With the recent expansion of renewable energy tax credits in the US, developers and bankers are not waiting for regulators to deliver final guidance to get down to business. Contractual tools for risk mitigation, such as tax credit insurance, are playing an important role in filling the liquidity gap as the fledgling market takes off. Joti Mangat reports.
“If you’d asked me three or four months ago, I probably would have said that most participants would wait for guidance before moving forward with transfer-related transactions. However, that hasn’t been the case and many transactions are moving forward with term-sheets and agreements already in play. We are seeing a lot of deals move full-steam ahead,” a Washington-based project finance partner says of the velocity of market development in the nascent tax credit transfer market.
“Most parties are moving to handle this risk contractually. No matter what guidance comes out, the seller is going to bear recapture risk and the seller is going to take the risk that the underlying project qualifies,” she argues.
The passage of the Biden administration’s Inflation Reduction Act (IRA) last year opened a new frontier for the US’s tax policy anchored renewable energy market by both expanding and simplifying the tax code, bringing more technologies into play with a wider audience of tax-motivated capital providers. While initial reaction had deferred to the dominance of the economic, legal, and regulatory status quo, the latest news suggests that the rules have rapidly gained traction across a spectrum of renewable project finance segments.
As a few predicted at the time of passage, transfer has almost immediately become an accretive tool for the established utility-scale developers and financial institutions that dominate the US$20bn tax equity market and has removed barriers to middle market and downstream firms and EPC companies looking to flex their balance sheets and join the big boys in driving the transition.
Signalling the crucial role played by renewable energy advocates during the IRA process, lawmakers were able to provide a skeleton of details via Section 6418 of the US tax code for the market to lean quickly into. For example, credits can be transferred up to the time the seller files their next tax return, typically extended to September in the year after the project is placed in service. Credits can only be transferred in exchange for cash to an unrelated party and payments are non-tax-deductible for the buyer. Credits can only be transferred once but may be sold to multiple parties at once via syndication. Buyers may carry credits back three years and forward up to 22 years.
Gaps remain, however. For example, the market is waiting for final guidance on procedural matters governing the sale of tax credits such as reporting and registration standards as well the application of passive/active loss rules for individual taxpayers. With respect to the application of credit value "adders" contemplated by the IRA that may allow tax credits to finance more than 50% of project costs, guidance is still pending on increased values for projects related to energy communities, low-income communities, and utilisation of Made in America materials, all of which promise potential credit "adders" if substantiated.
“The IRA is not the holistic solution that the renewable energy community had hoped for, Further, the act introduces new requirements to qualify for tax credits, the ability to qualify for higher amounts of tax credits, and new ways to monetise tax credits. These requirements introduce uncertainty. Tax risk mitigation tools, including tax insurance, are therefore centrally important for participants seeking to utilise transfer in projects under development,” says Antony Joyce, who oversees tax liability insurance solutions in the renewable energy sector for global insurance broker Marsh.
An established feature of the traditional tax equity market, tax credit insurance, is typically deployed to protect the basis step-up achieved when an asset is sold into a tax equity partnership and becomes operational. Given a history of underwriting the risks related to both project bankability and plant operations, insurers have a level of comfort that makes a foray into the transfer market a logical extension of the existing business.
Applied to the credit transfer methodology, the basic thesis is an arbitrage play Double A minus balance sheet, whereby sellers can extract a higher yield from the tax credit, net of the cost of insurance, than they would in a naked transfer. Insurance against the risks of qualification, recapture and audit mean tax insurance is an important tool to preserve liquidity.
“We are seeing the market bifurcate into two key constituencies in this initial phase of section 6418 with a more vanilla segment of developers transferring credits directly to buyers and holding the project and associated depreciation on their balance sheets. This negates the basis step-up play, but moves projects forward in a simple process. At the more sophisticated end, we are seeing transfer incorporated into conventional tax equity structures or other hybrid structures to achieve a basis step up for ITC eligible projects,” Joyce notes.
The latter approach is establishing itself as a new standard in the utility scale market, where large projects or portfolios getting funded by a single tax equity provider has involved hybrid structures that blend elements from typical partnership flip and inverted lease vehicles that allow monetisation of credits and depreciation by a true third party, while preserving the right to transfer the credit later, should that add benefit to the developer’s business model. Somewhere in the middle are structures that contemplate a sale to quasi-unrelated parties.
“Preservation of the right to transfer is quickly becoming a standard feature of tax equity agreements and, in some cases, we are seeing it added retroactively to partnership agreements that closed before the IRA was enacted,” says Joyce.
With credit pricing estimates ranging between 85c and 95c on the dollar such that a transfer could yield a buyer a double-digit return in less than 12 months, the initial attraction of the product is clear. Developers and their transfer agents therefore have a strong incentive to incorporate credit risk mitigants to support pricing, while buyers are in a strong position to push back, especially with transfer timelines ticking ahead of tax filing deadlines, by which time it is already too late to put together a tax equity partnership. As such, option value decay will likely play an important role in pricing dynamics, especially as relates to the investment tax credit as opposed to the volumetric production tax credit.
“Tax insurance is an arbitrage tool. It allows sellers to consummate a transaction or to sell tax credits at higher prices, yielding a better all in value net of the cost of insurance. The protection afforded by the insurance policy provides access to buyers that would not have been available without it, allows developers to bring in third parties and generally helps reduce the friction involved in getting the transfer consummated,” Joyce says.
