Financial Innovations for Achieving Energy Independence

Apr 01, 2007

Preparing the economy and financial systems to support an energy independent American requires more than catch phrases. It takes innovation in public policy and in the capital markets. The Milken Institute hosted a Financial Innovations Lab to focus on the innovation and this report gathers the ideas of the participants and our research. The report 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.