The Inflation Reduction Act (IRA) of 2022 is the most significant climate legislation in U.S. history. It fundamentally shifts the economic landscape for renewable energy, providing more than 70 investment, production, and excise credits designed to facilitate a broad transition away from fossil fuels and towards a sustainable energy system. The bill comes at a moment when, after decades of clean technology development and pioneering procurement approaches, renewable energy resources have reached a tipping point of economics and adoption. To ensure the IRA’s immense promise is fulfilled, a new generation of innovators and investors must now step forward and fuel the market’s next chapter of robust growth.
The IRA provides a wide array of incentives that promote various aspects of the energy transition. Importantly, it also makes these incentives available to a greater number of participants, and for an unprecedented ten-year period. The bill’s cornerstone is investment tax credits (ITC) and production tax credits (PTC): dollar-for-dollar reductions in tax liability for credit owners.
Earlier versions of these tax credits have formed the financing backbone of renewable energy development in the United States for decades, allowing developers to secure as much as 60% of the capital required to finance project construction. Since most developers’ tax burdens are too small or not structured to leverage the full value of the tax credits earned by their projects, firms partner with investors capable of fully utilizing the credits. These investors — historically, a handful of large banks — provide an additional project construction capital source beyond standard project debt and equity, and in return, apply a project’s credits against their tax liability.
Today, the size of the renewable energy tax credit market is approximately $20 billion annually — though recent estimates suggest the market will grow to two- to three-times (or greater) in size compared to original estimates as a result of the IRA. These updated numbers mean as much as $40 billion in additional annual financing must be provided by corporate taxpayers who recognize the opportunity to partner with the federal government and use their tax liability to drive the energy transition.
Providing the tax investments needed to support fossil-free energy development is not only a financial opportunity for corporations. Indeed, such investments will be critical to funding the construction of the clean energy we need. In time, tax credit investments may be viewed as a means of providing “additionality” to the grid just as much as signing a corporate PPA is today. Since both provide significant financial commitments developers need to get their projects built, one could reasonably imagine renewable tax investments increasingly representing another form of climate leadership from committed corporate investors.
A Long and Winding Policy Road
The program underpinning the IRA’s provisions dates back to the Energy Policy and Conservation Act of 1975, signed into law by Gerald Ford amid the oil shocks of the 1970s. George H W Bush’s Energy Policy Act initiated the first tax credit tied directly to renewable production, and his son, George W Bush, extended these tax credits and introduced the framework we see today. The Obama Administration helped boost renewable economics with over $80 billion for clean energy R&D and deployment, and the IRA has now introduced by far the most comprehensive and far-reaching clean energy policy in U.S. history.
Similar to other policy-driven federal tax programs such as low-income housing, new markets, and historic rehabilitation tax credits, the demand for renewable energy tax credits has long been driven by a small group of specialized investors. The market has grown substantially in the last five years, nearly doubling in size — an expansion driven primarily by the renewable projects being constructed to meet rapidly growing demand for clean energy.
Tax investors recognize that they are doing well by doing good: realizing favorable returns while helping mitigate the existential threat of climate change. Minor and major players enter and exit the market periodically as risk appetite shifts and tax liability changes, but the primary players have remained relatively stable through the years. The market is largely a “buyers’ market,” with tax investors maintaining favorable terms despite the market experiencing a rapid de-risking as Internal Revenue Service (IRS) conflicts have been adjudicated and settled across tax law. The large tax credit players meet their demand by focusing on repeat business from incumbent developers, as third-party advisors work diligently to bring in new entrants to meet the need for new investment.
The IRA Has Changed the Tax Credit Game: Here’s How
One issue with traditional renewable tax equity investment is that its inherent complexity, and the historical characteristics of renewable tax credit policy, have limited who is willing to participate. For one, the complicated nature of due diligence and transaction execution presents a steep learning curve. What’s more, tax investor accounting departments are burdened by ongoing monitoring of and accounting for the arcane tax structures used to claim the tax credits.
Congress has historically passed short-term extensions of these tax credit programs that last just a few years at a time — providing relatively short and intermittent policy runways underpinning the market. The short tenor of these tax statutes, and the risk of these statutes not being extended, has made potential market players understandably hesitant to dive in, fearing a scenario in which internal tax departments are left with newly minted renewable tax investing competencies for an obsolete product.
The IRA fundamentally addresses much of what has made broader participation in this market prohibitive, and in doing so, provides remarkable opportunities for corporates looking to participate in the renewable tax credit market while simultaneously pursuing their ESG goals.
The IRA’s provisions bring two major changes that should revise the decision matrix for treasury departments at ESG-minded companies:
1. The IRA definitively ends the short-term cycle of policy uncertainty that has made potential participants hesitant to engage in the market. The law extends the tax credit program until the end of 2032, or until U.S. electricity sector CO2 emissions are equal to or below 25% of 2022 levels. This decade-long tenor provides corporate tax departments with a strong runway to integrate a renewable energy tax program into their tax planning process and operational competencies, allowing them to take full advantage of these incentives as the energy transition continues.
2. The IRA also provides for direct tax credit transfer for cash, eliminating the need for the tax investor to enter into a complex tax equity partnership, sale leaseback, or inverted leases.
