The Inflation Reduction Act of 2022 (IRA), which became law in August 2022, had the potential to significantly reshape the landscape of solar and battery energy storage system (BESS) projects. This encompassed a noteworthy shift in how tax equity financing was employed within the industry. Now, one year after the enactment of the IRA, it is an opportune moment to reevaluate whether the industry’s expectations, aspirations, and concerns regarding tax equity financing and the IRA have materialized.
The Investment Tax Credit (ITC) has consistently proven to be a two-edged tool. On one side, it undeniably stands as the most influential financial stimulant for the solar energy sector in the United States, drawing substantial capital investments into the industry. However, on the flip side, its tax credit nature has excluded various funding avenues and introduced potentially harmful, artificial incentives to the industry.
Tax Credits Shaping Solar and Storage Markets
When it comes to the Investment Tax Credit (ITC), one thing remains constant: the need for a substantial amount of income subject to US Federal income tax and the requirement for the claimant to be a US taxpayer. Before the Inflation Reduction Act (IRA), the ITC couldn’t be transferred, and depreciation wasn’t transferable either. Consequently, since project developers often couldn’t fully capitalize on all the tax benefits, external financing became a necessity to unlock the value of the ITC and depreciation.
The methods employed to capitalize on the ITC are intricate, with partnership flip and sale-leaseback structures being the most prevalent. Some tax equity participants opt for inverted lease structures, although they are less common. These intricate structures entail substantial transaction costs.
The dynamics of the solar and storage markets are intricately tied to tax credits. These prerequisites create a situation where the pool of potential Investment Tax Credit (ITC) investors is relatively limited. In practice, the majority of tax equity investors are financial institutions like banks and insurance companies.
Before the Inflation Reduction Act (IRA), Battery Energy Storage Systems (BESS) couldn’t qualify for the ITC independently. Instead, they were eligible for ITC benefits only if paired with other ITC-eligible electricity-generating assets, such as solar energy systems.
Moreover, there were significant usage restrictions on BESS. To qualify for the full ITC, following what are known as dual-use equipment rules, BESS had to be exclusively charged by the associated solar energy system or other ITC-eligible property for at least the first five years after their commissioning. Any charging from the grid or other ineligible sources would lead to a reduction in ITC benefits, and if the BESS received over 25% of its energy input from non-ITC-eligible sources, no ITC benefits were allowed for the BESS. These constraints diminished the appeal of standalone BESS, and most storage systems installed before the IRA were part of hybrid systems.
The IRA brought about significant changes in this landscape, affecting both solar and storage. The full ITC rate was reinstated at 30%, and standalone BESS were included in the list of facilities eligible for the ITC, eliminating the need for BESS to be paired with other ITC-eligible generation assets. The IRA also extended the ITC eligibility window for projects commencing construction no later than 2033, potentially even longer.
Additionally, the IRA introduced new eligibility criteria. Going forward, any facility exceeding 1 MWac must meet specific prevailing wage and apprenticeship requirements. However, projects that began construction before January 29, 2023, are exempt from these provisions.
These prevailing wage and apprenticeship requirements generally mandate that in the construction, repair, or modification of a facility, the taxpayer, contractors, and subcontractors must adhere to wages set at local prevailing rates published by the US Department of Labor. A certain percentage of the work must also be carried out by qualified apprentices.
If an otherwise eligible facility is subject to these requirements but fails to meet them, the credit rate for the facility drops drastically from 30% to 6%. Furthermore, for projects entering service from 2025 onward that didn’t commence construction before that date, a new rule mandates an anticipated greenhouse gas emissions rate of no greater than zero.
Transferability and Direct Payment Options
A significant transformation has occurred in the realm of renewable energy credits, specifically Investment Tax Credits (ITCs), Production Tax Credits (PTCs), and others. They are now tradable commodities, open for purchase on the market by eligible taxpayers.
Furthermore, tax-exempt entities, including universities, hospitals, state and local governments, as well as various tax-exempt organizations, now have the opportunity to receive direct cash payments from the US government in lieu of the tax credits they qualify for but cannot use due to their tax-exempt status.
These modifications, encompassing transferability and direct cash payments, raised expectations and concerns within the renewable energy industry about simplifying the complexities of tax equity financing. However, one year later, it’s evident that neither the optimistic hopes nor the apprehensions have fully materialized.
Nevertheless, there have been notable developments. Interest in tax credit transfers has emerged, with some transactions already in progress. Many direct payment transactions are in the pipeline, featuring tax-exempt entities embarking on solar and Battery Energy Storage Systems (BESS) projects they will own. Anticipated growth in such investments from tax-exempt entities suggests that more of these transactions are on the horizon in the renewable energy sector.
Continued Presence of Third-Party Tax Equity Financing
It’s important to note that there hasn’t been any shift away from the use of third-party tax equity financing. This is primarily due to two key factors. First, tax credit transfers themselves constitute a form of tax equity financing. While these transactions can be less intricate and costly compared to other tax equity financing methods, they still introduce considerable complexity and expenses into the project.
Furthermore, the tax credit purchaser must meet the same eligibility criteria and general constraints as any typical tax equity investor. As a result, the pool of qualified investors hasn’t expanded, although there may be some tax credit buyers who wouldn’t participate in conventional tax equity financing.
Individuals or entities unfamiliar with traditional tax equity financing might be hesitant to engage in credit purchases. Third-party brokers for tax credit transactions, permitted under the transferability guidelines, could potentially ease this reluctance, but this market is still in its early stages.
Secondly, and of greater significance, only the tax credits themselves—namely, the Investment Tax Credit (ITC) and the Production Tax Credit (PTC)—are transferable. The benefits of depreciation cannot be sold. With a potential value of approximately 20% of the project’s cost, this alone often justifies the use of comprehensive tax equity financing.
While smaller projects might opt to forgo depreciation benefits (due to the owners lacking taxable income to utilize depreciation), this isn’t a feasible choice for larger projects. A similar constraint applies to tax-exempt entities: the direct payment option exclusively pertains to the ITC. If a tax-exempt entity assumes tax ownership of the project, the depreciation benefits are permanently forfeited.