TODAY’S STUDY: NEW ENERGY AFTER ARRA

The return – and returns – of tax equity for US renewable projects
21 November 2011 (Bloomberg New energy Finance)

Tax credits are likely to again become the most important subsidies supporting renewable project development in the US, as the Treasury cash grant is on the verge of expiring. This report, commissioned by Reznick Group and undertaken by Bloomberg New Energy Finance, depicts the outlook for US renewable financing in 2012 and delves into the economics of tax equity, focusing on the applications and comparative advantages of the various tax equity structures.

● 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 programme in 2009 saved the industry from another drop, but that programme is due to expire at the end of 2011.

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● Alternative sources of tax equity may need to emerge to meet market demand for project finance. Bloomberg New Energy Finance estimates that the US wind industry alone will require about $2.4bn of third-party tax equity financing in 2012 to achieve our projected wind build targets in the coming years. Incorporating other renewable generation sectors, the total tax equity financing need could be more than $7bn. That requirement exceeds the investment appetite of the established tax equity providers, according to a clean energy trade group. Yet 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 could narrow the gap between demand and supply.

● There is life after the cash grant. Despite tax equity’s complexity and valid concerns about the depth of the market, tax equity economics can deliver meaningful returns to developers and investors, and there remains political support for this policy.

● 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 the structure thus requires no 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.

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● 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.

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INTRODUCTION

For the past three years, the US renewable sector has enjoyed the benefits of the Treasury cash grant, an incentive that entitles project developers to receive 30% of a project’s capital cost in the form of cash. This incentive is on the verge of expiring. When it does, tax equity – an incentive that drove much of the sector’s growth over the past decade – will re-emerge as the dominant form of federal support for development of wind, solar, geothermal, and biomass projects.

Tax equity is complex. It is more complex than other renewable-promoting policies such as the feed-in tariff incentives that are popular throughout Europe and the clean energy tenders available in some developing world countries. It usually involves multiple parties (developers, sponsors, investors, and sometimes lenders), switches of ownership midway through project lifetimes, legal arrangements to facilitate these instances of shared or swapped ownership, and a sophisticated understanding of the US tax code.

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However, despite this complexity, the system works. Annual US wind installations grew by more than 300% year-over-year the last two times that the tax equity incentive mechanism was extended by Congress, and developers and investors have both realised attractive returns in the past for projects funded partially through tax equity (provided the projects’ capital costs and power purchase agreement, or PPA, terms were reasonable).

This report delves into the economics of tax equity, focusing on the applications and comparative advantages of the various tax equity structures. It was undertaken by Bloomberg New Energy Finance and commissioned by Reznick Group – a national accounting, tax, and business advisory firm…

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STRUCTURES

Overview of tax equity structures

The US renewable industry has produced a variety of tax equity structures to accommodate the accounting rules applicable to tax equity and the distinct preferences of investors versus developers. Broadly, the important parameters that distinguish the different types of structure are:

• ITC vs. PTC: most structures allow the participating parties (developer, investor) to elect either the ITC or PTC. One structure (‘inverted lease’) actually only allows the former because of the way the accounting treatment works for credits that are ‘passed through’. The project’s technology may also limit this choice: the ITC is only available to wind projects through 2012, and the PTC is not applicable for solar.

• Primary project owner: part of the complexity behind tax equity structures is the dual presence of the developer and the tax equity investor. Often, these are distinct parties. The reason that most tax equity structures involve these two types of party is that many developers cannot make use of the full incentives behind tax credits (because their tax liabilities are not substantial enough). Furthermore, tax rules generally stipulate that a party meet certain ownership credentials to qualify for the tax credit incentive. Some structures, such as the ‘partnership flip’, feature the investor as the owner, at least in the initial years of the project; other structures, such as the ‘inverted lease’, feature the developer as the owner. In the case of the ‘sale leaseback’, the developer initially owns the project but sells the ownership to the investor at the project’s inception.

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• Nature of benefits ‘switch’: in many of these structures, the investor receives the bulk of the project benefits (eg, cash flows, tax credits) until midway through the project lifetime, at which point the benefits revert to the developer. In the case of the 5-year ‘partnership flip’ and the ‘inverted lease’, the benefits switch at the flip date or at the call date (sale date), respectively. In the case of the ‘sale leaseback’, the switch may occur when the ‘early buyout’ option is exercised.

• Leverage: the performance of tax equity projects can often be enhanced with debt. Debt can come in the form of lending to the project vehicle itself, or, in the case of ‘back leverage’, to the developer involved in the project.

Although these are the major parameters, there exist multitudes of variations to these structures – for example, the timing of the partnership flip can be contingent on a target IRR rather than on a specific time period; or debt can be tied to cash flows or tax credits.
The section below dives into the three primary structures employed in the industry, and the Appendix gives a high-level view of three other structures. Most of these structures could be deployed with either the ITC or PTC.

Three primary structures…Partnership flip…Sale leaseback…Inverted lease…Comparative advantages…Table 2…

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DISCUSSION OF RESULTS

The set of analyses about the various tax equity structures presented above yields insights that can serve as guidelines for potential tax equity project participants – developers and investors alike:

• Tax equity works. For relatively good projects (eg, 30% capacity factor and $1.73m/MW capex for wind, 15% capacity factor and $3.03m/MW capex for solar), returns from tax equity projects can be attractive for both developers and investors.

