Proximo Weekly: New avenues for US tax credits

The United States has always been unique in using the tax system to encourage renewable energy development. Europe and Asia used a combination of feed-in-tariffs, contracts for differences and indirect subsidies to encourage the build-out of new renewables capacity. The US used a set of tax credits that did wonders for tax lawyers’ practices but were prone to causing disruptions to the US development and finance pipeline. The Inflation Reduction Act, which signed into law this week, does not do away with these credits - in some instances it extends them handsomely - but it does offer developers much greater flexibility in how they use them.

The US used two types of tax credits - the production tax credit (PTC) - used mostly by wind developers - and the investment tax credit (ITC) - used mostly by solar developers. The PTC took the form of a per kW tax credit payable over ten years, while the ITC is calculated as a percentage of capital costs.

The tax credits had to be claimed by the project’s owner, and that owner had to have the right kind of taxable income against which it could claim credits. In practice this led to the emergence of the tax equity market, in which a small number of large US-based financial institutions could make premium returns for taking on debt-like risks. The tax lawyers made a living by carving up project cashflows and “equity” interests and allocating them in a way that kept developers, tax equity providers, and the Internal Revenue Service happy.

The system was liable to seize up when those financial institutions stopped making taxable profits, and did so with a vengeance in the years after 2008. For eight years after that crisis, the US government allowed developers to claim a cash grant in place of the ITC, and falls in wind and solar costs also kept the market humming.

The system was rather fragile, and Congress tended to make the situation worse by making the extension of the tax credit system part of its ritual brinkmanship. It has also yet to be meaningfully tested in the offshore wind segment. But compared to the UK, where onshore benefits from a supportive policy framework but suffers from a broken planning framework, the US onshore market is a model of stability.

The headline feature of the confusingly-named IRA (the act has very little to do with inflation reduction, and its initials have no relation either to Individual Retirement Accounts or the Irish Republican Army) are an increase in the amount of PTCs and ITCs that can be claimed if projects are built in favoured locations, using US content, or their labour is paid the prevailing federal wage.

But two other features are just as important. The first is that municipal utilities, community choice aggregators, rural cooperatives, the Tennessee Valley Authority and Native American tribes can claim the tax credits via direct pay. This will make them much less dependent on PPAs and developers raising tax equity. They may emerge as big players in renewables in their own right.

The second is that it will be much easier for projects to sell tax credits on to third parties. Those buyers may need to be in the right tax position to use them. And they will require some certainty, even insurance, about whether projects will deliver credits as promised, to make contracted credit sales bankable. But the partnership flip, the structure pioneered by defunct leasing boutique-to-infrastructure fund manager Babcock & Brown, may be heading for history, or at least a radical makeover.

Keith Martin, the partner at Norton Rose Fulbright who has been one of the main movers in the development of tax equity structures, stressed in a recent client note that “tax equity will still remain of interest to many developers, particularly those claiming investment tax credits.” He added that monetising accelerated depreciation benefits, which can be substantial, will still require a tax equity investor.

The biggest opportunities for project developers to receive tax credits in cash will be in carbon capture, producing hydrogen, and developing manufacturing of wind, solar and storage components and minerals. All three have attracted respectable amounts of interest from developers, though none have been the subject of a non-recourse financing. Direct pay tax credits should make that process a little easier.

Together, these provisions mean that tax equity investors will need to work much harder to prove they add value to project developers, and the tax equity market will be much less of a potential bottleneck.

Selected news articles from Proximo last week

 

NORTH AMERICA

Brightline closes short-term bonds for commuter sections

Brightline Holdings has closed on a $770 million unrated tax-exempt bond issue to fund completion of the commuter sections of its Florida passenger rail project.

EUROPE

NeuConnect pricing emerges on DFI/ECA-backed facility

The £2.2 billion ($2.6 billion) DFI/ECA-backed debt package funding the construction of the interconnector project linking Germany to the UK – NeuConnect – reached financial close on 21 July this year.

ASIA-PACIFIC

Denham and Nexif announce sale of energy portfolio

Denham Capital and Nexif have signed a $605 million share sale agreement with Thailand’s RATCH Group for Nexif Energy’s 2.67GW portfolio of Australian and Southeast Asian energy assets.

MIDDLE EAST & AFRICA

Ivory Coast signs ECA-backed drinking water project

KfW IPEX-Bank, together with Swedish Export Credit Corporation, has agreed ECA-backed financing for the construction of 1,000 drinking water boreholes with solar pumps, as well as the construction of drinking water supply plants and water pipelines to supply 189 Ivorian villages in Cote d’Ivoire.

SOUTH AMERICA 

Sacyr awarded contract for Buga-Buenaventura road

Sacyr has been awarded a €900 million contract to develop a road project between Buga and Buenaventura in Colombia. The PPP project will consist of a 128 km multi-lane highway and a smaller 116 km road.

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