Bridging the tax equity funding gap
The past few years have seen dramatic shifts in the renewable energy finance markets, as the financial crisis and regulatory uncertainty have impacted the availability of both project debt and tax equity for renewable energy projects. By Michael Meyers, Ben Davidson and Christopher Gladbach, attorneys in Orrick Herrington & Sutcliffe’s Energy & Infrastructure Group.
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With the expiration of the start of construction deadline for the 1603 Treasury cash grant, most in the industry expect that over the next two years the demand for tax equity financing for renewable energy projects will substantially outstrip supply. Several recent trends drive this supply-demand imbalance, and although tax equity financings will need to overcome several hurdles in the coming year, some potential trends are developing that may positively impact the tax equity markets.
Renewable energy projects in the United States usually rely on a variety of financing sources, including sponsor and investor cash equity, investor tax equity and project-level debt. Renewable energy projects benefit from a variety of tax credits and other incentives. These include the production tax credits that are available for wind facilities and certain other technologies and provide an inflation-indexed tax credit for every kilowatt hour produced over a 10-year period.
Investment tax credits are available for solar, wind and other technologies and provide a one-time tax credit of 30% for solar and wind and lesser percentages for certain other technologies of a project’s qualifying capital costs. Accelerated depreciation benefits are also available. Because sponsors generally do not have sufficient taxable income to use these tax benefits, the financing of these renewable energy projects depends on tax equity investors providing equity in return for the use of the project’s tax benefits and some of its cashflows.
Large financial institutions dominate today’s US tax equity market. Approximately 15 to 20 tax equity investors lead the market, although they vary in their level of activity. The high-water mark for tax equity was 2007. More than 20 active market participants supplied approximately US$6.1bn in overall tax equity financings, according to the US Partnership for Renewable Energy Finance (US PREF).
Following the financial crisis, tax equity financings dwindled to approximately US$1.2bn in 2009. Although the tax equity market has recovered from its recession lows, fewer investors have displayed an appetite for the risk and benefits associated with tax equity investments.
The US Congress responded to the recession’s impact on tax equity markets in the 2009 American Recovery and Reinvestment Act. The ARRA created cash grants under Section 1603 available to renewable energy projects in lieu of investment and production tax credits. (The ARRA also broadened the US Department of Energy loan guarantee programme for renewable energy projects and extended the sunset dates for the renewable energy investment and production tax credits.) The Section 1603 cash grant programme was notably successful in filling the role previously played by tax equity. Indeed, on an aggregate basis, the combined tax equity and grant financings in each of 2010 and 2011 exceeded the amount of tax equity financings in 2007.
The cash grants have proved to be a boon to renewable energy projects, especially smaller solar projects. According to US Treasury Department statistics, through to the middle of March wind facilities and solar facilities have received approximately US$8.2bn and US$2.1bn in grants, respectively. Approximately 4,750 cash grants were made to solar facilities, averaging approximately US$440,000 per grant, compared with an average grant of approximately US$15m for the approximately 550 cash grants to wind projects.
The smaller average size of the grants to solar facilities shows that, in addition to providing cash grants to projects that would have traditionally used tax credits, the Section 1603 grant programme enabled many smaller-scale solar facilities to take advantage of federal support. This is an important attribute of the grant because US$25m to US$30m is generally considered to be the floor for tax equity investments.
Industry consensus estimates for 2012–13 suggest that tax equity providers expect to deploy approximately US$3.6bn annually, while the estimated demand for tax equity amounts to between US$7bn and US$10bn, according to US PREF. This shortfall compared with the combined grant and tax equity investments of 2010 and 2011 have many in the industry worried that tax equity investors will not be able to fill the void left by the expiration of the cash grant.
With the expiration of the cash grant, and the currently scheduled expiration of the production tax credit at the end of 2012, the next few years are expected to be a transition period for tax equity financing on both the supply and demand side based on a number of factors. These factors can be divided into two main categories: regulatory uncertainty surrounding the expiration of the cash grants and the production tax credit and the political support for renewable energy incentives, generally; and macro-economic market uncertainty.
