Innovative Financing within Renewable Energy Projects: Tax Equity Financing
Overview of Tax Equity Financing and its importance to Renewable Projects
Written by Jack Wong
Table of Contents
Introduction
How does Tax Equity Financing Work?
Post-Inflation Reduction Act
New financing option for Investors? Credit transfer and Direct Pay
Introduction
In this series we will talk about the innovative ways renewable projects are going about financing its capital intensive projects. Unlike other capital intensive sectors such as Oil & Gas or Real Estate, the renewable energy sector has certain traits such as support from governments world wide for its push towards Net Carbon Zero within this century. Therefore, they have enacted laws to increase demand, funding and boost renewable projects overall. One financing solution that has grown within the last ~15 years is Tax Equity Financing. It has been present in the Real Estate Market, but its popularity has grown mostly in the renewable energy sector. As of 2022, the tax equity market was around ~20 billion invested dollars and it is expected to double and triple because fo the Inflation Act. In this article we will provide an overview of how the Inflation Reduction Act is changing the tax equity market.
Up Next in “Innovative Financing within Renewable Projects”: GSS+ Bonds
In future articles we will also shed more light on key players, issues within tax equity, supply/demand analysis etc. But for now just an overview of Tax Equity…
How does Tax Equity Financing work?
The passage of the Investment Tax Credit (ITC) and the Production Tax Credit (PTC) provided an opportunity for a unique form of financing option called Tax equity financing. Similar to other forms of financing, the use is to provide upfront payments for developers in exchange for tax credit to deduct their own liabilities. Depending on the type of project, tax equity financing funds ~20% – 50% of the projects capital, while the rest is covered by traditional forms of financing (Debt & Equity). Historically they have been funded by large banks (BoFa and JPM funded about 50% of the tax equity market. Source)
The Investment Tax Credit (ITC) and Production Tax Credit (PTC) are fundamental drivers of the widespread adoption of tax equity financing in the renewable energy sector. The appeal of tax equity financing stems from the substantial financial benefits these tax credits offer, enabling the removal of a significant portion of the overall project cost. As a result, tax equity investors are drawn to these financing opportunities due to the potential for high returns on their investments.
The Investment Tax Credit (ITC) provides a one-time credit based on the investment made in a renewable energy project. It has the potential to offset up to 30% of the total project costs. For instance, in a hypothetical project with a $10 million investment, it could result in a tax credit of up to $3 million (Pre-Inflation Reduction Act).
On the other hand, the Production Tax Credit (PTC) specifically applies to wind energy facilities, granting developers a credit of up to 2.5 cents per kilowatt-hour (KWh) of electricity generated. It is also granted on a annual basis unlike ITC where it is granted once in the lifetime of the project. To illustrate, an average onshore wind facility producing approximately 100,000 megawatt-hours (MWh) of electricity per year could generate tax credits worth $2.5 million annually (Pre-Inflation Reduction Act).
However they had to enact tax equity partnerships because most projects were not able to reap the benefits of the tax credit as they most of the time did not have sufficient tax liability for it to be effectively used. Instead, they turned to larger banks to invest who had a propensity for these tax credits while also providing upfront financing which the developer needed most.
There are 3 main structures of tax equity financing (In very very basic terms):
Partnership flips - When partnership is formed, the investor acquires typically 99% of income, loss, tax credit (investor is trying to recoup investment by gaining ITC/PTC benefits). When certain yield or operational milestone is met. Investors share drops to typically 5% while developer receives most of its profit.
Most common structure in tax equity
Inverted Lease - Company “sells” project to Investor providing upfront capital to the developer in exchange for tax credit of the project. The investor then leases the project back to the developer, at a rate generally less than the tax credit.
Provides least amount of tax credit to investors/developers
Sale Lease back - The easiest to understand. Developer signs PPA or customer contracts for system. Investor purchases system for developer which allows them to receive ITC credit. Investor leases systems back to Developer. Customer pays Developer for system.
