proposed technologies called alternative energy. That phrase
refers to the power acquired from photovoltaic cells, solar-thermal
stores, subterranean heat, oceanic-temperature strata, nuclear fission,
hydroelectric dams, wind turbines, biomass, and other relatively recent
technologies. These modern methods create effluents on a far smaller
scale than do fossil fuels, and so we often associate alternative energy
with its relatively light environmental footprint.
Appeal
Merchant bankers, fund
managers and other venture capitalists keep their eyes open to emerging
markets and growth industries. They then devote their acumen to
identifying undercapitalized businesses within those industries and
markets. Not surprisingly, the alternative-energy industry has, over
the past decade, earned increased attention from venture capitalists,
leading to a marked rise in invested dollars.
Frequently, such
investments take the form of a joint venture, in which a money partner
and an operating partner establish a single-purpose enterprise to own
and conduct the mutually held business (a “Venture”). Interested
parties will thereby effectuate their funding decision, and implement
their business plan, through the Venture. That business plan not only
will govern the Venture as the developer of a new business, but also
will control the managerial, financial and participatory rights of those
involved.
In this way and others,
investment dollars have found their way to (a) energy producers whose
technologies have yet to demonstrate much practical effect (such as
deuterium-based fusion), (b) energy producers with proven technologies
but with still-limited commercial viability (witness the current state
of wind turbines in Germany), and (c) energy producers whose
technologies have thrived in the marketplace as well as in the lab (as
affirmed by France’s successful and extensive reliance on nuclear
reactors).
Nonetheless, one might
well argue that, in those many regions with the proper physical
characteristics, no form of alternative energy surpasses geothermal
technology for cost competitiveness, efficiency of generation, and
gentility to the environment. Moreover, geothermal energy, unlike many
other alternative-energy sources, promises base-load power
(referring to a steady stream of around-the-clock wattage). Even within
the field of base-load energy, geothermal technology carries none of the
political baggage that has impeded nuclear development in the United
States, nor does it face the geological saturation point that now limits
the growth of America’s hydroelectric industry.
The creation of
geothermal energy does, of course, require capital investment. Hence,
the Venture structure suits this form of power generation, whether
engaged in by (a) a financial partner and a technology partner wishing
to dedicate themselves to a new enterprise, (b) two established firms
seeking to pool resources for a third business, or (c) a private company
and a government agency intending to employ their respective rights and
assets to soften a fossil-fuel crunch bearing down on their region.
Although many firms have exploited this method of power generation, and
although a great many happy tales have come from such efforts,
geothermal energy remains an underemployed resource that, relatively
speaking, lies beneath the proverbial radar.
Focus
One may harness the
subsurface-temperature gradient to warm or cool buildings using heat
exchangers. Such a technique entails the circulation of fluids via a
closed loop running through both the earth and a neighboring structure.
This effective and simple brand of alternative energy already lowers the
utility bills of numerous families and firms, which often exploit the
geological resource using electronic heat pumps and heat sinks.
However, the regime offers little benefit to anyone outside the
immediate vicinity.
Hence, most Ventures
planning to sell geothermal-based energy to the public will elect to
generate electricity. Using injection wells and production wells
reaching thousands of feet into the earth, the Venture creates steam to
animate turbine-powered generators. The resulting electricity then
either feeds into the regional power grid through a trunk line, or
serves as the dedicated power source for a neighboring development.
Incentives
Such states as Alaska,
California, Hawaii, Idaho, Nevada, Texas and Washington boast readily
exploitable strata. Happily, though, geothermal-energy production holds
promise in even those regions of the country with relatively subtle
subsurface heat gradients. For instance, Michigan’s government has,
through legislative fiat and executive policy, sought to facilitate
alternative-energy development in the state. Earlier this autumn,
Governor Granholm signed a bill to ensure that, by 2015, at least
one-tenth of electricity sold in Michigan will come from geothermal,
solar and other alternative sources.
Even in geologically
dormant areas like those comprising most of Michigan, geothermal
production shows significant potential. That potential will depend on
tried-and-true advances in low-temperature-resource technologies.
Thanks in part to such technologies, Michigan’s place in the world of
geothermal energy might come to depend on the harnessing of hot
wastewater drawn from fossil-fuel wells. (The U.S. Department of Energy
recognizes the astronomical possibilities, and awarded a
multi-million-dollar grant to establish the commercial viability of
wastewater-based electricity.)
Accordingly, those who
harness geothermal energy may seek regulatory assistance or may
otherwise pursue governmentally conferred economic incentives. One
class of potential benefit entails the grant of subsidies intended to
reduce the Venture’s cost to develop its project. Another type of
possible subsidy pertains to regulatory programs designed to facilitate
entry into the broader market for electricity.
