Investing in the renewable energy infrastructure in the US needs to address the challenges and risks associated with tax equity investing, a structure that allows investors to monetize tax credits on a dollar-per-dollar basis. The recent IRS guidance on tax credit transferability paves a promising path ahead to de-risk these investments and create a seamless mechanism to monetize tax credits.
Our global community recently witnessed discussions at the UN Climate Change Conference, COP 28, and for the first time transitioning away from fossil fuel appeared in the formal outcome. While we all celebrate that moment, we should also cherish the one-year anniversary of the Inflation Reduction Act (IRA), the landmark climate policy that the Biden administration announced in August 2022, and its potential to revolutionize clean energy financing in the US. IRA does so by reenergizing the “tax credit” market alongside other incentives, especially the investment tax credit (ITC).
Origin of the tax credit market in the US
The Energy Policy Act of 2005 established the ITC, which provided a 30% credit on the cost of any system with a cap of $2,000. This limit proved to be problematic for the growth of the renewable energy industry, and as a result, the Obama administration removed the cap in 2008 to incentivize the faster adoption of renewable energy. Since then, the ITC expiration deadline has been extended multiple times, and last being the extension in December 2020 which established a 26% ITC till the end of 2022. Since the adoption of investment tax credit incentives, the solar industry has grown by more than 10,000%.
Monetizing tax credits: opportunities and challenges
A renewable energy project, especially during the early years of its operations, makes a negative gross income because of accelerated depreciation. Thus, the developer doesn’t have the required tax appetite to absorb ITC, and this highlights the importance of tax equity investments, wherein a corporation with a large tax appetite invests in a project primarily to reap the benefit from tax credits generated. The structure that has primarily been used to attract ITC investors is “Partnership Flip”, wherein the tax-equity investor forms a partnership with the developer to develop and operate the renewable energy asset. As a majority owner in the project, in the early years, a tax equity investor reaps ITC and depreciation benefits on a step-up basis. IRA, a $ 369 billion climate package, further strengthens the industry by extending the tax credits for another 10 years and by expanding the stack of credits for meeting qualifying requirements. As a result, projects can recover anywhere between 30% to 70% of the total project cost in tax credits in the first year of operation of the asset.
However, the willingness of investors to form tax equity partnerships remains a challenge, given the costs and complexities associated with it. For example, in 2021 the tax equity market was estimated to be $ 20 billion, with more than 50% of the supply coming from only two large banks. Most of these investments have been executed for large-scale solar projects given the better benefit-to-cost ratio and predictability of tested technology. This is where Distributed Energy Resources (DERs) fail to benefit, primarily because the scale of tax credits each project can generate pales in comparison to the costs associated with forming tax-equity partnerships.
To help resolve this challenge and expand the tax equity investor pool, the IRA created a new mechanism to sell tax credits to qualified investors for cash, more widely known as “tax credit transferability” guidance. The goal of this mechanism is to facilitate the democratization of tax-equity markets, and it is expected to strengthen financing in renewable energy assets, especially for DERs.
Comparative analysis of transferability
The way the transferability provision will work is that first, a solar developer gets the credits from the government based on the cost and eligible ITC percentages. Since the developer doesn’t have the tax appetite to benefit from the credits, it can sell them to companies with substantial tax liability, and the buyer, in turn, gets the credits at a discount to their tax savings. For non-profits and public entities that don’t pay income taxes, there is a provision of “Direct Pay”, wherein they could get direct payment for selling credits.
As developers and buyers evaluate the benefits and tradeoffs, a key benefit of transferability is the speed of deal execution. This is particularly true for DER developers, as the ease of registration for the ITC and execution of a transfer transaction will outweigh the losses resulting from their inability to monetize depreciation and Step-up basis.
To highlight this, let us look at a sample $100 million solar project and draw a broad comparison between tax-equity partnership and transferability. This example is very high level, avoids certain details for the sake of simplicity, and assumes 100% of benefits go to tax equity investors.
|Tax Equity Partnership
|$ 100 MM
$ 100 MM
|Step Up* multiple
Doesn’t get section FMV# step-up benefit
|$ 110 MM
$ 100 MM
|$ 33 MM
$ 30 MM
|Reduction in Depreciable Basis
|50% of ITC
|Depreciation is not applicable in case of Credit Transferability
|$ 94 MM
|YR 1 5 year MACRS Depreciation (20%)
|$ 19 MM (Approx)
|Net Benefit from depreciation to investor given 30% federal tax rate
|$ 5.6 MM
|Year 1 Total Benefit
|$ 38.6 MM
$ 30 MM
|NPV at Discount rate (8%)
|$ 35.74 MM
$ 27.78 MM
|Price per Credit
*Step up assumption, #Fair Market Value (FMV) = Step up multiple X Project Cost
In this example, we can see that transferability avoids a lot of complex tax treatment and depreciation accounting and corresponding legal structuring behind it to make the deal simpler and faster.
This sample scenario also highlights another important aspect of pricing – that being the willingness of the buyer to compensate for each dollar value of ITC, between transferability and tax-equity partnership. Although a tax equity partnership is complex to set up, an investor still will be interested in such a structure if they value the potential benefits of step-up, depreciation, and a small tranche of cash more than ease of alternative. Moreover, developers can get a higher compensation per dollar of ITC value. Having said that, oftentimes developers may have an appetite for absorbing the losses generated from accelerated depreciation of assets. Another important benefit for buyers is to align the transferability transaction closer to the timing of their quarterly tax payments to maximize their returns.
In a time when conflicting narratives on climate-positive investing are pursued in our public debates, IRA with its guidance on “transferability”, a novel financial structure, will certainly revolutionize financial markets and investments in renewable energy projects. However, there are challenges in deal structuring such as recapture risk, basis risk, inertia of a single transaction etcetera that remain to be explored in detail as and when those arise. Nonetheless, the factors that will drive the choice between a tax-equity partnership and transferability are the size of the project, the maturity of technology, and how valuable is the depreciation for the parties involved in the transaction. Yet it goes without saying that with the introduction of transferability, the market is going to evolve rapidly, and we will see more deals, investors, advisors, and brokers doing business in this market.
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