Under the US Inflation Reduction Act (IRA), signed into law in August last year, the ability for solar and other renewable energy projects to transfer tax credits is creating a whole new market, according to a prominent lawyer in renewable energy and private equity.
The option of adopting the solar investment tax credit (ITC) or the production tax credit (PTC) now comes with a credit transferability that is putting developers in the “driving seat” by giving them the flexibility to sell all or a portion of the credits to third parties to “optimise projects, capture maximum value, or significantly reduce exposure to risk from a project”, Carl Fleming, a Washington DC-based partner at law firm McDermott Will & Emery, tells PV Tech Premium.
Prior to the IRA, the vast majority of US tax credit investments were structured as a joint venture mechanism where a tax equity financier invested in a project for the federal tax credits such as PTCs or ITCs. However, the market was constrained because only a certain number of tax equity providers and institutions were able to arrange for these complex and heavy diligence investments into these tax credit investment vehicles. The market was also constrained to only those PTCs and ITCs that each provider or institution was able to allocate in a given tax year.
However, the new tax credit transferability option has created another market where those same providers and institutions can now structure some of their transactions to remain joint ventures for the full amount of the tax credits, divide a portion of the tax credits among a joint venture and also sell a portion of these credits to third parties. The IRA has also opened the door for third parties to enter the game and begin to broker these tax credits alongside the more traditional players.
New entrants monetising tax credits
“We are seeing a slew of new participants in the tax credit market, many of which are large corporates, insurance companies, or bespoke brokerage services, because this creates another avenue for monetising these tax credits, and we are also seeing the existing players shift their models to accommodate for the changes,” says Fleming.
In sum, the transferability option has created a much larger pool of potential investors and allowed for much greater access to these credits, whilst providing the upper hand to those that understand the legislation and how to use it to structure and broker deals optimally.
Another key change is that developers can now custom tailor their use of these credits in various markets, with the option to peel off all or some of the tax credits and sell them to a third party. In the past, developers typically invested in all of the PTCs from a wind project or ITCs from solar project. But now, Fleming says developers can custom tailor a traditional joint venture tax equity financing for a portion of the credits (for example, the baseline ITC of 30%), with the remainder of the credits (for example, 10% to 30% for IRA ‘adders’ that can be stacked onto the underlying ITC) sold to a third party in the transferability market to manage risk.
This raises the question of who are these third parties. Fleming says many are large corporate companies who are looking for the economic, tax, environmental, social and governance benefits from renewable energy projects, who may not previously have been in the business of setting up elaborate tax equity, joint venture investments. They can now work with intermediaries who will arrange such joint ventures or, if the corporate has enough size and sophistication, it can execute it directly. The transferability due diligence process and documentation are much less complex than the arduous joint venture process.
Fleming‘s IRA team – comprised of a group of seasoned renewable tax credit specialists, tax equity transactional specialists and public policy advisors – are amongst the first people helping to structure and close on such transferability deals as middlemen, he claims.
As of the publishing of this article, Fleming and his McDermott team have already closed their first IRA transferability deal, closed and funded a few IRA energy community adder deals and signed up commitments for a few IRA domestic content deals with funding to follow. They are also leading another dozen or so early-stage transferability transactions. This is in addition to both being heavily involved with a number of banks, investors, trade associations and developers in their “great rethink” of the market as well as helping shape the forthcoming IRA guidance.
“Part of the demand has been from our own corporate clients saying, ‘hey this was off limits before, what can we do now? How do we get into this market?’ There’s a lot of appetite for that,” Fleming adds. But an even larger part of the demand, and where he has seen the most transactions, is around seasoned developers and providers smartly selecting projects that check the boxes on the IRA guidance or entering into transferability arrangements for tax credits that are less at risk for recapture going forward.
Tax appetite, discount trading and ESG driving demand
Having not had access to these credits before, corporate companies with tax appetite can now satisfy that inclination with the tax credit transfers. Fleming notes that while the transferability market takes time to solidify there will likely be a range of discounts applied to present transfers when trading on the secondary market, ranging anywhere from a company paying US$85 cents to US$97 cents on the dollar for such credits, for example, because it may involve taking on certain risk on project completion and timelines. The riskier the project, the greater the discount, whereas “a slam dunk” project near completion will entail paying closer to the full amount of the tax credit. This is not uncommon as McDermott’s experience in various state tax credit and transferability programmes had similar trajectories before ultimately settling out at close to full payment for tax credit transfers once the market was comfortable with the transactions.
