Mid-Year Analysis: Emerging Tax Equity Trends and their Impact on Transferability
As we approach the one-year anniversary of the Inflation Reduction Act (IRA), Reunion’s President, Billy Lee, reflects on five emerging trends in the tax equity market.
Over the past six months building Reunion, we have interacted with hundreds of market participants – developers, tax equity providers, lenders, syndicators, accountants, and lawyers. We have been excited to see the discussion evolve from binary debates about transferability versus tax equity, into more nuanced conversations about the future of renewable energy financing. In this piece, we reflect on several themes emerging from our conversations:
- Tax equity will continue to play a valuable role in a post-IRA world
- Tax equity is becoming scarcer on a relative basis
- Most tax equity deals will take on hybrid structures, involving components of tax credit transfer
- The sale of investment tax credits from hybrid tax equity deals should, in theory, command a slight premium
- “Standalone” tax credit transfers can close the tax equity supply gap
Tax equity will play a valuable role in the post-IRA world
Much has been written about the cost, complexity, and constraints of tax equity, so we won’t rehash those issues here. Instead, we’ll explore the three principal benefits of tax equity in the post-IRA market.
Monetization of depreciation
In any tax equity transaction, the sponsor expects to get value from monetization of the investment tax credit (ITC) as well as accelerated depreciation. Generally, however, the vast majority of near-term depreciation is allocated to the tax equity partner, so the sponsor is not able to absorb any material tax losses during the early years of the partnership. This is an important and sometimes under-appreciated point, especially in the context of step ups and phantom income (see below).
Flexibility for changes of control
With tax equity, a developer can divest its interest in a project without a material negative financial impact resulting from ITC recapture, because a developer typically owns only 1% of the project’s profits interest during the five-year ITC recapture period. This is important because many developers are owned by private equity or infrastructure funds, and some sponsors may plan to sell their interest within five years. Tax equity was not designed to create liquidity for project sponsors, but it has become a meaningful mechanism to support such secondary sales.
Step up for fair market value
When a project is sold by a developer to a tax equity partnership prior to mechanical completion, the purchase price is typically determined by a third-party appraiser who values the project above the developer’s cost to build. This step up allows the developer to apply the project’s ITC percentage – 30%, for instance – on a higher cost basis. Without detailing the appropriate sizing and risks of FMV step ups, we’ll simply emphasize their substantial value.
However, market participants often overlook that basis step ups create phantom income. If, for example, a developer builds a project for $100 and sells it to a tax equity partnership for a 30% step up to $130, the $30 of gain is taxable income. While the developer benefits from the additional ITC value generated from that incremental $30 – $9 for a project with 30% ITCs – they (or their partners) will realize a tax burden on that gain. Further, almost no depreciation from the project is available to reduce that burden since it has been allocated to the tax equity partner.
If individual partners in the developer live in high-tax states – California, New Jersey, and New York, for instance – those individuals may realize a marginal tax that exceeds the ITC and depreciation benefit from this step up.
Tax equity is becoming scarcer on a relative basis
In our conversations with developers, we’ve noted a near universal theme: tax equity has gotten materially harder to raise since the passage of the IRA, even for sponsors that have significant tax equity experience with large, contracted projects. The reason is simple – supply and demand.
Static supply of tax equity
The supply of existing tax equity is not expected to rise materially beyond the oft-quoted $18-20 billion of the previous several years. Many of the incumbent tax equity suppliers do not expect to budget major increases in the amount of tax liability allocated to tax equity, and we do not expect the arrival of major new entrants who can move the needle, especially given that transferable tax credits are a far simpler alternative.
Increasing demand for tax equity
The developer community, on the other hand, is generating more tax credits and this pace is accelerating. Projects that had not qualified for tax credits before the IRA – storage, biogas, nuclear, carbon capture, manufacturing, hydrogen, etc. – are now generating tax credits. What’s more, the relative number of credits per project is increasing. A solar project can now reasonably generate ITCs worth 40% or even 50%, as opposed to 22% pre-IRA.
Increasing bifurcation between the tax equity “haves” and “have-nots”
The largest sponsors with the deepest tax equity relationships may find themselves in an advantageous market position over the near-term, with the ability to close transactions with the best terms relative to their competitors. The majority of sponsors, however, will find capital raising process more competitive, challenging, and protracted.
Most tax equity deals will take on hybrid structures, involving components of tax credit transfer
A tax equity investor’s investment appetite is limited by both its total corporate tax liability as well as the amount that has been allocated internally to renewable energy transactions. In our discussions with tax equity investors, virtually all of them have indicated that they intend to use transferability as a “release valve” to spread their tax liability across existing clients who have more projects and more credits.
Investors will continue to underwrite tax equity deals but may retain only a portion of the credits generated from the project and sell off the remainder. This trend carries implications for sponsors.
The amount of credit that the tax equity investor will be able to sell will emerge as a significant point of negotiation
The value of an ITC that is sold (at a discount to a third party) is going to be less than the value of an ITC that is retained. Either (or both) the sponsor, or the tax equity investor, will need to absorb this economic hit. Given the scarcity of tax equity today, it seems unlikely that tax equity will bear the brunt of the discount of transferred ITCs.
Tax equity will become more complicated and expensive
Finally, expect tax equity to become more complicated and expensive. Introducing tax credit transfers to tax equity deals brings a new layer of complexity and deal documentation. This will increase the tax equity barrier to entry.
ITCs from hybrid tax equity deals – those “release valve” credits – should, in theory, command a slight premium
Large, institutional buyers of tax credits may prefer to buy credits from tax equity partnerships for three reasons:
- They can rely on the underwriting diligence of experienced investors
- Most financing in tax equity transactions is back leverage, meaning a borrower default would not result in a foreclosure, causing tax credit recapture
- In the event of an IRS challenge of eligible basis, the IRS will first assess any disallowance to retained credits before assessing them against credits sold to third parties. Said differently, the tax equity partnership takes the first loss (up to the amount of credits it did not sell) for any credit reduction by the IRS
Assuming the tax equity partnership retains a significant portion of credits, tax credit buyers are in a safer position, particularly where there are aggressive step ups or bonus credit adders.
“Standalone” tax credit transfers can close the tax equity supply gap
Luckily there is also the option for a standalone tax credit transfer, which bypasses tax equity altogether. While much simpler and less cumbersome than tax equity, such transactions are still complex and nuanced, and require careful diligence and risk allocation. In a forthcoming article, we will explore a few common transaction structures relating to standalone tax credit transfers and analyze both the merits and pitfalls of each.
Tax equity has been a major source of financing for clean energy for the past 15 years and will remain an important financing tool for the foreseeable future. Tax credit transfers will increasingly be included as part of tax equity deals due to the shortage of tax equity relative to the number of tax credits being generated. In addition, standalone tax credit transfer deals that bypass tax equity all together with emerge as a new financing option, with applicability across a variety of technologies and developer profiles. Reunion is excited to play a role in the rapidly evolving clean energy finance market, working closely with tax credit buyers, project developers, and other ecosystem participants.
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