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Tax Credit Insurance Helps Power Up Credit Transfers
Reprinted with permission from Tax Notes - Volume 182 | January 1, 2024
The market for tax insurance has evolved alongside the market for credit transfers. At the opening of the new year, it’s likely on the cusp of a further expansion as more transfers are completed, with even more expected in the coming months.
Tax insurance has a long history and applications across many different types of transactions, but a new avenue for growth opened when the Inflation Reduction Act made transfers of renewable energy tax credits possible. Because tax insurance covers known risks, insurers want opinions or well-supported memoranda from outside counsel that offer a strong level of confidence about the credit, said Mark McTigue of Marsh. That generally means a “more likely than not” or should-level opinion or advice.
Even before the IRA, interest in tax insurance had steadily grown over the last 10 years, said Keith Martin of Norton Rose Fulbright US LLP. As more tax credit sales are completed, the demand for insurance will likely grow even more. Martin said that his firm had closed 11 sales of tax credits and has another 20 in documentation.
"The market for tax insurance has evolved alongside the market for credit transfers."
Investment tax credit buyers have so far almost universally required comprehensive risk mitigation, said Billy Lee of Reunion, an energy tax credit marketplace. “They either require a highly creditworthy seller (or guarantor) or tax credit insurance so there is a strong balance sheet that will make them whole for any reduction or loss of credits,” he said.
Credit buyers seeking a high degree of reassurance, particularly on recapture risk, are flocking to tax credit insurance. “If you’re buying a $100 million ITC and there is a possibility that in year 3 there is recapture because of a casualty that knocks the project permanently out of service, that’s a big tax bill,” said Lauren Collins of Vinson & Elkins LLP. Even sellers may prefer to get insurance instead of having to indemnify the buyer, she said.
But prospective credit sellers with smaller credit amounts may have difficulty offering, or be unable to offer, guarantees to buyers. And they might find it challenging to acquire insurance, too, although finding solutions to make the transfers of credits worth less than approximately $5 million is a focus for both tax credit marketplaces and insurers.
Historically, insurance provided tax equity investors with reassurance that the credits were good and provided a backstop when a developer lacked a strong balance sheet, said Antony Joyce of Marsh. The transfer market is similar.
There are two types of tax credit buyers in the market, Martin said. The traditional tax equity investors were more likely to be satisfied with the types of indemnities they’re used to having in tax equity financing transactions, but are now starting to shift to all-events indemnities as they see less-sophisticated buyers get them. The other set of buyers expect to be compensated if anything goes wrong with the credit, and they’re less familiar with the risks they’re taking. The latter group is more likely to be a corporation not previously involved in tax equity or renewable energy that wants to buy credits to offset tax liability or as a revenue item. Such buyers tend to want a full scope of coverage, including basis risk, ITC rate computation risk, prevailing wage and apprenticeship risk, and risks connected to the bonus credits for domestic content and energy communities, Joyce said. They’re seeking protection that the credit and the transfer are good, he said.
Joyce said that traditional tax equity investors typically seek insurance for the riskier piece of the credits, rather than attempting to insure 100 percent or more of the credit, as some of the new post-IRA buyers do. “From an insurer’s perspective, the risk that’s being underwritten has the traditional riskier component and has insurance covering components of the credit that were not traditionally thought of as being riskier,” he said. That’s a new phenomenon brought about by the transfer market, and it affects the pricing, Joyce added.
In addition to the two types of buyers, there are also two types of transfers, Joyce said. Many transfers don’t include the step-up in basis typical of tax equity transactions, but a pool of transactions does include it. In those deals is a completed tax equity transaction that includes an embedded step-up in basis in the ITC, and the partnership is selling the credits. For all buyers and transactions, acquiring insurance is currently a bespoke process. “Every project and risk is different,” McTigue said.
Risks in transfers
Recapture is one of the chief risks that buyers of ITCs seek to have insured. “It’s low probability, but high consequence,” Lee said. Recapture insurance also provides a sort of backstop for property and casualty insurance, which most projects already have to cover the investment, he said. There are recapture scenarios that insurance typically won’t cover, however, including if the seller intentionally sells the project or converts it into a facility that no longer qualifies for the ITC.
