A panel of four prominent tax equity investors discussed how the recent overhaul of the US tax code is affecting the solar tax equity market and also talked through a collection of current issues in deals at the annual Solar Energy Industries Association finance workshop in New York in March.
The panelists are Laura Hegedus, a managing director of Bank of New York Mellon, Joel Spenadel, an executive director at J.P.Morgan, Julian Torres, a director at RBC Capital Markets, and Darren Van’t Hof, director of renewable energy investments for US Bank. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
Effects of tax reform
MR. MARTIN: The lower corporate tax rate means that one of the two tax benefits for solar — depreciation — is worth less. Tax equity used to account for about 40% to 50% of the capital stack of the typical solar projects. What do you think the percentage will be going forward?
MR. VAN’T HOF: It is not uniform, but roughly 35%. The percentage depends on how much cash is distributed to the tax equity investor. We think there will be about a net 8% decrease in the amount of tax equity on an apples-to-apples basis.
MR. SPENADEL: We are seeing less than that, maybe a 3% to 5% decrease, and some of it may be that falling electricity prices are leaving less cash to distribute to the tax equity investor. The problem as the percentage drops is it raises both capital-account deficit and at-risk issues.
MR. MARTIN: We will come back to those issues. Next topic: BEAT, or the base erosion and anti-abuse tax. This new tax requires tax equity investors to do an annual calculation, and they may have to give back 20% of the investment tax credit to the government. Do you expect BEAT to cause tax equity investors not to take the full investment credit into account in pricing or is solar unlikely to be affected. BEAT is more likely to be a problem with wind deals where tax credits are claimed over 10 years.
MR. VAN’T HOF: BEAT is more of a problem for wind deals.
MR. MARTIN: Will tax equity investors take the risk that they will be subject to BEAT in the year a solar deal closes?
MR. VAN’T HOF: The transactions we have seen over the last three months suggest yes.
MR. MARTIN: Does anyone on the panel disagree?
MR. SPENADEL: No. We have not spent too much time on BEAT because our bank does not expect to be affected by it. We sometimes bring in other investors in our deals. They could be affected. I think it is still a moving target. It is hard to say where things will settle, but in general, it does not seem to be as big an issue as people feared.
MR. MARTIN: Are you speaking about your bank or about the market as a whole?
MR. SPENADEL: The market as a whole
MS. HEGEDUS: I think people are still figuring it out. It is still early. There is more analysis to do. BEAT is an on-off switch. Either you are in it or you are not.
MR. MARTIN: Do you think tax equity investors will take the BEAT risk for tax credits taken in the year the deal closes?
MS. HEGEDUS: I think that has yet to be played out. The supply and demand of tax equity will play a role in where the market settles on this issue. We do not really know where yields are headed or what the relative bargaining positions of the parties will be.
MR. SPENADEL: The BEAT is a work in progress. Investors have to figure out whether they will be subject to the BEAT and whether they can do something about it. It is triggered by payments to foreign affiliates. There may be ways to restructure arrangements with affiliates to avoid becoming subject to the tax. This is a transition year because the BEAT rate is lower in 2018 than it will be in 2019 and future years. You will not really know for sure if you are in it until after you do your tax return, which comes well after the year in which the solar project goes into service. If a sponsor were to say to us, “Prove it,” we would not be able to show him our tax return. I think if an investor expects to be subject to BEAT, then it should think long and hard about whether it makes sense to do the deal.
MR. MARTIN: Is it your impression, like Darren’s, that BEAT really only affects a small number of tax equity investors?
MR. TORRES: I think that sounds right, but it is just scuttlebutt and rumor. Before we move off, I just want to say that SEIA did a great job scaling back this provision, as did others in this room, from the original proposal. I want to make sure that is acknowledged.
MR. MARTIN: Not only did SEIA do a great job, SEIA and AWEA did it in a very short period of time, and it was thanks to a lot of people in the solar and wind industries who turned up in Washington quickly to make the case. And ACORE helped to get the word out.
Let’s turn to the depreciation bonus. Companies can now deduct the full cost of equipment they purchase immediately when the equipment is put in service. It does not matter whether the equipment is new or used.
