Investing in Renewable Energy Projects

The ITC generally allows qualified tax-paying project developers to take a 30% credit against their capital investment in a renewable energy project. This credit is earned when the equipment is placed into service. See World Resources Institute publication: Bottom Line on Renewable Energy Tax Credits, at http://tinyurl.com/hme69gf. Solar projects that begin construction before 2020 will receive the 30% tax credit with a gradual step down to 26%, and 20% for projects in 2020 and 2021, respectively. See http://bit.ly/1UdqgWp.

The PTC allows a tax credit (up to $0.023/kWh hour adjusted for inflation) for the production and sale of renewable electricity produced from wind, closed or open loop biomass, geothermal energy, landfill gas, municipal solid waste, hydroelectric power, or marine or hydrokinetic power. The PTC for wind energy will remain at full strength through 2016, followed by incremental reductions in value for 2017, 2018 and 2019 before expiring in January 2020. The ITC for solar will continue at 30% levels for both commercial and residential systems through 2018, then taper off in yearly increments to settle at 10% in 2022.

There will be a gradual phasing of the PTC from the $0.023/kWh in 2016 to 80% of that value in 2017, to 60% in 2018 and ultimately, down to 40% in 2019. Thus, while the ITC benefit accrues when the qualified facility is placed in commercial operation, the PTC accrues as and when the power is actually produced.

Most developers of these technologies are unable to claim the tax credits, since they lack the tax liability required to absorb the tax credits. See IRS Revenue Procedure 2007-65. Federal tax guidelines allow a developer to monetize the tax credits, i.e., opt to exchange its credits for monetary payments, from the so-called tax equity investors that have adequate tax liability to absorb the tax credits. Id. Monetization strategies are often executed between a developer and investor through partnership flips and sale-leaseback transactions.

These strategies can be contrasted with the now discontinued Department of Treasury Cash Grant program under the American Recovery and Reinvestment Act of 2009 (the Stimulus Act), which allowed the developer to directly monetize its tax credits by receiving reimbursement cash from the Treasury without investor intermediaries.

Herein, this article examines the various strategies that are adopted to monetize renewable tax credits. It will further discuss transactional issues that require consideration when a purchaser of the electric power, generated from the energy project, whose tax credits are being monetized, is structuring its power purchase agreement (PPA) with a developer.

Monetization Strategies

Renewable projects that are financed with a developer's funding sources rely on the stream of revenue from a PPA to either collateralize debt, monetize associated tax credits, or assure returns on developer's equity. As a financing structure, the PPA is a “third-party” ownership model that requires a separate, taxable special-purpose bankruptcy remote vehicle (SPV) to procure, install and operate the PV system on a purchaser's premises. The SPV will be a jointly owned partnership between the developer and investor. The purchaser will enter into a long-term PPA to purchase 100% of the electricity generated by the system. Relative to monetizing renewable tax credits, the following strategies may be pursued by the developer and the investor.

The Department of Treasury 1610 Cash Grant Program

The now discontinued Department of the Treasury Cash Grant program offered the eligible developer a surefire way of receiving direct cash grants in lieu of the ITC for projects eligible for either the PTC or ITC placed in service in 2009 or 2010. See ' 1603, The American Recovery and Reinvestment Tax Act (ARRTA) program. It reimbursed the eligible developer for 30% of the cost of installing qualified energy property. The reimbursement could only be made after the energy property was placed in service, not prior to or during construction. Id . Given the complexity and a dearth of investor interest in the tax credits using market-based monetization strategies discussed in this article, a good case could be made for reinstating this program.

Partnership Flips

In a partnership flip, the PPA that is signed between the developer and purchaser will be assigned to the SPV, which will get a priority equity distribution of cash flow from the sale of the power generated, and will be the entity to claim the tax credit. Under Internal Revenue (IRS) Guidelines, the developer is required to hold a minimum of 1% ownership in the SPV. The developer is required to hold a minimum of 5% ownership interest in the SPV. See IRS Revenue Procedure 2007-65. In a partnership flip transaction, a 99:1% equity allocation, respectively, between the investor and developer is regarded as adequate to satisfy the IRS requirements.

