CERB Appeal

This past Halloween, we brought home two identical bags of candy after being suckered in by a two-for-one deal. Living in an apartment, these particular bags weren’t going to be distributed to happy trick-or-treaters; they were for us. One of my kids promptly panicked, exclaiming that he was remarkably uninterested in consuming two whole bags of this particular confection (unnamed to protect innocent candy). He wanted options, and was worried that he was going to be responsible for eating down the sugary supply. He had succumbed to a version of the sunk cost fallacy, a perception that he was committed to this dreaded route because we had bought into this caloric bonanza.

We assured him that he was under no such obligation (a curious conversation unto itself), but he nicely illustrated a trap that many fall into - watching a movie that we hate just because we’ve already started, trying to salvage a recipe that’s gone terribly awry, staying in a harmful relationship, pulling the slot machine arm in hopes of making back lost cash, or doubling down on a bad business investment. When we fall into a sunk cost fallacy, we tell ourselves that we’re staying the course or attempting to make something right, when in fact the best option may just be to change course altogether.

Similar to the assurance that we gave our son, climate-oriented corporations may have an opportunity to help energy companies get un-stuck from the same loop.

Like movies that have gone too long or burned cakes, the energy industry is full of sunk cost fallacies, with notable examples in fossil-burning power plants (especially coal plants) that have lived well past their economic prime. Utility owners of uneconomic coal plants have a storied history of running them long after it has become apparent that they no longer yield benefits to customers. Institutional knowledge and fear of change are powerful factors, but so is a basic flawed financial premise: that a utility can pay down bad debt just by running a few years longer.

But this pathway does not have to be inevitable. A growing number of institutions are interested in proactively contributing to decarbonization, and looking to deconstruct some of the biggest barriers–including the sunk cost fallacy. Today, big tech companies with ambitious environmental sustainability goals and expanding data center portfolios are eager to demonstrate that they can contribute to a lower emissions pathway. This blog may offer the missing key to utilities with a debt-ridden coal plant to ditch. Specifically, we’re exploring a new concept that we’re calling Carbon Emissions Reduction Bonds (CERB, pronounced “curb”) where outside institutions, like big tech companies, take on a bit more financial risk to help risk-averse utilities hurdle a stranded asset barrier.

In effect, a CERB is like the post-Halloween candy swaps that some parents offer their kids—one where my son could trade out his abundant, yet nutritionally-empty sugar bombs, for cold hard cash.

Coal Plants Carry a Lot of Old Debt

For starters, most old coal plants still carry extensive debt, due to ongoing capital investments to keep them operating. When a regulated investor-owned utility makes an investment in an asset, like a coal plant, it puts that investment into a balance that it then expects to recover from its customers. Since investor-owned utilities expect a decent return on investment, those capital costs pile up on ratepayers’ bills. Coal plants are like old cars - they require continuous maintenance, and a lot of new parts. So while a coal plant that’s 40 years old may not carry much debt from when it first came online, it’s usually carrying an extensive balance of upgrades, replacement parts, and retrofits that have been added over the years. Despite the fact that our country’s coal fleet is getting smaller, the outstanding debt is not, which is a source of consternation for utilities and their ratepayers. For example, RMI’s Utility Transition Hub shows that for tracked utilities, coal capacity sank by 32 percent from 2010 to 2020, but the remaining book value for coal plants l (labeled “steam” in RMI’s hub) went up by 23 percent in that same period.

The way that utilities recover costs makes these outstanding debts particularly spooky. While regulators have pretty vast discretion on utility recovery, in most states, utilities are only supposed to recover costs for assets that are “used and useful,” and that makes it even harder to take a coal plant with remaining debt offline. After all, who’s going to pay for something that’s not providing service?

When an investor-owned utility decides to retire a coal plant, they’re faced with a tricky set of options: they can try to recover the remaining debt a lot faster (i.e. in 5 years instead of 20 years), resulting in a cost spike for ratepayers; they can ask regulators to help them recover costs as “regulatory assets” well after the plant is retired, but then they risk a future commission disallowing those costs (i.e. kicking them out of rates), or they can take a loss. In a few states, however, they can opt into a process for creating ratepayer-backed bonds, more broadly called “securitization.” We wrote about this process extensively a few years ago, when the Sierra Club saw a cycle of utilities, regulators, and consumer advocates consistently agreeing to reinvest in old coal despite the poor economics of doing so. And indeed, states like Colorado, New Mexico, North Carolina, and Missouri now have laws in place allowing utilities to take that route.

But securitizing a coal plant isn’t straightforward, and a lot of states don’t have laws on the books that provide the assurance utilities and investors need in order to get low-cost transition bonds, nor is there a guarantee that securitized cost-savings will be used for new clean energy investments. So is there another way to thread this needle?