Tax equity investors were never really keen on taking the earlier, 50% depreciation bonus, except in 2017 when they had an incentive to accelerate deductions into 2017 before the corporate tax rate was reduced. Do you think the tax equity market will return to form and not be interested in the depreciation bonus?
MR. VAN’T HOF: I think investors will not be interested in it. It forces the deficit restoration obligation to get too high and it tempts you to want to put debt at the project level in to avoid having to increase the DRO, which are both things that tax equity does not like.
MS. HEGEDUS: I think we have yet to see where the market will land. There has been a lot of competition among tax equity investors for deals in the last couple of years.
MR. MARTIN: That is an interesting point. In the debt market, the lenders have been trying to distinguish themselves by assigning value to a merchant tail, meaning two to three years of electricity revenue beyond the power contract term. This may be a way for a tax equity investor to distinguish itself.
Next question: The lower corporate tax rate should make the residual interest held by the tax equity investor after the flip more valuable. Are you seeing this play out already in sponsor call option prices?
MR. SPENADEL: That is a fact. It may play out in other ways by putting pressure on tax equity investors to reduce the target yield. The argument is that if the residual interest is worth more, then the investor’s all-in return will be higher. It could also cause sponsors to ask for fixed-price call options rather than options at fair market value.
MR. MARTIN: Interesting connection. You are getting a larger share of the yield through the residual.
MR. VAN’T HOF: There is also some volatility around interest rates and what discount rate to use. We have also seen the fair market value calculation be a pre-tax number in some instances and after-tax in others. This could cause some sponsors to be more interested in a fixed flip date or to try to define the target yield calculation more precisely.
MR. MARTIN: I would have thought the fair market value call price would be an after-tax value. Does anybody use a pre-tax calculation for this purpose?
MR. VAN’T HOF: We do not, but we have seen it.
MR. MARTIN: Next question: The renewable tax equity market last year was a $10 billion market, down $1 billion from the year before. What do you expect this year?
MR. SPENADEL: It should be a lot like last year. The composition of the market may change. We are not seeing a lot of utility-scale solar projects. The wind market may grow significantly this year not only because of new wind projects that face deadlines to be completed, but also because of repowerings and some secondary market sales that can occur in the wind market but not in solar.
MR. MARTIN: Roughly $6 billion of the $10 billion in renewable energy tax equity last year was wind. Solar was $4 billion. If you add repowerings, does that mean that the solar number will shrink in 2018?
MR. VAN’T HOF: We are forecasting solar to be pretty flat. Things should start to pick up late in 2018 and certainly in 2019 when all remaining solar projects must be under construction to qualify for the 30% investment tax credit.
MR. SPENADEL: This may depend also on how you track numbers. The $10 billion figure for last year is the volume of deals that were mandated last year rather than the volume that funded in 2017. I agree that we will start to see a lot more activity toward the end of the year.
MR. TORRES: Greentech Media released a forecast in January that new solar installations will be down 7% in 2018 compared to what they would have been without the solar tariff. Combine that with the lower funding ratio for solar that we have just been discussing and you get a dollar value that is flat to down in 2018. Solar megawatts financed could be flat to up.
Another factor that has not been mentioned yet is that other tax credits for so-called orphan technologies were just extended. So other types of generators will be looking for tax equity.
MR. MARTIN: The orphan technologies are things like fuel cells, combined heat and power projects, small wind turbines, biomass and geothermal.
The lower corporate tax rate means corporations as a whole will pay less in taxes. Do you expect that to have any effect on volume of tax equity?
MR. VAN’T HOF: I’ll take a stab. A lot of our syndication partners are corporates. Their tax rates have gone down, but the corporate alternative minimum tax also went away, so even though their rates may have gone from effective rates in the high 20% range down to a flat 21%, they are realizing that they can reduce the effective rate even further than that. We are seeing new entrants in the market. The tax credit did not get killed. The solar tariff case is over. And now people know what their tax liability is. Those are three things they did not know in November.
MR. MARTIN: So the tax equity pool might expand.
MR. VAN’T HOF: Yes.
MR. TORRES: One thing we see as a syndicator of tax credits is that many of the buyers are banks, and banks have fairly complex regulatory regimes with which they need to comply. Some such regimes are more friendly toward tax equity investments. Others are a bit more strict. Getting the approval to make the investments has kept some tax equity investors from realizing their full potential regardless of their capacity.
