Why clean energy boosters are watching the Fed

By Benjamin Storrow | 09/17/2024 06:17 AM EDT

High interest rates have deflated climate projects and undermined the Inflation Reduction Act. That could change beginning Tuesday.

Wind turbine blades for South Fork Wind are stored at State Pier in New London, Connecticut.

Wind turbine blades for South Fork Wind are stored at State Pier in New London, Connecticut. Seth Wenig/AP

Clean energy has a lot riding on the Federal Reserve meeting this week.

The Fed is expected to lower interest rates when it convenes a two-day gathering Tuesday, likely boosting an industry that has been hamstrung by high borrowing costs for several years.

High rates have helped blunt the impact of the Inflation Reduction Act, the landmark climate law signed by President Joe Biden in 2022 that provides more than $369 billion in clean energy tax breaks. As interest rates rose, the price of building renewable energy projects climbed, eroding their financial benefits and making them less attractive to investors.

Advertisement

The effects of a rate cut this week would likely be small, since the market has anticipated the move for months amid growing signs of a slowing economy, according to analysts. Yet the Fed’s expected move signals a directional shift that could be particularly important for capital intensive industries like offshore wind and emerging technologies like green hydrogen and carbon capture.

“The interest rate environment will have a significant impact on renewable energy deployment,” said Eric Scheriff, who leads Capstone’s global energy and sustainability practice. “In particular, the more capital intensive the project, the more interest rate sensitive it will be.”

The Fed began raising rates in 2022 to combat inflation. The federal funds rate — or the price one bank charges another to borrow reserve cash — rose from less than 1 percent at the beginning of 2022 to more than 5 percent this year.

The rate hikes upended the financial calculus that had propelled the decadeslong growth of wind and solar. The old equation for financing a renewable project looked like this: find a buyer to agree to a long-term power deal, borrow money to build the project and utilize federal tax incentives to reduce the overall cost.

But that approach became more complicated as interest rates began to climb. Wood Mackenzie, the consulting firm, estimates that for every two percent increase in interest rates, the overall price tag of a renewable project increases between 15-20 percent. A similar rate increase for the average gas plant, by contrast, resulted in an 11 percent increase.

The effects of rising rates were compounded by snarled supply chains and the climbing cost of materials and labor, all of which sent the price of projects higher. Suddenly, developers had to borrow more to build their projects — while paying more in interest to service their debt, said Srinivasan Santhakumar, a Wood Mackenzie analyst.

“It will have a double stage effect,” he said.

‘We are behind’

Higher rates also made renewables a less attractive investment relative to other industries, said Patrick Worrall, a vice president at LevelTen Energy, a renewable energy broker. Investors could make the same amount of money in other industries but without the risks that come with building clean energy projects.

The impact was twofold: Existing projects were not as valuable as predicted, and new projects no longer penciled out financially.

“You just saw a complete rethink by the market last September, October,” Worrall said. “Deals really, really slowed down in the fall, as people started to think about, ‘What is my strategy holding these assets?’”

Higher interest rates were particularly painful for offshore wind, where a single project can cost billions of dollars. Developers who struck deals to sell their projects’ power before interest rates rose were hardest hit. The expected revenue was no longer high enough to cover the cost of construction.

Developers canceled almost 10 gigawatts of offshore wind contracts in 2023 and early 2024, or nearly 40 percent of all signed contracts. Another 4 GW in offshore wind contracts were later canceled in New York due to turbines being unavailable.

The growth of newer technologies like carbon capture and green hydrogen has also been stunted by higher borrowing costs. Investors expect larger profits when lending to emerging industries because the technology and policy risks are higher, said Alex Dewar, who leads Boston Consulting Group’s work on CCS and carbon removal. Those types of projects already face questions over permitting, for instance. In the case of hydrogen, there is also uncertainty over how new tax credits will be administered.

Higher interest rates have compounded those challenges, prompting investors to seek even higher returns that few projects have been able to promise, Dewar said. The result is less progress than what was anticipated when the Inflation Reduction Act passed Congress in 2022, he said.

“I think we are behind when it comes to the scaling of other more emerging low carbon technologies,” he said.

Onshore wind and solar have continued to grow because demand has remained strong and the financial model for building them is well established, analysts said. Yet renewable development has been lower than what some analysts expected when Congress passed the IRA.

When researchers at the Repeat Project, an academic clean-energy initiative, modeled the law’s potential impact in 2022, they anticipated that the U.S. would add 37 gigawatts of solar capacity annually between 2022 and 2024 and 29 GW of annual wind capacity. The U.S. added 19 GW of solar capacity and less than 7 GW of onshore wind last year, according to data compiled by the U.S. Energy Information Administration.

It’s not solely due to interest rates.

Turning the corner?

Permitting challenges, transmission constraints and clogged interconnection queues have also contributed to slower installations. That has led researchers to lower their forecast of U.S. emissions cuts. In 2023, the Repeat Project forecast U.S. emissions would fall 37-41 percent below 2005 levels by 2030. They now think emissions will fall 32-34 percent lower than 2005 levels.

The backsliding would likely have been worse without the IRA, said Ben King, an analyst who tracks clean energy and emissions trends at the Rhodium Group, an economic consulting firm.

“Without the continued availability of tax credits, I think there would have been less deployment of these technologies than we are seeing today precisely because of a more challenging macro-environment and some of the other barriers that we harp on from time to time, like interconnection queues and supply chains,” he said.

The silver lining is clean energy developers have become more sophisticated in their financial approach to projects, said Worrall, the LevelTen analyst. Major clean energy developers are high-grading their portfolios, selling projects with less robust returns and buying projects that promise to make money.

“People aren’t going to spend time on very speculative projects,” he said.

But even if the Fed lowers rates, don’t expect a sudden boom in renewable financing, analysts cautioned. The price of financing clean energy projects shadows 10-year Treasury bonds, which are influenced by interest rates. Yields climbed last fall amid concerns over inflation but began to fall in the spring as inflation cooled and the market began anticipating rate cuts from the Fed.

A rate cut this week would likely boost investor confidence at a time when there is deep uncertainty about the outcome of the presidential election.

“I think we could see a very different environment for investments in 2025, based on the election outcome, based on the Fed and based on inflationary pressures in the supply chains for these projects and technologies,” Dewar said.