"Recapture is one of the chief risks that buyers of ITCs seek to have insured."
A primary use of tax credit insurance is when the project’s financing includes debt, Lee said. If the project is performing worse than expected and the borrower defaults, the bank could foreclose, which would cause a recapture if the bank has the first priority lien on the equipment. “Some insurers will require the lender to enter a forbearance agreement to agree not to foreclose in the five-year recapture period,” Lee noted. He said that insurance brokers should push more of the markets to cover recapture from foreclosures without such agreements. “Doing that would remove a big hassle factor and create a lot of value for sponsors because that lender negotiation can be very difficult and time-consuming,” Lee said.
Tax insurance has typically been used in the traditional tax equity market for situations when the project developer relies on the physical work test to show when construction began, Martin said. That date used to be important to lock in tax credit rates during the period tax when credits were phasing out, and it remains important today for the application of the prevailing wage and apprenticeship rules and the energy community bonus credit.
Another risk that buyers think about is the possibility that the IRS disallows a portion of the credit that is claimed by a seller and sold to a buyer. Those situations — such as a sale of a $10 million credit that the IRS values at only $9 million — can be caused by numerous factors, including challenges to the appropriate amount of developer margin or the inclusion of ITC-ineligible costs, such as fences and roads. Disallowance is more likely than recapture but is generally less consequential, and still remains an important concern for buyers, Lee said.
The domestic content bonus credit is another area in which credit buyers seek the reassurance of insurance, in part because there is still considerable uncertainty in the application of the rules. In light of that uncertainty, a will-level tax opinion is hard for outside counsel to give, Collins said. The alternative is for taxpayers to get a should-level opinion and tax insurance, she said. Martin said that as the domestic content bonus credit gains traction, insurance to cover that risk will likely become more prevalent. But so far, there has only been one deal in which the market was willing to price domestic content into the financing, he said.
Insurance has been used in the traditional tax equity market in repowering wind projects. When a wind project is repowered with an expectation that it will generate another 10 years of credits, the tax equity market has been careful, Martin said, noting that some tax equity investors have required two appraisals to show that the 80/20 test was passed.
Tax credit insurance could also be a creative mechanism for covering registration and reporting risk for transfers, Collins said. Because that risk is all or nothing, foot faults like failing to timely obtain the registration number could have disastrous consequences, she noted. Similarly, if a seller fails to appropriately report the sale, the buyer could lose the money they paid for the credit without some type of risk mitigation.
Although tax credit insurance is widely available, it comes at a price, and for smaller credits, the cost can be too high. Insurers’ minimum premiums may mean that insurance isn’t available. It can also be cumbersome, because insurers do extensive due diligence before writing a policy, and scale and simplicity are important factors in their decision to underwrite a contract. Consequently, projects that offer credits under about $5 million or have significant complexities can be hard to insure, and therefore hard to find buyers for, Lee said. But smaller projects may sometime soon be packaged into portfolios and sold collectively, and that bundling may open up insurance options for those credits, he said. The availability of insurance should make it easier for projects such as commercial and industrial solar and newer technologies to receive more bids from buyers, but for now, there are a lot of “orphan credits” because most buyers want full risk mitigation, Lee said, adding, “It’s a definite market inefficiency and an area we’re really focused on because the whole point of transferability is to make it easier for projects to get their credits monetized.”
"Although tax credit insurance is widely available, it comes at a price, and for smaller credits, the cost can be too high."
McTigue said that acquiring insurance on $2 million in credits, for example, is trickier because of the typical minimum premiums and the limits the insurance market is willing to entertain. “As much as it’s grown, it’s a fairly under-resourced space,” he said, but added that pooling credits by wrapping in other projects can be a creative way to overcome existing obstacles. “We say $5 million is the minimum limit on insurance, but there is some flexibility there,” McTigue said.