Renewable Tax Credit Equity Market : Growing but ....Uncertain?
The Renewable Energy Tax Equity Market Shows Promise
CohnReznick’s Renewable Energy Industry Practice and CohnReznick Capital released the fifth issue of US Renewable Energy Brief. Written in collaboration with Clean Energy Pipeline, a leading independent source of news, data, and analytics of the renewable energy sector, the issue focuses on the evolving tax equity market.
Highlights of The US Renewable Energy Brief
- Robust Growth in 2016: $11bn tax equity was raised or committed in 2016. This represents $ 2 billion decrease to the amount of tax equity raised in 2015. The decrease could be because of the uncertainty regarding the renewal of Federal Tax Incentives (ITC) in 2016. Many projects were accelerated to finish in 2015.
- Acute Shortage for small sized projects: The report also highlights that there is acute shortage of tax equity for any project that is not utility-scale and does not have an investment grade sponsor and offtaker, particularly for projects in the below categories. Three different types of solar energy projects have been identified in the report that are struggling to secure tax equity
- Distributed Generation (DG) Projects: When electricity is generated at or near where it will be used, it is called distributed generation (DG). DG projects often struggle to secure tax equity because they are significantly smaller than utility-scale projects.
- Residential Solar : Large residential developers such as SolarCity, Vivint Solar, and Sunnova have secured millions of dollars of tax equity dollars during the last five years. But smaller developers struggle to raise tax equity due to the small check size.
- Merchant Projects: Merchant power plants are those that sell power into competitive wholesale markets and are financed by investors. The lack of PPAs and basis risk means the cash flows cannot be predicted and makes such projects less lucrative to the tax credit market.
"Small and mid-sized facilities are difficult to finance – not because the sponsors can’t find a sufficient number of projects, but because tax equity investors are reticent to invest their efforts to underwrite transactions with a number of different underlying projects", says Joel Cohn, CPA, Partner
How does a PPA work?
A power purchase agreement (PPA), or electricity power agreement, is a contract between two parties, one which generates electricity (the developer) and one which is looking to purchase electricity (the customer or offtaker). The developer arranges for the design, permitting, financing and installation of a solar energy system on the customer’s property at little to no cost. The developer sells the power generated to the customer at a fixed rate that is typically lower than the local utility’s retail rate.The developer, besides the income from these sales, also gets any tax credits and other incentives generated from the system. The off-takers are usually utilities and such a PPA is called a Utility PPA. Utilities are supposed to buy renewable energy from developers in the form of solar renewable energy credits (SRECs) in accordance with the Renewable Portfolio Standards (RPS) set by individual states. Off late, many corporates are taking up the role of offtakers. Then it is called a Corporate PPA.
How does Basis Risk affect?
The difference between the current market price and the future price of a commodity or an underlying asset is called basis risk. There can be a difference in electricity price at the point where electricity is injected into the grid (the bus bar) and the point where it is extracted from the grid (the local hub). In the case of a Utility PPA, the utility takes this risk, but in the case of merchant projects or Corporate PPAs, the developer is expected to bear this risk, adding an extra burden to its cash flows.
- Corporate Purchase Power Agreements (PPAs): The Energy Brief also reports that the number of projects with corporate PPAs is increasing significantly. Despite this growth, it was found that there is dearth of financing smaller corporate PPAs. Unless the offtaker is a huge corporation like Google, Amazon or Iron Mountain, the investors are not forthcoming.
Tax Credit Equity Market Explained
There are three federal incentives for businesses that invest in solar systems:
- Investment Tax Credit (ITC) – Purchasers can take a tax credit equal to 30% of their basis in a new solar system. The basis of any property is generally the property's cost.
- Bonus Depreciation – Business owners of solar systems put in place before the end of 2017 are eligible to depreciate 50% of their basis in the first year.
- Accelerated MACRS Depreciation – Businesses can depreciate solar systems using a 5-year schedule even though the useful life of a solar system is 30-35 years.
In order to take direct advantage of these incentives, a business must have a tax liability to begin with. However, if a business does not have enough tax liability to claim the entire credit in one year, it can “roll over” the remaining credits into future years for as long as the tax credit is in effect. Many solar dealers - usually referred to as 'developers' - do not have sufficient such liabilities to make use of these incentives; hence they partner with investors - 'tax equity investors' - who bring in the upfront capital for the project and in turn benefit from the incentives.
The developer then leases the system back from the investor and makes lease payments to the investor. Sometimes, the developer and tax equity investor form a joint venture partnership and also share profits, cash, and tax benefits from the installation as per the terms of a contract; and some contracts come with a 'buyout option' wherein the developer has the right to purchase the Tax Equity Investor's position after a certain number of years of operation.
How has the Investment Tax Credit Impacted the Industry?
Solar Investment Tax Credit was first started in 2005 allowing owners 30% deduction in their tax liabilities. Rumors were rife that the federal incentive will expire in 2008 and then in 2016; but both times it was extended. Following are the details of the extension in 2016.
- 2016 – 2019: The tax credit remains at 30% of the cost of the system.
- 2020: Owners of new residential and commercial solar can deduct 26% of the cost of the system from their taxes.
- 2021: Owners of new residential and commercial solar can deduct 22% of the cost of the system from their taxes.
- 2022 onwards: Owners of new commercial solar energy systems can deduct 10% of the cost of the system from their taxes. There is no federal credit for residential solar energy systems.
Since the Introduction of the ITC, the solar industry has changed radically.
- In 2016, US solar installation nearly doubled over 2015.
- According to the Solar Energy Industries Association (SEIA), there are 1.3 million solar installations across the United States, with a cumulative capacity of over 40 gigawatts - enough capacity to power 6,560,000 U.S. households in 2016.
- Since 2006, the cost to install solar has dropped by more than 70%.
- The Solar Foundation’s (TSF) annual jobs census for 2016 showed a 25% growth in employment over 2015. The industry has grown almost three hundred percent as an employer since TSF started keeping track of statistics in 2010. In 2016, 260,077 jobs were supported by the industry, as against the 93,000 in 2010.
Then, there is this situation in Washington...
According to industry pundits, President Trump's withdrawal from the Paris Convention, EPA budget cut and dissolution of the Clean Power Plan will have very little effect on the solar industry, mainly because of two reasons:
- Clean energy has become so cheap that coal does not stand a chance.
- Individual states can still take their own actions to promote sustainable energy resources.
However, the worry is now about the proposed Tax Reforms. The following tax code adjustments could impact the financing and third-party ownership of solar projects by creating less tax equity in the market.
- Reduction in the corporate income tax rate: The corporate tax rate is currently set at 35 percent, but proposed tax cuts could lower it to as much as 15 or 20%. If this were to occur, it could have a negative impact on the tax equity available in the market, as banks, utilities, and insurance companies would not be able to monetize 100% of the ITC in the first year.
- Changes to or elimination of the ITC, the Accelerated and Bonus Depreciation (MACRS)
- Implementation of the border adjustment tax (BAT): This tax would give tax breaks for exports and remove existing tax breaks for imports. If enacted, it could raise prices of solar equipment, as many a components are imported.
Despite all the uncertainties surrounding the proposed Tax Reforms, solar industry is bullish about the tax equity market for its financing.