Canary Media - Navigating New Tax-Credit Transfer Rules for Unlocking Trillion-Dollar Cleantech Investments
Today’s tax equity markets can’t handle the IRA’s flood of clean energy tax credits. A provision in the law could fix that, but only if corporate buyers step up.
Canary Media thanks KORE Power for its support of our special coverage of the Inflation Reduction Act’s first year.
The Inflation Reduction Act has unleashed what could be a trillion-dollar flood of tax credits for U.S. clean energy and decarbonization investments over the next decade.
To capture as much of the value of these tax credits as possible — and, in turn, build as much new clean energy as possible — project developers need to partner with companies and financial institutions in what’s called a tax-equity market. Thanks to three decades of tax-credit-focused clean energy policy, this is a well-established ecosystem; it’s become the financial engine that makes solar, wind and battery subsidies work in the U.S.
But here’s the problem: The volume of tax credits introduced by the climate law is unlike anything these tax-equity marketplaces have ever dealt with — and without serious changes, these new credits would almost certainly overwhelm this key market.
A provision of the climate law known as “transferability” aims to solve this. The rules for how it works are as complicated as major new federal tax-credit policies tend to be, but the concept is relatively simple. For decades, financiers have had to become co-owners of the clean energy projects they invest in in order to claim the associated tax credits. In contrast, the new deal structure introduced in the Inflation Reduction Act allows investors to buy those credits on an open market, drastically lowering barriers to entry and potentially unleashing a torrent of new project funding worth billions.
“This will truly transform the way clean energy projects are financed,” said Andy Moon, CEO and co-founder of Reunion Infrastructure, one of a number of startups that have launched to facilitate and support the emerging market for tax-credit transfers. “It’s hard to overstate. This will be a huge deal.”
Many clean energy projects aren’t financially feasible without the help of tax credits, but the amount of money a project developer can receive from those credits is limited by the size of its tax bill — and most developers don’t pay nearly enough in taxes to make use of those credits. Today’s tax-equity markets help solve this: Clean-energy project developers partner with big banks and financial institutions with massive tax bills that are looking to reduce how much they owe to the federal government. In turn, these deep-pocketed partners return some of that value to the project developers in the form of cash payments.
That allows project developers to maximize the value of the credits and build far more clean energy projects much faster than would be possible if developers relied on their own tax liability alone.
At its peak prior to the new law, the U.S. tax-credit investment market processed about $20 billion in clean-energy projects per year. Under the Inflation Reduction Act, that annual figure is expected to be at least two to three times larger, according to multiple analyses. And with the supply of clean energy tax credits uncapped by the federal government and restricted only by the volume of creditworthy projects, the eventual demand could grow even further.
To incentivize project developers to build out clean energy as quickly as the climate crisis demands, the tax-equity market also needs to rapidly expand its capacity. That’s where transferability will play a vital role — and big banks, new startups, renewable energy developers and armies of lawyers and consultants are all rushing to put it into practice.
One of these advisory firms, Reunion Infrastructure, is benefiting mightily from the flood of interest in tax-credit transfers. In July, the startup announced it had amassed more than $1 billion in credits from “high-quality solar, wind, battery storage, and biogas projects” that are ready to be snapped up by corporate buyers. By mid-August, the total had doubled to $2 billion, according to CEO Andy Moon.
The pace of deals is likely to pick up even further in the wake of the U.S. Treasury Department issuing guidance in June on transferability and another option for streamlining tax-credit transactions, known as direct pay.
“There have been deals literally waiting on the sidelines to be implemented once the structure was in place,” said Allison Nyholm, vice president of government affairs at the American Council on Renewable Energy, a trade group representing clean energy companies and customers. An ACOREsurvey of clean-energy developers and investors in June indicated that more than 80 percent of them intended to use transferability or direct pay in their investments over the next three years.
This week, Bank of America unveiled details of the first tax-credit transfer deal to be made public, an agreement to buy $580 million in wind energy tax credits from a $1.5 billion wind farm being built by clean power developer Invenergy. “We’re creating a market where you can have more players around the table all participating in the clean-energy transition,” Karen Fang, Bank of America’s global head of sustainable finance, told TheWall Street Journal.
But Patrick Worrall, vice president of the asset marketplace at clean energy marketplace provider LevelTen Energy, warned that “the only way that the IRA can fulfill its promise is if there are many more parties who jump into the tax investment game.” That’s because the relatively small pool of large financial institutions that now do tax-equity deals don’t have the investment appetite or capacity to finance nearly as many projects as the Inflation Reduction Act’s expanded tax credits can support.
