Energy Tax Credits 101:
Tax Credits and Tax Equity

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Explainer

Energy Tax Credits 101:
Tax Credits and Tax Equity

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Following the passage of the Inflation Reduction Act (IRA) in 2022, Energy Tax Credits have been thrust into the national spotlight. Due to some notable updates, Corporate Sustainability and Finance teams across the U.S. are beginning to explore the implications and opportunities available to them under the IRA.

In this primer, our team explains how tax credits work, what changed with the IRA, and how companies can take advantage of tax credits in their decarbonization journey.

Energy Tax Credits 101

The Energy Policy Acts of 1992 and 2005 introduced tax credits for wind and solar technologies, respectively. Enacted in 1992, the Production Tax Credit (PTC) is an inflation-adjusted per-kilowatt-hour (kWh) tax credit for electricity generated by qualifying resources, including wind power. Enacted in 2005, the Investment Tax Credit (ITC) is a percentage tax credit applied to the capital invested into qualifying resources, including solar power.

Both credits provide for a dollar-for-dollar reduction in federal income taxes owed. Importantly, both forms of tax credits are unrelated to Renewable Energy Credits (RECs) and neither form of tax credit can be used to claim the consumption of renewable energy or reduce your GHG emissions. Energy tax credits are solely used for tax savings, creating a strong financial incentive to build new projects.

When projects are developed, the tax credits that are created belong to the owner of the project. Since companies often do not fund and own these projects themselves, opting instead to pay for the power through PPAs (Power Purchase Agreements) as it is produced, the tax credits belong to the owner(s) of the projects rather than the customer. The economic value of the tax credit is generally passed through to the customer in the form of a reduced PPA price (read more on PPAs).

This presents a problem, however, since most “Project Developers” do not have sufficient federal income tax liabilities to use the tax credits generated across all their projects. Before the Inflation Reduction Act, to solve for this and ensure that the tax benefits are used efficiently, “Tax Equity” became a foundational component of project finance (Exhibit 1).

This mechanism involves bringing in another equity investor (the “tax equity investor”) that does have tax liabilities, and creating a commercial structure whereby the tax benefits are allocated to the tax equity investor. Historically, almost all tax equity investors are large banks such as JP Morgan and Bank of America, which alone have accounted for over 50% of tax equity deals in recent years.

Exhibit 1

Renewable energy projects are funded by equity investors and lenders through special purpose vehicles (SPVs), commonly supported by long-term contracted revenue streams.
SPV

So, what changed with the Inflation Reduction Act?

The Inflation Reduction Act and Transferability

The Inflation Reduction Act made several significant changes to energy tax credits. Among other revisions, the IRA extended their expiration date, introduced new rules for qualification, created bonus credits for meeting certain criteria, and enabled solar projects to qualify for the PTC. See the table below for updated ITC and PTC values.

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Image: Summary of ITC and PTC Values (Source: DOE)

One of the most consequential changes in the IRA is the introduction of “Transferability.” For the first time, energy tax credits can be sold (only once) by the project owner(s) to a third-party that is not an investor in the project. Transferability creates an alternative option for monetizing tax credits, enabling Developers to sell the tax credits to other companies for cash, rather than relying solely on traditional tax equity.

In practice, traditional tax equity will remain a common component of project finance, partially due to its efficiency in monetizing depreciation benefits, which can’t be sold to a third-party. Still, the optionality provided by transferability will expand both the pool of capital available for this portion of the capital stack and the pool of developers that can finance their projects affordably – inducing more competition that should ultimately benefit customers.

Transferability also creates an opportunity for companies to buy tax credits – redirecting tax payments to fund sustainable projects and earn a return. Buyers can expect to purchase credits at close to a 10% discount to their economic value, resulting in a Year 1 ROI of roughly 110%, and an even stronger IRR since credits can be applied to quarterly tax payments. These tax credits typically don’t come with RECs or any reduction in GHG emissions, however they can be a valuable addition to a company’s ESG program and marketing strategy.

Interested in exploring tax credit opportunities for your organization? Get in touch with our team.

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