MR. MARTIN: Is the bank regulatory climate for tax equity changing?
MR. TORRES: The Trump administration talks about rolling back bank regulation, but we have not seen it do so in ways that affect the merchant banking authority or other regulatory authority on which banks rely to do tax equity.
MR. MARTIN: Is it becoming harder for banks to do tax equity?
MR. TORRES: It depends on who you are talking to at your regulator. What we are hearing is that the regulators have been slow to respond to some investors.
MR. MARTIN: Laura Hegedus, you are with a bank. Have you seen any change in the regulatory climate?
MS. HEGEDUS: I have not. Returning to the original question of tax capacity, a lot of the investors in this space either expect to continue to have significant tax capacity, the BEAT question aside, or they have been in this space, at some points in time, without regard to their tax capacity, so tax capacity is not the only driver.
MR. MARTIN: Is there competition within your banks for what tax capacity there is among low-income housing, renewables and other competing investments that was not there before tax reform?
MR. SPENADEL: We are invested in renewables, low-income housing, new markets tax credits and other related fields. Our marginal tax rate was just reduced by 40%. There is no guarantee that we will continue to have capacity in every future year. It is something that we have to evaluate over time. There will probably be some investors who run into capacity constraints. They may have to cut back. Hopefully the syndication market will continue to gather pace and we will get some new investors who are willing to invest from inception rather than just buy into existing or already negotiated deals.
MR. MARTIN: Most of you are out syndicating these deals. Word at the end of last year was that there were at least 10 significant institutions that are investing alongside more experienced investors like you. Does that sound like the right number?
MR. SPENADEL: That is probably right, and the number is increasing. There are some who will do smaller tickets, but the number who will invest $20 or $30 million at a time is probably now greater than 10.
MR. MARTIN: So the tax rate has gone down but the number of people who are willing to invest is increasing. We see about 35 active tax equity investors between wind and solar, but not all are in the market at any given time. Does that sound like the right number?
MR. TORRES: I think it is higher than that.
MR. MARTIN: What number would you use?
MR. TORRES: I would peg it closer to 50.
MR. MARTIN: That is 50 in addition to the 10+ investors who will invest on a syndicated basis?
MR. TORRES: There are opportunistic investors, but I think the number of investors who have been consistent players is about 30 to 35 in any given year. A significant percentage are just doing solar.
MR. MARTIN: With that many investors chasing deals, there should be downward pressure on yields.
MR. TORRES: It has been a bifurcated market. I think there are some institutions, represented by those sitting to my left, that invest solely in big-ticket deals.
MR. MARTIN: Let the record show that everyone on the panel is sitting to his left. [Laughter]
MR. TORRES: Then there are more opportunistic investors who are willing to do deals with smaller developers who are more start up in nature and who have to pay higher yields for their tax equity. Developers in the C&I solar sector are an example.
MR. MARTIN: The opportunistic investors are in sectors where there is not as much competition?
MR. TORRES: Correct.
MR. MARTIN: Falling electricity prices mean that there is less cash in deals, and this is also contributing to a reduction in tax equity as a percentage of the capital stack. How high have you seen deficit restoration obligations go to try to deal with the problem that the investors do not have enough capital account to absorb all the depreciation?
MR. VAN’T HOF: We have seen a couple that have gotten as high as 70%. That is probably a tipping point at that number.
MR. MARTIN: Another way to deal with the absorption problem is to move debt ahead of the tax equity in the capital stack. Are you seeing a move in that direction?
MR. TORRES: We are definitely seeing such a move in the right situation. It makes the leverage a bit more efficient, although the cost of the debt is the same in the current market whether it is front or back levered. The lender would have to agree to a fairly generous forbearance provision where it would forbear from foreclosing on the project after a non-payment default, unless the borrower is bankrupt.
MR. MARTIN: If the lender is getting its principal and interest paid, it cannot foreclose.
MR. TORRES: That’s right. That protects the tax equity investor against recapture of the investment tax credit and an acceleration of minimum gain during the five-year ITC recapture period.
