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We have launched Crux to accelerate the energy transition through software that lowers financing costs and increases execution speed. Click here to read our Introducing Crux blog – and read more below for a deeper dive into our perspectives on transferability, how this new market is emerging and what Crux can do to make transferring tax credits more efficient.
Authored by Robert Parker, Chief Commercial Officer
None of the contents should be construed as legal or tax advice.
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The Inflation Reduction Act (IRA) is projected to lead to ~$85B per year in tax attributes to be transacted by 2031. This volume represents a five-fold increase from today and would consume an estimated ~16% of all CBO-estimated corporate tax liabilities when the market reaches maturity.
Alongside the expansion and extension of clean energy credits – and a focus on achieving an equitable distribution of benefits, with numerous targeted bonus credits – the IRA enables transferability of tax credits. Transferability provides a complement and an alternative to tax equity, a great new “pressure release valve” on the supply constrained market. Transferable tax credits are expected to have lower transaction costs and attract many new market participants.
The history of new asset types show that they typically evolve to become more standardized, efficient, liquid, broad-based, and transparent. The “ISDA Master Agreement”, commercial loan syndication platforms, and electronic trading for certain bonds and structured products provide interesting reference points for this fast-evolving market.
While transactions of transferable tax credits (TTCs) are happening, there are a number of areas that developers, credit buyers, and intermediaries are actively assessing, to understand, adjust to, and craft this new market:
In this piece, we delve into these questions, what we have observed in the market, and the role that technology will play to support developers, tax credit buyers, banks, syndicators, and advisors to build an efficient market.
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.
Critically, the new tax credits support advanced manufacturing job creation and introduce new tax credits incentivizing jobs in communities nationwide that have historically relied on fossil fuels or been disproportionately harmed by pollution and left out of clean energy development.
Overall, tax attributes associated with clean energy and decarbonization projects are expected to grow to ~$83 billion per year by 2031.
Perhaps most critical to realizing the value of the credits, the law introduces the new transferability mechanism that enables nine types of 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 form of transferability exists for a limited number of federal credits (LIHTC and NMTC) and is employed in a number of states, those credit programs are at least an order of magnitude smaller and there are substantial differences in the structure of those markets.
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 transaction is structurally complex and generally requires domain knowledge. So, 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 corporate 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 to be monetized to corporations, roughly 16% of all 2031 corporate tax liabilities would need to be allocated to tax credits.
This new market for transferable tax credits opened on January 1, 2023. It will take time for Treasury to finalize guidance on a range of points, and some will wait until after guidance to transact. But the market is taking form faster than many anticipated even just a couple of months ago. Transactions are already taking place and transferability is changing the calculus for clean energy project finance.
To absorb more participants, more deals, more dollars, and the significant increase in fragmentation that will result, deal processes will need to adapt.
A new industry is growing before our eyes.
Transferability is a critical complement to tax equity, adding an important new tool for developers to monetize projects' tax attributes. Some key benefits of transferability include:
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These benefits will lead transferable clean energy tax credits to become a new large category of tradable financial product. While credits can only be transferred once, they are more easily divisible and can be sold to many counterparties. Because of this and the massive tailwinds driving total growth, our industry will see rapidly increasing transaction volume.
In situations where a large volume of product is sold to a diverse set of buyers, and with substantially similar characteristics, it is natural to look to an exchange or other many-to-many forum. Tax credit transaction volume could easily exceed notional values of other energy-related tradable assets, such as RECs. But, those who expect tax credits to be traded like shares of Apple or General Electric misunderstand the complexity of the underlying assets, the legal agreements necessary around them, and the key role that counterparties and advisors will continue to play.
When new asset types are created and grow larger – even those that are not exchange-traded, or have no secondary market – they typically evolve to become more standardized, efficient, liquid, broad-based, and transparent. It’s helpful to look to the past as a guide to the future.
In the early days of the market for over-the-counter derivatives, every transaction had to be carefully and specifically negotiated. In the mid 1980s, the market coalesced on the “ISDA Master Agreement”, which standardized the template to document trades and pre-specified the variables that could be changed. Standardization allowed trades to clear more efficiently and enabled the growth of the category.
Early in the life of a new market, risk management standards tend to be unspecified and uncertainty is high. Over time, markets develop tools to evaluate and better manage risk. Insurance, guarantees, and structure help simplify underwriting by mitigating certain risks, opening up a product to a larger base of buyers. Over time, written standards and various conventions emerge - and, in some cases, formal or informal ratings. This process accelerates as purpose-built technology provides tools to transact and manage investments. We’ve seen this evolution in the development of platforms to syndicate commercial loans and real estate, to name a couple. This feeds a virtuous cycle.
