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Current Challenges to Tax Equity (Part Three)

In Brief

The reasons to finance renewables look countless. 

But tax equity has remained a somewhat rare specialty. Why should that be? 

In our series' third installment, we lay out challenges to renewables' key financing source. 

When Covid-19 hit, the renewable energy industry had to confront new challenges, the effects of which continue to linger. Project development stalled, supply chains froze up, and energy demand fell. Compounding those woes, renewable energy project developers faced yet another hurdle thrown at them by the pandemic: tax equity investment was drying up. According to BNEF analysis, of the 57 gigawatts of wind and solar projects slated to begin construction in 2020 and 2021, more than 36 gigawatts were struggling or delayed in finding tax equity investment.
The economic downturn caused by the pandemic has revealed the tenuous nature of tax equity supply. When corporate profits fall, so too do corporate taxes, thus lessening the need for tax management strategies. SEIA, the industry association for the solar industry, reported that between Q2 of 2019 and Q2 of 2020, the weighted average net income among the U.S.’ four top tax equity investors fell by 74%. Several of these tax equity investors continued to expand tax equity investments in clean energy – but many others cut back on their tax equity commitments.
We can hope that Covid-19's lockdowns and supply chain freezes will mellow over time, but this dip in corporate tax-equity appetite shows developers’ vulnerability. Below, we dive into a number of the limitations of the tax equity market as it exists today.
Challenge #1: Limited Supply of Tax Equity
The supply of tax equity dollars is neither limitless nor diverse. Unlike most financial markets, characterized by intense competition with many buyers and sellers, the tax equity market is largely composed of just a few major investors. From 2020 to 2021, over 50% of the $20 billion tax equity market’s investment supply came from two large banks: JP Morgan and Bank of America. Other large players include Wells Fargo, US Bank, and Credit Suisse.
Limitations on the supply of tax equity threatens the rapid deployment of clean energy projects in the United States. Without tax equity, clean energy projects are unable to fully take advantage of federal tax incentives, and thus have worse off project economics. Without the ability to offset project costs with tax credits and receive the cash up front, developers are left with far worse alternatives, such as looking to equity investors with a higher cost of capital,  taking on more debt, or changing the project economics such as capacity or PPA price such that the project is less desirable. Doug Stiegler, a renewable energy project finance and M&A professional, described how he’s seen “many good projects fall apart because the tax equity investment wasn’t there.” 
Another result of the limited field of tax equity investors is that the cost of tax equity investment (i.e. the expected amount of benefits that tax equity investors require from a project for every dollar invested) may be higher than it needs to be. But this could change. CohnReznick, an investment bank that specializes in clean energy tax equity, observed that new entrants into the tax equity investing space in 2021 prevented the cost of tax equity capital from rising proportional to broader interest rate increases, as a result of increased competition among tax equity investors. However, as the field of clean energy development expands, this supply and demand dynamic could shift back again to further favor tax equity investors, if the supply of tax equity dollars is not able to keep up.
Why is the field of tax equity investors so limited? The answer is that potential tax equity investors need to have sufficient taxable income to want a tax break, and institutional capacity to navigate the instrument’s complexity. New entrants to tax equity would likely need to hire dedicated teams with tax equity structuring and financial modeling expertise.
One possible source of new tax equity investors are large corporates who are already supporting clean energy projects through power purchase agreements. In 2020, the 250 megawatt Taygete I Energy Project in Pecos County, Texas, received 100% of its tax equity investment from Nestle, which was also taking the project’s renewable energy credits (RECs). Amazon, Google, Patagonia, and Toyota have also served as a source of tax equity in similar clean energy project deals. As large corporations increasingly feel pressure to reduce their greenhouse gas footprint and meet climate goals, providing much needed tax equity capital to support clean energy project development may be a new way to demonstrate “additionality.” 
Whether this becomes a trend, however, remains to be seen. At a clean energy conference in April at Yale University, Bryn Baker, the Senior Director of Market and Policy Innovation at the Renewable Energy Buyers Alliance (REBA), commented that the percentage of corporate offtakers providing tax equity investment “remained in the single digits” to date.
At the same conference, Monica Opderdeck, an Assistant Vice President at Pattern Energy and former tax equity investor, commented that large corporations would need an organizational mindset shift to participate in tax equity investing. “Tax equity investments are weird – they can look like you are taking losses. You need to get the energy teams of companies to talk to their treasury groups.”

