About a month ago, Chevron announced that it is pursuing “tax equity” financing of solar photovoltaic projects, an encouraging sign that U.S. renewable energy tax equity investment will grow from the $3 billion-$4 billion seen in 2011.
An oil major jumping into complex and challenging tax equity renewable power finance, generally the domain of big banks and sustainability-oriented corporations such as Google, is nearly the best news possible for renewable power projects. Even better news would be not needing such investors.
What is Tax Equity?
Under tax equity financing, a company provides financial backing for a project and in exchange earns a return on investment, which includes value received by reducing its tax bill from tax credits and depreciation. Tax equity is particularly important to renewable energy projects, which have historically benefited from production tax credits or investment tax credits as well as accelerated depreciation. Development companies with uncertain year-to-year tax liabilities or private equity funds, whose capital is often based on non-taxable institutional investors like pension funds, generally cannot benefit from tax credits. So many renewable deals involved a high percent of equity for a tax equity participant. Chevron, with $5.5 billion in income tax for just third quarter of 2011, could contribute a major bump by itself to the tax equity market.
Recently, tax equity came from only about 15 large corporations, such as Google, GE, Walmart, some major banks, and, to a lesser degree, utilities such as PG&E and San Diego Gas & Electric. Although a small group, 2011 participation represented a significant rebound from 2009, which had fewer participants and just $1.2 billion. Nevertheless, the renewables industry hasn’t caught up to the $6.1 billion of pre-crash 2007.
Tax equity investment structures are complicated and varied, with little copy-and-paste repeatability even when using the same general structure. Participating companies generally require sophisticated treasury departments familiar with complicated tax-reducing actions. Such companies must also have confidence in forecasting out several years’ profit and future tax liabilities (not the easiest in these jittery post-crash years).
Tax Equity Now More Important
Tax equity has grown in significance since the beginning of the year when the U.S. Treasury’s 1603 grant expired. The 1603 grant, active from 2009 to 2011, significantly eased project financing, as tax equity participation wasn’t required to earn the grant.
More U.S. Fortune 100 oil companies, such as Exxon Mobil, Marathon, Conoco Phillips, Sunoco, Valero, and Hess, could benefit by participating in the tax equity market. Participation would diversify their energy businesses and provide a reasonable investment return, recently about 8 percent after taxes, according to Bloomberg New Energy Finance. The Department of Energy also encourages broader tax equity participation, announcing a forum in March to encourage nearly 80 companies to join or continue participation in the market.
Tax Equity Is Not the Long-Term Solution
Unfortunately, tax equity has several shortcomings. It is unlikely to bring enough capital to the table, depends on expiring legislation (e.g. wind has boomed and busted several times based on on-again/off-again production tax credit availability), and has very high transaction costs. More streamlined access to low-cost capital is necessary to meet RMI’s 2050 energy vision, provide a meaningful curb to greenhouse gas emissions, accelerate green-collar job creation, and maintain America’s position as a renewable energy leader.
This past fall, RMI and the DOE convened a group of about 20 industry and government stakeholders to look at ways to accelerate commercial and industrial solar PV development and financing. RMI is working to improve the solar PV financing climate with direction provided by workshop participants, including streamlining access to public finance.
We’re already excited by some of the financial ingenuity being developed to bring in public, low-cost capital to renewable energy—at times eliminating the need for tax equity for economic viability. Residential Property Assessed Clean Energy (PACE) programs put residents’ PV system payments on their property tax bill, improving the credit quality because property tax collectors hold a superior collateral position to mortgage lenders.
Residential PACE programs have faced regulatory challenges, though a resolution may be in the works. Commercial PACE, however, has proven more acceptable, such as in Sonoma County, California. In such commercial PACE programs, public bonds can be sold by municipalities or banks to provide the capital for loans to commercial PV projects.
Large-scale bundling of many distributed sites into single financing structures, such as SolarStrong and Project AMP, enables bank lending. These and similar future project loans may lead to public debt in the form of asset-backed securitization, where pools of many projects’ cash flows as sold as distinct securities. In addition, several solar development companies are expanding into energy efficiency services to grow their businesses and create new financing models that include both efficiency and PV, where the tax-reducing incentives of PV are not the primary driver.
To enable more financial ingenuity, the industry will need unsexy but critical contract standardization, interconnection uniformity, more system performance and grid management data, improved solar lease customer payment history data, and improved real estate industry education. These challenges are being addressed on many fronts, some involving RMI, and will improve over time.
Chevron’s entrance into the tax equity market provides an important signal to other corporations and to the solar PV industry that impressive growth in U.S. PV capacity should continue. Longer term, the PV industry must move away from tax equity. For this transition, we need more creative financing models that bring in lower-cost financing and enable development scale. Rapidly declining cost of PV installation and more of the financial ingenuity we are already witnessing will create a more reliable and substantial solar PV financing future.