New technologies: “I gar-on-tee!”
Posted by Evan Herrnstadt on July 1, 2008
Yesterday the DOE announced three solicitations for a total of up to $30.5 billion in loan guarantees for energy technology. Up to $18.5 billion will go to nuclear power, $10 billion to renewables and efficiency, and $2 billion to “front end” nuclear, such as uranium enrichment. For those unaware, a loan guarantee essentially means that the federal government co-signs at least a portion of a loan, an implicit subsidy. With this backing, lenders will lower interest rates, knowing that total default is very unlikely.
The economic justification for loan guarantees is the classic informational asymmetry which plagues most credit markets. A potential borrower may have private information and expertise that the lender cannot match. In the case of a new technology, lenders can look at a firm’s fundamentals and history, but in the end most emerging energy technologies are bound to either look extremely risky or be so unfamiliar that an accurate assessment of default risk cannot be made. Basically, loan guarantees aim to mollify this information gap to help finance the move from pilot to full commercial scale.
Projects associated with energy loan guarantees have had a mixed levels of success. In the past the federal government funded loan guarantees for large portions of coal gasification and ethanol plants and geothermal facilities. The coal project defaulted on its loan and the DOE sold the facility; it runs at a net profit and the revenues are paying off part of the DOE’s initial investment. All three ethanol plants defaulted; one is now a major producer after much refinancing. Four of the eight geothermal defaulted, but one of the success stories (based in California) has expanded to other states and overseas.
So are loan guarantees justified in the present case? The category that strikes me as odd is nuclear. Nuclear power in the United States already receives massive implicit subsidies in the form of the Price-Anderson Nuclear Indemnification Act. Also, most private utilites have very good credit and probably don’t need the government’s backing to get a reasonable interest rate. On the other hand, nuclear technologies face a unique level of regulatory risk, so perhaps guarantees are somewhat justified. Renewables are quite defensible, assuming the guarantees go to small upstart firms, or even more established firms looking for a stonger toehold (e.g. Tesla Motors, which has applied for past DOE guarantee programs). Energy efficiency seems like perhaps a good fit as well, as many advances must simply be made by building large facilities in which to manufacture more energy-prudent products and materials.
On the whole, it seems that past projects under loan guarantees were riskier than average, i.e., it wasn’t just an information asymmetry keeping them down. On top of the nature of the projects, federal support brings out the potential for moral hazard. A firm whose debt is backed by the government has incentive to take riskier actions than would normally be optimal. However, in the case of energy demonstration, it might be worth dealing with these issues simply to show that a full-scale version of a technology is commercially viable.
H/T: Daniel Hall.