Sometimes new assets are created before a common transaction forum is established. In the early days of a new market, transactions are heavily brokered, comps and pricing are opaque, and fees are higher. Sometimes multiple competing venues emerge. When markets converge and/or become interoperable, pricing improves and transaction costs are reduced. Platforms for electronic trade matching in certain bonds and structured products demonstrate the potential to unlock larger markets via centralizing software that connects many potential counterparties.
The market for transferable tax credits is being created in 2023, not 1987. It will evolve even more rapidly than prior markets due to our current access to technology. Through hundreds of conversations with buyers, sellers, and intermediaries, we’ve heard some common themes:
In the rest of the piece, we’ll describe what we’re beginning to see in the market, how we think this will evolve, and the role we expect Crux to play.
The pending explosion in tax credit supply requires a rapid expansion of the buyer universe. Owners of clean energy infrastructure will need to be confident of their ability to sell into the market. There are a number of areas that developers, credit buyers, and intermediaries are actively assessing, to understand, adjust to, and craft this new market:
Answers to all of these questions are in flux. Below, we summarize what we are seeing in the market, and what we expect to emerge.
We expect transferability to be a particularly powerful tool in certain segments of the market:
Early market participants are expected to include developers with projects for whom tax equity was suboptimal: storage, community solar, merchant projects; developers who value certainty and simplicity. Other project types beyond storage and generation, such as biofuels, will likely also use transferability as a primary financing mechanism.
There are a number of situations where people are already transferring credits out of existing tax equity partnerships (see more on new structures below) – for example, because new enhanced tax credits are increasing credit value beyond what existing tax equity partners could absorb.
Transferability is also seen as a powerful fall back and escape valve. People are sizing tax equity commitments more conservatively, knowing that there is an emerging market to sell transferable credits as needed.
Production tax credits (PTCs) are also anticipated to be an especially attractive candidate for transferability, given limited risks on valuation and basis, recapture, and the ability to sell them in closer-to-real time in a spot market.
The first deals are beginning to price in this brand new market. As we wait for guidance, counterparties are getting comfortable with more “plain vanilla” transactions in wind, solar and storage.
There will be a spread associated with transactions, as buyers’ gross prices are reduced for insurance and transaction costs, with developers seeing a price of around 90¢ - 92¢ per dollar in the early days for most well-structured investment tax credit (ITC) developers. We are seeing in the market that this is net of insurance and transaction costs. Similar pricing is observed in the Low Income Housing Tax Credit (LIHTC) market.
Given estimated transaction costs between insurance and others of 2-5%, this leads to discount values of closer to 5-8% to the face value of the credit (100 cents). Given the possibility of timing near quarterly estimated tax payments, IRRs on cash outlays to purchase credits have the potential to be very high in a liquid “just-in-time” market.
Even today, though, the range of discounts can move up or down based on a number of factors:
We expect those factors to continue to impact pricing over time. We also expect that long-term price levels will depend on interest rates, how much insurance markets adjust to transferability (see Risk Mitigation below) and total market liquidity.
There’s strong indication that for many projects, credit pricing and flexibility will make transferability competitive with and – in many cases – preferable to tax equity, especially taking account of the substantial transaction costs associated with tax equity.
We expect technology to play a key role in providing the features and security required to reduce transaction costs, reduce uncertainty in execution timelines, entice large volumes of new buyers through price and risk transparency, and establish liquidity in the market.
Treasury guidance is expected this quarter and should answer some key questions about the market and the standards that will define it.
In the meantime, most are operating under the assumptions that executing the transfer of credits will mimic the procedures for claiming the credits in a tax equity partnership - from the election of monetization of the credits to the filing of Form 3800.
A couple of key areas that are awaiting guidance at this time include:
There are a myriad of other detailed topics that many will likely have to draw on precedents, absent more detailed guidance. The hopeful imagine that there may be revisions of the triggers for ITC recapture - for example, asset sales not causing recapture. In addition, some hope for changes in the active/passive income rules, to make credit purchases accessible to a wider universe of buyers. In the absence of guidance stating otherwise, many law firms are advising individual taxpayers that Section 469 passive activity restrictions will apply.
Guidance will likely influence deal structures and transaction processes, which will ultimately drive transferable tax credit economics and impact the steady state volume of buyers in the market. Still, early deals happening in the absence of comprehensive guidelines illustrates the potential and necessity of this new market.
Transferable tax credits are never going to be as simple to transact as ‘one-click checkout’ on Amazon. Businesses must weigh important commercial, tax, financial, sustainability goals, and other considerations. And, different buyers and sellers will assess different project attributes and risks differently. Still, many risks are reduced or eliminated with transferability versus tax equity.