Transferability makes such expansion possible — but it doesn’t guarantee it. “There’s nothing there if these parties don’t start coming to the market and making these investments,” Worrall said. “This was all set up by the federal government to enable these corporations to enable this transition.”
From tax equity to transferability: A sea change in how clean energy is financed
Why can’t today’s tax-equity markets handle the coming wave of clean energy tax credits initiated by the Inflation Reduction Act? Simply put, the traditional way of doing things is just too complicated and expensive to meet the scale and scope of investments coming, Moon said.
Moon and his co-founder at Reunion Infrastructure, Billy Lee, both come from the tax-equity investment world, starting together at solar development pioneer SunEdison and then working separately at large banks and private equity firms. “We’ve pitched tax equity [deals] to corporates for 15 years — and they very rarely do it,” Moon said. “It’s very complex.”
At the core of that complexity is the long-standing rule that allowed only the project owner to claim tax credits associated with the project. The government structured the rules that way to ensure that the benefits of the tax credits would go to an entity with a vested interest in ensuring the project was actually built and operated properly.
But it also complicated the process of using tax credits to build clean energy projects. Project developers and deep-pocketed tax-equity investors used complex transaction structures, such as partnership flips and sale-leasebacks, to make the investor the owner of the project for as long as it would take for them to be eligible to claim the tax credit. After that, they would “flip” ownership back to the developer for the remainder of the project’s lifespan.
These labyrinthine partnerships can take millions of dollars in legal and administrative costs to put together, and because of their inherent complexity, there is little opportunity to streamline or standardize based on past efforts and make future deals simpler or cheaper, Moon said. They also force investors into the position of owning a clean energy project for years at a time, exposing them to risks that very few companies are willing to take on.
That’s why the pool of tax-equity investors is as small as it is, LevelTen’s Worrall said. “Over 50 percent of it is JPMorgan and Bank of America,” with about 40 other institutions rounding out the market, he said. And because these deals are so complex and risky, these investors have little appetite or capacity to expand how much new business they can take on — “they’re investing regularly, and they’re full.”
These conditions have led to a “huge supply-demand imbalance for tax equity,” Moon said. “Projects that could previously get tax equity are in the last six months struggling — there just isn’t enough. And if you don’t get tax equity, you can’t build a project.”
Another problem with the status quo is that tax-equity investors tend to only target deals of $100 million and up. That has forced developers of smaller-scale projects like community solar to sell to project aggregators that bundle numerous smaller projects together into high-dollar portfolios valuable enough to attract the interest of banks.
The IRA’s new transferability option upends this landscape entirely, Moon said. “Now there’s an option for those developers to build the projects and sell the credits themselves.”
Would-be buyers of tax credits also have a much simpler road ahead under the new transferability option, Worrall said. “There’s no longer a partnership investment with a ton of due diligence upfront and a ton of maintenance over the lifetime of the investment. You’re talking about a simple transfer: corporate tax credits for cash.” These deals also have much simpler accounting requirements, he added.
Some projects making use of the new tax-transfer deal structure have already started to be put together. Moon said that participants in his company’s marketplace include developers of smaller-scale projects that would struggle to get the attention of traditional tax-equity investors.
Crux Climate is another recently launched startup that provides software and services to manage this new breed of tax-credit transfer transactions. CEO Alfred Johnson said Crux has “gotten past the term-sheet stage,” which precedes the writing of a binding contract, on its first deal with a smaller clean-energy project developer and an unnamed corporate tax-credit buyer that’s new to the tax-equity market.
While tax-credit transferability opens the door to smaller developers and inexperienced corporate investors, it could also be an option for those already active in the existing tax-equity markets, Moon added. “Large and very experienced developers are talking about how this will be part of the portfolio. All the banks and tax-equity investors are looking at how to integrate transferability,” with financiers including Bank of Americareporting deals in progress.
That’s a good thing, because the growth needed to expand the pool of investment capital flowing into clean energy projects that must be built at an unprecedented pace and scale to combat climate change is immense, Johnson said.
“We need to move from a world where there are 40 or 50 credible” financial institutions investing in the market and processing about $20billion in traditional tax-equity deals per year, to one capable of processing about “$85 billion in credits per year” by 2031, as per a Credit Suisse forecast of the market spurred by the Inflation Reduction Act, Johnson said. That $85 billion figure would be roughly equivalent to 20 percent of all corporate taxes paid in the U.S. last year, representing an unprecedented level of commitment from corporate America to a form of investment that barely exists today.
