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Small Changes in Investment Incentives Can Have a Powerful Effect on Energy Independence

Global environmental concerns and national security demands have everyone talking about alternative energy sources. But preparing Americans to be energy independent requires more than talk. It will take innovation in public policy and in the capital markets, according to a new report from the Milken Institute.

A recent United Nations Environment Programme report noted that global investment in alternative energy was up, rising 158 percent over the last two years to $71 billion in 2006. However, in the U.S., alternative technologies account for less than 5 percent of the transportation-fuels market. Meanwhile, the U.S. continues to import 60 percent of its oil, increasingly from volatile or hostile regions.

"We believe that American ingenuity and investment can tackle this problem," said Joel Kurtzman, Milken Institute senior fellow and director of its SAVE initiative, which focuses on how to reduce U.S. dependence on foreign oil. "Public policies and market tools that appropriately balance the investment risk and reward can move us toward cleaner, domestic sources of fuel."

The report, "Financial Innovations for Achieving Energy Independence," includes recommendations for public policy interventions and capital-markets solutions that can accelerate the U.S. transition to cleaner, alternative energy sources.

Public policy recommendations include:
  • Establishing a price floor for oil through a federal tax. Oil price volatility, particularly the threat of dropping prices, dampens investment in alternative energy technologies. Similar to bank deposit insurance for savers, this tax would take effect only when oil falls below $40 a barrel and would protect investors who want to explore new technologies.
  • Alignment of biofuel taxes and subsidies. The convoluted maze of taxes and subsidies for ethanol and biofuels not only confuses consumers, but also investors. Doing away with these conflicts would help investors assess risk and return in a variety of new technologies -- leveling the playing field and allowing the markets to work efficiently.
  • Setting a price floor for alternative fuels. Although somewhat controversial as an increased role for government, price supports could provide security to investors who are interested in exploring alternative fuels and technologies that currently lag in research and development.
Capital market innovations include:
  • Using advance-purchase commitments. Greater application of advance purchase commitments -- a relatively new financial instrument -- has the potential to increase demand for long-duration hedging, which could also increase the amount of investment for the kinds of long-term hedges that are needed to bring technologies to market.
  • Introducing BTU bonds. A newly proposed financial instrument, a BTU bond is issued by a fuel provider and has innovative repayment terms: when the bond matures, the alternative energy company redeems the bond for either a preset dollar amount of the value of a preset number of BTUs.
  • Credit reserves and enhancements. These capital structure mechanisms increase the ability of philanthropic and mission-driven foundations to increase investment in alternative-energy technologies. The credit reserve is a set of funds that would be used only when oil prices fall so low that the project's credit worthiness is threatened, if they are used at all. The presence of a credit reserve, in this case provided by a foundation or charitable organization, makes projects more attractive to investors, thus decreasing the costs of financing. Credit enhancements operate as insurance and work like a put option, and the funds are used only if oil prices drop to a preset low.
SAVE (Strategic Action Volunteer Effort) brings together teams of volunteers adept at deploying state-of-the-art financial technologies and capital-market solutions to tackle complex economic and public policy challenges. The report is the result of SAVE participants' work throughout the year and a Milken Institute Financial Innovation Lab to address challenges in funding new fuels for the U.S. transportation sector.

Participants in the Financial Innovation Lab included CEOs and executives from clean technology, transportation and project-finance arenas, as well as policy analysts, lawyers and academics. Attendees identified oil price volatility and financial scalability concerns as the key barriers to financing energy independence.

"People think that alternative fuel choices have to help either a specific industry or only focus on environmental interests. They get overwhelmed by thinking that this will take another Manhattan Project," said Kurtzman, the former editor of the Harvard Business Review. "Instead, our proposals are technology neutral, avoid radical changes in consumer or business activities, and actually boost investment and economic development in the United States."

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