A broad shift towards environmental, social and governance (ESG) values among corporates is also drawing interest to the credit transfers. Fleming notes that some proactive investors now state that they will not invest in companies that don’t adhere to ESG guidance or have a plan towards that.
Many of these companies are not energy companies, but they now see the value of either procuring green energy or partaking in this tax credit transferability to help bring more of these renewable energy projects to fruition.
The great rethink of the energy markets
The key takeaway is that the new credit transfer market allows developers to be more in the driver’s seat of their projects and finances by having more flexibility on how to use the credits generated by them. It also allows investors and institutions to use the transferability option to syndicate credits or offload them further down the life of a project in the case there is a need on their end for commitment and funding purposes.
“Before you only had one way to do it and some pretty stringent due diligence requirements on the tax equity,” says Fleming. “There’s still going to be a lot of due diligence for the joint ventures, but you can now begin to parse this out into different vehicles. Or you can go the transferability route only and circumvent some of the rigours of the joint venture due diligence process.”
Some teams may keep doing the exact same process by working on tax equity joint ventures and relying on existing quality relationships. Other teams, however, have sat down and done what Fleming calls “the great rethink of the energy markets”, working on a 10-year tax credit timeframe for the IRA as opposed to the one- or two-year increments of the past.
Bonus credit game changers
Under the IRA, there is the baseline PTC and ITC as well as a new standalone ITC for storage. On top of this, however, one can stack on various adders (bonus credits) based on incentives for projects being built in certain areas like old coal mines or using certain pieces of domestically sourced equipment. This “game changer” has opened a whole new environment, says Fleming. With this new playbook for optimising projects, developers are ultimately trying to capture as much additional value as possible from one project. The question of how to monetise these credits is key, and it’s not just developers, but private equity and banks that are taking interest because it opens up new pools of people to do business with.
The IRA includes adders for clean energy projects developed in energy communities, locations which had previously relied heavily on fossil fuel production or may face challenges associated with the energy transition. Fleming says energy communities is an area where the legislation is already clear enough, with adequate certainty on whether a project meets the requirements, so McDermott has already committed to and funded a number of those transactions already.
Domestic content adders
The adder for domestic content is the big ticket item, says Fleming, with its details being the most pervasive area of interest in his educator office hours with clients. There are uncertainties hanging over the domestic content classification, however, including the wait for Internal Revenue Service (IRS) guidance to formalise and clarify requirements, as well as clarity on what comes under the domestic content classification.
“It’s one thing to say domestic content gets you an additional – let’s say 10% – adder,” says Fleming. “That’s great, but if I’m a bank or an investor, I have to know what domestic content means with a definitive checklist and have that checklist in my developers’ financing documents.”
Despite the ambiguity, some players are getting a head start by setting up structures or setting up commitments right now with the funding for those made contingent upon the IRS guidance whenever it comes, notes Fleming.
The adder for domestically sourced equipment comes after the US renewables industry encountered problems in recent years sourcing the PV module and energy storage battery components that it usually buys from China and other Asian countries. The US has also added further supply chain pressure by introducing laws against products manufactured with forced labour.
The attempt to stand up a US supply chain with a domestic content incentive is complicated in terms of which components qualify or not, especially as some components must be sourced from overseas until the US has begun its own supply chain of that item.
Given the complications, Fleming forecasts the domestic content guidance will come out in Q2 this year “if we’re lucky”.
The biggest challenge at present is navigating the complexity of the inputs in the IRA, he says, adding: “It’s a challenge and an opportunity because this is so complex and so lucrative. It presents an opportunity to rethink almost every developer’s business model.”
PV Tech publisher Solar Media will be organising the second edition of Large Scale Solar USA Summit in Austin, Texas during 3-4 May. With the Inflation Reduction Act (IRA) targeting US$369 billion for clean energy and US$40 billion for manufacturing, the solar industry has never been brighter. The IRA, securing financing for future projects or supply chain bottlenecks will be among the discussions at this year’s event. More information, including how to attend, can be read here.