Edge of Tomorrow: Tax credit transfer considerations
One of the biggest changes to renewable energy financing introduced with last year’s passage of the Inflation Reduction Act (IRA) is the concept of transferability – that is, the option for project sponsors to sell tax credits generated by their clean energy projects to third parties.
Prior to the IRA, tax credits could only be utilized by owners of the renewable energy projects which generated those credits. But few renewable infrastructure investors had sufficient annual tax liabilities to efficiently monetize tax credits worth up to hundreds of millions of dollars. This circumstance led to the creation and proliferation of tax equity: partnerships between project sponsors and large taxpayers (typically banks) to jointly invest in tax credit-generating assets. U.S. tax law allows for separate allocation of (1) cashflow and (2) taxable income (and tax credits) among members of a partnership. By allocating most project cashflow to the sponsor and the majority of tax losses and tax credits to the tax equity investor, these partnerships enabled efficient monetization of the significant tax benefits granted to renewable energy assets in the U.S.
Tax equity has enabled hundreds of billions of dollars of investment in gigawatts of solar and wind projects over the past two decades. But the structure is not without its drawbacks. First, tax equity is (relatively) expensive. Depending on the deal, tax equity investors may take between 10 and 40 percent of project cashflows, in addition to 99% of tax credits and losses, and earn returns superior to lenders – and even some sponsors! The cashflow tax equity takes also reduces projects’ leverage capacity.
A main reason tax equity is expensive is another of its negatives: it’s complicated! Ask any seasoned renewables executive (or overworked associate) and they’ll surely share tales of countless nights filled with reading and negotiating tedious partnership operating agreements, painstakingly modeling the financial and accounting intricacies of various structures, and, of course, many hours (and many more dollars) spent on calls with legal and tax advisors to ensure each transaction is documented just right. Simply put, very few companies have both sufficient expertise and taxable income to make tax equity investments – and that’s why they can charge a premium.
Does that mean that transferring tax credits is a better option than using tax equity? The answer is: it depends! Let’s look at some things sponsors should consider when weighing their options, with some help from the works of Hollywood icon.
“Show me the money!”
Let’s be honest: the goal of project financing is to raise the most money possible from your financing partners and generate the best possible returns. Under pre-IRS structures, tax equity typically provided about 30 to 40 percent of total capital for ITC-eligible projects, and 40 to 60% of PTC-eligible projects. As Rod Tidwell might say, that’s a lot of “Quan.”
On ITC deals, sponsors that opt to transfer credits should expect to receive less upfront capital from credit sales than they would have from tax equity. Since tax equity investors receive not only tax credits but also the significant value of tax losses caused by accelerated depreciation, they usually commit 1.1x to 1.2x the value of the ITC upfront. In a transfer scenario, sponsors can only sell the tax credits, and are unable to “sell” the depreciation benefits. Tax credit buyers, therefore, will necessarily expect to pay less than the value of the credit in order to make a profit on their trade. Early transactions have seen credit buyers paying roughly 90 cents on the dollar for ITCs. That pricing implies upfront proceeds in ITC transfer deals would be 20 to 25 percent less than tax equity equivalents.
With PTC, the difference is far more striking. PTC tax equity funders commit at least 75% of their capital upfront, with the remainder being earned over time based on actual generation (“PAYGO” contributions). Since buyers will expect to pay for credits as they are generated, credit sellers should expect ZERO proceeds upfront proceeds when opting for transfers. As with ITC, PTC buyers will also haircut the price they are willing to pay for credits below their actual value.
It’s not all bad news, though. While tax credit transfers will deliver less upfront capital than tax equity deals, they should be able to raise substantially more debt. Projects that eschew traditional tax equity financing won’t see major shares of their cashflows taken by tax equity investors, meaningfully increasing CADS and, therefore, debt sizing. This impact will be most significant for PTC deals, which will see all of the tax equity funding they would otherwise have received upfront shifted to payments over 10 years, but ITC projects will benefit as well.
Sponsors with some amount of taxable income may also be able to benefit from retaining tax losses caused by accelerated depreciation, rather than passing them on to tax equity partners. Accurate forecasting is necessary to evaluate whether this may be the case for your organization.
