By Bill Lemon, Co-Chair, Element 8
As many of the Element 8 members know, I have a “day job” as Director of Renewable Energy Finance for StoneBridge Securities, a local boutique investment bank. Ever since the election, I’ve been hearing people’s questions and concerns about the prospects for renewable energy under a Trump administration. The Clean Power Plan, which focused on reducing emissions from coal-burning power plants, as well as increasing the use of renewable energy and energy conservation, is destined for the recycling bin (if not the landfill). Other drivers of renewables, however, are not so ill-fated.
Many have asked me, “Will tax credits for renewables go away?” To that, I say, “no”. The current extensions of the solar investment tax credit (ITC) to 2020 and wind production tax credit (PTC) to 2022 were recently passed by a Republican-controlled Congress. Rural constituents, most of whom voted Republican, are increasingly benefactors of the construction of clean energy and their elected representatives understand the value of the industry. So while the future of statutory incentives beyond their sunset dates remain uncertain, they are safe for the interim.
The relative security of the federal ITC and PTC doesn’t mean wind and solar projects are set to thrive under the new president, for reasons that can be a bit obscure to the average citizen. Understanding their vulnerability will take a bit of explaining, so please bear with me.
Unlike most start-up companies, renewable energy projects in the U.S. are organized as limited liability companies, or LLCs for short. The tax laws over LLCs allow owners to unequally share different streams of benefits that can and do accrue to them, some of which can be surprisingly substantial. Different owners can receive different percentages of the free cash flow according to ownership interests. In fact, some categories of owners can get all of the tax credits to the near exclusion of other owners in the LLC. That’s a good thing because some LLC owners, like the entrepreneur-developer, often do not have much initial tax liability, while other owners, such as banks or insurance companies, are paying near maximum corporate tax rates.
The U.S. government offers tax benefits on solar projects that are worth roughly 56¢ per dollar of project capital cost. There are two benefits: a 30% investment tax credit, and the ability to deduct 85% of the cost or fair market value of the project, depending on how the tax equity transaction is structured, over five years on an accelerated, or front-loaded, basis.
Most solar developers in our Element 8 portfolio do not have the tax liability to use the tax benefits against their own balance sheet. Thus, a core financing tool for most solar companies is “tax equity,” where the benefits are effectively bartered for capital to build the solar project. Most outside equity that goes into projects comes from dedicated private equity partnerships (structured like VCs) that don’t have any tax exposure at all, and of course the lenders, if involved, only want their principal and interest. So who does want and need these tax benefits? Tax equity investors do.
Tax equity investors tend to be big corporations that have a predictable and large tax liability that they seek to profitably minimize by making investments in solar and wind projects, among others. The original model for tax equity investing came from the government’s desire to incent the construction of low-income housing, which to this very day competes for investments.
So if the tax credit allowances for projects aren’t changing, and there are still profitable companies looking to minimize their taxes, what could go wrong?
It is the value of the tax credits that is now in doubt. Regardless of the corporate tax rate, the value of the 30% ITC on a project will remain constant. It is a dollar-for-dollar reduction in the income taxes the company (i.e. tax equity investor) claiming the credit would otherwise pay the federal government. The ITC is based on the amount of investment in solar property.
The value of the accelerated depreciation, however, is dependent on the company’s corporate tax rate. You know, the tax rates that the new administration is talking about cutting. If the value of the whole package is 56¢ per dollar of capital cost and 30¢ of that is the actual investment tax credit, that means 26¢ is the value of the accelerated depreciation given the current 35% top marginal tax rate.
If the 35% tax rate were to be cut to 17.5% (the average between the House and Trump proposals), the value of accelerated depreciation is also halved, causing the total value of the renewable energy tax credit to drop from 56¢ per dollar to 42.5¢ per dollar total of capital cost. Given that big renewable energy projects tend to make their money slowly, but oh so steadily, this matters.
There is little margin to absorb the difference. It will likely mean that some projects that would get built today under current tax rates, would be deferred under the lower tax rate and have to either wait for development costs to fall, or power purchase prices to rise, before they can move ahead. Analysts expect that regardless of the tax regime, the cost of solar will continue to decline, and “see no fundamental change in the drivers and outlook for solar” . By contrast, they predict the cost of wind power will rise significantly once the PTC expires in 2020, curtailing its growth prospects.
Perhaps just as damaging, if only in the shorter term, is the FUD factor – fear uncertainty and doubt- that is instilled in tax equity investors as they try to figure out how much to “bid” in the barter game for a given project’s tax equity. So even though tax rates have not yet changed, tax equity investors are acting like they have changed, or are likely to change. The FUD factor brings more consternation to project developers than to investors; by definition, tax equity investors are profitable and well-off, project developers, not so much.
The market impact of this change in project finance, precipitated by reduced corporate tax rates, may be a diminished appetite for tax equity investments overall. In 2015 there were 30-40 tax equity investors in the renewable energy market (up from 11 in 2009). Lowering the U.S. corporate tax rate may motivate corporations, who are current and prospective tax equity investors, to repatriate their profits now held overseas, estimated at some $2.6trn. If companies return their profits to the U.S., they may be looking for federal tax relief. Trump, however, proposes a one-time tax rate of just 10% to incentivize companies to return these funds to the U.S. That low rate may not equate to a tax burden sufficient to stimulate interest in tax equity at a level that would maintain or grow the market.
It costs money to develop projects to the point of construction and it still costs money in the form of renewed land options, equipment deposits, and extended permits to hold them there. So, while I’ve just recently invested in a renewable energy project developer’s next round, I’m still a little queasy about the next few months as rumors of a corporate tax cut are bandied about.
Renewable energy project investing continues to be a profitable way to put money to work while doing good things for the planet, especially for people or entities that are seeking an annuity-like steady return. For now I’d have to say the balance has been slightly adjusted away from wind, in favor of solar, biomass, hydro and waste-to-energy plays. But don’t go away, this will change again. I just don’t know how.
If you’ve made it this far, and want to know more, join me this spring when Element 8 hosts an expert panel on project finance for angel investors.