US PTC TAX CREDIT
This is an extract from our tax equity modeling course.
In this lesson, we’re going to focus on renewable energy tax credits, something which is unique to the US market.
As a way of encouraging the rapid deployment of clean energy, most countries have historically provided cash-based incentives for renewable energy and this has commonly taken the form of government mandated feed-in tariffs, which are essentially PPA prices with enough subsidy to make the project economics attractive for private investors.
But in the United States, the power to approve utility PPA prices typically rests with a public utilities commission in each state, and the United States Congress doesn’t have the authority to enact PPA pricing in 50 different states. So, instead, they opted for a federal tax credit because Congress ultimately controls US tax policy.
The production tax credit, often abbreviated as PTC, is the predominant tax incentive for wind projects in the US, and it’s available for the first 10 years after the wind farm is placed in service, but unlike depreciation, which is an expense that reduces our taxable earnings, tax credits directly offset our taxes due. So at a 21% federal tax rate, one dollar of depreciation would reduce our tax bill by 21 cents. However, one dollar of tax credit would reduce our tax bill by a full dollar. The credit, as of the 31st of December, 2019, was worth 2.5 cents per kilowatt of electricity that is generated.
The credit was introduced back in 1993 as 1.5 cents per kilowatt hour and every year since then, the Internal Revenue Service has released a bulletin with the amount of inflation to be applied. As of 2019, this inflation has cumulated to bring us up to the 2.5 cents. The production tax credit can be carried forward for 20 years into the future, and then also one year back. So just like net operating losses, you can accrue tax credits and use the benefit later. And the PTC is being phased out.
If your project started construction in calendar year 2017, that PTC amount is 20% less than 2.5 cents per kilowatt hour. Instead, you would receive 80% of that at 2 cents per kilowatt hour. If you started in 2018, it’s 40% less than 2.5 cents per kilowatt hour, and in 2019, 60% less. Until the December 2019 Tax Extenders Bill, the PTC was fully phased out for projects starting construction in 2020, this year. But the recent Tax Extenders Bill allows projects that start construction this year, in 2020, to receive 60% of the full PTC value, or 1.5 cents per kilowatt hour. But then, fully phased out the credit for projects that start beyond 2020, from 2021 and beyond. And as a result of this step-down in PTC, there’s been this rush to start construction as soon as possible, in order to maximize the tax credit. And given this rush, one point of clarification required was the rules around when construction started.
In order to be eligible for the full PTC, a project needed to have begun construction by December 31st, 2016, but many projects commissioned in 2019 and 2020 started construction before December 2016, such that they could receive the full credit. What is odd here is that most projects commissioned at the end of 2019 actually started construction in 2016. So these projects with 2019 COD dates, or commercial operation dates, are receiving the full PTC amount without any phase-out. It doesn’t usually take three years to build a wind farm, so what’s really going on here?
It’s largely because of some guidance published by the IRS. The guidelines establish two methods for determining the start of construction date. There is what’s known as a physical work test, which means that the project has begun what’s known as work of a significant nature, and this can mean a lot of different things, including excavation for the foundation, or setting anchor bolts into the ground, or pouring concrete pads. Or it might be physical work on a custom designed, step-up power transformer for the project, or even the construction of roads that are critical for the project on site.
But if your project isn’t ready for physical work, there’s a second way that you can use to establish the start of construction date. You can meet what’s known as a safe harbor test by incurring 5% or more of the total cost of the facility. And you actually don’t have to pay the 5%, you just have to commit to paying it. So signing a binding purchase contract for wind turbines is enough to meet the standard.
But our work doesn’t stop here, so to speak. It’s not enough just to start construction. You can’t just pour a foundation, or build some roads and then wait 20 years before you start generating energy. The IRS imposes a continuous construction test, if you’re doing physical work, or a continuous efforts test, if you’ve opted for the 5% safe harbor. But it’s really hard to define what is continuous. Like, do I have to demonstrate that I’m working on weekends and holidays, or can I take a break for a few months? Or how about a break for a few years? And investors were really worried about this, and so the IRS issued guidelines establishing a continuity safe harbor rule, and this says that you will be deemed to have engaged in continuous efforts provided that the project is built within four calendar years after the start of construction.
So, just in case you’re wondering, it’s safe to assume that developers have started construction on a lot of projects over the past several years. So even though the PTC is already gone for projects that start construction after the end of 2019, investors will be receiving tax credits for projects that achieved COD well into 2023.
-The most important thing to remember about the PTC is that it is production-based. It’s quantified in terms of cents per kilowatt hour. The amount of tax credit you receive is a direct correlation to the amount of electricity that you generate. If you produce less than planned, well, the actual tax credit would also be less, and vice versa.