By Daniel Gross | September 1, 2023
As the summer of 2023 continues to deliver intense weather patterns and record-breaking heat across the Northern Hemisphere, public attention has refocused on the importance of lowering carbon emissions and transitioning to sustainable sources of energy.
In the USA, however, there’s a looming threat that just might jeopardize the clean energy transition by restricting the availability of tax equity financing at a pivotal moment when the nation strives to meet its climate change goals. This threat stems from newly proposed banking rules established to enhance the resilience of the American banking system following the collapse of Silicon Valley Bank and First Republic Bank in March of 2023.
The Need For Tax Equity
The US Inflation Reduction Act of 2022 (IRA) provides various incentives to lower the cost of capital and increase the pool of available investment dollars for clean energy and carbon-reduction projects. These incentives take the form of accelerated depreciation and federal tax credits for the construction of assets producing renewable energy, green hydrogen or carbon capture and sequestration. The IRA also provides bonus tax credits to promote domestic manufacturing, job creation and project construction in low-income communities. As discussed in prior blog posts, tax equity investors play a crucial role in financing such projects in the US, as there are relatively few project developers and infrastructure owners who pay enough taxes to efficiently consume the available tax benefits. Not surprisingly, the universe of tax equity investors is dominated by a small number of banks that are profitable enough to use the tax benefits and knowledgeable enough to navigate the complex tax, legal and accounting issues surrounding highly structured tax partnerships.
In June 2023, the American Council on Renewable Energy (ACORE) published a report titled “Expectations for Renewable Energy Finance in 2023-2026,” detailing insights from a survey of investors and developers in the sector. (https://acore.org/wp-content/uploads/2023/06/ACORE-Expectations-for-Renewable-Energy-Finance-in-2023-2026.pdf) To meet the additional opportunity created by the IRA, ACORE anticipated the need for the tax equity market to grow from the current $20 billion in annual tax equity investment to over $50 billion per year.
The ACORE report, however, foreshadowed a potential roadblock: proposed new banking regulations that would impose higher capital reserve requirements upon the US banks who have provided the vast majority of the tax equity in recent years. Such banks include JPMorgan Chase, Bank of America, and Wells Fargo.
Rulemaking Notice by American Banking Regulatory Agencies
On July 27, 2023, the US Treasury’s Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Fed Board), and the Federal Deposit Insurance Corporation (FDIC), issued a Notice of Proposed Rulemaking entitled “Regulatory capital rule: Amendments applicable to large banking organizations and to banking organizations with significant trading activity.” (https://www.fdic.gov/news/board-matters/2023/2023-07-27-notice-dis-a-fr.pdf)
The proposed changes seek to implement the final elements of the Basel III agreement, known as the “Basel III Endgame” while also strengthening the banking system by increasing capital reserve requirements for large banks. The rules apply to banks with $100 billion or more in total assets. Under the proposal, banks would begin transitioning to the new framework on July 1, 2025, with full compliance starting July 1, 2028.
Basel III Capital Adequacy Rules
The financial crisis of 2007 and 2008 demonstrated the devastating consequences that can ensue when investors underestimate the inherent risks of their investment portfolios. The crisis was fueled by financial institutions heavily investing in subprime home mortgage loans, which were often packaged in a manner that underestimated the probability of default and misled investors about the true risk exposure of these Mortgage Backed Securities.
As the housing market collapsed, mortgage loans started to fail, triggering a financial crisis that precipitated the bankruptcies of Lehman Brothers, Washington Mutual and about 25 regional banks. The repercussions produced near insolvencies of banks and insurance companies around the world. In the wake of the financial crisis, global financial regulators recognized the need for a coordinated effort to strengthen the stability of the banking sector. So, the Basel Committee on Banking Supervision, a global forum for banking regulators, embarked on an effort to revamp the existing regulatory framework, creating the Basel III Accord.
At the heart of the Basel III framework lies a collection of capital adequacy metrics which are designed to ensure that banks can weather financial storms without jeopardizing their own solvency or that of the broader financial system. To understand capital adequacy, it’s essential to delve into two key components: Common Equity Tier 1 Capital (CET1) and Risk Weighted Assets (RWA).
