Tax investors provided $2.7 billion worth of financing to the US wind sector in 2010, substantially up from $818 million the previous year (see chart overleaf). This is still far below the heady, pre-meltdown days of 2007, when companies looking for tax shelters ploughed $5.2 billion into wind energy.
"As each day went by last year we saw the market getting better, getting healthier. I think the trend will continue," commented John Eber, managing director for energy investments at JP Morgan, speaking to delegates at Infocast's recent Wind Power Finance and Investment conference in San Diego.
The tax equity market is critical to wind financing in the US. For years, a combination of two tax benefits has driven investment. The first is the $0.022/kWh federal production tax credit (PTC) and the second is accelerated depreciation of wind farm assets, which together equate to about 50% of the capital cost of a typical project.
The challenge has always been that most developers do not have a big enough tax liability to use the credits, so they have sought investors who do. However, the bottom fell out of the tax investment market when financial crisis hit in 2008. Most of the companies that were active in the sector saw their taxable income, and therefore their need to reduce their tax bill, drop. As a result, the number of tax equity players shrank, from about 14 to four.
Congress responded by temporarily changing the rules so developers have the option of taking a cash grant equivalent to 30% of eligible project costs instead of the PTC. This reduced pressure on tax investors to make full use of wind-related deductions and helped ease companies back into the tax investment market.
The number of tax equity investors participating in deals rose to 12 in 2010, but whether they will all stick around after the cash grant expires is unclear.
"We have seen some new entrants and that is a good thing, but I don't think that some of the new entrants will play if we go back to a PTC world," says Kevin Walsh, managing director at GE Energy Financial Services. "It means much more stress on their tax capacity."
The cash grant was originally scheduled to expire at the end of last year, but the wind industry won a last-minute reprieve allowing projects that start construction this year to receive it. Few at the Infocast event expect it to be extended again. Republicans, who took control of the House of Representatives - the lower house of the US parliament - in January, are just not interested.
"They weren't all that keen to see it extended at the end of last year and they certainly won't allow it to happen again," says Keith Martin, a Washington-based partner at law firm Chadbourne & Parke.
The prospect of losing investors in what is still a tight market worries developers, who are already paying significantly higher rates for tax equity money than they did before the 2008 economic crisis. In 2007, tax equity returns dropped as low as 5.8% compared with 8-9% today. If there is debt in the deal, the expected return jumps to 11% or more to cover the risk that lenders could foreclose on the project. Those rates could rise if investors drop out at the same time as demand for tax equity jumps due to the end of the cash grant.
"The industry needs to look beyond the financial institutions that have traditionally played in the tax equity market and to attract other types of companies with large tax bills requiring offset," says Steve Ryder, vice-president of finance at Invenergy, a Chicago-based project developer. Positive moves on this front were made in 2010. Both Google and Tyr Energy, an affiliate of Japanese trading giant Itochu, made their first tax equity investments in US wind projects. In addition, California utility San Diego Gas & Electric awaits a ruling from state regulators on its application to invest $600 million in tax equity in NaturEner's 309MW Rim Rock wind project in Montana.
"Our firm has probably brought more investors into this business than anybody and I can attest to how difficult it is to get somebody from being interested to actually closing a deal. It's very, very difficult. We were successful with Google, but we've been talking to Google for four or five years," says Eber.
Tax equity deals are complex and the accounting that accompanies them is far from straightforward. "This is not a core asset for a lot of companies and when you layer on the accounting complexities and the tax aspects of the transactions, the learning curve is pretty steep," says Anu Yadav, a director at Citigroup.
Lack of clarity over long-term policy is another factor. Companies are wary about spending the time necessary to become comfortable with wind-based tax investment only to see rules and incentives change in a year or two, says Phil Mintun, managing director at Capstar Partners Capital.
Returns are another issue keeping non-traditional players out of the market. "It's financial players that are used to writing big cheques, putting them out the door and leaving them there for a long period," explains Eber. "And it's financials that are used to the kinds of returns you can get for this sort of equity, as compared to a typical corporate that thinks of an equity investment as something that is supposed to generate a return of twice as much."
Even among companies used to making tax-based investments, wind is not always an easy sell. "People talk about how expensive tax equity is, but we have investors that have historically done tax products but aren't doing wind because they say the yields are too low compared to other things they can invest in," says Mintun.
Wind projects are also facing competition for investor attention from other renewable-energy technologies. "We haven't seen it yet, but we're hearing a lot about utility-scale photovoltaic transactions coming to the market in 2011 and 2012," says Jack Cargas, managing director of renewable-energy finance at Bank of America. "Those transactions have some appeal and there is a limited amount of tax capacity in the marketplace."
Eber agrees that it has proven easier to attract new solar tax investors. "For some reason, they just look at solar and it doesn't seem so complicated. The deals are a little bit smaller compared to wind."
The ongoing challenge of bringing new capital into the wind sector even has some tax equity players wondering if there is a better way to provide policy support for the industry. A federal renewable-energy standard mandating that a minimum amount of electricity come from renewable sources, as is the case in the EU, would provide long-term certainty to the industry, says Yadav. "It takes the emphasis away from relying on the tax code to support this industry and moves it to the utilities and to the ultimate consumer. I think that is really the way to move forward."
Others, including Eber, believe that tax credits can be made to work. They have helped build huge investment bases in, for example, the affordable housing and the oil and gas industries. The big difference is that tax credits in those sectors do not expire. "I don't think there's anything wrong with managing an industry through the tax code. The problem is that the credits for wind are not permanent," he says.
The PTC is scheduled to expire at the end of 2012 and Eber expects the wind industry to start lobbying for an extension this year. The wild card in such discussions will be corporate tax reform. Momentum is building on Capitol Hill to overhaul the US tax system by lowering the tax rate and, at the same time, cutting off some of the loopholes companies use currently to avoid paying taxes. The corporate tax reform agenda has potential to undermine some tax subsidies, but no one yet knows which ones.