Carbon Emissions Reduction Bond (CERB)

The first green bonds were issued in 2007, and have grown quickly, with an estimated $2.8 trillion of financing offered between 2014 and 2023, according to the Climate Bonds Initiative.  A green bond is, in overly simplified terms, a loan provided for the specific purpose of achieving a sustainability-linked goal, with its top uses, according to International Monetary Fund tracking, in building clean electric vehicles, financing renewable energy or energy efficiency, or supporting climate change adaptation efforts. Green bonds are usually issued by a public or private entity hoping to achieve a specific outcome, with the largest blocks to-date from countries, followed by financial institutions, industries, utilities, and other energy producers. Green bonds may identify a specific set of benchmarks, or specify how proceeds may be used. The entity issuing the green bond may hope to assure potential lenders and bondholders that it has a trackable goal, and in some cases may hope for a lower loan cost (a green premium).

How does this world of green bonds potentially help utilities in a pickle, or corporate entities that are looking to achieve better climate outcomes? Utilities looking to retire uneconomic coal plants may be able to find corporate partners who are willing to backstop stranded coal debt, shouldering some cost and risk as their green premium. In particular, large load customers, like tech companies, may find that financing stranded coal debt is an effective way - when used in conjunction with clean energy purchases - to more rapidly decarbonize their own energy supply. 

We’re calling this type of green bond a Carbon Emissions Reduction Bond, or CERB (pronounced “curb”).

Here's How CERB Might Get Used

Let’s say that a utility owns a 1,000 MW coal plant, and has internal clarity that the coal plant is no longer in its ratepayers’ best interests. Relative to a portfolio of clean energy, the coal plant is almost certainly more expensive than replacement options. But the utility is also holding $500 million in unrecovered balance at the plant, which it is slowly recovering from ratepayers. Indeed, the utility has told regulators that it can operate the plant for another 20 years, and at a 7.5 percent weighted average cost of capital, it will charge ratepayers $62 million next year to recover that debt. The utility thinks that it might actually be able to transition off of the coal plant in about four years, but knows that its customers would revolt if it tried to amortize (i.e., collect) that debt faster: customers would face a $100 million rate shock.

At the same time, the utility is courting a new big tech customer, who has a serious climate goal (and has read Demanding Better), and isn't so excited about the coal plant in the utility’s portfolio. The big tech customer offers the utility a CERB-deal. The big tech customers will finance the outstanding $500 million coal plant debt, and in return, the utility will retire the coal plant in four years while repaying the loan over 20 years at 4 percent interest. 

It’s a great deal - the utility gets the bond proceeds in hand quickly to help pay for new, lower-cost clean energy, thereby increasing its rate base with a solid, low-interest and low-operating cost investment that will ensure a steady return for decades; ratepayers see a $17.5 million savings in year one from the lower-cost loan, and ultimately save $114 million in financing costs (present value) over the next two decades. And of course the coal plant avoids emitting tens of millions of tons of CO2 over 16 years, which is a huge win for the climate and public health.

What’s in a CERB for the big tech customers? Well, first, assuming the utility with the obsolete coal plant is the one that was going to serve them in the first place, they now have an assurance that the emissions profile is better than it was, and the system is going to be a lot cheaper (and healthier!) for everyone, not just themselves.

Okay, here’s where the rubber meets the road.

Why Aren’t Banks Extending CERBs on Their Own Today?

First, the cost of extending a CERB isn’t zero: in extending a low-cost loan to retire a coal plant, the big tech customer forgoes the opportunity to realize the benefit of higher value investments elsewhere, and may take on a small, but non-trivial risk of non-payment, for reasons we’ll discuss in a moment. Lets say that the big tech customer also could realize 7.5 percent earnings if invested elsewhere: the CERB loan has an opportunity cost of about $114 million to the big tech customer on a present value basis. However, in return, the customer has an assurance that it has substantively reduced emissions. Conservatively assuming that the coal plant had a 50 percent capacity factor and is replaced with a 50 percent clean portfolio, retiring it avoids nearly 53 million tons CO2. In present value terms, the CERB achieves emissions reductions at under $4 per ton CO2, a tiny fraction of the cost of carbon capture, nuclear, or direct air capture.

Second, big banks get a bit touchy when it comes to debt that might not be recovered. When a big bank extends debt (and particularly low-cost debt), it needs an assurance that it’s going to get paid back, and recalling earlier, there’s a small - but nonzero - chance that regulators could ultimately deny recovery for retired coal plants. To get that sweet sweet low-cost debt, a bank needs an ironclad guarantee.

That’s where securitization, or ratepayer-backed bonds, have come in handy: they create a legal mechanism that virtually guarantees that lenders will get paid back, with ratepayers as the ultimate backstop. Securitization, usually enacted through state legislation, sets up a series of protections around these specialized bonds, like a bankruptcy-remote vehicle (a fancy term for a pool of money that can’t be accessed in a bankruptcy proceeding), non-bypassable charges, and a state pledge not to walk back the terms of the loan. With those elements in place, a bank can rest assured that its loan is pretty secure, and can offer very low-cost debt. Big banks generally want the terms of securitization to be anchored in state law to extend low-cost loans. 