Traditionally, IRS rules required that the tax credit claimant have a true ownership interest in a project. In order to fulfill these requirements, the accepted deal structures needed to secure project partial ownership demanded that tax investor returns involve a cash outflow component, or another clear economic risk to validate the structure. Such investments carry material project performance risk, thereby requiring extensive due diligence. Partnerships, sale leasebacks, and inverted leases require extensive legal documentation defining the allocation of cashflows and/or risks. These structures require tax investors to expend resources for significant ongoing monitoring, and to engage in complex partnership accounting or take the full asset on the balance sheet. Simply put, these requirements create administrative costs and financial statement impacts that extend beyond the interest of most corporate treasury departments.
Tax credit transferability largely eliminates these hurdles. Investors can invest cash, transferring tax credits for use in the tax year of generation, or to fund renewable energy projects under forward contracts for delivery of tax credits in future years. This vastly simplifies monitoring and accounting for a tax credit investment. The investment return is not reliant on any cashflow generation from the project, so performance risk is reduced. Many of the project and tax risks are anticipated to be fully indemnified by the renewable energy project and the project’s owner, and tax credit transfer is driving the development of innovative third-party tax indemnity insurance products. In short, the market is entering a new chapter of opportunity, with risks and burdens being broadly reduced, and with far greater flexibility around tax credit monetization and strategy.
To Bundle or Not to Bundle
As stated above, the key hurdle to realizing the IRA’s full potential is tax investor demand sitting well below the capability of developers to produce policy-supported clean energy projects that supply tax investment capacity. Beyond the large banks and insurance companies that dominate the market, few corporate taxpayers have taken up the charge to leverage their tax liability for clean energy advancement. Some forward-thinking companies, recognizing the additionality component of providing this missing tax monetization ingredient, have entered the market. But these investments often require the developer to bundle RECs into the deal as part of investors’ quest to meet Scope 2 emissions reduction targets.
The bundling of RECs in the tax investment transaction introduces a structural inefficiency for developers. By definition, RECs in such arrangements have been unbundled from the renewable energy production they were originally associated with, thereby closing off the renewable PPA market: another key aspect of renewable energy financing. Generally, developers are incentivized to keep RECs and their projects’ energy production bundled, thereby preserving PPA optionality on this part of financing.
These two competing priorities — fully bundled RECs and fully independent tax investment opportunities — create a gap in the product specifications between buyer and seller. In order for the tax investor universe to grow, this gap will need to be closed. Corporate tax investors must be more flexible in recognizing the full financing formula developers are trying to solve, and developers need to accept that some RECs may need to be apportioned via a tax investment. The various permutations and combinations that result will be reflected in the pricing of the bundled investment, with developers likely to receive a price premium for arrangements that provide for investors’ REC and tax credit needs alike.
Ultimately, neither parties’ goals will be realized without creating a deeper pool of tax investors stepping in to fund the construction of new projects. Tax attribute monetization remains a key constraint to financing the energy transition, representing anywhere from 30-60% of the cost of construction financing. Without a broadening of the tax investor market, PPAs and RECs will remain undersupplied and their prices will almost certainly rise. Substantial tax investment will be key to realizing the massive clean energy additions the market, and our planet, requires.
Corporate Participants Will Play a Critical Role in Unlocking the IRA’s Full Potential
The development of the tax credit transferability market has been slowed by the wait for IRS guidance around tax audit risk, and who wears the liability associated therewith — among other issues impacting developers. However, the market is developing with anecdotal input from advisors, attorneys, and incumbent investors on term sheets that are being signed and transactions that are being finalized.
At a 7-10% market rate of return, renewable tax investments have been a strong source of investment returns for the limited pool of banks, insurance companies, and corporate treasury departments that have thus far participated. The market’s existing players have stepped up to fulfill the majority of the needs of the energy transition up to this point, but have indicated that they are largely at capacity for new investment. New tax investors — whether highly profitable tech companies, large oil companies realizing windfall profits, or industrial manufacturers looking to hit ESG goals — must enter the market to avoid severe limitations to renewable energy deployment resulting from a lack of investments.
The IRA’s provisions are many, and some corporate treasury departments may not yet recognize or fully appreciate the opportunities these new tax credit policies can provide their organization. Through providing a source of tax credit investments for renewable projects, corporates wise enough to jump on this opportunity will realize strong returns while supporting a decarbonized energy future. We highly encourage corporate sustainability managers and PPA champions at companies capable of leveraging these incentives to begin conversations with relevant departments to ensure they understand the significant value and possibilities these incentives present. Internal education and alignment will be critical first steps in helping corporates understand how they can help finance new-build clean energy projects while reducing their federal tax burdens as provided under the federal government’s clean energy policy incentives.
LevelTen Energy’s robust network of clean energy developers, buyers, advisors, and financiers are all poised to play key roles in realizing the investment potential of the IRA’s tax credit incentives. Interest in leveraging LevelTen’s network and capabilities to realize the potential of tax credit transferability has been strong and consistent since the IRA’s passage last August. We look forward to continuing to inform the industry on how this burgeoning market continues to develop, and to furthering our mission of enabling the energy transition through renewable energy transactions of all types that support a clean energy economy.
The Emerging Market for Transferable Tax Credits
Join LevelTen for a discussion on how the Inflation Reduction Act’s transferable tax credits impact the clean energy transition, and the opportunities it could open for your business. Register here for the webinar.