The perceived complexity of tax equity transactions for renewable energy has kept a damper on participants in this niche market, limiting players to large US banks, followed distantly by other financial services companies and technology giants.
But tax equity experts say new provisions allowing for transferability should, over time, help to smooth out gaps between the demand for and supply of tax equity – even as the capital needs of the energy transition continue to scale higher.
“In the tax equity space, an imbalance between supply and demand has always existed and, with the passing of the Inflation Reduction Act, additional types of technologies are eligible for tax credits, which will further increase the demand for tax equity,” says Gary Durden, the managing director at CohnReznick Capital.
On the one hand, the new transferability provision should help bring new investors that will finance both new and established industries. On the other hand, appetite for ESG-related investments is sky-high and trending up.
“The introduction of transferability should increase the supply of tax equity product and buyers of the credit, thus helping to alleviate some of the imbalance,” Durden says. “Transferability could become the most impactful provision of the IRA; it has the potential to completely change capital markets for renewable energy projects because it will make investments much more accessible to capital providers.”
A report published by CohnReznick highlights that the IRA contains USD 369bn in investments to boost clean energy and curb greenhouse gas emissions. With the support of the US government, investors are incentivized to deploy resources in everything from seed capital allocated in innovative and disruptive technologies, to investments in renewable power generation, stand-alone electricity storage, carbon capture and sequestration (CCS), renewable natural gas development, and green and blue hydrogen, among others.
While some sectors such as CCS can benefit from periods of direct payments in its financial models, tax credits are supposed to be the source of biggest boost.
Beginning in 2023, CohnReznick anticipates USD 40bn in annual demand for tax equity funding from renewables and CCUS combined, with some investors moving away from solar and wind, and toward carbon capture.
Meanwhile, in a webinar hosted by Norton Rose Fulbright on 13 January on the outlook for cost of capital, experts were forecasting that, while expecting to see USD 20bn to USD 21bn of new commitments for tax equity investments into renewable projects this year, there would be a gap between demand and availability.
New investors in the tax equity space could help fill the gap.
“There is a huge demand for ESG related investments. Some of the companies that have met that demand to deploy ESG related goals via PPAs, as offtakers, could now consider doing so as tax equity investors,” notes Elias Hinckley, a partner in Baker Botts’ Washington DC office. “As tax equity investors, they are more shielded against the volatility of the energy market, because there is a degree of cushion between the exposure to the market risk as a tax equity investor.”
Hinckley adds that a track record of tax equity transactions could factor in as a third source of confidence for newcomers.
“Albeit more recently, some fundamental changes in the market are further supporting the entry of new investors,” he says. “Not only the passing of the IRA and its incentives, but the overall awareness among people that these investments convey returns: folks have seen others being successful as tax equity investors.”
So far, the perceived complexity of tax equity investments has been a chief reason why so few players other than banks have participated as investors. A tax equity investor must find comfort with construction risk, given that a tax equity commitment is required in most cases by project finance lenders. It must also understand the risks and rewards that its participation in the ownership structure entails. But “transferability” takes the ownership hurdle out of the way.
“Although the monetization of tax credits for renewable energy projects, especially solar and wind, has been in place for some time, these transactions have been perceived as complex from the perspective of outsiders,” Hinckley notes. “Transferability is a simpler entry point, it becomes only a financial transaction that doesn’t require ownership in the project, and the related financial structuring.”
New financial structures must be created and then embraced. One option is to have the banks acting as syndicators, underwriting the tax equity investment transaction and selling down the credits to some of its clients.
Some new transactions are already taking shape with the participation of new investors. An advisor says that he would characterize these newcomers as a cross section ranging from retailers to tech companies, heavy industry and fossil fuel companies.
Stand-alone storage could become a big beneficiary of these new structures, because of the higher merchant exposure of these projects, says a project developer. Within this new framework, it is easier for a stand-alone storage developer to monetize the tax credits and lower the need for back leverage debt.
“We are going to see an uptick in new tax equity investors, either through syndications allowed by the transferability provision, or participating in the ownership,” Hinckley says. “The challenge is how quickly these new investors can be positioned in the market to fill the gap that the increased demand will create. It is an education and execution exercise.”
Time can be the bigger factor at play. Time to assess the new legislative framework, to digest the new opportunities and risks, and to observe how pioneers do it and what the outcomes are. The project developer agrees that it may take years before these new structures become mainstream.
Additionally, the industry is also waiting for more clarifications from the government regarding the new law.
“At this point, we are still waiting for further guidance from the IRS about how to interpret the provisions in the new law; we’re not likely to see much transaction activity related to the IRA until that guidance is provided,” Durden points out. “Once that becomes available, we’ll see transactions getting done and new investors entering the market.”
Another layer to this process is how project finance lenders take on the presence of these new tax equity investors. The structure of project finance transactions has seen lenders providing term loans, and especially tax equity bridge loans, based on commitments from already familiar institutions acting as tax equity investors.
“However, something that we are still waiting to see evolve is how market-based tax equity monetization through transferability will be accepted by the project finance community,” Hinckley points out. “Most lenders require a committed tax equity investor before disbursing loans; financing arrangements that are based on a market that will theoretically be available to buy credits is much different than lending against a commitment from traditional tax equity investors that commit capital once an asset is built. The market will need sophisticated intermediaries to build this financing bridge.”
Participants at the Norton Rose Fulbright’s webinar indicated that, though they observed a high demand for tax equity investments, and commitments to these transactions were already underway, levels should not surpass those of 2022.
A more challenging financial environment, marked by uncertainty and volatility still compounds with persisting difficulties in supply chain and higher cost of funding. But the increasing need to deploy ESG-linked capital and the flexibility of the new tax credit framework are expected to generate the anticipated boom of investment opportunities.
“Renewables project developers are still dealing with challenges to their processes, such as higher capital costs, renegotiation of offtake contracts in some instances, supply chain problems, and higher borrowing costs. There is still a lot of optimism for the long term, but there is still anxiety for the nearer term,” Durden says.
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