by Jessie Robbins
The Inflation Reduction Act created or expanded tax incentives for all sorts of sustainable infrastructure. It also introduced new payment mechanisms – direct pay and transferability – to make those tax benefits easier to access. Yet unfortunately, tax equity terms have since deteriorated even for tried-and-true technologies like solar and wind.
The simple dynamics of supply and demand help explain the paradox. The IRA expanded and extended existing tax credits for wind and solar, namely the Section 45 production tax credit (PTC) and the Section 48 investment tax credit (ITC). It created various adders for domestic content, energy community, and low to moderate income qualified projects. Finally, technologies such as hydrogen and standalone storage became eligible for credits. This wave of new credits began hitting the market in earnest in 2023, and total tax capacity demand could increase four-fold during the ten-plus-year runway created by the IRA (J.P. Morgan, BloombergNEF). Traditional tax equity supply simply can’t keep up.
Fortunately, the IRA did provide a “release valve” for all these new tax credits: “direct pay” for tax exempt project owners and certain technologies, and transferability for most Section 45 and 48 credits. “Direct pay” refers to a taxpayer’s ability to file for direct payment from Treasury instead of needing to work with a third party to monetize the tax benefits. “Transferability” refers to a brand-new provision that permits the sale of tax credits to a third party that isn’t an owner of the asset generating the credits. Both allow for project owners to get value for the tax credit without going through complex, structured tax equity funds.
Transferability and direct pay ameliorate the supply and demand issue, but they come with their own challenges, and these are exacerbated by their newness. Traditional tax equity funds bring in a tax efficient partner that both values the depreciation benefits it receives from its ownership in the partnership and provides the grounds to claim a “step up.” This means it can calculate the value of the ITC on the fair market value at which it was sold into the partnership as opposed to just its cost basis. Neither direct pay nor transferability on their own capture this value.
As a result, projects owners seeking to maximize the value of tax benefits typically still prefer traditional tax equity. And here the supply and demand imbalance rears its head again. The big tax equity banks are still there. Bank of America and J.P. Morgan make up half the estimated $20bn+ annual wind and solar tax equity market but even they have limited tax capacity. Similarly, traditional structures with corporate investors aren’t going away, but the pool seems both smaller and choosier than in the past. There are ways to stretch this capacity but the result for sponsors is additional transaction cost, execution friction, and ultimately, less efficient capital. Alongside this, if newer structures prove less valuable compared to traditional structures, the traditional players will likely adjust their returns expectations accordingly.
So what’s a sponsor to do? First – build relationships. Strong and sticky relationships with good capital providers is the first moat against changing market terms. Second – solve for certainty. The tax equity space is noisier than it’s ever been, and that noise has a cost. With so much newness in the space, a smart sponsor will prioritize partners and structures with higher execution certainty. In November 2023 for instance, battery storage developer esVolta secured tax equity for its Santa Paula project in California even though standalone storage is only recently eligible. Finally – innovate. We’ve barely taken the wrapping off the new features and structures unlocked by the IRA. It would be a mistake to confuse temporary dislocation with long-term value loss. The IRA created a wealth of opportunity, and savvy companies will lead the market towards optimal structures that realize that value.
