TODAY’S STUDY: THE COSTS AND BENEFITS OF SUPPORTING NEW ENERGY

An Analysis of the Costs, Btarget="_blank"enefits, and Implications of Different Approaches to Capturing the Value of Renewable Energy Tax Incentives

Mark Bolinger, May 2014 (Lawrence Berkeley National Laboratory)

Executive Summary

In the United States, Federal incentives for the deployment of wind and solar power projects are delivered primarily through the tax code, in the form of accelerated tax depreciation and tax credits that are based on either investment or production. Both wind and solar projects are equally eligible for accelerated tax depreciation, but tax credit eligibility varies by technology: solar is currently eligible for the investment tax credit (“ITC”), while wind is eligible for either the ITC or the production tax credit (“PTC”), though wind project sponsors typically choose the PTC.

For either technology, and with either the PTC or ITC, the combined value of tax deductions and credits (in combination, referred to as a project’s “tax benefits”) generally exceeds a project’s internal ability to use them in each of the first five (or more) years of the project’s life. Some project sponsors, said to have “tax appetite,” are able to efficiently (i.e., in the years in which they are generated) apply these excess tax benefits against other sources of taxable income external to the project in question. This is the best possible outcome for the sponsor. Other project sponsors that lack tax appetite can carry forward excess tax benefits to future years until they can eventually be used internally by the project itself, but this strategy sacrifices some of the incentives’ value, due to the time value of money. A third option is to bring in – at a cost – a third-party “tax equity” investor who is able to efficiently use the project’s tax benefits, and who invests in the project in exchange for being allocated most or all of its tax benefits; this is known as “monetizing” the tax benefits (i.e., converting their value into money that can be used to finance the project).

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This report compares the relative costs, benefits, and implications of capturing the value of renewable energy tax benefits in these three different ways – applying them against outside income (labeled as “Tax Appetite from Sponsor” in Figure ES-1), carrying them forward in time until they can be fully absorbed internally (labeled as “No Tax Appetite”), or monetizing them through third-party tax equity investors (“Tax Appetite from Tax Equity”) – to see which method is most competitive under various scenarios. As summarized in Figure ES-1, it finds that under current law and late-2013 market conditions (denoted by the two green-shaded columns – one for wind, one for solar – in Figure ES-1), monetization makes sense for all but the most tax-efficient project sponsors. In other words, for most project sponsors (i.e., those without much tax appetite), bringing in third-party tax equity currently provides net benefits to a project.

Under a variety of plausible future scenarios relevant to utility-scale wind and solar projects (and summarized in Figure ES-1), however, the benefit of monetization is found to no longer outweigh the incremental cost, and it makes more sense for sponsors – even those without tax appetite – to use the benefits internally rather than seek out third-party tax equity. A permanent expiration of the PTC (“0% PTC” in Figure ES-1) is one obvious example of such a scenario, but even just a reduction in the size of the PTC (e.g., “50% PTC” in Figure ES-1) could still render monetization uncompetitive. Similarly, monetization is likely to become much less critical for solar projects if the ITC reverts to 10% at the end of 2016 (as is currently scheduled), and is also found to not be competitive under a refundable ITC (at any level), 2 a solar PTC (either refundable or nonrefundable), or tax reform (as recently proposed by the Senate Finance Committee).

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These and other findings highlighted in the full report have implications for how wind and solar projects are likely to be financed in the future, which, in turn, influences their levelized cost of energy. In the event of a PTC expiration, for example, the conclusion that a wind project sponsor without tax appetite will likely find it more advantageous to finance with debt and carry forward depreciation deductions as necessary rather than to partner with third-party tax equity means that the impact of a PTC expiration on PPA prices might not be as severe as one might otherwise assume under a static financing structure. In other words, the shift from third-party tax equity to project-level debt with a lower cost of capital helps to mitigate – though only to a degree, and certainly not fully – the loss of the credit. The same is true for the scheduled reversion of the solar ITC to 10% at the end of 2016: for many sponsors, the negative impact of the reversion is likely to be partially mitigated by a shift away from tax equity and to a lower cost of capital based on project-level term debt. In all scenarios, this beneficial shift to a lower cost of capital could be both heightened and hastened – and at no incremental cost to taxpayers – by making renewable energy tax credits refundable.

