The 2022 Inflation Reduction Act (IRA) is the United States’ largest ever investment in clean energy. The clean energy sector has already been growing exponentially and the IRA is expected to catalyze $3 trillion of investment in the US over the next 10 years, according to Goldman Sachs.
The IRA makes principal use of tax credits, which are more generous to developers than ever before and are extended for at least 10 years, providing stability and certainty to our industry. In addition, the IRA added eligible categories for new decarbonization technologies (such as stand-alone energy storage, hydrogen, and carbon capture) and advanced manufacturing.
To allow the marketplace to realize the full value of the credits, the law introduces a new transferability mechanism that permits 11 federal clean energy tax credits to be sold for cash. The IRA also creates “direct pay” for tax exempt entities (like schools, tribes, and governments) and certain categories of credits on a limited basis. Though a limited form of transferability exists in a number of state tax credits, those credit programs are at least an order of magnitude smaller than the new IRA credit regime, and there are substantial differences in the structure of those markets. True transferability has never existed at the federal level until now.
The 11 energy tax credits that the IRA makes eligible for transferability are:
Before the IRA, various forms of tax equity were the only external mechanism to monetize project tax attributes, with “tax investors” investing directly into partnerships with developers and receiving a special allocation of cash, tax credits, and depreciation in exchange for investment.
In 2022, tax equity accounted for roughly $18 billion of financing for projects. Being a partner in a tax equity transaction is structurally complex and generally requires domain knowledge and monitoring and oversight capabilities. As a result, tax equity has principally been the domain of banks and insurance companies – and more than 80% of the market is composed of the 10 largest tax investors.
Given the ability to monetize depreciation and step-up project basis, tax equity and partnership structures have been and will continue to be an important tool to finance renewables.
However, the existing tax equity market will not be able to absorb the five-fold increase in the dollar value of tax attributes generated. Many new buyers will need to participate in this market. In 2022, US corporations paid $334 billion in taxes and the Congressional Budget Office forecasts that number to grow to $527 billion by 2031. For $83 billion (Credit Suisse’s independent estimate of the potential annual outlay of IRA credits) to be monetized to corporations, roughly 16% of all 2031 corporate tax liabilities would need to be allocated to tax credits.
Historically, renewable energy project developers were required to enter into joint-ventures and leasing arrangements with other private companies that had a sufficient tax liability in order to capture the full value of the major clean energy tax credits like the ITC and PTC. These arrangements are known as "tax equity" and are relatively complex financing structures. This has created a bottleneck on the deployment of renewable energy over the last several decades. Generally, only large financial institutions with project finance underwriting capabilities and a small cohort of non-financial companies have been repeat "tax equity" investors.
The transferability feature for various clean energy tax credits included in the IRA makes it possible for a larger universe of corporate taxpayers to take advantage of the credits since they will not be reliant on entering into complicated tax equity structures to see a benefit. Transferability is a simpler structure and should entice a much bigger pool of corporate taxpayers to participate in clean energy project financing.
With more buyers, a larger pool of project developers should be able to benefit both from the ability to monetize their tax credits and the simpler process for doing so. Tax credit monetization plays a significant role in capitalizing clean energy projects, so more capital access should be a catalyst for many project developers, especially those who may not have established relationships with tax equity providers.
Finally, while the IRA streamlined the process for project developers to monetize their tax credits, this transaction is still complex and it will continue to be important for buyers and sellers to engage their advisers throughout the process. Syndicators, tax advisors, and other intermediaries are going to continue to play a critical role in connecting buyers and sellers, structuring transactions, and conducting due diligence on TTC investments.
At Crux, we're laser-focused on creating the ecosystem that will enable all industry participants to scale their businesses and maximize opportunities in this emerging market:
Our network and tools will help all parties streamline the transaction process, access a large and liquid market, and reduce risk through our tools and advisory partners – facilitating more and cheaper transactions that achieve internal goals and accelerate the energy transition.
We also know that these transactions are and will remain complex and bespoke for some time. Crux enables better coordination between credit buyers and sellers as well as their advisers, lawyers, and other partners.
