The return – and returns – of tax equity for US renewable projects

Executive Summary

Tax credits are likely to again become the most important subsidies supporting renewable project development in the US, as the Treasury cash grant is on the verge of expiring. This report, commissioned by Reznick Group and undertaken by Bloomberg New Energy Finance, depicts the outlook for US renewable financing in 2012 and delves into the economics of tax equity, focusing on the applications and comparative advantages of the various tax equity structures.

• Growth in the US renewable sector has been largely driven by the availability of tax equity or its temporary substitute in the aftermath of the financial crisis, the cash grant. 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 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. Bloomberg New Energy Finance estimates that the US wind industry alone will require about $2.4bn of third-party tax equity financing in 2012 to achieve our projected wind build targets in the coming years. Incorporating other renewable generation sectors, the total tax equity financing need could be more than $7bn. That requirement exceeds the investment appetite of the established tax equity providers, according to a clean energy trade group. Yet there is a vast pool of potential incremental tax equity supply: the 500 largest public companies in the US alone paid $137bn in taxes over the past year. The participation of even a small number of these firms could narrow the gap between demand and supply.

• There is life after the cash grant. Despite tax equity’s complexity and valid concerns about the depth of the market, tax equity economics can deliver meaningful returns to developers and investors, and there remains political support for this policy.

• 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 the structure thus requires no 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. Our 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 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. For both investors and developers, priorities – whether NPV matters more or less than IRR, or whether other strategic considerations matter more than these financial measures – may drive the choice.

• 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 (ie, those with high capex and low capacity factors), the ideal structure may be a sale leaseback for a developer and a 5-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.

Please download the full report for more detailed analysis.

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