Notably, the lower costs of capital realized under the “no tax equity” structures modeled in this report are not dependent on renewable energy projects having access to new capital formation vehicles like master limited partnerships (“MLPs”) or real estate investment trusts (“REITs”). Although MLPs and REITs could, in the future, potentially muster important new sources of low-cost capital, project-level debt from both bank and institutional lenders (not to mention the bond market) is already widely available to utility-scale wind and solar projects, and at costs that are competitive with what MLPs and REITs are likely to deliver.3

Capitalizing on this ready and willing debt market simply requires tweaking Federal incentives in a way that makes it more advantageous for project sponsors to finance their projects with low-cost debt rather than expensive tax equity. Moreover, any such tweaks (e.g., making renewable energy tax credits refundable) would, in turn, enhance the potential usefulness of MLPs and REITs – neither of which is particularly compatible with tax equity.

The scenarios examined in this report are all modeled on an “all else equal” basis, assuming most notably that tax equity hurdle rates do not change in response to any of the scenarios. But it is entirely possible that tax equity investors may be willing to lower their required rates of return under various scenarios, in order to remain competitive with the “backstop” of foregoing tax equity in favor of lower-cost debt. Indeed, there is already some evidence of this responsiveness, as certain tax equity investors reportedly differentiate between deals involving the ITC and the Section 1603 cash grant by charging a premium for the former.

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Even if tax equity investors were to actively compete with financing structures involving just sponsor equity and debt under the scenarios modeled in this report, however, only those conclusions about how wind and solar projects are likely to be financed under those scenarios – i.e., with or without third-party tax equity – would be impacted. The resulting levelized PPA prices, which are of most importance to this analysis, would not be affected. In this light, if tax equity investors are willing to reduce hurdle rates in order to compete with alternative financing structures, so much the better, as project sponsors will then be able to achieve the same low PPA prices through a variety of financing options.

This thought experiment highlights the importance of the debt market (in combination with a sponsor’s ability to carry forward unused tax benefits) as a backstop against which tax equity must ultimately compete in order to remain relevant in the renewable energy marketplace. It also highlights the usefulness of the tools and methodology developed in this report as a way to place bounds on the likely range of market impacts stemming from future policy changes. In fact, given current policy uncertainty impacting the wind and solar markets, the methodology and capabilities developed in this report are likely just as important as, if not more important than, the results presented. The policy environment over the next few years is likely to remain fluid, spawning a variety of possible future scenarios – including not only those modeled in this report, but also various combinations and permutations thereof, along with others not yet envisioned. The methodology and capabilities developed within this report will enable more-refined and - targeted policy analyses of these scenarios as they arise.

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Introduction

In the United States, Federal incentives for the deployment of renewable energy, such as wind and solar projects, have historically been (and are currently) delivered primarily through the tax code in the form of accelerated tax depreciation, as well as tax credits that are based on either renewable energy investment or production. As explained later in Section 2, however, the combined value of these deductions and credits (in combination, referred to as a project’s “tax benefits”) often exceeds the project’s internal ability to use them in the years in which they are generated.

Some project sponsors, said to have “tax appetite,” are able to efficiently (i.e., in the years in which they are generated) apply excess tax benefits against other sources of taxable income external to the project in question. Other project sponsors that lack tax appetite can carry forward excess tax benefits to future years until they can eventually be absorbed by the project itself, but this strategy sacrifices some of the incentives’ value, due to the time value of money.

A third option is to bring in a third-party “tax equity” investor who is able to efficiently use the project’s tax benefits, and who invests in the project in exchange for being allocated most or all of its tax benefits. To date, most project sponsors with little tax appetite have found it advantageous to pursue this tax benefit “monetization” strategy involving third-party tax equity investors, rather than carrying forward the tax benefits on their own over time.

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Third-party monetization clearly provides a benefit to the project – i.e., tax benefits are efficiently used in the years in which they are generated rather than being carried forward and devalued by the time value of money – but also comes at a cost, as tax equity is an expensive form of capital. In fact, tax equity is the second-most-expensive of six sources of capital commonly tapped by renewable energy project sponsors in the United States. In order of least-to-most expensive, these are: government grants, government-guaranteed project-level term debt, regular project-level term debt, back-levered debt, tax equity, and sponsor equity (adapted from Chadbourne & Parke 2013b). With the primary government grant (Section 1603) and loan guarantee (Section 1705) programs having recently sunset, however, sponsors of new wind and solar projects are left with just the four most-expensive capital sources. And given that third-party tax equity investors will often not tolerate project-level debt (and the accompanying risk of foreclosure), the pool of capital is effectively even more limited in a monetization structure, to just the three most expensive sources.

