The financing of renewable energy projects is a critical risk in the ongoing transition to a low carbon future. When investors agree to finance a solar, wind, or other renewable energy project in the US, tax credits play a key role in their decision-making. Because tax credits form a large part of a project’s economic value, financing parties need to be comfortable that the credits will actually be there down the road, including potential implications of legislation such as Build Back Better.*
Implications of Build Back Better for renewable energy tax credits
Tax credits have played a major role in the US in the development of renewable energies. The Investment Tax Credit (ITC) has helped the US solar industry grow by more than 10,000% since its introduction in 2006. While there have long been plans to phase out the credits, the ITC, along with the onshore wind-related Production Tax Credit (PTC), have to date been renewed, albeit at varying percentage eligibility. (The PTC for 2022 is an exception as it has not been renewed at this writing.)
The administration of President Joseph Biden does not seem likely to reverse the trend of renewing these tax credits. In fact, many are looking ahead to possible expansion of the credits in the administration’s Build Back Better program, for which the green provisions may pass Congress this year as a separate piece of legislation.
As currently written, Build Back Better’s green provisions would simplify the ability of developers to finance renewable energy projects; however, gaps remain, meaning that risk mitigation tools will continue to be important. Build Back Better’s green provisions, if passed in substantially their current form could, among other things:
- Reduce some, though not all, uncertainty regarding renewable energy-related tax credits, particularly “begun construction” and “continuity” requirements.
- Provide for increased tax credit amounts, albeit dependent on prevailing wage/apprenticeship requirements and domestic content bonuses.
- Introduce tax credits for new asset classes, such as transmission and standalone storage.
- Introduce a “direct pay” option, which could eliminate or reduce the reliance on sourcing tax equity.
- Allow solar projects to qualify for the PTC.
Potential challenges for renewable energy developers
Build Back Better should not be viewed as a holistic solution; challenges would remain, including the following (as the program is now written):
- When construction began on a project is a key factor in qualifying for tax credits. Projects that began construction prior to 2020 are excluded and continue to depend on their original facts, unless they are able to abandon their original “begun construction” facts (for example, by deliberately not incorporating into the project the transformer that began manufacture in 2016) and show a restart in 2020 or beyond.
- Likewise, where a project is bound by its original pre-2020 begun construction facts the clock cannot be reset on continuity. Other than offshore wind, the safe harbor remains 6 years; although the bar for meeting this test was lowered by Notice 2021-41, which permitted “continuous efforts” to be applied to physical work begun construction.
- Valuation/appraisal risk is not addressed, such as qualified basis for ITC projects and the 80/20 test in repowering.
- Critical areas without guidance remain open, such as whether the offshore inverter, export cable, and onshore inverter for offshore wind are ITC eligible.
- There will be uncertainty in the process, procedure, and timing of a direct pay option until guidance is issued. Direct pay adopted by a solar developer/sponsor will reduce overall tax benefits related to a step-up in basis (from cost to eligible fair market value) and monetizing depreciation. Further, direct pay does not eliminate tax risk, it merely moves that risk to a different balance sheet (i.e., from tax equity to the developer/sponsor and/or lenders).
- The risk of a recapture of ITCs (from unrepaired natural catastrophe damage or project loan foreclosure) or 45Q credits (from geological or engineering failure) is unchanged, and a similar concept will be introduced for the direct pay option.
Financing projects with one or more of the above items often cannot simply be addressed by “should” level tax opinions, appraisals, and broader insurance packages. Tax equity has been slower to commit to financing in this context, which will continue to be a challenge even after Build Back Better’s green provisions. A weak balance sheet from an indemnity provider exacerbates the challenge.
The demand for tax equity commitments exceeds supply, and is likely to continue to do so as additional large-scale offshore wind, carbon sequestration, and potential new assets — such as transmission and hydrogen — are added to the mix alongside solar/storage, onshore wind, biofuels, and others.
The high demand from developers for investment in renewables allows financiers to be selective. Tax equity providers typically prefer developers with large pipelines and a proven track record and/or projects that are safe-harbored, which can put lesser-known developers and smaller projects at a disadvantage.
Using tax credit insurance as a risk mitigation tool
Tax insurance can facilitate project financing. It supports tax credit eligibility and credit enhancement by transferring the risk of a lesser quantum of tax credit to a diversified pool of highly rated insurers that supplement the developer’s or sponsor’s tax indemnity.
Common areas of coverage include:
- Begun construction: Confirms that onsite or offsite physical works are significant and/or that joint venture structures that combine a development with a third party’s safe-harbor equipment will be respected.
- Continuity and delay: Provides assurance that the facts and circumstances satisfy the continuous efforts requirement for tax credit eligibility, notwithstanding the placed in service date is beyond the continuity safe harbor period.
- Continuity and mitigation: Underwrites strategies to switch the year construction began for those developments that would otherwise fail the continuity test to bring them back within the continuity safe-harbor.
- Repowering: Underwrites both the (re)qualification for tax credits and the 80/20 appraisal. Policies can cover repowered projects originally under the Section 1603 cash grant.
- Qualified basis: Provides assurance that the fair market value used to compute ITCs and the allocation between eligible and ineligible will be respected by the IRS.
- Battery energy storage system (BESS): Included in a qualified basis policy for battery storage integrated into a solar facility and that the solar facility and BESS are both within a “single facility.”
- Recapture: Protects against the claw back of (a) ITCs due to the potential forfeiture of project under project level debt or unremediated damage on ITC projects; and (b) 45Q credits as a result of leakage.
- Structural: Provides a backstop in the event the allocation of tax and cash attributes between parties is not respected as anticipated in the financial model. Policies can cover business purpose.
- Hybrid representations and warranties (R&W): Adds coverage for non-tax R&Ws in the equity capital commitment agreement and operating agreement tailored toward providing credit enhancement for a broad indemnity package.
Managing tax insurance in 2022 and beyond
Project developers have an intimate understanding of tax credit use for energy projects. Tax insurance is a risk mitigation tool that can help overcome financing constraints for projects that do not fit squarely and unambiguously within the scope of tax legislation and IRS guidance.
Renewable energy companies can find value in working with specialized advisory services that bring thorough knowledge of changing and new tax credits — including issues likely to arise even if the green provisions of Build Back Better pass — to provide protection required by capital providers.
Tax credits for new technologies are still in development, so it is important to seek specialist advice on appropriate risk management tools. As with any tax issue, it’s important for developers and investors to obtain qualified tax expertise regarding tax credits.
If you have questions or want more information about tax insurance for renewable energy projects, contact your Marsh representative.
* This article is based on the legislative environment as of the date of publication, March 16, 2022.
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