This article will touch upon a few of the growing trends in alternative energy and now environmental remediation investments. These technologies may require more complex financing structures because they provide premium returns by efficiently
monetizing tax benefits. We will touch upon the technologies and the structures.
Tax incentives (largely tax credits) subsidize the costs of assets or supplement the future cash flows so that they may attract capital and better compete with more traditional technologies. Any investor in these structures must understand that
their return is dependent on the tax incentives and must consider the “cash equivalent” of those tax benefits to measure their returns. A dollar of a tax credit is equivalent to a dollar of after-tax return.
Below is a brief list of some of these evolving technologies.
- Battery storage – Batteries extend the availability of solar power, may be added after the initial installation and are eligible for tax credits under certain conditions. The IRS requires that the battery be charged at least
75% by the renewable energy facility. The credit (currently 26% of cost) is available proportionately when the battery draws from 75% to 100% of its recharging from the alternative energy source. Obviously, this condition requires the opinion
of an engineer for the tax credits to be claimed.
- Fuel cells – In general, a fuel cell is an electrochemical cell that converts fuel, such as hydrogen or liquified natural gas (LNG) and an oxidizing agent (often oxygen) into electricity through a pair of redox reactions. Through a chemical reaction, fuel cells convert the fuel into electricity without combustion and with minimal emissions.
The chemical element within a fuel cell degrades over time (from 7 -10 years) and thus must be maintained and replaced as necessary. This trait has been analogized to an aircraft engine that must be maintained with parts replaced regularly to operate
for many years.
A substantial benefit of a fuel cell compared to a solar or wind installation is that power is available on-demand and is not dependent on Mother Nature. Fuel cells can vary in size and because they are somewhat modular, can range in facility
size from a few modules to many modules to supply power to a building. Fuel cells generally qualify for a current 26% tax credit.
- Carbon Caption, Usage & Storage (CCUS) facilities capture carbon from otherwise polluting processes such as from a coal-fired power plant, chemical plant or biomass power plant. Carbon is then stored underground
to prevent its release into the atmosphere or incorporated into another process where it is an input. IRC Sec 45Q provides for tax credits from $35 to $50 for 12 years for each metric ton of carbon captured. The IRS issued Revenue Procedure
2020-12 that created a safe harbor for the allocation rules for carbon capture partnerships like those found in the wind industry.
The returns to an investor arise largely from the tax savings created along with residual cash flows. Returns are usually at a premium compared to other types of investments owing to (i) structural complexity, (ii) unusual accounting,
(iii) the need to provide tax capacity and (iv) occasionally the tenor of the investment.
An added benefit of these investments could also be fulfilling the “environmental” aspect of Environment, Social and Governance reporting trends.
The following structures are more frequently used to finance these technologies; investors should become familiar with them to make any investment decisions.
- IRC Sec 467 Lease – In this structure the developer sells the asset to the lessor and then leases it back and on-sells the power. Given the relatively lower credit rating of the developer, the investor/lessor seeks a large upfront
prepaid rent amount so that their risk is somewhat mitigated. For federal income tax purposes only, a portion of this advance rent is treated as a loan from the lessee to the lessor; there is no loan on the books of either the
lessee or the lessor.
- Tax-equity flip structure – In a tax-equity flip structure, a partnership is formed between the developer who desires to own the installation but cannot efficiently use the tax benefits and a financial investor who has use for
the tax benefits and is seeking a higher return. The financial investor is allocated the tax benefits disproportionately, usually being allocated 99% of the tax incentives. As the tax benefits and cash flows are allocated to the investor as their
return, their basis in the partnership decreases until they have achieved their targeted return, at which time the other partner usually buys out their ownership interest, often within 10-12 years. This effectively has enabled the developer
to monetize the tax benefits that they otherwise would not have been able to utilize and the investor to achieve a premium economic return.
The equipment finance industry is presented with great opportunities to invest in alternative energy and environmental remediation opportunities. The challenge pertains to (i) understanding the complex nature of the investments and their book and
tax treatment, and (ii) properly incenting management to make those investments without fear of being penalized due to unusual accounting treatment. Are we big enough to do this?
Thanks to David Burton of Norton Rose Fulbright US LLP, Rubiao Song of J.P. Morgan, Frederick Lowther of BlankRome and John Bober of IXL Lease Advisory for their input into this article.
Disclaimer: The views expressed here are that of the author and not of the organizations or entity that the author works with or for. The author is not providing tax, accounting, legal or business advice herein. Any discussion of U.S. tax matters is not intended or written to be used by any taxpayer for the purpose of avoiding U.S. tax-related penalties. Each taxpayer should seek advice from their own independent tax, accounting or business adviser.