The Essence of Tax Equity (Part One in a Series)

In Brief

How do we finance trillions in infrastructure in time to fulfill net zero pledges? 

A device called tax equity accounts for a growing share of project finance in the United States. How does it work? 

In a four-part series, our writers trace tax equity's history, rationale, and future. 

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In 2021, tax equity investments in the renewable energy industry reached an estimated $19-20 billion in the United States (compared to $105 billion invested in the renewable energy sector). This article series aims to explain what exactly tax equity is, its history, and its current impact on the renewable energy industry in the United States.

Renewable Energy Tax Credits, explained

To explain tax equity, it is first important to understand tax credits. The federal government created tax credits to incentivize and facilitate investments into the renewable energy sector. In the U.S., there are two main tax credit structures used for renewable energy projects. These are the Investment Tax Credit (ITC), an up-front credit awarded based on the total capital expenses required to build a particular project, and the Production Tax Credit (PTC), a credit awarded over time based on a project’s annual energy production. Traditionally, the ITC is most commonly used for solar projects while the PTC is used for wind projects.

The ITC and PTC were first introduced into the U.S. renewable energy market with the passing of the Energy Policy Act of 2005. Since then, the exact amount that investors will receive in tax credits for their projects has varied over time across numerous extensions. As an example, the current phase-out schedule for the ITC is depicted below: 

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Table 1. Current ITC rate schedule (Source: Congressional Research Service)

For example, a solar project that began construction from 2019 to 2021 would be eligible for the full 30% ITC and the developer would receive this amount during the first year of the project’s operation. If a project were to start construction in 2022, however, the ITC rate would drop to 26%. Under the current rate schedule, the ITC will “expire” for all solar projects starting construction in 2024; projects built from this time onward will only receive the permanent 10% ITC unless Congress passes legislation that extends this phase-out schedule (as has happened numerous times in the past).

What, then, is Tax Equity and why do we need it?

Tax equity occurs when one party (usually a large corporation with a relatively large balance sheet) acquires a project’s tax benefits from the developer (usually a much smaller company) in exchange for a cash investment in the project. In the past, tax equity deals were prevalent in the industrials and transportation sector. However, since the introduction of ITC and PTC, the majority of tax equity deals have been focused on the renewable sector.

To illustrate the need for tax equity investments in the renewable energy industry, consider a hypothetical solar project with the following specifications: 

Project Assumptions 

Project Location 

Sonoran Desert, AZ (Zip Code 85377) 

Project Size (MWDC) 

100 

Project Installed Cost, $/WDC 

$1.03 

Project CapEx (cost to build) 

$103MM 

Investment Tax Credit (ITC) Rate, 2022 

26% 

Tax Credit Amount (26% of $103MM) 

~$27MM 

Power Purchase Agreement (PPA) Price, $/kWh 

$0.06 

Annual Energy Production, kWh (Source: NREL) 

170,674,576 

Estimated Annual Revenue (Year one) 

$10.2MM 

Project life (years

20 

Financial Assumptions 

Equity Allocation (From developer/owner) 

20% 

Debt Allocation 

40% 

Tax Equity Allocation 

40%

Table 2. Project data for hypothetical solar project

As noted in the table above, this project shows great promise to a utility-scale developer. Located in an area with high levels of sunlight, a starting revenue of $10.2MM, and a competitive installed cost of $1.03/W, this project could have a levered internal rate of return (IRR) of about 20%. In other words, this is a very attractive investment to many lenders! However, issues arise for this project’s developer regarding the use of the $27 million ITC for this project.

As a small, privately held company, the developer for this solar project very likely does not have enough taxable income, or “tax appetite”, to efficiently utilize the $27MM tax credit. This is especially true during the first five years of the project’s life, when a project will have a negative taxable income under (also intricate but separate) accounting rules. When a company has more tax credits on-hand than taxes owed, the remaining balance will simply carry forward year after year until the tax credit is exhausted. For our example, using the full $27MM ITC internally as a “self-sheltering” taxpayer could take almost the entire 20-year life of the project. This is a cause for great concern to developers simply because a $27 million tax credit that slowly pays out over the course of 20 years is much less valuable than a $27MM cash payment today.

As a result of the economic inefficiencies from the current tax incentive structure, the tax equity industry has emerged as a solution. A tax equity investor, typically a large institutional bank like J.P. Morgan, can solve this time value of money problem for renewable energy developers. In exchange for putting upfront cash in the project (in this case, at least $27 million), the tax equity investors can receive the tax credits and tax losses from the project and use those to offset taxes elsewhere in their business.

How did we get here? A brief history of Tax Equity

The inspiration for the current tax incentive framework for renewable energy projects in the United States most likely came from the observed success of government-led incentive programs for renewable energy deployment in Europe, namely a mechanism known as a Feed-in Tariff (FiT). In an FiT, governments set electricity prices for renewable energy at a percentage of the going retail rate, essentially forcing renewables to be cheaper than their fossil-based competitors . Germany’s FiT stands out as the most notable example of this; renewable energy capacity in the country grew from 6.6% of total generation in 2000 to 33.3% in 2017, in no small part due to the FiT.

However, since the U.S. government leaves electricity prices to state-level Public Utility Commissions), an FiT is not a feasible federal policy tool. So the U.S. chose to levy the tax system to incentivize growth of renewable energy in the country by enacting the ITC and PTC starting in 2005.

The impact of overreliance on the clean energy industry

As we will discuss later in this series, tax equity presents challenges for the clean energy industry for a number of reasons:

1) There is a limited supply of tax equity dollars. Due to the specialized nature of tax equity investment transactions, there is a high barrier to entry for potential competitors in this space. As a result, J.P. Morgan and Bank of America, accounted for about half the tax equity market in 2019 alone.

2) The need for tax equity creates a broader social equity issue.  The instruments heavily favor larger, less-risky projects who are able to successfully navigate (and afford) the process. Consequently, homeowners and smaller-scale projects are more likely to struggle to take advantage of these federal subsidies.

3) The tax equity market for new energy technologies is lacking. The ITC and PTC have been used almost exclusively for wind and solar projects, while other clean energy sectors such as (CCS), are having a much more difficult time acquiring tax equity investments.

In our next article, we will discuss the mechanics of tax equity transactions to explain exactly how this process works. 

 

 

 

 

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