Hurdles to clear to make a market: Recapture and insurance
A lot of industry watchers say the new tax-credit transfer deal structure will make things simpler, but it won’t exactly make them easy. That’s why companies like Reunion Infrastructure, Crux Climate and others have sprung into being.
The first challenge is “finding the big corporations and making them comfortable with it,” said Ben Ullman, founder and CEO of transferability marketplace startup Common Forge. That leaves it up to companies like his to “find a way to standardize this for corporations” so it’s as simple and painless as possible for the tax departments of the companies being courted as buyers of clean energy tax credits, he said.
One way to make the new tax-credit transfer deals more appealing to skittish corporate buyers is by reducing their risk exposure as much as possible, according to Ullman. “The key to that is the buyer protections” that dealmakers must structure to protect companies from the risks they take on when they purchase large amounts of tax credits, he said. “No corporation looking to buy a tax credit is going to start on a big deal process” without a clear understanding of the risks and how to protect themselves against them.
Right now, the biggest risk lies in what’s called “recapture,” Ullman said, referring to the Internal Revenue Service’s right to reclaim the tax credits from failed, sold or otherwise ineligible clean energy projects. Many clean-energy tax credits, including those for solar power projects, are pegged to the value of investment into a project in the year it begins operating. These credits can then be used to offset a buyer’s tax liability in the following year.
But what if that project ends up going bankrupt and shutting down, or is destroyed by extreme weather, or is sold to another party, or otherwise fails to meet the rules that allowed it to claim the tax credit in the first place? If that worst-case scenario occurs, the IRS can claw back the value of those tax credits.
When the project owner is the same entity using the tax credits to offset their tax bill, that’s a fairly straightforward process. But any third party looking to buy those tax credits and retain their value over time will need to find a way to protect themselves.
That’s what makes the risk of “recapture a headache” for would-be corporate tax-credit buyers, Ullman said. “The company has to defend itself to the IRS and to pay the IRS — and they could either pay out of pocket when that happens or buy an insurance product and pay that premium over time.” That’s why Common Forge and other players in this market are building insurance into their standard transaction structures, he said.
The good news is that there are already established ways to mitigate this risk. “Recapture insurance and qualification insurance is a mature market — all the big carriers and brokers carry that insurance,” Moon said. “We’re working closely with them.”
In fact, Ullman noted, “Insurers are all quite excited by the market opportunity.” And because insurance rates tend to decline when there’s a bigger pool of stuff to insure, that’s another argument in favor of encouraging standardization across deal terms in the burgeoning tax-credit transfer market, he added.
Building markets that work at scale — and that sellers and buyers can trust
Crux CEO Johnson believes that another key to successful standardization will be the availability of reliable technology to connect clean-energy developers selling credits with potential buyers. His company is focusing on providing its software to the big banks and financial institutions that are already the key players in the traditional tax-equity market, he said.
Clean-energy developers need software “to easily list…their credits for sale” to the widest audience possible and “to distribute the credits at the highest net price” they can hope to secure, Johnson said. Buyers need to be able to “find projects that meet their desired characteristics” and access project data they need to do their due diligence, and they need this information both before making a decision to buy and afterward, in case “the IRS comes knocking.” And companies like Crux are needed “in the middle” to “distribute these credits and make markets,” he said.
Ullman warned that this new market is not going to develop overnight. “The first thing — the existential thing — is getting buyer interest,” he said. “You have to do a bunch of transactions this year, show that buyers can engage with minimal overhead time internally, show a bunch of savings, and show it didn’t blow up at the end.”
Eventually, a healthy market will be able to sort tax credits from project developers with weaker or stronger underlying financial underpinnings and price them accordingly, Johnson said. It will also be broad-based enough to ride out disruptions that dogged the traditional tax-equity investment markets during the recessions of 2008–2009 and 2020–2021, when big tax-equity investors were making less money and thus had smaller tax bills, and had largely stopped looking for tax credits as a result.
A vibrant tax-credit transfer market could also create a new way for climate-conscious companies to invest in decarbonization, Worrall noted. For clean energy to grow at the rate needed to reach the Biden administration’s carbon-cutting commitments under the Paris Agreement, “these corporate taxpayers need to step up to support this federal policy,” he said.
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