• Size matters. An important concern about tax equity is its limitations for small projects (eg, solar assets under 5MW). The fixed costs of employing tax equity are relatively large (compared to structures such as cash grant or feed-in tariff models) and require economies of scale; many banks usually do not even consider applying tax equity below some threshold on the order of $30m. However, there have been some developments in the US financing arena that may fill this gap – for example, the bundling of small projects to create a sizable enough ‘portfolio’ to attract investor interest.

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• Investor and developer return profiles differ. Our base-case analysis shows developers achieving returns of 6-19% for wind and 13-36% for solar depending on the structure, whereas IRRs for investors can be as high as nearly 50% for wind and solar. Far from suggesting that developers do poorly and investors profit extravagantly, these results instead highlight the very different cash-flow profiles of the two parties – investors often put in significant equity but can very quickly recoup the investment under some structures (ie, in the form of the ITC), while developers, under most structures, earn their returns over the long haul. These results also suggest that IRR is not the only metric worth evaluating.

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• NPV and IRR analyses yield different answers to the optimisation question. This is especially true for tax equity investors. For wind projects, for example, the 10-year partnership flip with the ITC has a 17% IRR and an NPV of $12.7m while the 10-year partnership flip structure with the PTC has a higher NPV ($15.8m) while yielding only 13% in IRR. Again, this discrepancy arises from the variability in the stream of cash flows delivered under the different types of structure.

• The choice of ITC versus PTC comes down to three ‘P’s: performance, perspective, and priorities.

– Performance: all else equal, the higher the capacity factor, the more advantageous the PTC option becomes, as this credit is linked to production. (By the same token, projects with low production but high capex are ideal for ITC election.)

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– Perspective: investors almost always prefer the ITC on an IRR basis and the PTC on an NPV basis. For developers, on the other hand, this choice depends on the structure and the project quality (Figure 11, Figure 13, and Figure 15).

– Priority: for investors and developers, the choice of ITC versus PTC is often contingent on which financial metric is prized more, project value or project returns. For instance, on an IRR basis, investors would prefer the ITC while on an NPV basis, they would prefer the PTC due to reasons discussed in Section 5.2.

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• Structures outside of the partnership flip accommodate other preferences. The flip is probably the most well-known tax equity structure, but the other two primary structures studied have unique advantages. For example, the sale leaseback structure is ideal for developers with limited cash on hand or with costly projects, as it calls for minimal upfront investment. In contrast the inverted lease structure is suitable for investors which are sceptical about project performance as it spares them from primary project ownership and, paradoxically, allows them to benefit if significant losses are incurred.

• Structure selection may evolve into a tug of war... There is a degree of anti-symmetry to the charts that compare investor versus developer preferences. For example, the left-hand maps (capacity factors vs. capex) in Figure 16 and Figure 17 are relative opposites: one shows the investor choosing the 5-year partnership flip with ITC for an especially poor project (high capex, low capacity factor) while the developer would choose a sale leaseback with ITC for that same project. Similar results are true for the base case: the optimal structure on an NPV basis is a sale leaseback with ITC for the developer ($27.4m) and the 5-year partnership flip with ITC for the investor ($16.5m). These examples highlight the trade-off in value between the two parties: one party takes a larger slice of the pie at the expense of the other. Final structure selection may have much to do with relative bargaining power.

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• ...and the war is far from done even once the structure has been chosen. Even with structure selection, there are points of contention that would drive value from one party to another. The analyses in Section 5.5 show that project returns and profitability are highly sensitive to negotiated parameters such as: syndication rates on the partnership flip and inverted lease, terms of the early buyout price on the sale leaseback, and investor portion of loss allocation on the inverted lease. For example, a reduction in the syndication rate from 1.3x to 1.2x increases IRRs from 49% to 68% for the partnership flip structure.

• Numbers don’t tell the entire story. Our optimisation maps in Section 5 are based purely on quantitative comparisons: the structure with the highest IRR or NPV for a given scenario was awarded the place of privilege on the map. Yet there are reasons why companies may choose one structure over another, independent of financials. For example: a tax equity investor may especially prize the value of MACRS and tax losses; the investor may wish to avoid the PTC if there is insufficient certainty about the company’s long-term tax liabilities; or the investor may wish to avoid the ITC if it comes in too large a chunk to be useful (ie, the size of the ITC in a given year for a large project swallows up all of the investor’s tax equity appetite in that year). Developers or investors may not be inclined to tackle structures that are relatively more complex (eg, inverted lease) than others (eg, sale leaseback). Other examples of ‘non-quantitative’ considerations abound. Perhaps the most telling one has to do with the ‘tug of war’ conclusion above: the final structure selection may not be the ideal structure from the perspective of either the developer or the investor, but it is the structure that gets the deal done – the compromise, in other words.

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• There’s life after the cash grant. Tax equity is more complex than cash grant-based financing, and it requires all but a handful of developers to seek third-party participation to absorb the tax equity incentives. Additionally, there are valid concerns that the supply of tax equity financing from established providers will not be sufficient to sustain year-on-year growth for the renewable sector in the US.

Nevertheless, this analysis has shown that tax equity economics can work for the right projects. Returns for investors and developers can be meaningful. The ITC for solar looks to be securely in place through 2016, and the PTC for wind through the end of 2012 – with a decent chance of being extended. Google has been among the rare ‘corporates’ to have entered the tax equity field; while other non-financial companies have been reluctant to participate, the entrance of even a few big players could substantially and quickly amplify tax equity supply. Financing for the US renewable sector will look quite different in 2012 compared to the past three years, but different does not mean dead…