Financiers are beginning to ponder what life without the production tax credit (PTC) might look like, and it might not be so bad.
The PTC has been a mainstay of the renewable energy industry and a catalyst for renewable project deal flow for decades. So it would seem that its eventual demise – it is scheduled to be phased out by 2020 – would have bankers worried, but some seem, instead, to welcome the prospect.
“The phase out of tax equity makes for a healthy industry in the long term,” Jonathan Fouts, a managing director in Morgan Stanley’s global power and utilities group said at a recent finance conference in New York.
Renewable energy projects have dominated power sector deal flow for years. About 75% of all new capital is going into renewables, mostly from private equity and renewable energy funds, Fouts said at the recent Platts’ Financing U.S. Power conference.
That boom has been driven by several factors, including concerns and perceived risks about coal-fired generation, declining costs for wind turbines and solar panels, and the financial engineering that enabled the monetization of the PTC via what is known as the partnership flip structure.
The partnership flip requires the developer of a wind project to transfer nearly all the equity in a wind project to a financial institution. Tax credits follow equity ownership, so the financial institution collects the tax credits that the wind farm generates over a 10 year term. At the end of the term, or when the wind farm “earns out,” the structure flips and most of the equity reverts back to the developer.
The PTC and the partnership flip has been a boon to Wall Street, which is obvious if one tracks wind power development. The PTC has an expiration date, and until recently Congress has usually extended the subsidy for only a year or two at a time, which has resulted in a boom and bust cycle for wind projects, particularly on those five occasions when Congress has allowed the credit to lapse before extending it.
Congress last extended the PTC at the end of 2015, renewing it for five years but with a planned phase out in a series of steps: a 20% reduction in 2017, 40% in 2018, and 60% in 2019.
The extension of the PTC and an investment tax credit (ITC) for solar facilities are expected to drive a boom in renewable energy deployment into the early 2020s, supplanting gas generation as a primary compliance tool for the Clean Power Plan for many utilities.
But as beneficial as the PTC has been in jump starting renewable energy development, particularly of wind farms, it also has a downside.
“Tax equity is expensive,” Jonathan Boffi, a vice president at private equity firm First Reserve, said at the conference. Tax equity expects an all-in return of about 10% with no risk, he said. Over time he expects opportunities for other debt products will emerge.
Low interest rates and competition among investors eager for high yields have pushed down rates on other finance products. But there are only about a half a dozen firms that provide tax equity, so high returns have persisted.
Tax equity “is scarce because it complicated,” said Thomas Plagemann, executive vice president and head of capital markets at Vivint Solar, said.
Momentum and high returns will likely keep the tax equity market going for the next couple years, but eventually the market will be better off without tax equity, said Greg Wolf, CEO of Leeward Renewable Energy, a development company backed by ArcLight Capital Partners. Taking tax equity out of the mix could lower the cost of capital for renewable deals, hex said.
The most obvious post tax equity option would be for renewable power development to move back to a more traditional project finance structure, said Timothy Page, managing director at Whitehall & Co.
Fouts said he would expect to see a resurgence of the mini-perm financing structure, a form of short-term loan used to pay construction costs and bridge a funding gap until a project is operating and can be refinanced.
The market has been good at coming up with new products to meet evolving market needs, moving from power purchase agreements to hedges such as revenue puts. The next evolution is a proxy revenue swap where a reinsurance company takes the wind risk. “That is where we see the next wave of offtakes,” said Fouts.
A proxy revenue swap mimics a tolling agreement or capacity payment by swapping the floating revenues of a wind farm for a fixed annual payment. Apex Clean Energy and Northleaf Capital Partners closed on a 10-year proxy revenue swap with Allianz Risk Transfer (Bermuda) Ltd. for their 151-MW Old Settler Wind project in Floyd County, Texas, in July. Allianz at the time said the deal was the first in a pipeline of future wind financings.
That would be a welcome development for some bankers. Boffi at First Reserve said he “looks forward to the day when you need less tax equity, as it significantly complicates the capital structure and comes at a high cost in addition to other tax inefficiencies.”