MR. MARTIN: One reason that we were not seeing front leverage for the last four years is there seemed to have been a collapse in the market consensus about the terms of any lender forbearance. The forbearance you need is the lender cannot foreclose if it is getting its debt paid, and you told me during the break that it must forbear for just five years. For the first five years, it is limited to pushing out the sponsor and taking over its role. After that, it can take the project.
MR. TORRES: That’s right. During the forbearance period, the lender can squeeze out the sponsor and accelerate its ability to recover something. A front-levered lender is already at the top of the cash-flow waterfall. But what that does for the tax equity investor is it allows the investor to continue absorbing depreciation after it has run out of capital account.
MR. MARTIN: Another thing you told me during the break is you think a return to front leverage is more likely in the solar rooftop market than in single-asset solar deals. Why is that?
MR. TORRES: If you have 50 to 100 assets and 20 different offtakers with BBB+ ratings or better, the tax equity investor has more of a securitization pool than with a single utility offtake.
MR. MARTIN: So when you have risk diversification, you are more willing stand behind somebody else in line for payment. Does anyone else see a move toward front leverage?
MR. SPENADEL: We do not. One of the issues is if project-level term debt will run 15 years, we do not want to have to deal with the transaction for 15 years. The project will run net losses for tax purposes for the first three or four years. There are still another six, seven, eight or more years of debt repayment. We have effectively to repay the losses we claimed. Either the income gets accelerated or the depreciation is reversed. The losses have a time value, but it is not a big benefit and not one for which we would pay very much to be honest, especially the way we measure our deals from an accounting standpoint.
MR. MARTIN: When the sponsor buys you out after the flip, he is considered to pay not only the cash option price, but also to absorb your share of the debt and therefore you end up being taxed on the debt that shifts. Does anyone else see a return to front leverage?
MR. VAN’T HOF: We generally do not permit it, mostly for risk mitigation reasons, but we see people try to put debt at the project level. It is not that desirable. I agree with Joel.
MR. MARTIN: There are some tax equity investors who are looking to invest part of their money as tax equity and part as a lender either on a back-levered or front-levered basis. Are any of you looking at that and, if so, what issues does it raise?
MR. TORRES: Where we offer debt on tax equity transactions as a construction lender. We will bridge to the tax equity, and this works very well for large utility-scale projects that will have substantial tax equity and back-levered financing on a term basis. The tax equity group and the corporate lending and project finance groups at RBC will collaborate on a seamless package to finance both ends, but not be in the project at the same time. We are not really term lenders.
MS. HEGEDUS: We are not lenders either in this space, but we have contemplated construction finance. It is still at the early stages of contemplation, but that is probably the only place where we could do it.
MR. MARTIN: Another way to deal with the absorption problem would be to move to sale-leasebacks. Partnership flips are about 80% of the solar market today. Do you see a move to sale-leasebacks?
MR. VAN’T HOF: We don’t do them. We see a lot of people asking for them. They can be very efficient. From the developer side, there are a lot of attractive qualities, but from an investor side, it is just not a structure we are able to do.
MS. HEGEDUS: The term is too long from our perspective, so we have not done them, and we don’t expect to do them.
Other current issues
MR. MARTIN: One change in the new tax law is that you can now claim a 100% depreciation bonus on used equipment. Do you see any interest among sponsors in selling and leasing back their used assets, perhaps after the ITC recapture period has run, to get more cash into the business?
MR. SPENADEL: I have not seen that. It is still early. It is not clear to me the economics make sense where the only tax benefit for the lessor is depreciation and no tax credit.
MR. TORRES: I have not seen it either, but it would be an interesting refinancing post-flip structure where there is a long-term PPA or some other form of long-duration contracted cash flow. It could be attractive as a way to take out tax equity and re-finance the asset.
MR. MARTIN: Next question. The market managed to function last year despite uncertainty about what the tax code would say. It did it because the deal papers provided for a one-time resizing of the investment, usually in 2018. Have you seen any problems arise as a consequence of these resizing provisions or are they working properly?
