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By Elias Hinckley on Jul 27, 2016 with 2 responses

Opening The Floodgates On Clean Energy Deployment In The U.S.

The biggest constraint to renewable energy growth in the US is the availability of tax equity to support project investment. There is not nearly as much tax equity investment as is needed to support financing and building all of the renewable energy projects in development – as a result the pace of project financing and construction is being severely constrained. Many new investors will begin to enter this tax equity investment space in pursuit of outsized returns with virtually no risk created by a significantly undersupplied investment market. These new tax investors will usher in a period of unprecedented growth in the construction of renewable energy projects.

The Strange Market of Tax Equity Investing

Investment in renewable energy comes from three sources. (1) Project Equity –the investment that actually owns the clean energy facility, this includes the risk of operation and the long-term value of the asset, and there are plenty of investors willing to participate as part of (or all of) this investment. (2) Debt – this is generally traditional project equity lending, and as with project equity there are plenty of lenders – big banks, small banks, private debt funds – ready to lend to all kinds of renewable energy projects. For these traditional sources of project financing project risks are increasingly well understood and, provided there is enough project revenue to cover debt repayment, this money is readily available. (3) Tax Equity – this third, and vital source of capital are investments made in the project that will be repaid primarily through tax credits and other tax savings to the tax equity investor. There simply is not currently enough tax equity to support the pace of growth in renewable power development in the U.S.

To the surprise of most people in the clean energy industry, renewable power was given long term, stable extensions of the two primary economic supports for renewable electricity generation projects when Congress approved multi-year extensions for both the Production Tax Credit (which primarily supports wind power, but can also be used for biomass, geothermal and other clean energy projects) and the Investment Tax Credit (which primarily supports solar) in December of 2015. These tax credits (as well as some other tax benefits) are the primary federal tool in place to support the development and deployment of clean energy in the U.S., and are typically the single largest incentive available to one of these projects.

While the absolute value of the tax benefits supporting a solar or wind project are substantial, actually realizing that value can be extremely challenging for the owner/developer of one of these projects. Investments in electric generating equipment are appealing because the underlying electric generating equipment has a relatively long life and these assets have historically provided relatively stable, if modest, long-term returns. The challenge with tax credit-based subsidies arises because long stable returns don’t match up well with getting fair value for the front-loaded tax incentives (the ITC is generally returned and realized in year one as a dollar for dollar reduction in taxes paid, but can be carried forward 20 years). The owner/operator of the renewable generation assets typically does not have enough income in the early years to use the tax incentives (also important to note that for many owners or investors – electric coops, municipal power companies, pension funds, etc. – there may never be an opportunity to use the tax incentives). The longer use of the credits or deductions are delayed, like any investment return, the less they are worth.

For reasons deep in the byzantine psychology of Congress, tax credits can’t technically be sold from the party that creates the right to another taxpayer that can use the credits. Despite this prohibition on sales it is widely understood that not allowing the transfer of tax credits creates huge problems (arbitrary value creation for a taxpayer vs. non-taxpayer, undermines investment in exact activity the subsidy is meant to spur, etc.), so there are actually ways to move the value of these tax benefits to a taxpayer that can use them effectively and efficiently: structured investments and shared ownership in the project where a tax investor makes an investment in exchange for the value of the tax benefits, and the capital of any other investors or lenders is returned using the cash value created by the project (cash flow or sales proceeds).

These structured tax investments used to mirror the sale of tax credits are how tax equity investments are made. If a project can’t attract a tax equity investment it is generally understood that the project is not economically viable, won’t get financed and won’t get built. In the current market many – quite likely the vast majority of – renewable energy projects in development cannot attract the necessary tax investments not because the projects are not good, economically viable projects, but simply because there is not enough tax equity in the market.

There are a very limited number of tax investors currently active in the U.S. clean energy market and as a result a very limited amount of available tax equity investment available for projects. This undersupply of these special investment dollars puts an absolute limit on how many projects can be financed and built each year—essentially an undersupply.

Outsized Returns and a Huge New Market

The undersupply of tax equity also means that the market for tax equity doesn’t operate naturally and has allowed tax investors to be far more selective and conservative in choosing projects than would happen in a fully supplied investment market. Returns are outsized to risk. Tax equity returns – these are heavily front-loaded and are typically insulated from much of the operational risk – commonly run higher than the returns for equity investors who are first in line to absorb project losses. This is exactly backwards to what would be expected in a normally operating market (and is backwards from how tax investment returns work in real estate tax investing).

With returns larger than the associated risk, it would be natural for new investors to flood the market, but that hasn’t happened. For more than a decade the renewable development industry has expected an inflow of taxpaying corporations to arrive and add liquidity to the tax equity market. New investors have been slow to the market for a few reasons. The continuity of these tax credits has been unstable because cycles of congressional infighting. This lack of stable long-term extensions has made potential investors cautious about investing in the necessary knowledge for these investments. Energy investing can be complicated. The necessary tax structuring is complicated and the related accounting is complex. Transaction costs can be high and poorly planned investments can have a short-term negative impact on reported earnings.