In the absence of
accessible consumers, even an expertly developed power plant will fail.
So, federal law requires those in control of the transmission,
distribution and subdistribution network to make the power grid
available to alternative-energy suppliers on a commercial,
nondiscriminatory basis. Although the controlling federal statute
applies only to wholesale distribution, many states have expanded the
mandate, thereby entitling suppliers to transmit alternative energy to
retail customers via the grid.
Added expense arises
whenever large distances separate the facility and grid. The ideal
locale for a geothermal well might lie miles from the nearest
community. So, in the case of so-called location-constrained
generating resources, the Venture might have the ability to employ
government programs designed to help finance the cost of the intertie.
The federal tax code
confers two substantial subsidies on suppliers of geothermal energy.
The production credit will, subject to certain exceptions and
adjustments, reduce the Venture’s tax bill by $0.015 per kilowatt-hour
of geothermal-sourced electricity, a benefit that continues during the
first decade of facility operations. Last-minute amendments to the
Emergency Economic Stabilization Act ― colloquially known as the
financial bail-out ― have widened the scope of this tax incentive.
Prior law denied the credit to any power plant placed in service after
2008. Now, the credit covers geothermal-based generators fired up as
late as December 31, 2010.
By way of contrast, the
law conferring the investment credit includes no sunset
provision. The investment credit offers a pecuniary incentive to those
who acquire and operate new electric-power plants running on geothermal
energy. Speaking in broad generalities, the investment credit would
offset taxes by a sum equal to 10% of the Venture’s investment. (That
said, any financial benefits earned via the investment credit would pare
away at the production credit described in the foregoing paragraph.)
Government might also
provide the Venture with access to geologically suitable land. Thus,
the developer might acquire rights, whether via the purchase of a tract
(or even a completed facility) from the public agency, or via the
acquisition of energy rights through a geothermal lease sale
conducted by the Federal Bureau of Land Management.
As with all industrial
facilities, federal, state and municipal regulation will, to varying
degrees, dictate the manner in which plant construction moves forward.
Looking at only one of the features specific to geothermal operations,
the Venture must identify and hire a specially licensed driller to
install the injection and production wells. Also, states impose
licensing mandates for energy suppliers, and, moreover, promulgate codes
of conduct to regulate supplier activities. Accordingly, rules, manuals
and directives explain how the alternative energy supplier should (a)
solicit potential customers, (b) set the price of electricity, (c)
transfer willing fossil-fuel customers from the extant utility to the
alternative-energy supplier, (d) ensure an uninterrupted flow of
electrons to customers in good standing, (e) bill, and collect from,
each of its customers, and (f) procedurally and physically connect its
generator to the power grid.
Suitability
Geothermal-sourced
electricity offers the capitalist a scalable technology. Years of
experience have proven that one can harness geothermal energy — and can
maintain financial and technological efficiencies — even at relatively
modest capacities. (This advantage distinguishes geothermal methods
from many competing sources of alternative energy, and contrasts
dramatically with, say, hydroelectric power.)
Second, the geothermal
industry relies on a mature technology. The extant know-how not only
poses a lower risk of engineering failure, but also allows execution
using equipment that by and large comes off-the-shelf. So, the Venture
bears less expense, uncertainty and delay from the invention,
manufacture or customization of the facility.
Third, although the
evaluation of a proposed well site will ordinarily require a significant
outlay to cover due diligence, that financial challenge poses less of an
obstacle in light of the geothermal maps and related data that abound in
the public domain. Such information shows that vast regions of the
United States offer high-quality resources in the form of
shallow-and-abundant heat. Moreover, natural factors mitigate (but
cannot eliminate) the risk of a categorical failure within the
geothermal industry: Sufficient heat will ultimately lie at some depth,
even below a misjudged tract. Occasionally, a fruitful stratum will
reside only a manageable distance from the planned level. Certainly,
the necessary degree of geological analysis contrasts with the
more-extensive studies typically associated with, say, the extraction of
petroleum from newly targeted fields.
Fourth, various
engineering and consulting firms specialize in the facilitation of
nascent geothermal enterprises. Thus, the Venture might reasonably come
to depend more on its control of suitable land and investor capital, and
less on its own technical acumen.
In these ways, the
financial and managerial features of the smaller-scale geothermal
Venture conveniently resemble those of more-pedestrian commercial
undertakings. In particular, those seeking to create and sell
geothermal-based electricity might consult a financial template
generally reserved for the investor-occupied commercial building.