MR. VAN’T HOF: They are a little messy because the language got a little tighter closer to the end of the year. If you were closing in June or July, the people at the table did not have a collective sense that tax reform was likely to pass. The resizing language got better as the year wore on. In all cases, because of that, there is some subjectivity to the determination as to what gets adjusted and when. It becomes a negotiation, but we have gotten through it.
MR. MARTIN: “Messy” means that you may not have provided for an adjustment for everything that actually happened.
MR. VAN’T HOF: That’s right. For example, if the adjustment is supposed to get the investor back to its original yield, how do you do it? Do you adjust the cash sharing ratio? Do you elect faster depreciation? Who decides?
MS. HEGEDUS: I agree. What was drafted earlier in the year just was not as useful as what people were able to draft once they had a full sense of what could possibly be on the table. There were some lessons learned along the way.
MR. MARTIN: Do you think the market will go back to where it was before by doing deals without resizing provisions now that tax reform is behind us?
MR. TORRES: There is a tendency to add to the deal papers rather than subtract from them. I suspect the change-in-tax-law provisions will stay in the documents.
MR. MARTIN: That’s not unlike how the US tax code works. It gets longer and longer over time because of all the dead wood.
MR. TORRES: That’s true. What we have found is that the heavily negotiated provisions still have relevance even though the legislation has been signed into law. The agencies still have to interpret it. We think there is still relevancy there.
MR. MARTIN: Let the record show that Joel Spenadel is nodding yes.
MR. SPENADEL: There are two issues. I know next up is expected guidance on the start-of-construction rules for solar. We know they are coming. Other tax changes are already baked into our deals. We have a flip calculation that varies based on the actual tax rate if that were to change or other changes were to come about. There are historically certain risks that we as investors fully absorb.
MR. MARTIN: Next topic. The government is challenging a 12.3% developer fee paid in a wind farm. It was paid under a development services agreement. The case goes to trial July 23. Is this affecting your view of what developer fees can be put in basis?
MS. HEGEDUS: It sounds like someone started out with a good problem. In wind, you cannot contemplate a developer fee that high unless the PPA pricing is pretty rich because the valuation is a constraint for most investors.
MR. MARTIN: Next question. There is a sense in the market solar hedges will become available this year so that solar projects can be done on a merchant basis. The first project will probably be in ERCOT. Wind has been financeable on a merchant basis. The tax equity market has done merchant wind deals. Does that mean that solar should be financeable on the same basis?
MR. SPENADEL: Yes. It really depends on whether the economics of the hedge work. In a PPA, the buyer is paying for more than just power. Hedges are a way to protect against power price risk. If the economics work for the sponsor, then we will finance the project. The hedge has to be done right.
MR. MARTIN: How long does it have to be? Five years? Eight years? Ten, twelve?
MR. SPENADEL: For wind with the tax credits being claimed over 10 years, it had to be longer. It would probably need to be more than five years in a solar project. We will see how much longer.
MR. TORRES: The longer duration you can get with price certainty on your offtake in a solar deal, the more comfort you can take in the value of the project as a whole. Valuation is a more acute issue in the solar market than it is in the wind market because tax basis plays a larger role in the deal economics.
The other point is that we are seeing hedges in ERCOT. That will be a very interesting dynamic as solar generators drive generation during peak hours. You have wind generators that may not be as competitive during those hours. For many that have loaded up on ERCOT wind PTC deals, solar might be an attractive pivot.
MS. HEGEDUS: Also, solar hedging would not be starting at the same place that wind hedging started from an investor’s perspective because we have learned a lot over the past 10 years about how hedges work. The market has also shifted toward sponsors retaining a lot of basis risk. Investors are pushing back. That will be the starting point for the solar hedging market.
MR. MARTIN: So investors will focus on the amount of basis risk that sponsors are taking. The risk may be too great. That bleeds into the next question. Corporate PPAs are more common. Most of them seem to be virtual PPAs, which means they are financially settled rather than requiring physical delivery of electricity. Do such deals raise any special issues for you beyond the basis risk that Laura just mentioned?
MR. VAN’T HOF: I don’t think so. The credit counterparty may be a corporation that our banks have already underwritten. So in some cases, the underwriting can be the same or even a little easier than for a utility.
MR. SPENADEL: You do have to watch the credit though because, if the counterparty wants to use a special-purpose subsidiary for which you may not be able to get financials, then the focus shifts to what kind of guarantee you can get from the entity.