Yale Clean Energy Conference!
Limits on tax equity supply went for a going-over at our April conference.

Dan Gross, a lecturer at Yale University and Director of Amazon’s Climate Pledge Fund, further explained: “Many corporate teams evaluate their financial success at the EBITDA level… but for clean energy project investments, you need to look at an after-tax basis, which might be within the purview of a different team.”
According to CohnReznick, an emerging option for corporations looking to enter into the tax equity market is to work through aggregators or syndicates so as to outsource some of the external expertise needed to structure tax equity investments into clean energy projects.
Challenge #2: Unequal Access to Federal Tax Credit Incentives
Because tax equity deals require monetizing large tax credits that are not refundable or available in grant form, tax equity deals are far better in certain conditions than others. The result is that in the world of tax equity, big often always means better: large clean energy projects being financed by large banks being built by large developers dominate the market. The investor needs to have sufficient tax liability in order to access tax equity, which creates major barriers to entry for those with small balance sheets. 
In particular, small-scale developers, non-profit or public power providers, and developers in less wealthy areas disproportionately face challenges in a world where tax equity is a necessity for financing projects. Given that tax equity investors seek to achieve a 7 to 10 percent internal rate of return on a typical large clean energy project when monetizing investment or production tax credits, and are almost always able to do so due to the favorable structure for the tax equity investor, developers that can’t monetize tax credits in the same way are often out of luck. In fact, a 2016 study found that only 10 percent of ITC tax credits went to the bottom 60 percent of household income. 
Reliance on the tax code to incentivize renewable energy in the US makes it difficult for those who can’t claim the same level of tax deductions. Any not-for-profit organization pays no applicable taxes, while cooperatives and small businesses don’t have sufficient tax liability to be attractive to a tax equity investor. Taxable income differences aside, smaller and less wealthy developers are not able to deal with the transaction costs and legal fees involved with identifying and structuring a tax equity partnership, reducing their ability to finance projects.
Developers that receive upfront cash in the form of a grant or transfer could level the playing field for those with a smaller or larger taxable income. Historical evidence suggests that to be the case. As part of the American Recovery and Reinvestment Act after the 2008 financial crisis, the Obama administration modified section 1603 of the tax code to make the renewable energy tax credits effectively refundable. The result was an unprecedented number of projects funded, with residential solar making up the largest number of projects in absolute terms. 
Challenge #3: Limited Tax Equity Supply is a Challenge for Emerging Technologies
Tax equity investors seek out projects in proven technologies with stable cash flows and expectations of moderately high returns. That has limited the use of tax equity for less mature clean energy technologies that the tax code also incentivizes.  

Carbon capture projects, with less stable cash flows and greater inherent technology risk, present additional downside risks for tax equity investors.

Carbon capture projects, which are eligible for 45Q tax credits, have yet to see a single tax equity deal closed, according to Norton Rose Fulbright, a project finance law firm. The primary driver is the high return threshold for tax equity investors that can instead focus on getting double-digit returns for traditional solar and wind projects. Carbon capture projects, with less stable cash flows and greater inherent technology risk, present additional downside risks for tax equity investors.
The Biden administration has centered its clean energy agenda on incentivizing investments in next-generation green technologies via tax credits. The ability to finance improved transmission infrastructure, alternative fuels, offshore wind, clean hydrogen projects, and more could depend on whether project developers can monetize and sell tax credits . Especially if the solar and onshore wind tax credits wind down as a result of the Biden agenda not passing, tax equity investors are going to need to find new deals.
Tax equity’s limits have come to the forefront this past year as the Biden administration has sought to pass its clean energy investment agenda. Indeed, some advocates now  call out the tax credit system as inequitable and biased against smaller developers and smaller projects. 
A proposal to make a “direct pay” alternative to the existing federal tax credit incentives could greatly relieve the pressure on the current supply of the tax equity market. As we will further discuss in our fourth and final article, direct pay would allow developers to claim a refund on the ITC or PTC tax credits without the involvement of a tax equity investor.