Regulatory Capital and Risk Weighted Assets
Basel III introduced a concept of Common Equity Tier 1 (CET1) capital, which represents the most secure form of capital on a bank’s balance sheet. CET1 is largely comprised of common stock and retained earnings. CET1 is presumed to serve as an immediate cushion against losses, thus supporting a bank’s ongoing operations in the event of financial distress.
Risk Weighted Assets (RWA) is a measure of a bank’s asset portfolio. As some assets expose the bank to larger potential losses, different classes of assets are assigned different risk weights. For instance, under the FDIC’s implementation in the US, cash carries a risk weighting of 0% (as there is no risk of loss), US government bonds also carry a risk weighting of 0% (as there is very minimal risk of loss), and conventional residential real estate loans carry a risk weighting of 50%.
Under Basel III, the capital adequacy of a bank is often represented by the Capital Adequacy Ratio (CAR), which is calculated by dividing a bank’s CET1 capital by its RWA.
Mathematically:
CAR = (CET1 Capital / Risk Weighted Assets), expressed as a percentage
A higher CAR indicates that a bank has a larger capital buffer relative to its asset risk exposure, making it more resilient to economic shocks.
Let’s consider a simplified example comparing two banks, each with $100 million in assets.
- If Haydn Bank has a portfolio of $100 million in residential mortgages with a risk weight of 50%, the RWA for this portfolio would be $100 million x 50% = $50 million.
- If Dan Bank has a portfolio of $50 million in residential mortgages with a risk weight of 50% plus $50 million in government bonds with a risk weight of 0%, the RWA for this portfolio would be $50 million x 50% + $50 million x 0% = $25 million.
- Assuming that both banks have CET1 Capital of $5 million, then the Capital Adequacy Ratio of Haydn Bank would be $5/$50 = 10%, and the CAR of Dan Bank would be $5/$25 = 20%.
…once again proving that Dan is a much safer bet than Haydn.
Regulators determine the minimum CET1 Capital Adequacy Ratio that each bank must maintain based on the bank’s risk profile and relative importance in the financial sector and the broader economy. Globally Systemically Important Banks (G-SIBs) are required to maintain a higher CET1 capital adequacy ratio than smaller less systemically important banks.
Effective Oct 1, 2023, the CET1 capital requirement will be 8.9% for Wells Fargo, 9.5% for Bank of America, and 11.4%. For JPMorgan Chase. As of June 2023, JPMorgan’s Capital Adequacy Tier 1 Ratio was at 15.40%, well above its required level. (https://www.federalreserve.gov/publications/files/large-bank-capital-requirements-20230727.pdf)
So How Does This Impact Tax Equity?
Fasten your seat belt because this is going to be a bumpy ride. The July 27, 2023 notice of proposed rulemaking introduced a provision changing the risk weighting for tax equity investments … by a lot.
Under the existing RWA rules, tax equity receives a 100% risk weighting, provided that a bank’s total equity investments are below 10% of its capital. Under the proposed rules, tax equity would receive a 400% risk weighting (regardless of the bank being below the 10% threshold). Yeah, that’s right, 400%. This creates a 4x increase in the amount of CET1 capital that a bank must maintain against its tax equity portfolio. 400% is the same risk weighting applied to highly speculative private equity investments!
Several banks have suggested that the 400% risk weight will require significant increases in the effective pricing (or required yield) of their tax equity investments, causing many clean energy projects to become unfinanceable. More significantly, the preexisting portfolios of tax equity investments could consume so much of the risk reserves available to banks that they may have limited capacity for new tax equity deals in the future.
Bottom line: While the proposed banking regulations are intended to manage systemic risk, they are posing an unintended consequence. The increased opportunity cost of bank capital reserves will constrain the economic feasibility of clean energy projects. If the proposed rules are not amended, many tax equity investors anticipate curtailing their investments or entirely exiting the market at precisely the moment when ACORE tells us that the US needs to scale from $20 billion in tax equity issuances per year to $50 billion or more. Given the uncertainty, a few investors have indicated that they are already holding off from issuing new tax equity term sheets or capital commitments.
The reduced availability of tax equity would likely translate into fewer projects being executed, impacting carbon reduction goals, job creation, and manufacturing growth. For projects to be financeable, PPA prices would need to increase, running counter to the stated purpose of the Inflation Reduction Act (i.e., reducing inflation).