In 2015 U.S. corporations paid $344 billion in income taxes – total tax equity investment in the renewable power sector was reported to be $11.5 Billion. So there is plenty of investment available (there was more than $1.5 trillion in individual income tax paid during this same period, but tax investments by individuals is subject to a special set of passive loss rules make these investments extremely rare and require sophisticated professional guidance).

Long-term tax credit extensions coupled with huge growth projections for renewables has the industry again looking for an inflow of new tax investors from financial institutions and eventually a waterfall of corporate tax equity. This is starting to happen – anecdotally several new investors have emerged looking for guidance on whether to enter the market and how best to do it. The potential for several years of very strong returns on investment will help new investors overcome concerns about complexity and perceived risk.

This new inflow of tax equity will be the foundation for a huge uptick in financed and constructed renewable energy projects. As new investment comes into the market several non-core renewable energy markets, like rooftop solar for commercial and industrial buyers, corporate buyers of large utility scale renewables and projects with merchant power risk will all see easier access to project financing. Countless projects that wouldn’t otherwise get built will, unleashing a period of tremendous growth for clean energy.

There are significant rewards for those that can move fast into this tax investment market. Because of the undersupply of tax equity returns for these investments remain outsized to risk. Additionally, as more tax equity flows into the market, knowing how the transactions work will allow early entrants to better control transaction time and cost allowing these investors to find continued prosperity in an increasingly competitive market.

This article originally appeared in Power Finance and Risk.

  1. By Forrest on July 30, 2016 at 6:47 am

    Stable investment environment is critical to making the leap. Uncertainty, will undermine the funding. So, I’m sure what you post is correct per investor’s natural fear of Congress legislation and a new energy source, yet to be proven long term. Tax investments per the lucrative tax write offs and credits should provide much incentive, if not for the complexity and uncertainty of the process as you post.

    So, those entities with the highest tax burden rate will achieve the best return. The U.S. has way to much of this, what I will label cronyism. It’s the powerful gov’t politicians looking out for the wealthy. Giving them opportunities to earn more wealth, that are out of reach for those without such assets. It does frustrate me to know so much opportunities exists like this. Sure, wealth will have natural capitalistic opportunities, but it’s unattractive to me to see so much government regulated artificial environments. The U.S. has way to many billionaires and wealthy corporations that can engineer their effective tax burden rate below the middle class. For once I would love to witness regulations that help small business and middle class citizens with modest resources. This seems to be the doughnut hole of benefits. Either make less and have more kids or skip to millionaire status to hire the professionals that can fight for earnings.

    It is getting normal and popular for business to work the K Street influence game, to gain a leg up on competition. I’ve seen way to much of this, where in regulations and tax codes carve outs make winners and losers. It’s to the point of Lawyers value above that of accountants for business success.

    Small investors and general public has little of this influence. The busy middle class has no time to research the myriad choices for precious investment dollars. They have no resources to evaluate or conform to complex IRS regulations for such opportunities. The powerful work within the same rule book and have much more abilities to mastermind the maze. Complexity will always hose small business and middle class.

    Elderly, used to enjoy simple and reliable investments such as rental property or savings. Not any more. Regulations and liability have stripped them of simple rental property investment and the artificial government control of interest rates have done the same for their savings. The DIY workers whom have the least assets yet have a desire to save money are totally left out. It’s as if legislatures and regulators are jealous that they have no cost savings advantage per ineptness and thinks it’s unfair. Also, they hate that the activity is not controlled by their staff. Solar investment is a goldmine for the wealthy, but a DIY can’t save a nickle.

    • By Forrest on August 2, 2016 at 6:01 am

      You probably are flummoxed by this reasoning as personally thinking the average citizen merely needs to invest in a mutual fund to accomplish such superior investment strategy. Well, even that is a step to far for average poor or lower middle class that receive no public education on financial matters as they are instead treated to liberal indoctrination education in which this is a low priority, to be self sufficient without government control.

      I drive past the Indian casinos or the state run lottery gambling and realize if these folks had a simple way to invest such extra income in what you post their gambling would truly be a good risk and wealth generator. Shouldn’t the state work to maximize the ease for the lower class to accomplish this? Why do we regulate international corporations from the same rule books as average citizen? I understand a gaggle of lawyers need at the rich corporate level, to minimize fraud and corruption, but at the personal citizen level hardly any regulation needed. We should be empowered with magazine literature to gamble on hot picks with merely a swipe of credit card. Same for earning higher rates of interest within the personal loan market, same with renting out equipment or housing. Regulators are killing the wealth opportunities of the poor in attempts to control corporate and wealthy greed. The regulation shouldn’t even occur at this lower level. At this level it should be extremely easy, low cost, and of accurate information to maximize wealth generation of the poor. Government should work to minimize investment risk in this class.

      Unfortunately, currently, our politicians are trained to work the corporate cronyism circuit and need to pay attention to this market to get re-elected. This is a fatal flaw in our “new” political development.

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