The overall economic impact of opting for credit transfers vs. traditional tax equity will be unique to your project and organization and can only be evaluated with an accurate and well-designed financial model!
Tax credit sellers and buyers will need to think carefully about and agree on how the myriad risks associated with renewable energy tax credits are allocated.
For ITC deals, recapture risk will likely top the list. If an ITC-earning project is disposed of by its owner (via a sale or lender foreclosure) or stops generating electricity (due to damage or abandonment) within its first five years of operations, the ITC it generated must be repaid to the IRS on a pro rata basis (i.e. 100% if recapture occurs in the first operating year, 80% if in year two, etc.). Under IRS rules, tax credit buyers are liable to pay recapture penalties, despite the fact that the credit seller’s actions caused the event. Accordingly, smart credit buyers will likely demand sellers provide corporate guarantees or pay for tax insurance to protect against this risk. The cost of any guarantees or insurance will further erode net proceeds from credit sales.
That recapture penalty also means that sponsors are effectively “locked up” in their ITC project investments for five years, unable to sell their interests. In a tax equity transaction, sponsors can sell their project interests and trigger only a recapture of the portion of the ITC they are entitled to – typically only 1%. As such, investors concerned with near-term liquidity may need to re-think if credit transfers are right for them.
Since PTCs are earned on an as-generated basis, the primary risk for PTC deals will be actual energy production. Like energy off-takers, credit buyers may desire projects they contract with provide some level of production guarantee to ensure they are able to buy a minimum quantity of credits for tax planning purposes.
One thing that likely won’t change much between tax equity and credit transfer deals is the level and cost of diligence. Like tax equity investors, credit buyers will need to complete comprehensive due diligence to ensure the projects they agree to buy from meet all required criteria to qualify for and generate their expected tax credits. Lenders relying on credit sale proceeds for debt service payments will also need to understand the credit-related risks far better than they would in a tax equity deal where they are largely sheltered from any tax impacts. The costs of legal and technical advisors may be passed along to credit sellers.
It’s important to include the costs of guarantees, insurance, diligence, and any other risk mitigation strategies in your financial model when evaluating your tax equity and transfer options.
Mission: Impossible – FMV Step-Up
(I know. It’s a reach.)
One more consideration – specific to projects electing the ITC – is the matter of fair market value (FMV). In tax equity transactions, developer-sponsors typically sell the project to a partnership SPV. That sale can result in a “step-up” in the FMV of the project above its cost to build, often on the order of 20 to 30 percent. Since the value of the ITC is determined based on the value of the project, FMV step-ups create a proportional increase in ITC quantum.
Without the need for a tax equity partnership, sponsors taking the transferability route are unlikely to be able to effectuate an FMV step-up, reducing the potential ITC value a project can earn. The impact of this “lost” value will need to be considered when evaluating credit transfer options.
While credit transfer strategies and structures are just beginning to evolve, solutions to the FMV dilemma may be on the horizon. For example, sponsors could opt for a tax equity “lite” structure which incorporates a partner aiming to monetize only a project’s tax losses and some small portion (if any) of its tax credits. A sale of the project into that partnership might enable an FMV step-up while still allowing for all or most of the credits generated to be sold to third parties.
We’ll have more thoughts on the tax equity “lite” approach and other transferability considerations soon! For now, make sure to consult your tax advisors to ensure any structure you choose won’t run afoul of IRS regulations.
“I want the truth!”
So: will tax equity or transferability deliver the most combined upfront proceeds from investment partners and best returns? For most parties without tax capacity, it’s likely that tax equity partnerships will still offer superior IRRs due to the inability to sell depreciation benefits via transferability. But only your financial model can answer that question for sure!
A well-designed financial model utilizing the best practices taught by Pivotal180 can compare multiple scenarios and enable sponsors to make the best financing decisions for their projects. Check out the links below to learn how we can help you make All the Right Moves when it comes to project finance modeling for renewable energy and infrastructure investments:
- Financial Modeling and Support
- Project finance and infrastructure financial modeling
- Renewable energy project finance modeling
- Tax equity modeling
- Introduction to Battery Storage