According to the IRS, eligible entities that wish to pursue a TTC transaction may take the following steps (noting that not all steps need to occur in the order listed below):
Sellers and buyers complete a transfer election statement, including the registration number, which is attached to the seller and buyers’ tax returns. Importantly, according to Treasury guidance, “not all steps need to occur in the order displayed,” and “a transferee taxpayer may take into account a credit that it has purchased, or intends to purchase, when calculating its estimated tax payments.” This process principally affects filing and is not preventing deals from being signed and funded.
As developers and buyers evaluate the tradeoffs between tax equity and transferable tax credits, many are focused on two key value drivers: (1) achieving a ‘step-up’ in value from construction costs to fair market value to reflect the development premium; and (2) monetizing tax losses from depreciation. Tax equity inherently solves for both of these drivers. For transferable tax credits, there are a number of options developers and sponsors are considering.
For many developers, the ease and speed they can execute transferable transactions will outweigh the potential loss of step-up and associated tax attributes, as well as inability to immediately monetize depreciation. Many developers are able to monetize some level of tax attributes internally or via their sponsors or affiliated entities. In other hybrid structures, developers are sizing tax equity to a certain return or allocation — allowing them to monetize the depreciation and achieve an appropriate step-up — and planning to use transferability for the balance.
Some are using other structures to attempt to achieve a step-up, including selling the project into a partnership with a third-party. There are a range of opinions as to what types of partnership structures are sufficient to achieve this valuation step-up. Anecdotally, some have suggested that a 20% ownership stake from an unrelated third party is likely sufficient to get insured; while banks may look for something closer to 35%. It is likely we’ll see a wide variety of structures, depending on the unique needs of various developers.
Advisers will play an important role providing diligence, insurance, and indemnification for buyers of TTCs. While these roles are similar to those performed in tax equity deals, the TTC market is expected to streamline transactions, leading to:
Any "eligible taxpayer" (under the IRS definition) can take advantage of transferability, meaning that tax-exempt organizations are generally ineligible. Corporations and even individuals are able to buy tax credits.
While the buyer can be an individual, they will be subject to passive/active restrictions — meaning that the face value of the TTC can only be used to offset tax liabilities from passive, non-investment income. Some high net worth individuals and family offices that have participated in the tax equity market previously, may find transferable tax credit deals appealing if they can time the payout closer to their tax filing date. Overall, however, we do not expect the TTC market to open widely to individuals.
Credits typically are for sale for a discount to the face value of the credits, indicated as cents on the dollar (i.e. a $0.93 TTC price indicates a 7% discount to the face value of the tax credit).
Internal rates of return on TTC transactions are particularly high, and corporations are doing their best to time credit purchases as close as possible to their quarterly estimated payments. Most taxpayers set aside cash to make tax payments including quarterly estimated payments. Those funds would not normally be able to generate a return; companies cannot choose between paying taxes and building factories. With tax credit transferability, reserved cash suddenly has the capacity to generate a real cash return, making TTCs a uniquely attractive investment.
Transaction costs can include fees for advisers and syndicators, and for conducting due diligence. We find that the seller of the credit typically covers these fees up to a negotiated cap.
With transferability, the risk of the IRS not respecting the tax equity partnership as valid is eliminated because no partnership exists. There may still be a need to demonstrate the true third-party nature of the transactions. Project cash flow risk is much less of a concern so long as the project remains operational and solvent, given there is no participation on the part of the tax credit buyers in the project cashflows.
However, there are some key risks that buyers and sellers will have to navigate, particularly in the case of ITCs:
Many of these risks related to recapture are typically covered by insurance. The seller of the tax credit will commonly cover insurance costs, though buyers can also choose to purchase uninsured credits at a steeper discount.
The IRA entitles the tax credit buyer to carry the TTC forward for 22 years and back for three years, meaning that the buyer has up to 22 years of future tax filings to utilize the full value of the credit, and can also carry the tax credit back and apply it to previous years, as far as three years in the past.
The carryback is not as simple as applying the credit to the previous year’s return, however. Unused tax credits must first be applied to the earliest tax year in the carryback period, which is three years before the current tax year. Any unused tax savings can then be allocated to the tax year two years previous to the current year, and then finally to the last year’s tax return (illustrated in the figure below). Companies will have filed tax returns in these periods, so applying tax credits to previous years necessarily requires refiling taxes for as many as three previous tax years, and thus may be a prohibitively complex process.