For a more thorough explanation look here: Project Finance
Post-Inflation Reduction Act
Changes in ITC & PTC
As we know the Inflation Reduction Act was revolutionary for the renewable energy sector. As far as ITC and PTC a couple things have changed:
ITC and PTC have been extended
By fulfilling these conditions, projects become eligible for an additional 10% bonus on top of the regular tax credits. This incentivizes projects to focus on expanding the renewable energy market within the United States rather than outsourcing to other countries.
Wage and apprenticeship
Domestic Content
Energy Communities
Previously, the PTC was limited to wind projects only. However, with the changes introduced by the Inflation Reduction Act, both the ITC and PTC are becoming technology neutral. This means that the PTC can now be applied to solar projects and other projects such as CCUS as well, expanding the scope of eligible projects that can benefit from tax credits.
What does this mean?
Increased reliance on tax credits for financing: With the extension of the ITC and PTC and the introduction of bonus adders, tax credits play a more significant role in financing renewable energy projects. The availability of tax credits and bonus incentives allows developers to potentially cover a substantial portion of their project costs, reducing their dependence on traditional financing sources.
Larger market for tax equity investors: The changes in the ITC and PTC create a larger market for tax equity investors. Tax equity investors are entities that invest in renewable energy projects in exchange for tax credits. With the extension and expansion of tax credits, more projects become eligible, attracting a broader range of investors interested in utilizing tax benefits to offset their tax liabilities.
New financing option for Investors? Credit transfer and Direct Pay
The inclusion of Credit Transfer and Direct Pay provisions in the Inflation Reduction Act has introduced new financing options for investors in the clean energy sector, expanding the tax equity market.
Credit Transfer enables entities to transfer their clean energy credits to a third party in exchange for a tax-free cash payment. This provision allows for greater flexibility and liquidity, as investors can monetize their credits without having to wait for their tax liabilities to offset.
Direct Pay, also known as elective pay, is another provision that benefits local governments, non-profits, and tribal entities. It allows them to receive direct payment from the IRS in exchange for clean energy tax credits. This streamlines the process and provides more immediate financial support for these organizations.
The treasury announced that entities are prohibited from reselling tax credits, so unfortunately no trading markets could be designed at this moment. However, there are attempts at forming ecosystems around credit transferability to make it easier to buy and sell credits. Crux Climate has raised $8.85 million so far in its attempt create a market place for developers, tax credit buyers, banks etc. While no trading markets have been established yet, these initiatives aim to make the process of buying and selling credits more efficient and accessible.
Aside from PTC and ITC there are 9 other green energy tax credits available for transferability:
Section 30C credit for alternative fuel refueling property
Section 45Q carbon capture credit
Section 45U zero-emission nuclear power production credit
Section 45V clean hydrogen production credit
Section 45X advanced manufacturing production credit
Section 45Y clean electricity production credit
Section 45Z clean fuel production credit
Section 48C qualifying advanced energy project credit
Section 48E clean electricity investment credit.
Above shows range of each tax credit dollar to cash dollar (Sourced from CohnReznick Q1 '23 Newsletter)
What does this mean
Greater financing opportunities for other renewable industries – In the past, tax equity financing was primarily utilized by mature industries like solar and wind. However, as other renewable industries and technologies continue to mature, they will gain access to new tax credits, credit transferability, and direct pay. This opens up greater financing opportunities for these industries, allowing them to leverage tax equity financing to support their projects.
Greater financing opportunities for smaller projects – Previously, smaller projects faced challenges in accessing similar financing opportunities compared to larger projects. They were often overlooked due to the larger tax benefits associated with larger projects. However, with the introduction of tax credit transferability, smaller projects can now attract funding from corporations aiming to achieve Environmental, Social, and Governance (ESG) goals. This provides them with improved financing prospects.
New Investors – The ability to transfer tax credits enables smaller projects to receive funding from corporations that are interested in fulfilling their ESG objectives.
Transferability will supplement traditional Tax Equity? – Tax Equity partnerships would still remain prevalent because of the overall demand of financing. CohnReznick a leading advisor in Renewable project financing suggests that “transferability will not supplant traditional tax equity investing, but it will make it easier for developers and investors to acquire funding” (CohnReznick Capital)
Thanks for reading!