Opportunity
Various engineering
firms market their expertise in gauging the geothermal potential of
client-controlled tracts. In fact, given the right circumstances, the
Venture may ignore the process otherwise needed to evaluate — and may
skirt the potential disappointment associated with the validation of — a
proposed site. As noted above, private enterprise has from time to time
purchased (whether from government agencies or private enterprises)
tracts with already-proven commercially suitable energy resources.
Third-party contractors
― including United Technologies, Ormat Technologies and Raser
Technologies ― provide equipment, software, drawings and/or expertise as
an asset package for sale to clientele. Such packages include not only
tangible components comprising the infrastructure to produce geothermal
electricity, but also the know-how to facilitate such production.
Other early-stage
requisites include the contracting process through which the Venture
will link to the power grid. As already mentioned, the Venture may tap
into a ready-made distribution system by dealing with the local electric
company, Thus, the Venture harnesses a vehicle typically able to
transmit all electricity produced from hot rock.
A pioneer in the
industry, AltaRock Energy, has raised millions of investment dollars
from venture capitalists eager to underwrite its facilities. Through
such efforts, the producer/promoter has funded a geothermal enterprise
promising electrical current in the hundreds of megawatts. (Other
facilities, such as the unsurpassed Geysers complex owned by Calpine,
throw off hundreds of megawatts of power, while the smallest complexes
produce under 100 kilowatts of geothermal-sourced electricity.)
Today’s economic and
regulatory circumstances create a welcoming environment for profitable
investment in geothermal-electricity producers, whether at the levels
reached by Calpine or AltaRock, or at the more-modest levels that this
scalable technology permits. A Venture might spend little more than two
million dollars on engineering, design, exploratory, grading,
consulting, drilling, regulatory, construction, outfitting, testing and
start-up costs for a 400 KW facility. (The Venture’s capital infusion
must also account for certain additional outlays, to permit the funding
of such pre-cash-flow essentials as land acquisition, facility testing,
regulatory satisfaction, and working capital. The budget will also
contain a line for professional fees to help address organizational,
managerial, contractual, financial and syndication matters.) Of course,
the actual level of development capital will depend on the particulars
of the project, especially given such commercial variables as the size
of the power plant, and also given such geographic attributes as the
temperature gradient of the subterranean column, the access to water,
and the distance separating the turbine and the grid.
Illustration
The constitution of the
Venture may reflect structures traditionally associated with other joint
enterprises. To focus on fundamentals, one might identify two general
categories of participant, founders and investors. The
founders hold most of the managerial authority and attain their status
by virtue of (a) the vision and effort they might have devoted to the
nascent Venture, (b) the operational or engineering expertise they might
profess, and/or (c) the rights they might hold in a particular tract of
promising land. A venture capitalist or a syndicate of wealthy
individuals (or angels) act as investors, by risking their
capital and/or credit to finance the Venture’s anticipated operation.
The founders would
ordinarily cast the Venture as a limited liability company dedicated to
operations that entail (a) locating and vetting the site on which the
physical plant will reside and into which the Venture will dig the
wells, (b) applying for regulatory approval, (c) soliciting, and
contracting with, customers already on the power grid owned by the local
utility and the International Transmission Company, (d) acquiring the
evaluated parcel, (e) engaging contractors to sink the wells, design the
facilities, construct the plant, and connect with the grid, and (f)
hiring staff to operate and promote the station.
As the constitutional
document, the Venture’s operating agreement would authorize discrete
equity interests in the enterprise (“Units”). Each founder or investor
would become a member of the Venture upon his, her or its acquisition of
one or more Units.
One of the Units (the
“Control Unit”) would confer on its holder (a) managerial authority over
the Venture, and (b) a set of subordinated financial entitlements (the
“Carry”). (The designation of managerial authority via the Control Unit
might reduce the investors’ tax burden and would accommodate a
succession plan along most any preferred line.)
All remaining Units
(“Basic Units”) would mirror one another and would belong to the
investors. The Basic Units would grant the investors all economic
rights otherwise available to the members of a limited liability
company, subject only to the Carry. The Venture’s operating agreement
would specifically delineate the investors’ control over the Venture
(typically limiting such authority to terminating the Manager’s command
in the case of malfeasance, and also to vetoing proposed related-party
transactions). The Venture’s operating agreement would in addition
proscribe specified acts of disloyalty.