MR. MARTIN: Let’s talk briefly about community solar. Those projects seem to be getting financed in Minnesota and Massachusetts and perhaps other states. The subscribers are not locked into their subscription agreements. They can usually walk away. How comfortable are you with that feature?
MR. VAN’T HOF: The ones we finance have subscribers who are locked in. We do a fair amount of this type of project. Only a small percentage of subscribers in our deals might have a walk-away right. Most are pretty decent offtakers.
It is interesting that corporate community solar has not gotten more traction. I think there is a misunderstanding among the investor and lending communities around how such deals work. In our view, they are bankable, and they are good credits. They look like small utility-scale transactions.
MR. TORRES: I agree. We have done two funds in Minnesota and, by and large, they were with municipal offtakers. They have pretty tight termination provisions that are protective to tax equity.
MR. MARTIN: How fully subscribed does the project have to be before you will close, and do you care about the mix between residential, on the one hand, and commercial and municipal, on the other?
MR. TORRES: We have only financed 100%-subscribed portfolios.
MR. SPENADEL: Same here.
MR. MARTIN: And the mix? Do you allow residential, what percentage?
MR. VAN’T HOF: We will allow as much as 20% residential, in some cases. It depends on what the other 80% share looks like.
MR. MARTIN: The C&I solar rooftop market is still not getting the traction people expected. Is it just the fact that the customer agreements have so many varied terms so that due diligence is expensive or is it something else?
MR. VAN’T HOF: We spent a lot of time last year in our deal execution on C&I portfolios. I would say that the something else is probably more significant in terms of getting these deals done and finding portfolios that work for investors. That is the real estate diligence and the sponsor strength.
At this point, I think people have gotten efficient at dealing with PPAs. We have seen a number of portfolios that have semi-standard terms. So you maybe have three different types of PPA base forms with a few deviations in terms with individual customers.
MR. SPENADEL: We have found the same thing.
MR. MARTIN: Next question. Inverted leases raise less capital than the other two structures: sale-leasebacks and partnership flips. They were popular during the Treasury cash grant era, particularly for tax equity investors who did not have tax capacity. But they remain popular in some segments of the market. What accounts for their continued popularity?
MR. VAN’T HOF: We do a fair number of them. The sponsors generally drive the choice of structure. On the investor side, we have other investors who actually prefer the structure. Sponsors who choose it prefer to keep the depreciation. As an investor, we like the fact that we can call it before the end of the full lease term, and our pricing and advance rates are lower than for other structures.
MR. MARTIN: Next question. Are you aware of any IRS audit issues in the market?
MR. VAN’T HOF: There were challenges under the Treasury cash grant program, but we have not seen the IRS disallow investment tax credits on solar deals.
MR. MARTIN: No challenges to the tax bases claimed? No challenges to the structures? Nothing?
MR. VAN’T HOF: Correct. It is interesting to note that the premiums for tax insurance on these transactions have been falling. That may be a sign of a perception that the risks are small.
MR. MARTIN: Let’s work in a few audience questions.
MR. BARRETT: Jason Barrett from GAF. There was a comment earlier about the C&I market struggling to get traction. We have put close to a billion dollars to work in that market. Our sense is that market is working fine. It may just be a matter of finding the right investor.
MR. SHORE: Bill Shore from Hanwha. For those of you who will do hedge deals, are you requiring that the sponsor use your bank as the hedge provider or will you do a tax equity deal when someone else is the hedge provider.
MR. VAN’T HOF: Frankly, it is easier if another institution provides the hedge because then we are just underwriting another counterparty. But be careful how the hedge is structured. We are less keen on hedges that start to look like senior debt. The identity of the hedge counterparty also matters.
MR. GOARMON: Bernardo Goarmon from EDP Renewables. Have any storage deals combined with solar come across your desks and if so, can you elaborate the amount of ancillary services you feel comfortable allowing the project to provide without jeopardizing any investment tax credit on the storage device?
MR. MARTIN: [Pause] I guess the answer the answer no. For anyone interested in this topic, search on Google for “Batteries and Tax Credits.” A paper will come up that addresses this.