Several members of our team spent last month at the Solar Power International (“SPI”) conference. Putting aside the usual excitement about falling panel prices and overall capacity increases, the two phrases heard most – and usually together – were: “North Carolina” and “Tax Equity.”
Solar in North Carolina
Solar development in North Carolina is hot right now. Not only is North Carolina relatively sunny, but there is also an abundance of fairly inexpensive, buildable land upon which ground-mounted solar systems can be placed. Additionally, labor costs are not as expensive as in many other parts of the country. Perhaps most importantly, though, North Carolina has adopted a mix of state-level incentives that make financing a solar project within the state economical relative to other states.
These incentives include a modest renewable portfolio standard (“RPS”) with a small carve-out for solar: Investor-owned utilities such as Duke and Progress must obtain 12.5% of their generation from renewable sources by 2021, with 0.2% of it coming from solar by 2018. This has spurred the utilities to create programs offering standardized power purchase agreements (“PPAs”) for projects that are less than 5 MW. The state also offers a property tax abatement of up to 80% of the appraised value of the installation. Further, the state offers a corporate tax credit of up to 35% of the system cost (subject to a $2.5 million cap).
This last incentive is important to the financing of projects in the state. When combined with the federal Investment Tax Credit (“ITC”) of 30% of the system cost and sizeable taxable losses created by accelerated depreciation, it means that anywhere from 45% to 65% of the installed cost of the system often can be taken to offset an owner’s tax liability – depending on the system size and capital structure used.
Matching Tax-Paying Entities with Developers
However, as with the federal ITC, the project owner must have sufficient tax liability to realize the economic benefit of the tax credit. Since solar developers of many projects typically are small- and medium-sized companies, they rarely, if ever, have large enough annual tax bills to utilize the federal credit – let alone the state credit. For such project developers, they need partners who can take ownership of projects in order to make use of the tax credits (at least for the period that the tax credits are available).
Enter the “tax equity investor.” Given our national fetish with incentivizing certain investments through use of the federal and state tax codes, tax equity investors have been involved in various industries – from airplane leases to affordable housing to renewable energy – for decades. There are many variations on the theme, but the basic idea is that there is a tax equity investor who has tax liability that it wishes to offset by utilizing the credit that would otherwise be lost since the natural project owner lacks the tax liability to monetize it.
The tax equity investor makes an investment into the project, and in exchange, receives the tax benefits provided by the project as well as some amount of cash flow from project operations. The partnership is typically structured so that the tax equity investor retains ownership of the project until the time that the provision of the tax credits ends; at that time, project ownership “flips” to the cash (i.e. non-tax) equity partner (i.e. the sponsor equity).
The determination of how much money the tax investor contributes upfront is typically dependent on the amount of tax and cash benefits that it will receive during the time that it is involved with the project and the return on investment that the investor seeks. While the federal ITC is taken once the project is constructed, the North Carolina state credit is taken in five equal installments (e.g. $500,000 each year, assuming that the project cost is high enough such that all $2.5 million is available for use). In both cases, however, the tax equity investor must retain an ownership interest in the project for five years.
With this combination of federal and state incentives, the ideal tax equity investor in North Carolina solar projects is thus obviously an entity that accrues tax liability at both the state and federal levels. This naturally includes most large, profitable companies doing business in North Carolina.
So why was there so much talk at SPI this year about the need to find tax equity? For one, the state of the economy has weakened many companies’ profitability over the past few years and has meant that tax bills are in many cases much lower than they had been prior to the 2008 crash. Further, the solar market has only recently (i.e. in the past few years) begun maturing in such a way as to become mainstream enough for those whose core business is outside of renewable energy. Additionally, given the relative complexity of the investment, many corporate taxpayers are hesitant to become involved. As a recent U.S. Court of Appeals case on tax equity demonstrates, the investment must be structured in certain ways so as to ensure that it passes muster under IRS rules.
Having said all that, though, there are some compelling reasons why these investments should merit consideration.
First, the returns on many smaller solar deals are attractive – typically between 10% and 20% once the tax benefits are included. The bulk of these returns are not sensitive to the operational performance of the project, since they are derived from the tax credit related to the initial investment (which does not change with operational variability). This is not to say that there are no risk factors for the tax equity investor; there certainly are, but they do not seem out of proportion with the returns currently available.
Second, while the solar boom may be somewhat new, the use of tax equity has, as mentioned above, been used successfully for decades. Thus, the structures – while complex – need not necessarily be very pioneering. They merely must meet certain criteria.
Third, being a tax equity investor allows an investor to get a PR boost by helping to finance and support clean energy in a financially attractive way.
Given this, we expect that what may be a hot topic now will eventually become merely another readily available source of capital as the solar industry continues to mature and new players enter the market.
The above has been prepared and is being furnished solely for informational purposes, and does not constitute an offer to buy or sell any securities. It represents the views of the author and does not constitute investment or tax advice.
Joshua Herlands works at Captona Partners, an investment firm focused on the renewable energy sector. Captona is affiliated with Karbone, a leading environmental markets firm. At Captona, Mr. Herlands sources and analyzes investments in wind, solar, and biomass energy projects throughout North America. Prior to Captona, Mr. Herlands spent several years working in energy investment banking and wind energy development. Mr. Herlands holds a JD from Harvard Law School and BA and MA degrees in International Policy from Stanford University.