According to draft guidance from the IRS issued in June, “A contractual commitment to purchase eligible credits in advance of the date a specified credit portion is transferred satisfies the paid in cash requirement, so long as all cash payments are made…within the period beginning on the first day of the eligible taxpayer’s taxable year during which a specified credit portion is determined and ending on the due date for completing a transfer election statement” (emphasis added).
In the rapidly developing TTC market – like the tax equity market – one of the biggest challenges is the timing gap. Developers want to pull forward as much certainty and commitment as possible; buyers want to outlay cash as close to quarterly estimated payments as possible. Certainty around advanced commitments ensures that both objectives can be met, by allowing buyers to pre-commit to fund in the future and letting developers take those commitments to lenders and others to finance short-term needs.
In general, buyers seek to align purchases of transferable tax credits with their quarterly estimated tax payments. Buyers also assume certain risks when purchasing TTCs, and as such are likely to pay more for credits that are perceived as being lower risk.
While the market for TTCs is only beginning to take shape, we see TTC pricing organizing into tranches with pricing estimates reflecting relative risks.
Sellers typically cover transaction fees up to a negotiated cap. In addition to these fixed costs, the gross purchase price for TTCs would include costs associated with insurance and with transaction fees. Insurance costs can be 1.75-3.5% of the face value of the credit (depending on deal size and risk), and deal fees range from 0.5%-3%.
If a project sponsor sells a credit for $0.90 gross (a 10% discount to the face value of the credit), obtains insurance for 1.75% the face value of the credit, and pays a fee to an intermediary or broker for 1.25% the credit value, the seller will realize net proceeds of $0.87. If the buyer of the credit incurs $50,000 in additional advisory fees related to conducting due diligence of the transaction, and the seller has agreed to cover these fees up to that amount, then these costs, too, would be subtracted from the TTC sale to estimate the seller’s proceeds.
A developer has little to lose by exploring the TTC market. TTC deals can be relatively fast and simple to navigate and, as yet, we do not see pricing for TTCs that is unattractive relative to tax equity deal pricing.
To pursue a TTC deal, sellers will need to consider who their advisers and partners are and need to be prepared to obtain insurance or other indemnities to address the risks that are borne by the buyer in a TTC transaction. Crux is an enabling ecosystem for TTC deals, and our team can assist in helping sellers new to the market in identifying potential buyers, partners, and advisers.
TTC transactions are only just beginning to occur, with the first major deal, between Invenergy and Bank of America, announced in August 2023 (WSJ). As we discuss in our July 2023 State of the Market report, we anticipate that deal timelines for TTC deals will eventually compress to perhaps a couple of months. By contrast, tax equity deals can take between 6-18 months to complete.
Additionally, tax equity deals are relatively inflexible, negotiated agreements between a developer and an investor who is the recipient of the tax credits. Delays related to when a project is placed in service can create headaches for all parties involved, since a developer cannot easily pivot to another party that is better able to use the tax credits and impact complex partnership economic allocations.
For investment tax credits, the TTC is generated when the facility is complete and placed in service. Importantly, projects that intend to claim the ITC but have regular, multi-year construction timelines may claim partial credits for qualified production expenditures (QPEs). These QPE credits are not eligible to be sold or transferred; only the ITC generated in the year the project is placed in service may be transferred.
Production tax credits (PTCs) are generated after a project enters service and begins producing energy. PTCs are generated for each unit of production (like a megawatt-hour of electricity or a kilogram of hydrogen) for a long period of time — ten years under the IRA. Developers can sell forward a stream of future PTCs (or a “strip”), either as a TTC deal or as a tax equity transaction. Typically, a developer will sell a conservative estimate of their future PTCs in a forward transaction in order to minimize the risk that the facility will not generate enough energy in a year to meet the required supply of PTCs. Excess PTCs generated in each year can also be sold as “spot” PTCs, which must again be transferred and used in the tax year in which they are generated.
Because TTCs must be used to offset taxes in the year in which the credits are generated, buyers of credits are incentivized to execute transactions as close as possible to the end of their tax year (when they have the greatest certainty around their tax liabilities). For developers, it may be necessary to procure bridge financing to access cash before the tax credits are generated/sellable. So far, our team has observed that lenders are entering the market to provide this capital, and that the market for TTCs already appears reliable enough to lend around.
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