Congress designed the cash grant to address a shortage of tax equity, and it filled this role well. There are many projects in the marketplace that put in place arrangements to meet the US Treasury’s start of construction safe-harbour rules to maintain cash grant eligibility. But once those facilities are placed in service, sponsors will need to revert back to the pre-cash grant paradigm and sources of financing for their projects. Until then, the marketplace will be bifurcated between those projects that are grant-eligible and those that are not. Although projects needed to start construction by the end of this year, the outside termination date for grant eligible projects to be placed in service is January 1 2017 for solar and January 1 2013 for wind.
Additionally, the production tax credit for wind facilities expires at the end of this year unless Congress extends the credit. The 2012 presidential election will make it more difficult than usual for either of the political parties to find consensus on extending the production tax credits – even though they have historically garnered bipartisan support.
Historically, the wind industry has experienced boom and bust cycles around expiration and then renewal of the production tax credits. Developers currently are pushing to place wind projects in service by the end of this year. Signs are already clear that projects that cannot be placed in service in 2012 are being delayed, because of the economic impact of expiration of the production tax credits. As a result, without an extension of the production tax credit in the very near term, 2013 will almost certainly be a down year for the installation of wind capacity.
In addition to changing governmental incentives, macroeconomic factors are also affecting the availability of financing for US renewable energy projects. Financing for renewable energy projects is largely provided by large financial institutions, and all are being impacted by macroeconomic factors, including world-wide budgetary woes, regulatory uncertainty in a post-Dodd-Frank world, tepid economic growth and the European debt crisis. Evidencing this, a number of banks that were significant providers of project debt have left or are expected to shortly leave the US market.
On top of this regulatory and macroeconomic uncertainty, tax equity transactions have several built-in “frictions” that must be overcome. The financing structures used to employ tax equity, such as “partnership flip” structures, sale-lease back and inverted lease structures, are complex. The active players in the tax equity market have developed expertise in these types of transactions, but the steep learning curve required for these transactions is often identified as a barrier to new entrants.
If the currently projected funding gap materialises, the cost of tax equity likely will increase. Where high single-digit returns are now commonplace for tax equity returns for projects employing established technologies, yields could significantly increase in a tax-equity financing constrained environment. If the market becomes constrained, the consensus view is that only the largest projects with proven technology, strong experienced sponsors, and strong power purchase agreements with creditworthy offtakers will be favoured for tax equity investments in the near future.
Despite these challenges, there are reasons for some optimism and a few developments, if they come to fruition, could provide additional liquidity to the tax equity markets within the existing incentive paradigm.
First, new players are considering entry into the tax equity market. These players include utilities, technology companies and other large industrials or retailers with significant tax liabilities. Second, the renewable energy finance industry is pushing for document standardisation, master programme financing structures that aggregate projects and securitisation structures, all of which may broaden and deepen the renewable finance landscape.
New entrants and bridging the tax equity gap
When Congress introduced the investment tax credit for energy property in the Energy Policy Act of 2005, utilities were initially barred from claiming the investment tax credit. This changed, however, with passage of the Emergency Economic Stabilization Act of 2008. Congress eliminated the prohibition that prevented regulated utilities from taking advantage of the investment tax credit for energy property. With the ability to take the investment tax credit, utilities suddenly became logical tax investors.
In the past, most utilities used power purchase agreements as the predominant means of complying with renewable portfolio standards and participating in the renewable markets, but recently several utilities, including several California utilities and municipal utility districts and Duke Energy have increasingly sought to make direct investments in renewable energy projects.
Large-scale participation by utilities in the tax equity markets, however, faces meaningful obstacles, notably rate of return regulation by state public utility commissioners. Some utilities have responded by investing in the tax-equity market through unregulated subsidiaries. Others have worked to obtain regulatory approval for utility investment, with one example San Diego Gas & Electric’s recent commitment to invest US$285m of tax equity in the Rim Rock wind project in northern Montana, as a way to lower the cost to its ratepayers of meeting renewable portfolio standard requirements. Additionally, bonus depreciation has reduced the tax base of capital-intensive companies such as utilities.
Utilities also face competition with municipalities and electric co-operatives, which, although lacking tax appetite, have recently participated in the renewable finance market (in conjunction with more typical tax-equity investors) with increased vigour through power pre-payment financing structures that take advantage of their ability to borrow at low costs. For example, Sacramento Municipal Utility District recently completed a transaction that involved a prepaid power purchase agreement to buy renewable energy. It developed the 128MW wind farm, and then sold the project to an affiliate of Citigroup NA that participated as the tax-equity investor.
