Tax equity: Earn amazing risk-free returns with this one weird trick!

By Matt Davis | February 13, 2024

Tax equity: Earn amazing risk-free returns with this one weird trick!

“No risk, no reward.”

It’s a common expression, known the world over. Without taking risks, one can never expect to reap real rewards. And as a corollary, of course, the biggest risks offer opportunities for the greatest rewards.

Even a first-year university undergraduate struggling through a Finance 101 course can explain the risk-return tradeoff at the core of investing. Investors can only hope to achieve high returns if they are willing to accept a reasonable probability of losses. Investments with virtually zero chance of loss – U.S. Treasury bills are the typical example – provide returns equal to the “risk-free rate.”

As of February 2024, the 10-year U.S. Treasury bill rate sits around 4.15% per annum. According to the risk-return tradeoff, nobody can achieve consistently better returns than that without taking at least some risk.

But what if there was another, better risk-free rate: a way to earn excess returns – two-to-three times the risk-free rate or more! – with almost no chance of loss? “Impossible!” you say? Well, according to a recent report by the American Council on Renewable Energy (ACORE), such a mythical investment class does exist. Its name? Tax equity.

Wow – that sounds amazing! I want in! Just one question: what is tax equity?

Over the past two decades, the U.S. Federal government has largely incentivized development of new clean energy resources via two key mechanisms: (1) tax credits and, to a lesser extent, (2) accelerated depreciation. Tax credits provide a dollar-for-dollar reduction of tax due to owners of certain renewable energy assets. Accelerated depreciation reduces asset owners’ taxable income, thereby decreasing the tax they owe by a factor of their tax rate (e.g. a $1 reduction in taxable income equals a $0.21 reduction in tax payable at a 21% tax rate).

Combined, tax credits and depreciation typically account for a substantial proportion of the economic benefits of clean energy projects!

There’s just one problem: most developers of and investors in solar, wind and other low-carbon energy assets don’t owe much (or any) tax! Credits and losses can’t reduce a company’s tax liability below zero – the IRS issues refunds, but they don’t pay back more than they’ve received. On their own, developers would be stuck with credits and losses and they couldn’t use, wasting substantial value.

Enter tax equity. As a very smart and handsome Director at Pivotal180 described it late last year:

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.

Put more simply, tax equity investors owe lots of taxes and co-invest in renewable energy projects with partners who don’t owe (much) tax. The tax equity partner takes most of the tax benefits from the project and leaves most of the cash to the other partner.

Got it – they make equity investments in renewable energy projects. Doesn’t that come with risks?

Normally, yes. Renewable energy assets are subject to a number of risks: lower-than-expected generation, power price fluctuation, increased operating expenses and construction cost overruns, just to name a few. But those risks are mainly for regular investors – sponsor equity and debt – to worry about. Tax equity – or “TE,” for short – is special.

How special? Well, to start with, TE is senior not only to the sponsor’s “regular” equity, but also (in almost all cases) to debt! This arrangement, where an equity partner’s claim to distributions from the project is senior to that of project lenders, is known as “back-leverage” and is unique to U.S. renewables with TE partnerships. Almost nowhere else in the world does an equity investor get paid before the lenders!

Where a lender’s interest would ordinarily be secured by a lien on the project company’s assets and cashflows, when TE gets involved, lenders have to settle for just the sponsor’s equity interest in the project cashflows as collateral. Tax equity gets paid first, with remaining cashflows going to the sponsor, and only those reduced cashflows then used for debt service. If the project underperforms, TE is the last to feel the pain, and only the most extreme (and least likely) downside scenarios eat into their distributions. Underperformance might cause a loan default, but even then a lender can only step into the sponsor’s interest in the project partnership, not take over the assets themselves.

On top of that, TE’s investment is usually structured to earn them a fixed return by a certain date – typically 6-8 years for ITC deals and around 10 years for PTC transactions. If TE fails to achieve that return by the target date, they simply “sweep” cash – taking most or all of project cashflows – until they reach their desired IRR. In that event, equity (and their back-leverage lender) is left with little-to-no cash until TE finally hits their hurdle rate. Ouch!

Tax equity’s investment is further de-risked by a number of other factors:

  • High credit “offtaker”: Project sponsors derive most of their cashflows and returns from selling energy, often via a power purchase agreement (PPA). The creditworthiness of PPA offtakers may range from investment grade to unrated. The majority of TE’s value, on the other hand, comes from tax credits – ITCs or PTCs – which are granted by the U.S. Federal government. That’s the highest-credit – and, consequently, lowest-risk – “offtake” any investor could hope for.
  • Short investment horizon: As mentioned above, typical TE partnerships are structured to deliver a target return to the TE investor within a limited time. After that, TE expects to exit the partnership via a sponsor buyout. While solar and wind projects deliver returns to equity investors over their full useful lives of 30+ years, TE earns its return much more quickly and is sheltered from longer-term operating risks. This impact is most pronounced for projects electing the ITC. On those deals, TE invests just before a project is placed in service (tax equity does not take construction risk!), then receives 99% of the ITC – returning 80% or more of their investment – within a few months!
  • Cash/tax performance hedge: Though it varies by deal, a common partnership structure might allocate 99% of income and tax credits and 20% of cashflows to the TE investor. That sharing mix largely insulates TE’s return (particularly in ITC deals) from variance in project performance. If a project generates more cash and income than expected, TE’s extra cash is offset by a similar reduction in tax benefits. In the case of underperformance, they get less cash but more tax losses and benefits.