Were tax benefits not so crucial to a project’s competitiveness, project sponsors would likely replace expensive tax equity with cheaper project-level term debt (or, perhaps in the future, with other forms of low-cost capital, such as master limited partnership (“MLPs”) or real estate investment trusts (“REITs”) – neither of which are currently available to renewable energy projects). The resulting reduction in the project’s weighted average cost of capital (“WACC”) could be considerable. As shown in Figure 1, adapted from Bloomberg New Energy Finance (2014), tax equity is currently more than twice as expensive as 15-year term debt on an after-tax basis.4

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Assuming that tax equity (with an after-tax cost of 8%, per Figure 1) makes up 60% of the capital stack while sponsor equity (with an assumed after-tax cost of 12%) makes up the remaining 40%, replacing tax equity one-for-one5 with project-level term debt (with an after-tax cost of 4%, per Figure 1) would reduce a project’s after-tax WACC by 240 basis points, which in turn could have a significant impact on levelized cost of energy (“LCOE”).

This report develops tools and methods to quantify both the costs and benefits of different approaches to capturing the value of the tax benefits generated by representative utility-scale wind and solar projects.6

It then uses these methods to analyze a variety of plausible future scenarios in which these costs and benefits, and in particular the costs and benefits of tax equity monetization, could change significantly. For example, increasing demand for tax equity might increase the relative cost of monetization, while making tax credits refundable, or reducing or even eliminating them, will decrease the benefits of monetization. To the extent that any of the scenarios examined – either alone or in combination – shift the economic balance away from tax equity and towards lower cost sources of capital, or vice versa, they could have significant implications for how (and at what cost) wind and solar power projects are financed, which, in turn, could impact the levelized cost of wind and solar energy.

This report proceeds as follows. Section 2 describesthe primary Federal tax incentives for utility-scale wind and solar project deployment and introduces three different approaches that a project sponsor can use to capture some or perhaps all of the value of those incentives. Section 3 describes three pro forma financial models (as well as the input assumptions to those three models) developed to explore and quantify the impact of these different approaches to capturing the value of tax benefits. Section 4 uses the models to analyze a variety of future scenarios relevant to wind power and in which either the costs or benefits of monetization could change significantly, in order to gauge the resulting impact on wind’s levelized cost of energy (as proxied by levelized prices for long-term power purchase agreements, or PPAs). Section 5 does the same for solar projects, while Section 6 concludes. An appendix provides more details (e.g. capital structures) from each modeling run. Guideposts are located at various points throughout the report, directing advanced readers to skip certain sections if they wish.

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Ultimately, this report demonstrates that, because of their impact on project finance, nonrefundable tax incentives are an inefficient way to encourage renewable energy deployment -- at least relative to refundable tax credits or cash incentives, either of which would likely lead to a lower cost of capital, thereby helping to move wind and solar power closer to achieving LCOE goals (and at no additional taxpayer expense). It is worth emphasizing, here and elsewhere, that driving down the cost of capital does not require granting utility-scale renewable energy projects access to new capital formation vehicles like MLPs or REITs (though having access to such vehicles could certainly help – particularly if tax equity becomes less crucial). Nor does it require courting investors to make them more comfortable with the risks entailed in utility-scale renewable energy projects. Instead, it simply requires providing incentives in a way that makes it more advantageous for project sponsors to finance their projects using low-cost debt – which is already widely available to utility-scale renewable energy projects – rather than more-expensive tax equity. This realization highlights a number of key policy implications for Federal policymakers in particular that will be drawn out throughout this report.

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Conclusions

This report compares the relative costs, benefits, and implications of capturing the value of renewable energy tax incentives in three different ways – applying them against outside income, carrying them forward in time until they can be fully absorbed internally, or monetizing them through third-party tax equity investors – to see which method is most competitive under various scenarios. It finds that under current law and mid-2013 market conditions, monetization makes sense for all but the most tax-efficient project sponsors. In other words, for most project sponsors (i.e., those without much tax appetite), bringing in third-party tax equity currently provides net benefits to a project, although the size of the net benefit is diminished by the fact that tax equity is currently twice as expensive (on a comparable after-tax basis) as the project-level term debt that it likely supplants. Modeling results presented here suggest that project sponsors forfeit one-third or more of the notional value of a project’s tax benefits when they bring in tax equity investors to monetize those benefits; these results are roughly in line with previous estimates.