Fortune 500 companies are also showing some interest in tax equity investments. These include technology companies, industrials and large retailers. The Obama administration has been actively courting these potential market entrants as part of the administration’s “all of the above” energy policy approach. On March 13 this year, the US Department of Energy hosted 79 large US companies, including Exxon Mobil, the Walt Disney Company and Wal-Mart, to encourage them to participate in the renewable tax equity markets.
These potential market entrants meet some of the threshold criteria for tax equity investing. They have fairly predictable and reliable taxable income and large balance sheets. There does appear to be significant capacity to take on these tax-equity investments: according to Bloomberg New Energy Finance, the 500 largest public companies paid more than US$137bn in taxes last year. Of new investors, Google’s entry into the renewables market is well documented. The company has invested more than US$900m in renewable projects, including several sizeable tax equity investments in solar PV funds.
For all of the enthusiasm for increased participation from industrials, retail and technology companies, however, a few challenges must be overcome. These companies will need to successfully climb the renewable energy learning curve, and will need to find the risk/return profiles of particular projects attractive. But because these kinds of tax equity investments have the dual purpose of boosting a company’s “green credentials” and lessening their tax burden, and given recent success of these companies in the space, the investor base may broaden in the coming years.
In addition to new entrants, non-bank institutional investors have shown some interest in re-entering or enlarging their participation in the tax equity market. Although several insurance companies participated in the tax-equity market prior to the 2008 financial crisis, with a couple of key exceptions, such as MetLife’s participation in 2010 and 2011, they have been largely absent since that time.
Smaller projects will have more difficulty in the absence of the cash grant, which both plugged the tax equity funding gap in the wake of the financial crisis and expanded the market for smaller to medium-sized projects. Nearly 98% of claims for the grant were under the US$30m range. The tax equity sweet spot, due to transaction costs and deal sophistication and complexity, is generally two to three times that amount. But absent an extension of the Section 1603 cash grant programme, the tax equity market is not currently well equipped to accommodate smaller projects without a meaningful shift in the industry.
There is some hope, however. In addition to new investors that may emerge, there has been movement to shrink transaction costs by standardising transaction documents and financing projects on a programme basis. New methods of accessing increased investor participation may also emerge, including securitisation of residential solar power purchase agreements or leases.
One method that has been proposed to expand the potential investor base and lower transaction costs is developing a set of industry standard documents for various forms of transactions. This would be similar to the progression of the loan syndication market, where the Loan Syndications and Trading Association has, with industry participation, developed a set of core provisions that are generally agreeable to parties to syndicated loans. If this course is pursued, the documents could be drafted and peer-reviewed by key industry participants, energy finance lawyers and financial institutions, and then reviewed by various trade associations, including the American Wind Energy Association, the Solar Energy Industries Association, and the American Council on Renewable Energy.
Standardisation in the marketplace could drive transaction costs down for individual projects, but another development that may gain traction is the use of master programme financing structures for portfolios of distributed renewable energy projects that are not individually large enough to garner interest from tax equity investors. These master programme structures can reduce the transaction and documentation costs for sponsors. For example, sponsors and investors in portfolios of renewable projects can realise some economies of scale in the diligence and negotiation process. But they are also more complex than one-off financings and still require due diligence for each of the individual projects in the portfolio.
Additionally, securitisation of residential and commercial scale distributed solar leases and power purchase agreements may also expand sources of financing for these renewable projects. As more uniform standards develop to evaluate the collateral quality of residential solar lease payments, the receivables from diverse projects could be sold and financed together in fully scaled securitisations.
The projected supply/demand imbalance in the tax equity markets is being affected by several factors. The overall US renewable market outlook today is hampered generally by the lack of a cohesive and consistent national energy policy. Many wind developers are waiting to see if Congress will extend the production tax credits, and this uncertainty is stalling growth in project development due to the nine to 12-month construction period for most utility scale projects. All are lamenting the lapse of the Section 1603 cash grant programme, which brought smaller scale projects to the table and bridged the tax-equity gap created by the financial crisis.
Despite these challenges, and the frustrating cycle of on-again/off-again tax policy incentives, the renewable market remains large, is growing and has significant room for new players and creative financing structures. Therefore, there is room for hope for developers and investors, and most expect the renewable finance market to be robust for years to come.