After the investor attains a set rate of return, the partnership ownership will inversely flip to 5:95% equity, respectively, between the investor and the developer. The investor's shareholding is secured with a cash payment to the developer equal to the monetary value of the ITC. See Sean Shimamoto and Paul Schocket, Renewable Energy Tax Credit Monetization Strategies: Opportunities and Uncertainties For Partnerships, PLI Order No. 27150.

In exchange for this cash payment, the PPA, the income from the sale of the power, and “all items of the project company's income, gain, loss, deduction and credit that will ordinarily inure to the developer from the ITC will be assigned to the SPV.” Id. Essentially, the SPV becomes the nominal taxpayer. The developer may have an option to purchase the remaining minority share of the investor at market value.

Sale-Leaseback

The sale-leaseback is used extensively to monetize the ITC in solar projects. With this strategy, the developer signs a PPA to install and operate the project. Within three months of the commercial operations date, the developer will sell the project to an investor, the investor will lease back the project to the developer for a term equal to the PPA. Thus, the PPA becomes the collateral for its lease payments, and PPA revenue will be used to make rental payments under the lease.

The Investor is considered the owner of the project for tax purposes, and thus claims the ITC and the other tax benefits. The investor shares the tax savings with the developer in the form of reduced rent payments. The developer has the first right of refusal to purchase the project from the investor at the end of the lease term at fair market value.

Transactional Considerations

From the foregoing, it should be evident to the purchaser that crucial downstream activities involving developer and investor should be factored into negotiating the PPA and its assignment to the SPV. Those activities include the following:

• To enable the SPV to claim all items of the project company's income, gain, loss, deduction and credit that will ordinarily inure to the developer from the ITC, the PPA will be assigned to the SPV. The purchaser, particularly, if it is a public sector entity, must ascertain whether there is any prohibition or restriction on its ability to assign the PPA to the SPV. See NYS Fin Law, Section 138.
• The purchaser should also bear in mind that if a partnership flip strategy is pursued, the investor will have a yield-based interest in which, upon the attainment of its yield target, its ownership interest in the SPV will “flip down” with the developer inversely assuming majority or full ownership of the SPV.
• The purchaser should also note that the SPV is a bankruptcy-remote special-purpose entity whose function will be limited to the acquisition of the tax credits. Therefore, the SPV solely relies on the tax credits and revenue from the PPA to satisfy its financial obligations to the Investor and lenders, with limited or no recourse to the developer to satisfy any obligations. Thus, the SPV is purely a financing structure with no ability to provide ongoing maintenance of the project. The purchaser should reserve the right to look solely to the developer to meet its ongoing operational obligations. See Rating Project Finance by BDRS at http://tinyurl.com/hcwwnfx. For an in-depth analysis of commercial risks in project-financed transactions, see Hoffman, “The Law and Business of Project Finance,” Cambridge University Press at p. 58-67
• Last, the project asset may be used as a collateral or security for any debt that the developer may secure to finance and install the project. Such lenders will have second priority security interest in the assets of the project after the investor.

Protections Against Pitfalls

The PPA and its assignment should be structured properly to protect the purchaser who will not be privy to the monetization transaction in the following manner:

First, the solicitation document that is issued to select the developer by the purchaser should require the developer to disclose its financing sources and downstream securitization methodologies, including monetization strategies and structures that will be utilized to monetize the tax credits.

Second, because the SPV assumes all responsibilities with regard to manner of performance of the PPA, there should be a continuum of the insurance coverages by the SPV that was originally provided by the developer. This should be coterminous with the date of the assignment, so there is no gap in insurance coverage.

Third, the SPV must warrant to defend, indemnify and save the purchaser harmless from any claims, damages or causes of action in favor of the purchaser.

Fourth, the purchaser must reserve any and all rights of any kind or nature whatsoever against the SPV that it may have against the developer. Thus, the assignment should be conditioned upon the premise that it shall not operate to discharge any claims, demands or causes of action the purchaser may have against the developer.

Conclusion

It is clear that the purchaser of renewable energy projects financed with the developer's funds and monetized tax credits ought to look far beyond the conclusion of a PPA to fully protect its interests.

Kingsley Osei is associate counsel in the Office of General Counsel at the State University of New York, Albany. This article also appeared in The New York Law Journal,' an ALM sibling publication of this newsletter.