The economic blow may be softened by IRA provisions allowing for transferability and direct pay, as these provisions enable clean energy projects to monetize some of the tax incentives in the absence of a traditional tax equity investment. However, the leading tax equity advisors anticipate that transferability will be inadequate to fill the gap. They assert that tax equity will remain critical because of its inherent efficiency in monetizing not just the tax credits, but also the tax losses associated with accelerated depreciation.
But Isn’t Tax Equity Less Risky Than Private Equity?
Of course, it is.
While tax equity is technically an equity security, is has a risk profile that is very much akin to a loan. The cashflows received by tax equity investors are largely comprised of depreciation and tax credits, both of which can be regarded as receivables from the federal government. So even following Fitch’s recent downgrade of the US government, the primary obligor repaying the tax equity investor has a AA+ credit rating. Good luck finding that risk profile in a private equity investment.
Tax equity deals are usually structured to deliver a full return of capital plus an adequate after-tax IRR within in 6-11 years. And if a project underperforms, the tax equity investors typically sweep available cashflow until they have achieved their contractual hurdle rate. As clean energy projects have a useful life of 30+ years, this provides ample buffer for the tax equity to recover over time. Furthermore, tax equity covenants almost never allow special purpose project companies to borrow money from senior lenders, so tax equity investors maintain a priority claim on the assets and cashflow of the project in the event of financial hardship or liquidation. Again, this sounds a lot less risky than a typical private equity deal.
Recognizing the special nature of tax equity, the US Department of Treasury issued guidance to banks explicitly enumerating the ways in which tax equity is “the functional equivalent of a loan.” On March 25, 2021, The OCC released Bulletin 2021-15, addressed to the CEOs of all National Banks, offering perspective into its own view of tax equity finance (TEF) transactions. The bulletin stemmed from the OCC’s final rule issued on December 22, 2020, which formally established the authority for banks to engage in TEF transactions under their lending authority. (https://www.ecfr.gov/current/title-12/chapter-I/part-7/subpart-A/section-7.1025)
The bulletin instructed that banks may undertake a TEF transaction provided that it is “the functional equivalent of a loan.” The OCC then listed specific characteristics necessary to meet this requirement, including:
- The transaction is of finite tenor, though it may include a limited residual exposure that is required by law to obtain certain tax benefits or needed to obtain the expected IRR
- The tax benefits and other payments received by the bank from the transaction provide a full return of capital and achieve an expected return on capital at the time of investment approval
- The bank does not rely on appreciation of value in the project or property rights underlying the project for repayment
- The bank uses underwriting and credit approval criteria and standards that are substantially equivalent to the that of a traditional commercial loan
- The bank is a passive investor in the transaction and is unable to direct the affairs of the project company
- The bank obtains a legal opinion or has other good faith reason to determine that the tax benefits will be available
- The bank limits the total dollar amount of TEF transactions undertaken to no more than 5 percent of its capital and surplus
Suffice it to say that virtually all tax equity issued in the market fulfills these criteria. Thus, in light of the debt-like risk profile of tax equity and the precedent for US Treasury to view tax equity as the functional equivalent of a loan, it’s reasonable to conclude that tax equity risk has very little in common with private equity risk. Applying a 400% risk weighting to tax equity is both unjustified and inconsistent with public policy.
What Can We Do?
The OCC, the FDIC and the Federal Reserve Board are seeking public feedback on the Notice of Proposed Rulemaking until November 30, 2023. The agencies have hailed the change as a means of reducing the probability of another Silicon Valley Bank. As published, the notice did not convey a plausible rationale for risk weighting tax equity 400%. And curiously, the notice proposed a 100% risk weighting to “public welfare investments,” including low-income housing tax credit investments which resemble tax equity. This may be wishful thinking, but perhaps it signals a willingness of the regulators to reconsider the risk weighting on clean energy tax equity before it’s too late.
In the meantime, the FDIC and OCC are soliciting comments on the proposed rules from interested parties. If your organization is adversely impacted, speak now or forever hold your peace.
Please use the links below to find out about Pivotal180 and our financial modelling courses and experience the Pivotal180 difference.
Share This Resource
