By Kari Williamson

The US renewable energy industry has received over US$65 billion in tax credits, grants and soft loans under the American Recovery and Reinvestment Act. However, unless the private sector steps into the breach with substantial new investment, project development will slow.

The cash-based incentive programme is due to expire at the end of 2011, and tax credits are likely to again become the most important Federal subsidies supporting renewable project development in the US. These incentives propelled the sector’s growth for much of the past decade, particularly in the run-up to the financial crisis.

The report, The Return – and Returns – of Tax Equity for US Renewable Projects, delivers two major findings about tax credits: first, that the economics of ‘tax equity’ – the part of a renewable project’s financing structure used to take advantage of tax credits – can provide attractive returns for parties involved in these transactions; but second, that the US renewable sector will require new sources of tax equity if it is to meet market demand for project finance.

“This analysis shows that tax equity economics can be made to work for the right projects,” says Michel Di Capua, Head of Analysis, North America, at Bloomberg New Energy Finance in New York. “There is life after expiry of the Treasury cash grant programme. Financing for the US renewable sector will look quite different in 2012 compared to the past three years once the cash grant is gone, but different does not mean dead.”

Key findings:

• Since 1999, the production tax credit has been allowed to lapse by Congress on three occasions, with each lapse resulting in a precipitous drop in new wind installations. The introduction of the Treasury cash grant programme as part of the American Recovery and Reinvestment Act in 2009 saved the industry from another drop, but that programme is due to expire at the end of 2011;
• Alternative sources of tax equity may need to emerge to meet market demand for project finance. The total need for tax equity financing next year could be more than US$7bn. That requirement exceeds the investment appetite of established tax equity providers, according to US Partnership for Renewable Energy Finance, a clean energy trade group;
• There is a vast pool of potential incremental tax equity supply: the 500 largest public companies in the US alone paid US$137bn in taxes over the past year. The participation of even a small number of these firms in the tax equity market for renewable energy could narrow the gap between demand and supply. Tax equity is also not unique to the renewable energy sector; US corporations have historically made use of these kinds of incentives in the low-income housing sector, for example;
• Expiry of the cash grant should not be expected to result in collapse of the US renewable sector. Tax equity is undoubtedly more complex than a cash-based incentive. Nevertheless, tax equity economics can deliver meaningful returns to developers and investors, and there remains political support for this policy. However, significant uncertainty will remain until Congress reaches a decision about whether or not to extend the production tax credit, currently set to expire at the end of 2012;
• The three primary tax equity structures offer distinct advantages to developers and tax equity investors. With the ‘partnership flip’ structure, the investor receives most of the project benefits until a change in ownership event – a flip – occurs. Under the second structure, sale leaseback, the developer ‘leases’ the asset from the investor and so requires much less investment upfront from the developer. Finally, in an inverted lease, the investor leases the project from the developer and enjoys the benefits associated with a ‘pass-through’ tax credit;
• The economics of these structures can be attractive. For relatively good but not necessarily exceptional renewable projects, the internal rates of return (IRR) and net present values (NPV) for most of these structures can meet hurdle rates for both developers and investors. The study's base-case analysis shows developers achieving returns of 6-19% and investors achieving 10-49% for wind projects, depending on the structure. IRRs for investors reach the higher end of their ranges in the case of upfront receipt of tax benefits. The financing structures also usually present a trade-off between IRR and NPV. A structure which yields high returns (due to upfront receipt of benefits) may have a lower NPV than a structure which yields moderate returns and whose benefits are spread over a longer period;
• The choice of investment versus production tax credits (ITC vs. PTC) comes down to the three ‘P’s: performance, perspective and priorities. Very high performing projects tend to favour the PTC. The perspective – tax equity investor vs. developer – also governs the decision; for example, investors almost always prefer the ITC on an IRR basis and the PTC on an NPV basis, whereas for the developer, this choice depends on the structure and the project quality; and
• The optimal tax equity structure depends on the project characteristics... but perfect optimisation may be a pipedream. ‘Optimisation maps’ show the ideal tax equity structure from the developer’s or tax equity investor’s perspectives for a given scenario. For example, for less high-performing projects (i.e. those with high capex and low capacity factors), the ideal structure may be a sale leaseback for a developer and a five-year partnership flip for an investor. The fact that the two parties’ preferred tax equity structure usually differs highlights the trade-off in value: one party benefits at the expense of the other. Ultimately, selection of the final structure – as well as fixing the terms of variables such as ‘syndication rates’ and ‘early buyout price’ – depends on relative negotiating power.