The biggest constraint to renewable energy growth in the US is the availability of tax equity to support project investment. There is not nearly as much tax equity investment as is needed to support financing and building all of the renewable energy projects in development — as a result the pace of project financing and construction is being severely constrained. Many new investors will begin to enter this tax equity investment space in pursuit of outsized returns with virtually no risk created by a significantly undersupplied investment market. These new tax investors will usher in a period of unprecedented growth in the construction of renewable energy projects.
The Strange Market of Tax Equity Investing
Investment in renewable energy comes from three sources. (1) Project Equity — the investment that actually owns the clean energy facility, this includes the risk of operation and the long-term value of the asset, and there are plenty of investors willing to participate as part of (or all of) this investment. (2) Debt — this is generally traditional project equity lending, and as with project equity there are plenty of lenders — big banks, small banks, private debt funds — ready to lend to all kinds of renewable energy projects. For these traditional sources of project financing project risks are increasingly well understood and, provided there is enough project revenue to cover debt repayment, this money is readily available. (3) Tax Equity — this third, and vital source of capital are investments made in the project that will be repaid primarily through tax credits and other tax savings to the tax equity investor. There simply is not currently enough tax equity to support the pace of growth in renewable power development in the U.S.
To the surprise of most people in the clean energy industry, renewable power was given long-term, stable extensions of the two primary economic supports for renewable electricity generation projects when Congress approved multi-year extensions for both the Production Tax Credit (which primarily supports wind power, but can also be used for biomass, geothermal and other clean energy projects) and the Investment Tax Credit (which primarily supports solar) in December of 2015. These tax credits (as well as some other tax benefits) are the primary federal tool in place to support the development and deployment of clean energy in the U.S., and are typically the single largest incentive available to one of these projects.
While the absolute value of the tax benefits supporting a solar or wind project are substantial, actually realizing that value can be extremely challenging for the owner/developer of one of these projects. Investments in electric generating equipment are appealing because the underlying electric generating equipment has a relatively long life and these assets have historically provided relatively stable, if modest, long-term returns. The challenge with tax credit-based subsidies arises because long stable returns don’t match up well with getting fair value for the front-loaded tax incentives (the ITC is generally returned and realized in year one as a dollar for dollar reduction in taxes paid, but can be carried forward 20 years). The owner/operator of the renewable generation assets typically does not have enough income in the early years to use the tax incentives (also important to note that for many owners or investors — electric coops, municipal power companies, pension funds, etc. — there may never be an opportunity to use the tax incentives). The longer use of the credits or deductions are delayed, like any investment return, the less they are worth.
For reasons deep in the byzantine psychology of Congress, tax credits can’t technically be sold from the party that creates the right to another taxpayer that can use the credits. Despite this prohibition on sales it is widely understood that not allowing the transfer of tax credits creates huge problems (arbitrary value creation for a taxpayer vs. non-taxpayer, undermines investment in exact activity the subsidy is meant to spur, etc.), so there are actually ways to move the value of these tax benefits to a taxpayer that can use them effectively and efficiently: structured investments and shared ownership in the project where a tax investor makes an investment in exchange for the value of the tax benefits, and the capital of any other investors or lenders is returned using the cash value created by the project (cash flow or sales proceeds).
These structured tax investments used to mirror the sale of tax credits are how tax equity investments are made. If a project can’t attract a tax equity investment it is generally understood that the project is not economically viable, won’t get financed and won’t get built. In the current market many — quite likely the vast majority of — renewable energy projects in development cannot attract the necessary tax investments not because the projects are not good, economically viable projects, but simply because there is not enough tax equity in the market.
There are a very limited number of tax investors currently active in the U.S. clean energy market and as a result a very limited amount of available tax equity investment available for projects. This undersupply of these special investment dollars puts an absolute limit on how many projects can be financed and built each year — essentially an undersupply.
Outsized Returns and a Huge New Market
The undersupply of tax equity also means that the market for tax equity doesn’t operate naturally and has allowed tax investors to be far more selective and conservative in choosing projects than would happen in a fully supplied investment market. Returns are outsized to risk. Tax equity returns — these are heavily front-loaded and are typically insulated from much of the operational risk — commonly run higher than the returns for equity investors who are first in line to absorb project losses. This is exactly backwards to what would be expected in a normally operating market (and is backwards from how tax investment returns work in real estate tax investing).
With returns larger than the associated risk, it would be natural for new investors to flood the market, but that hasn’t happened. For more than a decade the renewable development industry has expected an inflow of taxpaying corporations to arrive and add liquidity to the tax equity market. New investors have been slow to the market for a few reasons. The continuity of these tax credits has been unstable because cycles of congressional infighting. This lack of stable long-term extensions has made potential investors cautious about investing in the necessary knowledge for these investments. Energy investing can be complicated. The necessary tax structuring is complicated and the related accounting is complex. Transaction costs can be high and poorly planned investments can have a short-term negative impact on reported earnings.
In 2015 U.S. corporations paid $344 billion in income taxes — total tax equity investment in the renewable power sector was reported to be $11.5 billion. So there is plenty of investment available (there was more than $1.5 trillion in individual income tax paid during this same period, but tax investments by individuals is subject to a special set of passive loss rules make these investments extremely rare and require sophisticated professional guidance).
Long-term tax credit extensions coupled with huge growth projections for renewables has the industry again looking for an inflow of new tax investors from financial institutions and eventually a waterfall of corporate tax equity. This is starting to happen — anecdotally several new investors have emerged looking for guidance on whether to enter the market and how best to do it. The potential for several years of very strong returns on investment will help new investors overcome concerns about complexity and perceived risk.
This new inflow of tax equity will be the foundation for a huge uptick in financed and constructed renewable energy projects. As new investment comes into the market several non-core renewable energy markets, like rooftop solar for commercial and industrial buyers, corporate buyers of large utility scale renewables and projects with merchant power risk will all see easier access to project financing. Countless projects that wouldn’t otherwise get built will, unleashing a period of tremendous growth for clean energy.
There are significant rewards for those that can move fast into this tax investment market. Because of the undersupply of tax equity returns for these investments remain outsized to risk. Additionally, as more tax equity flows into the market, knowing how the transactions work will allow early entrants to better control transaction time and cost allowing these investors to find continued prosperity in an increasingly competitive market.
Photo Credit: Brian McNamara via Flickr