Unless the private sector steps into the breach with substantial new investment, project development will slow.
With electricity demand weak and stimulus funds dwindling, the US renewable energy sector must attract new investors and make use of unique tax-based financing structures in the next 18 months or risk a sharp drop in new project builds, according to new research by specialist research firm Bloomberg New Energy Finance commissioned by Reznick Group.
The clean energy industry in the US has been a major beneficiary of public support from the American Recovery and Reinvestment Act in the form of over $65bn in tax credits, grants, and soft loans. But nearly all of those stimulus funds have now been deployed. Unless the private sector steps into the breach with substantial new investment, project development will slow.
Bloomberg New Energy Finance, a research firm specializing in clean energy, water, power, and carbon markets, has worked with Reznick Group, a national accounting, tax, and business advisory firm, to explore where the US renewable energy financing market stands today and where it is may go from this critical juncture. It also explains how tax-based financing structures work and appraises their economics. The resulting report, “The return – and returns – of tax equity for US renewable projects”, can be downloaded here.
With a cash-based incentive which was part of the US stimulus program due to expire at the end of 2011, tax credits are likely to again become the most important federal subsidies supporting renewable project development in the US. These incentives propelled the sector’s growth for much of the past decade, particularly in the run-up to the financial crisis. The report delivers two major findings about tax credits: first, that the economics of ‘tax equity’ – the part of a renewable project’s financing structure used to take advantage of tax credits – can provide attractive returns for parties involved in these transactions; but second, that the US renewable sector will require new sources of tax equity if it is to meet market demand for project finance.
More specifically, the report draws the following conclusions about US renewable financing and the use of tax equity:
· Growth in the US renewable sector has been largely driven by the availability of tax equity or its temporary substitute in the aftermath of the financial crisis, the cash grant. Since 1999, the production tax credit has been allowed to lapse by Congress on three occasions, with each lapse resulting in a precipitous drop in new wind installations. The introduction of the Treasury cash grant program as part of the American Recovery and Reinvestment Act in 2009 saved the industry from another drop, but that program is due to expire at the end of 2011.
· Alternative sources of tax equity may need to emerge to meet market demand for project finance. The total need for tax equity financing next year could be more than $7bn. That requirement exceeds the investment appetite of established tax equity providers, according to US Partnership for Renewable Energy Finance, a clean energy trade group.
· There is a vast pool of potential incremental tax equity supply: the 500 largest public companies in the US alone paid $137bn in taxes over the past year. The participation of even a small number of these firms in the tax equity market for renewable energy could narrow the gap between demand and supply. Examples of non-financial companies which have participated in recent tax equity deals are the technology firm, Google, and the California utility, Pacific Gas & Electric. Other US companies, public or private, across any number of sectors, could follow their lead. Tax equity is also not unique to the renewable energy sector; US corporations have historically made use of these kinds of incentives in the low-income housing sector, for example.
· Expiry of the cash grant should not be expected to result in collapse of the US renewable sector. Tax equity is undoubtedly more complex than a cash-based incentive. Nevertheless, tax equity economics can deliver meaningful returns to developers and investors, and there remains political support for this policy. However, significant uncertainty will remain until Congress reaches a decision about whether or not to extend the production tax credit, currently set to expire at the end of 2012.
· The three primary tax equity structures offer distinct advantages to developers and tax equity investors. With the ‘partnership flip’ structure, the investor receives most of the project benefits until a change in ownership event – a flip – occurs. Under the second structure, sale leaseback, the developer ‘leases’ the asset from the investor and so requires much less investment upfront from the developer. Finally, in an inverted lease, the investor leases the project from the developer and enjoys the benefits associated with a ‘pass-through’ tax credit.
· The economics of these structures can be attractive. For relatively good but not necessarily exceptional renewable projects, the internal rates of return (IRR) and net present values (NPV) for most of these structures can meet hurdle rates for both developers and investors. Our base-case analysis shows developers achieving returns of 6-19% and investors achieving 10-49% for wind projects, depending on the structure. IRRs for investors reach the higher end of their ranges in the case of upfront receipt of tax benefits. The financing structures also usually present a trade-off between IRR and NPV. A structure which yields high returns (due to upfront receipt of benefits) may have a lower NPV than a structure which yields moderate returns and whose benefits are spread over a longer period.
· The choice of investment versus production tax credits (ITC vs. PTC) comes down to the three ‘P’s: performance, perspective and priorities. Very high performing projects tend to favour the PTC. The perspective – tax equity investor vs. developer – also governs the decision; for example, investors almost always prefer the ITC on an IRR basis and the PTC on an NPV basis, whereas for the developer, this choice depends on the structure and the project quality. For both investors and developers, priorities – whether NPV matters more or less than IRR, or whether other strategic considerations matter more than these financial measures – may drive the choice.
· The optimal tax equity structure depends on the project characteristics… but perfect optimisation may be a pipedream. ‘Optimisation maps’ show the ideal tax equity structure from the developer’s or tax equity investor’s perspectives for a given scenario. For example, for less high-performing projects (ie those with high capex and low capacity factors), the ideal structure may be a sale leaseback for a developer and a 5-year partnership flip for an investor. The fact that the two parties’ preferred tax equity structure usually differs highlights the trade-off in value: one party benefits at the expense of the other. Ultimately, selection of the final structure – as well as fixing the terms of variables such as ‘syndication rates’ and ‘early buyout price’ – depends on relative negotiating power.
“This analysis shows that tax equity economics can be made to work for the right projects,” said Michel Di Capua, Head of Analysis, North America, at Bloomberg New Energy Finance in New York. “There is life after expiry of the Treasury cash grant program. Financing for the US renewable sector will look quite different in 2012 compared to the past three years once the cash grant is gone, but different does not mean dead.”
“The results of the study are clear – optionality is necessary for the industry to attract more tax equity into the marketplace,” said Tim Kemper, Renewable Energy Practice Leader at Reznick Group. “It is now evident that previous assumptions about yields are not true, because not all yields are the same. There can be significant advantages in using the investment tax credit even for wind deals that exceed a 30% capacity factor. Developers will need this optionality to make sure they can maximize their returns with the right structure.”
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