Large US banks that provide the bulk of tax equity to the renewable energy sector could reduce activity by around 90% if proposed Basel III rules that increase capital requirements are implemented, according to industry groups and market participants.

“People are alarmed,” a tax equity investor told Infralogic, adding that the worries are already slowing down decision-making. “Some bank investors were caught off guard," he said. "The natural reaction was to take a pause to make sure senior management understands the issue.”

Concern has been growing since the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency approved a notice of proposed rulemaking (NOPR) that would increase capital requirements for banks with more than USD 100bn of assets by around 16% in aggregate. For non-publicly traded equity, there will be a 400% risk weight, four times the current 100%. Banks with less than USD 100bn in assets and non-bank corporate investors are not subject to the rules.

The quadrupling of the requirement is unwarranted, given tax equity’s risk profile, the American Council on Renewable Energy (ACORE) wrote in a 22 August letter to the National Economic Council. It warned that the higher capital costs would lead to fewer projects being built, undermining the goals of the Inflation Reduction Act (IRA).

“The increase in pricing that would be needed to accommodate the 400% risk weight would be astronomical, and the project investment would no longer be viable for the developer if that cost is passed along to them,” the letter states. “Despite the effective date of the proposed rules being 2025, this uncertainty has already caused many bank investors to take a pause on issuing new investment commitments.”

The weighting requirements imply that tax equity is eight times riskier than residential mortgages and 60% riskier than public equity, Norton Rose Fulbright partners David Burton and Hilary Lefko wrote in a 5 September blog post.

“Anyone who has followed a tax equity portfolio knows this is not the case,” they wrote. “Typically, when one thinks of non-publicly traded capital one thinks of venture capital, hedge funds or private equity.  A well-structured tax equity partnership has little in common with the risk profile of any of those investments.”

90% decline

The proposed changes will reduce tax equity investing by 80% to 90% for large banks, the tax investor said, adding that he hopes the high risk weight is an oversight and not an intended policy position. The key message to regulators is that clarification is needed as soon as possible, he said.

His firm is continuing to close commitments for 2023 and is moving forward with the deals to which they have already committed, but has had to put conditions on deals for 2024 and 2025, such as making transactions contingent on the 400% risk weight not taking effect. 

The deadline for public comments on the proposal is 30 November. After that, regulators will conduct an analysis of the feedback and eventually issue a final rule - for which there isn't a hard deadline. That could include changes to the language surrounding tax equity investments or other areas of concern raised through the process. Experts say a decision is likely to drag on into 2024.

While representatives for the FRB, OCC and FDIC told Infralogic they will not comment on potential changes to the proposal during the comment period, FRB Vice Chair Michael S. Barr said in a statement upon release of the proposal that the rules are subject to revisions based on evidence submitted through the comment process before the issuance of a final rule.

“We will be vigilant in working to avoid unintended consequences and I encourage commenters to provide us their analyses on all of the issues presented,” Barr said.

Warning to Congress

The issue has caught the attention of renewable energy advocates on Capitol Hill, where representatives from the banking sector recently told lawmakers of the chilling effect the Basel III regulations could have on tax equity investment if changes aren’t made. Greg Baer, chief executive of the Bank Policy Institute - a trade group representing the banking sector - told a congressional panel that the regulations, as proposed, would almost certainly shrink the market for tax equity investment in the renewable energy sector.

“We’ve talked to banks. They would absolutely exit this market if their risk rate went from 100 to 400%,” Baer said.

Regarding the justification for the change, Baer said there’s no evidence that the proposed increase in weighting, roughly four times that of a corporate loan, reflects the actual risk profile of tax equity investments in renewable energy or in other sectors.

“I don’t believe there’s evidence that the loss rates on this are higher than a corporate loan would be," he said. "Certainly, there’s nothing in the proposal that demonstrates that.”

Illinois Democrat Sean Casten, a vocal renewable energy and climate advocate, said during the hearing that the increase in risk weighting could undermine progress toward decarbonization achieved through major legislation like the Inflation Reduction Act.

“It’s important for our banks to be well capitalized, but on this narrow point if we agree that the risk profile isn’t different, then let’s not cut off our nose to spite our face,” Casten said. His criticism was notable, as it came during a hearing in which Democrats largely sought to push back against aggressive GOP criticism of the rules’ broader focus on raising capitalization requirements.

Casten said that he would push for a fix in what he described as a likely oversight by regulators in the language of the rules. “I would hope that we can fix this in some other fashion. I hope that some of my colleagues would work with us,” Casten said.

Monetizing incentives

If the proposed rules do go into effect, project sponsors would have to pursue other methods of monetizing incentives for renewables projects. 

“It would be challenging for any one of those groups to step into the shoes of any of these big banks on these deals because they are very large,” says Bryen Alperin, a managing director at tax credit specialist Foss & Co. Some deals may require syndication of multiple tax equity investors. 

The transfer market, established by the IRA, also provides an alternative for sponsors, though traditional tax equity generally remains the preference of the industry when available. 

Burton and Lefko list these and three other possibilities. Tax equity investors can try to qualify as community development investments under section 24 of the National Bank Act, which would require just 100% capital weighting. Or the tax equity investment can qualify for “proportional amortization” under Generally Accepted Accounting Principles (GAAP) and be viewed as debt. Finally, the market could shift towards sale-leaseback transactions.

“However, all of [these strategies] combined are unlikely to be able to fill the hole left by the largest banks exiting the tax equity market,” they said.