Although deals are being papered with transfer provisions, for now pricing remains a modelling exercise in anticipation of the first wave of transfers to execute. Anticipation for the first closes and observable prices, even those supported by insurance policies, is palpable among market watchers.
“There is a fair price between the level at which developers want to transact, and what value will bring a buyer to the table. Given that the risk the buyer is taking is minimised by representations and indemnities, we expect clearing prices to quickly become more transparent,” says Erik Underwood, co-founder and chief executive at Basis Climate, a start-up transfer marketplace seeking to establish an early foothold in the market.
Basis Climate is one of a cadre of start-up project finance platforms that have a strong motivation to scale quickly and establish price data authority as a means of wrestling deal-flow from the handful of powerful tax equity houses, improved price transparency and liquidity. From a business model perspective, the new breed of brokers is keen to strike a contrast with the documentation, due diligence and asset management hurdles of traditional tax equity investing.
“The goal is to develop a standardised risk allocation approach between buyers and sellers which will appeal to a larger, broader group of corporate and individual taxpayers. A core concern is how to keep this as simple as possible, but still transact with confidence,” Underwood says.
Andy Moon, co-founder, and chief executive officer at start-up Reunion Infrastructure, built his career on the front lines of traditional tax equity structuring, starting with SunEdison in 2009. He argues that without the IRA’s expansion of the tax credit investor base, the size and risk appetite for the traditional tax equity investor community would significantly constrain and undermine clean energy goals.
“Reunion did a bottom-up analysis of wind, solar, energy storage and EV charging infrastructure, and the magnitude of tax credits generated from these technologies alone far outstrips what the current tax equity market can provide. The majority of traditional tax equity is supplied by a handful of the largest banks, which won’t be able to fill the funding gap,” he says.
“The concern that the legislation left certain aspects of the transfer framework vague or uncertain and that the market opportunity would be stalled in wait-and-see mode has proved unfounded. We are actively negotiating live deals, and moving them forward to closing. We have analysed what is still pending from the IRS and take a very conservative view in terms of allocating risk between credit buyers and sellers. Some of that risk is baked into the transaction, and some can be managed through insurance. The market has shown a strong appetite for moving transactions forward,” Moon says.
For example, with respect to initial project qualification for credits, Basis Climate notes that its standardised agreements remove execution risk, as the credit buyer’s final payment and associated transfer can only be paid after the project reaches commercial operation – after which credit recapture insurance of seller guarantees will cover any further recapture risk during commercial operation. Similarly, with respect to guidance on credit adders, Basis notes that transactions may be sized to include the adders ahead of final guidance, but will only become transactable once the final guidance and due diligence can be performed, which is expected by this summer.
Given the IRA’s expansion of qualifying renewable technologies and simplification of taxpayer eligibility criteria, Underwood argues that audit risk is significantly reduced via transfer as opposed to equity ownership of an operating asset.
“We believe that if you structure the transaction correctly, and that you have solid upfront diligence that the project does indeed qualify, audit risk is actually very limited. Sale and purchase agreements, and any associated insurance policies, will incorporate representations and warranties limit that prevent audit risk from increasing post transaction,” he says.
Reunion’s Moon is also focused on getting the initial deal template right. “The heavy lift is on getting the transaction documentation and structure exactly right. For the next six to 12 months of market evolution it’s critical that we get the framework locked down. Sloppy contracts and half-baked due diligence will be bad for the whole sector. Getting these first projects right is just so important,” he adds.
What is at stake in the battle for transfer supremacy? According to Segue Infrastructure managing partner and Reunion seed investor David Riester, transfer-based deals will make most economic sense in the sub-200MW sector of solar, wind, storage, and EV project finance, with a total addressable market in the region of US$15bn in 2023, rising to almost US$30bn by 2030, or approximately 30% of the entire tax appetite required to achieve the IRA’s climate goals. If credits are transferred at an average price of US$0.87, Riester assumes that brokers may be able to extract fees of 3%–6% taking the cost of insurance into account, which will presumably fall over time. Taking all that into account, annual transfer revenues could ramp to a billion dollars in short order.
Ironically, despite transfer’s appeal to smaller developers, projects, and investors, it’s the initial enthusiasm of the tax equity superpowers that have given the tool immediate relevance and will likely validate it as a standard feature of US project finance.
“For the large-scale developers and tax equity investors, tax credit transfer fits neatly as a tool that adds transaction flexibility. Hybrid structures may allow these players to do more business than internal tax capacity supports,” says Joyce. “The online platforms are going to be more relevant to one-off and smaller scale projects but it's impossible to tell at this point. We will certainly need significant market development to get to the levels needed to support accelerated project deployment,” he adds.
Although the first projects to close will likely be on the larger end of the scale, it’s hoped that transfer will finally be the democratising force to open bankability to smaller scale opportunities from downstream developers.
“As we get the first, larger projects flowing the goal is to enable both sellers and buyers of distributed generation projects and reverse the brain drain toward utility scale. There are great projects out there that have previously been ignored where capital scale, timing or geographical profile don’t fit neatly into a tax equity portfolio that has already been negotiated. Transfer will allow developers to put more capital to work with the same headcount,” Reunion’s Moon says.
“My takeaway is that the transferability intermediary/market-maker market is a big enough prize to be interesting and unlocks a massive opportunity that the right finance experts can access by simplifying financing structures for developers. If you’re thinking 'sure, but it feels like too many companies are popping up to chase a market of that size', I’d have to agree. I’m not sure everyone’s really thought it through, especially those who try to go big out of the gates and drown their business in SG&A levels not supported by the market opportunity,” Riester concludes.
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