With such a high price being exacted, tax equity’s position in the marketplace should not be taken for granted. In fact, under a variety of plausible future scenarios examined in this report and relevant to utility-scale wind and solar projects, the benefit of monetization is found to no longer outweigh the incremental cost, and it makes more sense for sponsors – even those without tax appetite – to use the benefits internally rather than seek out third-party tax equity. A permanent expiration of the PTC is one obvious example of such a scenario, but even just a reduction in the size of the PTC could still render monetization uncompetitive. For example, based on the analysis and assumptions used in this report, reducing the nonrefundable PTC to less than 50% of its current level would make third-party tax benefit monetization more costly than other financing structures; this threshold would increase to 90% if the PTC were made refundable. Similarly, monetization is likely to become much less critical for solar projects if the ITC reverts to 10% at the end of 2016 (as per current law), and is also found to not be competitive under a refundable ITC (at any level), a solar PTC (either refundable or nonrefundable), or tax reform (as recently proposed by the Senate Finance Committee).

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These findings have implications for how wind and solar projects are likely to be financed in the future, which, in turn, influences their levelized cost of energy. In the event of a PTC expiration, for example, the conclusion that a wind project sponsor without tax appetite will likely find it more advantageous to finance with debt and carry forward depreciation deductions as necessary rather than to partner with third-party tax equity means that the impact of a PTC expiration on PPA prices might not be as severe as one might otherwise assume under a static financing structure. In other words, the shift from third-party tax equity to project-level debt with a lower cost of capital helps to mitigate – though only to a degree, and certainly not fully – the loss of the credit. The same is true for the scheduled reversion of the solar ITC to 10% at the end of 2016: for many sponsors, the negative impact of the reversion is likely to be partially mitigated by a shift away from tax equity and to a lower cost of capital based on project-level term debt. In all scenarios, this beneficial shift to a lower cost of capital could be both heightened and hastened -- and at no incremental cost to taxpayers – by making renewable energy tax credits refundable.

Notably, the lower costs of capital realized under the “no tax equity” structures modeled in this report are not dependent on utility-scale renewable energy projects having access to new capital formation vehicles like master limited partnerships (“MLPs”) or real estate investment trusts (“REITs”). Although MLPs and REITs could, in the future, potentially muster important new sources of low-cost capital, project-level debt from both bank and institutional lenders (not to mention the bond market) is already widely available to utility-scale wind and solar projects, and at costs that are competitive with what MLPs and REITs are likely to deliver.53 Capitalizing on this ready and willing debt market simply requires tweaking Federal incentives in a way that makes it more advantageous for project sponsors to finance their projects with low-cost debt rather than expensive tax equity. Moreover, any such tweaks (e.g., making renewable energy tax credits refundable) would, in turn, enhance the potential usefulness of MLPs and REITs – neither of which is particularly compatible with tax equity.

click to enlarge

The scenarios examined in this report are all modeled on an “all else equal” basis, assuming most notably that tax equity hurdle rates do not change in response to any of the scenarios. But it is entirely possible that tax equity investors may be willing to lower their required rates of return under various scenarios, in order to remain competitive with the “backstop” of foregoing tax equity in favor of lower-cost debt. Indeed, there is already some evidence of this responsiveness, as certain tax equity investors reportedly differentiate between deals involving the ITC and the Section 1603 cash grant by charging a premium for the former.

Even if tax equity investors were to actively compete with financing structures involving just sponsor equity and debt under the scenarios modeled in this report, however, only those conclusions about how wind and solar projects are likely to be financed under those scenarios – i.e., with or without third-party tax equity – would be impacted. The resulting levelized PPA prices, which are of most importance to this analysis, would not be affected. In this light, if tax equity investors are willing to reduce hurdle rates in order to compete with alternative financing structures, so much the better, as project sponsors will then be able to achieve the same low PPA prices through a variety of financing options.

This thought experiment highlights the importance of the debt market (and a sponsor’s ability to carry forward unused tax benefits) as a backstop against which tax equity must ultimately compete in order to remain relevant. It also highlights the usefulness of the tools and methodology developed in this report as a way to place bounds on the likely range of market impacts stemming from future policy changes. In fact, given current policy uncertainty impacting the wind and solar markets, the methodology and capabilities developed in this report are likely just as important as, if not more important than, the results presented. The policy environment over the next few years is likely to remain fluid, spawning a variety of possible future scenarios – including not only those modeled in this report, but also various combinations and permutations thereof, along with others not yet envisioned. The methodology and capabilities developed within this report will enable more-refined and -targeted policy analyses of these scenarios as they arise.

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