Concurrently, the
founders would establish, and would serve as the sole members of, a
second limited liability company (the “Manager”). The Manager would
take title to the Control Unit and thereafter act as a uniquely
categorized member of the Venture. As such, the Manager would hold (a)
the Carry (through which the founders would, on a subordinated basis,
indirectly share in the Venture’s profits), and (b) managerial sway over
the Venture (through which the founders would exercise ultimate control
over the operation). Each founder would contribute (or sell) to the
Manager any and all of his, her or its rights in the tangible or
intangible assets on which the Venture plans to rely. In turn, the
Manager would contribute (or sell) to the Venture those newly acquired
rights. The Manager’s operating agreement would divide authority among
the founders, and would constrain specified activities that might place
a founder in competition with (or that would effect the transfer of an
equity interest in) the Manager.
As noted, the Carry
would contain the Manager’s financial rights as a member of the
Venture. To further the illustration, such rights would correspond to a
set percentage of all distributions by the Venture. However, the
Manager would share in those distributions, only after each investor has
received (a) the recoupment of his, her or its invested capital (the
“Corpus”), and (b) a premium entitling each investor to an accrual of
“interest” on his, her or its Corpus (the “Coupon”). After satisfying
the investors’ priority right to the Corpus and Coupon, the Manager
would, by virtue of the Carry, take a set share of all future
distributions of the Venture’s available funds. (Although the Manager
must wait until the investors collect their priority return, the
founders may earn undelayed fees for any services that the
Venture might have engaged them to perform.)
The Manager will set the
price and size of each Unit in light of the outlays anticipated by the
Venture’s development budget (net of any debt financing). After
ascribing an equal price to each Unit, the Manager can, in reliance on
the Venture’s pro forma income statement, generate a schedule. That
schedule would, for any one Unit, associate (a) a particular rate of
return (an “IRR”), with (b) a particular Carry fraction and Coupon rate.
The chosen IRR must
satisfy the relevant, narrowly drawn capital market. The operative IRR
might effectively materialize from negotiations with a particular
venture capitalist. In other cases, the IRR will approximate the
Venture’s considered impression of the return needed to sell all offered
Units to a syndicate of targeted angels. In any case, the selected IRR
will evolve from a study of the competing returns projected by other
closely held start-ups, and from a concurrent analysis of the specific
risks that might distinguish the Units from other privately placed
securities in the market. By applying the chosen IRR to the schedule
described in the foregoing paragraph, the Venture will select the Carry
fraction reserved to the Manager (although the founders remain free to
increase the Coupon rate, if they would prefer a higher Carry fraction).
In deference to the laws
that regulate the issuance of unregistered securities like the Units,
the Venture will, when soliciting investors, (a) employ conforming
prospectuses and subscription agreements, (b) eschew public notices to
promote Unit sales, (c) prohibit investors from transferring Units,
except under extraordinary circumstances, (d) pay commissions, if at
all, only to persons registered as brokers under federal law, and (e)
promise to remunerate the founders and their affiliates only to the
extent, and only under the circumstances, disclosed to the investors
prior to the Venture’s capitalization.
This foregoing
hypothetical presents only one possible method of dividing and
prioritizing distributable cash. (Specifically, today’s example
illustrates a rather simple method of splitting proceeds. At the same
time, the template also places an especially elementary foundation under
the required tax allocations and accounting rules.)
Conclusion
We note that
legislatures have, in recent years, tended to retract, rather than
create, subsidies for land development. Yet, federal, state and local
governments still demonstrate a desire to accommodate real estate
devoted to alternative energy. We contend with an economic downturn
that has undercut the suppliers, and that has bewildered the consumers,
participating in various industries. Yet, the industries focused on
technological innovation continue to capture the public’s imagination
and inform the government’s plans. We face — with unprecedented clarity
— environmental, political and sociological challenges borne from the
American appetite for fuel. The nation’s geothermal potential offers a
means to assuage that appetite. The developer or financier may pursue
the opportunities using the Venture model.
Unlike many other types
of alternative-energy projects, the successful geothermal Venture
requires no scientific advancement, needs no further engineering to
implement the necessary technology, poses a remarkably manageable risk
of commercial failure, demands a relatively modest amount of capital,
presumes no particular level of internally developed expertise,
satisfies standards of environmental safety, and incites none of the
larger controversies that shape today’s political debate.
Abount Author:
Mr. Logan practices law in the Bloomfield Hills, Michigan, office of Dykema. You may access his curriculum vitae via the following link: http://www.dykema.com/bio/display.asp?mode=web&empID=144
The author wishes to acknowledge and thank Donald B. Koretz for his expertise in helping to interpret the engineering analyses and technical models encountered over the course of the author’s research, and also for Mr. Koretz’s insightful critique of the penultimate draft of the article’s manuscript.
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