Tax Credit Transferability - Episode 93

In order for the IRA to realize all of the benefits from the subsidies it allocated to renewable energy and advanced manufacturing, the legislation needed to revise how tax credits were going to work. The traditional form of tax equity financing wasn't going to be enough, so the IRA introduced something called tax credit transferability. This new process has opened up the tax credit market to a whole new batch of investors, able to invest in even smaller projects, and at rates that are encouragingly beneficial to the clean energy economy.

Paul outlines how this new structure works and the impact that it is already having on clean energy projects.

For more research:

"Monetizing Energy Tax Credits: A Guide to Transferability and Tax Equity Transactions" - Cherry Bekaert

"Understanding Direct Pay and Transferability for Tax Credits in the Inflation Reduction Act" - Cap 20

"Transferable Tax Credit Market Intelligence Report, 2023" - Crux

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Transcript

This is Eight Minutes – a podcast helping you understand the energy and climate challenge in just a few minutes – I’m your host, Paul Schuster.

The IRA supercharged climate action – spurring investment into renewable energy, hydrogen, advanced manufacturing. According to Goldman Sachs – it could subsidize up to $1Trillion dollars into clean energy technologies.

The primary means to doing so isn’t through direct cash payouts, though – it’s through tax credits. In order to ensure that those credits were actually USED, though, the IRA needed to reimagine HOW credits were going to work. Our old system of tax EQUITY needed to be supplemented with a system of tax TRANSFERABILITY. 

This episode is all about how this new system works and the impact it is already having on climatetech investment.

Eight Minutes – it’s how long it takes the sun’s rays to hit earth – or in honor of labor day, it’s about how long you should spend thinking about work stuff today … let’s get it on!

The IRA doesn’t just give cash to renewable energy developers. The mechanism that the federal government uses to promote projects is through tax credits. So – every dollar in a tax credit can be used to offset (by $1) the taxes that you owe back to the IRS.

Which is powerful, because then developers can sell those credits to companies who have big tax burdens … say they sell that 1 million dollars of credits to a big bank for about 750K. The bank now pays a million less on their taxes (and only paid 750K FOR that) while the developer gets 750K to invest into their project.

These tax credits have been around for a while, but the process to unlock them has always been pretty convoluted. The Tax Equity requirements meant that the developer couldn’t just SELL these credits to a big investor – they needed to be allocated as part of a partnership structure on the project. Essentially, the investor would OWN the majority of the project in order to access the credits. And then, after a certain amount of time and metrics had been hit, the ownership would flip to where the developer owns the majority and the investor’s involvement is lessened.

THAT is tax equity – Big projects, big investments, big complications. These are projects that typically above $100M in tax credits and – well – that limited the types of investors that could really participate. Crux, a climate marketplace that has emerged since the IRA was signed into law, estimates that about 80% of the tax equity marketplace was basically managed through 10 investor entities. At about $18B per year or so.

THAT … isn’t enough to unlock everything that the IRA is intended to do. Credit Suisse estimates that our annual tax credit market needs to scale from that $18B per year to something on the order of $83B per year.

Which means the legislation needed to rethink HOW tax credits could be monetized if there were to ever be any hope of seeing that happen.

As a result, the IRA introduced a couple of new mechanisms. The first was a Direct Pay option where, literally, the government sends cash to non-profits for the investments that they make into renewable projects. Makes sense – they’re non-profits so they don’t have a tax burden and wouldn’t be able to use tax credits. The IRA simply makes it easy and say – here’s the cash equivalent.

For for-profit companies, the IRA simplified the tax credit process through something called transferability. This process essentially allows renewable projects to sell their tax credits directly to a company – NO weird, obtuse partnerships and flip structures involved. Understand the difference? In the old structure, the investor needed an ownership stake, so the process had to involve these convoluted partnership arrangements. Tax transferability simplifies that and allows investors to simply buy the credits in kind of an open marketplace.

This has a lot of benefits. For one, it has opened up the tax credit process to a LOT more entities. Now, just about anyone with a tax burden can buy a $1 tax credit for about 80 or 85 cents on the dollar. That enables companies to invest in more renewable projects AND gives them a nice little return on the invested dollar.

Notice that the transfer rate of those credits has gone up, too – the old system had to price in the complexities, legal costs, and risks of tax equity financing – whereas transferability can transact easier. Oh – there still needs to be a discount, and the PROJECT risks are still very real, but instead of 70 cents on the dollar, Crux and other marketplaces are seeing 85 or even 90 cents for the sale.

That’s good news, too – because it means that the effectiveness of each dollar that the IRA is subsidizing is far greater, too – MORE of that subsidy is actually financing renewable projects and not just reducing a tax burden for a wealthy bank.

Transferability has also lowered to deal size that developers are seeking. Instead of hundreds of millions of dollars, much smaller deals are materializing – with MOST transferability deals happening BELOW $50M. Which means that more distributed, smaller projects are getting built on the back of these tax credits.

And it’s not just renewable projects that are benefitting from the new credit structure. The IRA includes tax credits (called 45X) for advanced manufacturing – and THOSE credits are seeing a very robust market, so far. Both domestic manufacturing AND clean energy are seeing a boom.

The new structure, though, does NOT mean that traditional tax equity has gone away. There are still some benefits to traditional tax equity financing that the new transferability rules couldn’t address. Chief among these is something called MACRS – or Modified Accelerated Cost Recovery System.

What MACRS does is it essentially accelerates the depreciation a big project can claim on its capital investment. In accounting terms, a company can claim depreciation of assets against their profit in order to lower their profit (and, in return, the taxes they need to pay). So accelerating the depreciation means you can lower your taxes MORE in current years and not have to wait the fully 30 years or so that a project is expected to be in service.

Transferability? It doesn’t really address this – so some institutions have continued to invest via project equity financing in order to take advantage of this accelerated depreciation.

But – as with any market change – innovations are starting to emerge that are trying to take advantage of BOTH sides of the coin. Namely hybrid models where the project partnership is established – and then credits are sold independently, allowing the project to value both the depreciation AND the new tax credit marketplace.

Will those new models start to emerge as the defacto choice of investors? Maybe – though it also implies big, utility scale projects may be the only option worth going through the hassle to invest behind. What’s likely to happen is that three types of tax investing will happen – traditional tax equity, tax transfers, and then this hybrid concept.

Tax transferability has a lot of implications for clean energy growth in the US. It’s an important mechanism that the IRA has introduced to scale up the investment needed to subsidized not only renewable projects but the advanced manufacturing needed for the clean energy economy.

I’m Paul Schuster – and this has been your eight minutes.