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The 2022 Inflation Reduction Act (“IRA”) is the largest commitment made by the United States government to fight climate change. It comes in the form of nearly $400 billion in tax incentives for clean energy projects, which will reduce carbon emissions and accelerate the country’s energy transition away from fossil fuels.
Importantly, the government has expanded its tax credit incentive policy, now allowing most tax credits for climate infrastructure projects to be sold for cash to an unrelated party, under a framework known as “tax credit transferability.” Direct Pay is another option for tax-exempt entities, but for all other corporations and developers, these one-time sales vastly simplify the complicated structures previously required to monetize government tax credits. This post discusses the challenges of previously monetization structures, and opportunities to fully take advantage of the new policy.
What is tax credit monetization and why is it important?
Tax credit monetization is when a developer of a qualifying asset sells their tax credits they receive for the asset, in exchange for cash up-front. As a small, private company, the developer likely does not have enough taxable income, or “tax appetite”, to efficiently utilize the project’s tax credit. When a company has more tax credits on-hand than taxes owed, the remaining balance will carry forward year after year until the tax credit is used up. While this is allowed under the tax policy, it means slowly getting benefits over the course of up to 22 years, rather than getting up-front value for the credit in the form of a cash payment at the end of construction. Tax credit buyers, on the other hand, take advantage of these tax credits to help reduce their organization’s tax burden and get a short term guaranteed return on their investments. They also can help buyers meet Community Reinvestment Act (CRA) requirements or Environmental/Social/Governance (ESG) initiatives.
How were tax credits for renewable energy projects monetized before the IRA?
Since the Energy Policy Act of 2005, the main subsidies for solar and wind projects are the Section 48 Investment Tax Credit (“ITC”) and Section 45 Production Tax Credit (“PTC”). Because these credits were not sellable or transferable, the IRS developed an evolving set of regulations that pushed to ensure “true ownership” of tax equity investors. As a result, traditional tax equity deals relied on complex, longer-term partnership structures. These evolved into three main categories:
Arranging these structures is legally complex, and (for partnership flips in particular) may involve ongoing reporting requirements and GAAP accounting implications for publicly listed companies - specifically around partnership equity accounting standards. These accounting requirements can have strong effects on earnings impacts, and are challenging for many corporations to incorporate. An entire industry was built up around these complicated rules and guidelines, working to help project developers monetize their tax credits but consequently taking a lot of time, energy, and brain-damage. From the above, we can make the following key conclusions about the previous market:
It has been a buyer's market There have been a limited number of tax investors available to invest in these tax credits due to their complex nature and long-term obligations.
Tax equity investors have typically favored larger transaction sizes, with a minimum commitment of above $50-75 million. This makes it harder/impossible for smaller commercial solar developers to monetize their tax credits.
Bankability is everything Because it has been a buyer’s market, tax equity investors have prioritized larger projects with reputable, “bankable” sponsors, and strongly favor repeat business.
Big challenge for small developers Tax equity investors historically push to invest in only the projects with strong revenue profiles, often rejecting deals with higher merchant risk or weaker financial sponsors. This squeezes the smaller developers with the trickier projects out of the market.
What is transferability, and why should it be used?
Tax transferability is inherently a much simpler transaction than tax equity partnership investing, and has the potential to expand access to and lower the cost of capital available for renewable energy. There are some key differences between the two, which are summarized in the following table:
However, because of entrenched behavior from the previous regulation, there are a few misconceptions that need to be resolved, including:
Educating the new buyer universe on these tax credits and how to appropriately utilize them
Streamlining the diligence process to reduce soft costs
Allocating risk between tax credit buyer and developer in a clear way, and the risk itself can be further reduced through tax recapture insurance
Transferability is a clear option for your organization if your projects are smaller than the minimum threshold of traditional tax equity investments, or you simply want to spend less time structuring complicated transactions, and spend more of your valuable time building projects. Basis Climate aims to solve all three areas of education, diligence, and risk allocation for our stakeholders, and provide them with a one-stop-shop for their tax credit monetization.
Now with the IRA allowing tax credit transferability, Basis is here to revolutionize the way tax credit monetization is accomplished, and even the playing field between buyers and sellers in our marketplace. We look forward to working with developers and tax credit buyers on the Basis platform.