That sounds pretty safe! Aren’t there any risks to tax equity investors?

In fact, there are really only two key risks that tax equity faces, both related to the tax credits that provide the majority of their return. The first is recapture risk. Specific to ITC projects, ITCs are “recaptured,” or paid back to the IRS, on a pro rata basis (20% per year) if a project is abandoned, destroyed or changes ownership within five years of being placed in service. But recapture is exceedingly rare. Of the investors surveyed by ACORE for their report, more than half had never seen a recapture event. The fraction that had were minimally impacted: recapture hit less than 1% of their overall portfolio, and even those investments still provided positive returns.

PTC projects are not subject to recapture risk but do possess some performance risk as PTCs are earned based on actual energy generation. Still, TE mitigates this risk by deferring up to 25% of their investment and paying it out based on actual PTCs earned, a structure known as “PAYGO.” And even if poor performance causes TE to miss their hurdle rate by the target date, they’ll get there eventually by sweeping cash.

In short: tax equity earns a senior, fixed return and almost can’t lose!

Not bad. What kind of returns can TE really earn while taking so little risk?

Pretty great ones! ACORE surveyed banks that made approximately $70 billion in renewable energy tax equity investments from 2018 through 2023, more than two-thirds of the total market over that time. The results of that survey, per ACORE, “show that investments in both PTC and ITC projects overwhelmingly yield positive returns and demonstrate resilience to key financing risks.”

What does “overwhelmingly positive” mean? For PTC deals, survey respondents reported a median after-tax return of 7.5% on investments they’ve exited, and a comparable 7.4% expected after-tax return on current investments. Top quartile returns ranged from about 14% to 18% on exited PTC deals. Only two investors experienced slightly negative returns (-0.2% or better) on any investments, less than 1% of their total book.

Not positively overwhelming enough for you? Then you might prefer ITC deals. Tax equity investments in exited ITC deals returned a median 13% after-tax, with a top quartile of between around 22% to 24%. Expected returns on active investments are only slightly lower, at a median of 9.8% and a top quartile of about 15% to 16%. The absolute worst TE investment in an ITC deal – exited or current – was expected to yield a 6.8% after-tax IRR.

Check out the full report for more detail but be forewarned: exposure to such unprecedent risk-free return data can lead to injuries sustained from rapid collisions between your palm and forehead.

That doesn’t… I mean… How? Why?

Back to Finance 101. The fact is, TE investors can earn these returns while taking almost no risk because – historically, at least – supply has been short. There simply are not many companies that possess the combination of taxable income AND expertise to make these investment. Tax equity structuring is complicated, and the accounting rules even more so. That’s resulted in a handful of big banks providing the vast majority of TE financing since its inception. On top of that, renewable tax credit legislation has been at risk of expiring multiple times over the years, largely dissuading new entrants from setting up shop for fear of missing the window to invest.

The IRA should help. By extending tax credits for clean energy technologies by a decade, 2023’s landmark bill has provided confidence that ITCs, PTCs and other credits will be around for a while. That’s already leading to new players – from banks to non-financial institutions – exploring TE investments. And that’s a good thing, because even with new investors jumping on board, the IRA is likely to spur growth in new project development that far outpaces the increase in tax equity supply.

I’m all in. How can I get some of that sweet, sweet tax equity return?

Unless you have millions or billions of dollars in tax liabilities to offset, it’s unlikely that you’ll be making tax equity investments yourself. But as we’ve noted, the tax equity market is growing. Companies setting up new practices and growing existing ones will need to hire. And just as organizations that understand and can execute TE deals are rare, so too are individuals that know the ins and outs of modeling and transacting in the space.

The upshot: understanding tax equity can give you the edge to grow in your career and snare the clean energy project finance role you’re dreaming of. Pivotal180’s world-class, intensive Tax Equity Modeling course enables our students to:

  • recognize drivers and structure of tax equity transactions
  • gain detailed knowledge of tax equity calculations including tax equity investment sizing, s704(b) capital accounts, outside basis, sponsor buyouts, and more
  • understand changes to tax credit structures and laws under the IRA, including credit transfer and hybrid tax equity structures
  • build and review tax equity financial models used to execute transactions.

Check out the links below to learn more about Pivotal180 including all of our financial modeling courses and services. Come model with us!


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Matt Davis

Complexity simplified.

Advisory, financial modeling, and training courses within climate change, sustainable finance, renewable energy, and infrastructure.
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