Is there a way to bypass state securitization legislation? Yes! That’s where we get CERBs.

Going Beyond Ratepayer-Backed Bonds

But what if a state doesn’t have a securitization framework in place or a utility just doesn't want to use it? Is there a mechanism for providing low-cost debt that can help utilities decarbonize, or help corporates get utilities on board? This is where CERBs could potentially come in, shifting some of that risk from the utility (or ratepayers) to a well-financed entity with decarbonization interests. Utilities are gearing up to build a huge amount of new infrastructure because of new demand, but are cash-poor, and entities like tech companies need a huge amount of infrastructure deployed at their behest, and are often sitting on huge piles of cash.

Here’s how a CERB might actually work, assuming that a utility, private financial institution, and utility regulators are on the same page.

1. The utility puts forward an application before its regulators seeking a financing order with several key elements: (a) the establishment of a special-purpose vehicle (SPV) company whose entire purpose is to recover CERB debt; (b) permission to create a non-bypassable charge to ratepayers to pay the SPV through the duration of the bond term; and (c) permission to sell the “property” of a stranded asset to the SPV. The application sets out the terms of the loan, and how the loan would protect ratepayers. Where it differs from a legislatively-protected securitization framework is that there is no statutory state pledge.

2. Once approved, the big tech customer funds the SPV with bond proceeds that are then transferred to the utility in exchange for the right to collect a bond payment through the utility’s ratepayer charges. In this transfer, the utility gets an immediate injection of cash and relief for stranded asset debt, then the utility will collect a (far smaller) charge from ratepayers over time.

3. The utility uses a dedicated surcharge to collect money from ratepayers used to pay the principal and interest of the bond, and removes the stranded asset cost from the ratebase.

An equivalent of this process is discussed in an issue brief from RMI, which discusses how state regulated electric utilities can tap into low-cost financing of the Energy Infrastructure Reinvestment program at the Department of Energy.

The benefits of a CERB for ratepayers are similar to those of securitization and are at least three-fold. First, the costs of a stranded asset shift from being recovered through traditional rates (which are relatively high interest rates) to being recovered through the bond repayment (at a low interest rate). Second, the costs of the stranded asset recovery can be recovered over an extended period of time, rather than compressed into the years prior to the coal plant’s retirement, reducing rate impacts. And third, the utility can build lower-cost energy sources like wind, solar, and storage while retiring the high-cost coal plant, resulting in operational cost savings.
The benefits of a CERB for a utility are straightforward: they receive an immediate cash injection, relieving the pressure of stranded asset cost recovery, and (with regulator approval) can use that cash injection to invest - on behalf of ratepayers - in cleaner, lower-cost generation.

To be successful, it is imperative that a CERB get regulator buy-in. At the end of the day, the regulators need to approve elements of the financing structure that will allow the CERB to move forward, and allow the utility to collect charges that are used to pay down the bond. Once the benefits of reduced utility risk, reduced customer cost, and huge benefits for new clean energy investments become clear, regulators should get pretty enthusiastic about private support to crack this sticky issue.  

Do we really need all the complicated bits?

Maybe not. The structure of CERB seeks to leverage low-cost financing from a financial institution, or corporate lender, who has a specific decarbonization interest and is willing to forgo a premium to realize the preferred outcome. But the option can also be dramatically simplified through a bilateral agreement between that corporate entity and a utility where the corporate entity helps to pay down the stranded asset cost in exchange for an expedited transition from the specific asset. Such an agreement would be subject to regulatory approval, but with a clear value proposition for the utility, its ratepayers, and the corporate buyer, it would be hard to pass up.

Or even simpler, a large energy user could just seek to buy out an uneconomic generator and retire it quickly on their own.

Financing coal transition in action!

Over the last few years, a number of parties have been working on Energy Transition Mechanisms and Just Energy Transition Partnerships to allow governments and private institutions to buy down coal plant debt and fund clean energy, in a drive towards lowering emissions. These mechanisms have been explored by the Asian Development Bank, World Bank, and organizations like RMI and the Sierra Club, and are under negotiation in Indonesia, Vietnam, and South Africa. These efforts provide clarity and direction to use corporate financing to relieve stranded asset debt in the relatively well-controlled environment of the US power sector.

Private sector financing for energy transition can be a win-win-win-win for utilities seeking to derisk their portfolio and reduce costs for ratepayers, ratepayers looking to reduce the cost and volatility of their energy supply, climate-motivated corporates looking for effective emissions mitigations, and our climate and public health. And avoiding emissions in the first place can be achieved at a far lower cost and risk than speculative new technology, or trying to suck carbon back out of the atmosphere.

We’re well past Halloween now, and the excess candy supply has slightly depreciated in the interim. But while we still have (nearly!) two bags of candy in the closet, my son has happily decided that he doesn’t have to carry the redundant caloric burden himself. All he needed was a little support and we were able to pivot to more productive questions… like which Thanksgiving pie leftover needed to get eaten first.