The Inflation Reduction Act brought a sense of confidence and certainty to the business of clean energy. Lawyers Adam Schurle and Morten Lund at Foley Lardner take a closer look at what that means for tax equity financing of energy storage, while exploring some of the questions still to be answered.
This is an extract of a feature article that originally appeared in Vol.36 of PV Tech Power, Solar Media’s quarterly journal covering the solar and storage industries (Premium access).
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The Inflation Reduction Act of 2022 (IRA), enacted in August 2022, had the potential to flip on its head the manner in which solar and battery energy storage system (BESS) projects were developed and financed, in particular how tax equity financing is utilised in the industry.
Now that we’re a year removed from passage of the IRA, it’s a good time to revisit whether some of the predictions, hopes, and fears attendant to tax equity financing and the IRA have been realised.
The ITC (investment tax credit) has always been something of a double-edged sword. On the one hand, the ITC has without a doubt been the most significant financial incentive for solar energy in the US and has attracted immense amounts of capital investment to the solar energy industry. On the other hand, the nature of the ITC as a tax credit has excluded many funding sources and introduced potentially detrimental artificial incentives to the industry.
Nothing is certain, except taxes
To utilise the ITC, a significant amount of income subject to US Federal income tax is required, and the claimant generally must be a US taxpayer.
Prior to the IRA, the ITC was not transferable. Depreciation is not transferable. As a result, and because project developers typically can’t absorb all of the tax benefits themselves, outside financing is generally required to realise the value of the ITC and depreciation.
The structures used to monetise the ITC are complex. The most common are partnership flip and sale-leaseback structures; some tax equity participants use inverted lease structures, but those are less common. These complex structures come with high transaction costs.
Solar and storage markets shaped by tax credits
These requirements combine to create a set of circumstances where there is a fairly small pool of possible ITC investors. In practice, most tax equity investors are banks and insurance companies.
Pre-IRA, BESS were not eligible for the ITC on a standalone basis. Instead, BESS were eligible for the ITC only if they were paired with other ITC eligible electricity producing property, such as a solar energy system.
There were also significant limitations on how the BESS could be used. In order to qualify for the full ITC, under what are known as the dual use equipment rules, BESS had to be charged only by the associated solar energy system or other ITC eligible property through at least the first five years after the BESS was placed in service.
Any charging from the grid or other ineligible property, and the ITC was subject to reduction; and if the total energy input for the BESS from non-ITC eligible property was greater than 25% then no ITC was permitted with respect to the BESS.
These restrictions made standalone BESS much less attractive, and most storage systems installed pre-IRA were part of hybrid systems.
The IRA significantly changed this landscape, for both solar and storage. The full ITC rate was reinstated to 30%, and standalone BESS were added to the list of facilities that are eligible for the ITC, meaning that BESS now no longer need to be paired with other ITC-eligible generating property. The IRA extended the window for ITC eligibility for projects that begin construction no later than 2033, and possibly longer.
In addition to the extension, the IRA added new eligibility requirements. On a going-forward basis, any facility that is over 1MWac must satisfy certain prevailing wage and apprenticeship requirements (although projects on which construction began before January 29, 2023, will be exempt from these requirements).
These prevailing wage and apprenticeship requirements generally require that in the construction, repair, or alteration of a facility the taxpayer, contractors, and subcontractors must pay wages at local prevailing wage rates published by the US Department of Labor and a certain percentage threshold of such work must be performed by qualified apprentices.
If an otherwise eligible facility is subject to but does not satisfy these prevailing wage and apprenticeship requirements, the credit rate for the facility drops to 6%, rather than 30%. Further, for projects placed in service beginning in 2025 that didn’t begin construction before then, a new rule will require that those projects have an anticipated greenhouse gas emissions rate of not greater than zero.
Transferability, direct pay options
For the first time ITCs, PTCs, and other renewable energy credits can now be sold to taxpayers on the open market.
Second, tax-exempt entities, including many universities and hospitals, state and local governments, and tax-exempt organisations, are now entitled to claim direct cash payments from the US government for the tax credits they otherwise would have been eligible to claim (but could not use due to their tax-exempt status).
These changes – transferability and direct cash payment, respectively – left some within the renewable energy industry hoping (and others concerned) that we would soon see a day when the complexity of tax equity financing would be no more. One year on, it is clear that neither those hopes (nor the fears) have been fully realised.
There have been some changes. We have seen interest in tax credit transfers, and some transactions have already been signed up. Many direct pay transactions involving tax-exempt entities building solar and BESS projects that they will own are in the works, and more are expected as more such entities dip their toes into renewable energy investing.
Third-party tax equity financing here to stay
What we have not seen is any movement toward abandoning third-party tax equity financing. There are two principal reasons for this. First, a tax credit transfer is itself a form of tax equity financing. While these transactions have the potential to be less complex and costly than other tax equity financings, they still add significant complexity and cost to the project.
Moreover, the tax credit purchaser is subject to the same qualification requirements and general limitations as any tax equity investor, so the pool of eligible investors has not grown, although there will certainly be some tax credit buyers that would not be willing to participate in traditional tax equity.
Taxpayers without experience in traditional tax equity might be hesitant to make the leap to buying credits. This reluctance could be eased by third-party brokers of tax credit purchases, which the transferability guidance expressly permits, but that is a nascent marketplace at this time.
Second, and more significantly, only the tax credits themselves – the ITC and the PTC –are transferable. The depreciation benefits cannot be sold. With a potential value of roughly 20% of project cost, this by itself is often enough to justify a full-on tax equity financing.
While smaller projects may elect to forgo the depreciation benefits (because owners don’t have taxable income to utilise depreciation), this is not a realistic option for larger projects. A similar effect is in place for tax-exempt entities: the direct pay option only applies to the ITC. Depreciation benefits are forever lost if a tax-exempt entity is the tax owner of the project.
This is an extract of a feature article that originally appeared in Vol.36 of PV Tech Power, Solar Media’s quarterly journal covering the solar and storage industries. Every edition includes ‘Storage & Smart Power,’ a dedicated section contributed by the team at this site and is included in a subscription to Energy-Storage.news Premium.
About the Authors
Morten Lund is Of Counsel at Foley & Lardner LLP’s San Diego office, and a member of the firm’s Energy Sector. For more than 25 years, Morten has advised developers, lenders, investors, and other project participants. Morten has a particular focus on solar energy and energy storage projects, but Morten’s wide range of project experience also includes wind energy projects, combustion generator projects, nuclear energy facilities, hydroelectric facilities, cogeneration facilities, chemical facilities, forestry/paper facilities, large aircraft, and shipping fleets.
Adam Schurle is a Milwaukee-based partner in Foley’s Tax Practice Group. Schurle counsels clients on a wide variety of federal and state tax matters. A significant portion of his practice is focused on tax advice for developers and financial institutions in wind, solar, hydroelectric, biomass, and other renewable energy finance transactions. He helps these clients qualify for federal, state, and local tax incentives and implement transaction structures that maximise the value of those incentives.