As the world fights against an unprecedented health crisis in the form of COVID-19, we are going to take some time to discuss tax equity. As major corporations and financial institutions have changed their 2020 outlook—expecting to see a reduction in profits which translates into a reduction in tax liability—we will discuss how this impacts the tax equity market.
The tax equity market had already anticipated a rush of passive investments over the next 24 months, due to the ITC step-down and expiration of the PTC in 2020, and now we are facing the market compressing even further. Tax equity is a key component and, arguably, in the United States, the party has the most leverage in the entire transaction. Now, as we are expecting the quantity of tax equity investors to decrease, developers and sponsors will need to adapt to the new environment and find innovative ways to finance their projects.
In this blog post we will go over the basics of tax equity in order to understand how this market works. In the near future, we will publish a follow-up blog with our predictions for tax equity in 2021 and beyond.
First of all, what are the main renewable energy funding structures available to developers and investors in 2020? Well, although tax equity investment is often the best option, there are others.
Bank Financing: This is the most expensive option of the three.
DOE Loan Guarantee: This is cheaper—when available.
Tax Equity: This will be our core focus for this blog post as it’s often the best option. Tax equity makes use of tax benefits to finance a renewable energy project—tax benefits which may go unused otherwise.
Tax Equity: What is it?
To understand tax equity, we must first define tax credits and understand their purpose. A tax credit is a tax incentive which allows a company to reduce its tax liability dollar-for-dollar. In the United States, the government uses tax credits as a means of incentivizing projects which serve a social, economic, or environmental purpose. For example, affordable housing, or renewable energies like solar and wind.
When it comes to financing renewable energy projects, a tax credit can serve as an important source of capital. However, not all developers in the renewable energy sector, or indeed many other sectors, have enough income to take advantage of these tax credits. As a result, many developers monetize tax credits through the use of a “tax equity” investor.
The term tax equity describes passive ownership interest in a project, where the return of the tax equity investor is based on both cash flow from the project and tax benefits. A partnership involving tax equity investment facilitates both the investment of capital and the allocation of tax credits. Of course, there is no set template for these kinds of partnerships and they will vary based on the type of project, the type of tax credit, and the overall transaction structure.
The same dollars used as part of the tax equity investment are those dollars which had been earmarked to satisfy the company’s tax liability. In the case of a qualified project like a solar farm, for example, those funds are invested and then generate tax credits. Then, as noted above, the investor receives both tax benefits and cash returns from the project, with the tax benefits eliminating a corresponding amount in tax liability.
As with most investments, the returns on a tax credit investment can, of course, vary greatly depending on a number of different factors surrounding the specific program and project. According to Bloomberg, after-tax returns for investors generally fall between 5% and 12%. Though again it’s important to note that this rate of return is dependent on a number of variables. Below, we’ve highlighted the typical yield scale for a few different scenarios.
Lower Yield: The Low-Income Housing Tax Credit (LIHTC)
Middle Yield: Utility-scale Renewable Energy Projects
Top Yield: Mid-to-small-scale Renewable Energy Projects
Tax Equity Structures
Essentially, there are three primary structures which are utilized for tax equity investment. Within each of these structures, the project developer seeks capital in exchange for tax benefits. These three primary structures are:
To learn more about solar financing, get in touch with YSG Solar today. YSG will assist you in making your solar project a financial reality, securing the best return on your investment across the project’s lifetime. Send us an email, or call at 212.389.9215 to get started.
YSG Solar is a project development vehicle responsible for commoditizing energy infrastructure projects. We work with long-term owners and operators to provide clean energy assets with stable, predictable cash flows. YSG's market focus is distributed generation and utility-scale projects located within North America.