Tax equity has traditionally required a heightened level of due diligence as tax investors enter into legal partnerships with developers – tax investors are part owners and some of their return derived from the operations of the project. Further, to the extent other project level debt exists, and/or the tax equity is behind leverage, further financial analysis is warranted.
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.
Construction timelines are less likely to impact transferable tax credit transactions given most transactions are expected to clear after being placed in service. Given the risk of credits slipping into future fiscal years, buyers may still diligence construction timelines to better align to their tax capacity.
However, there are some key risks that buyers and sellers will have to navigate, particularly in the case of ITCs:
Given the above, diligence requirements will not disappear in transferable tax credit deals. However, industry parties expect them to materially decrease – in time and cost, leading to:
Technology will streamline and simplify diligence and risk management processes. Using a platform to diligence and execute transactions will keep all multiparty documentation like term sheets, diligence checklists, definitive documentation, and closing checklists in a centralized location. Developers will be able to upload and update critical project information for wide ranges of buyers to check against their internal diligence criteria. Sellers will also be able to upload financials and indemnity language, allowing buyers to quickly decide additional risk mitigation options they may require. Insurance options available to buyers and sellers could be seen here as well, further increasing a platform's ability to provide large numbers of risk management tools to all parties. Ultimately, this all means fewer back and forths, less time dedicated to administrative tasks, and more certainty of execution timelines.
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 depreciation without a tax investor. 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.
Although structuring creativity is anticipated, buyers, sellers, and intermediaries should be cautious and consult with counsel, ensuring their chosen structure and approach are supported by the law and guidance. This is especially true during early transactions and in those where credit values are stepped up above the project’s hard costs. In addition to the risk of disallowance and penalties, widespread pushing of the boundaries could cause blowback - limiting interest from buyers and hindering the growth of renewables.
Tax equity and the emerging transferable credit transactions have so many stakeholders around the table: developers; developer-side counsel; lenders; lender counsel; appraisers; tax advisors; independent engineers; insurance brokers and underwriters; buyers; and buyer-side counsel and buyer-side tax advisors. Surrounding communities play a critical role and the Federal Government will be the ultimate arbiter of credits that are claimed.
Syndicators, advisors, and other intermediaries have historically played a pivotal role in unlocking the market by navigating this long list of stakeholders and educating buyers. Banks have been the leading provider of tax equity especially for the largest projects.
Given the magnitude of the opportunity around transferable tax credits, banks, syndicators, advisors, and other intermediaries are adjusting – and many more are looking to enter the market.
Trusted partners will be needed to identify and educate new buyers, make markets for their existing clients on both sides of the transaction, and structure transactions appropriately to the needs of the parties.
Banks and financial institutions are well-positioned to be leaders in the market, but will need to find credit buyer demand beyond their own balance sheet tax capacities. Many banks have told us of their intention to scale syndication businesses. Banks are also looking to strengthen their clean energy lending businesses and launch novel financial products to support the growing market.
There are some consistent themes and challenges we hear from intermediaries:
Technology is urgently needed to solve these problems. More efficient internal processes mean intermediaries can focus on scaling their businesses and, ultimately, making the financing of clean energy more efficient.
Transferability will create a new multi-hundred billion dollar market in the months and years ahead. This is an enormous, multidisciplinary problem.
We have built an early team with decades of experience in the power industry, project finance, financial markets, financial workflow management, and software engineering – particularly in regulated industries. Alfred and Allen co-founded, built, and sold a marketplace software company. After the acquisition, Alfred re-joined the Treasury Department where he also started his career.
I joined the team after most recently being the CFO of REV Renewables. Prior to that, I was at AES, Google, and LS Power. Our rapidly growing product and engineering team have scaled products to millions, and to large enterprises in regulated industries.
We are combining these experiences to build the ecosystem for developers, tax credit buyers, banks, syndicators, and advisors to transact and manage transferable tax credits.
Crux’s network and tools help developers, tax credit buyers, banks, syndicators, and advisors:
We're laser-focused on building solutions for the many different people and organizations around the table to take advantage of this new market:
As the industry converges around Crux as the platform for transactions to be managed, the benefits will compound for everyone: Thousands of clean energy credits with details and attributes centralized. Buyers looking to achieve sustainability goals and manage tax liabilities and their advisors can identify credits that are best for them based on size, timing, geography, and risk. Banks, syndicators, and intermediaries will have the tools to engage clients in their own branded environments – and ensure they have access to a more liquid market to balance supply and demand. Developers will be able to tap into many buyers and intermediaries who represent them, as well as financial institutions who offer related financial products. Everyone will have a platform to transact, reducing administrative burden.
Crux’s ecosystem will make sustainable finance more efficient and interconnected. Get in touch today and we’ll show you more.
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