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| | Meeting financing challenges for retrofits and new installations |
On June 7, Sen. Chris Coons (D-Del) and Sen. Jerry Moran (R-Kan) introduced a bill to extend to renewable energy a financing structure that has been available to the oil and gas industry for decades. The Master Limited Partnership Parity Act would be a significant step towards leveling the finance playing field for renewables.
Renewable energy is coming of age as an investment class. At the recent Renewable Energy Finance Forum (REFF) in New York, renewables were described as a ‘mature market’ and ‘attractive investments for institutional capital’. They generate long term, stable cash flows. While the upfront cost is higher than traditional facilities, they are not exposed to the risk of fuel price volatility. This makes them attractive assets for insurance companies and pension funds that need long-dated assets and have plenty of capital to deploy.
Financial markets have not kept pace with technology innovation. The cost of solar and wind has come down dramatically, but access to capital remains constrained and the cost remains high. It is a private market, with a small number of investors and no liquidity. The importance of tax equity in financing renewables severely limits the ability to include lower cost debt. Richard Kauffman, special advisor to Secretary Chu, makes the case that enabling renewable energy projects to tap the capital markets will reduce financing costs by lowering the cost of equity, encouraging standardization and expanding access to debt.
While no one in the industry recommends an abrupt end to tax credits, the talk at REFF was around ‘glide paths’ to phasing out credits, and adoption of financing practices and structures that are common in other industries but have not yet been applied to renewable energy finance.
Three new approaches that build on existing models are under active consideration:
- Master Limited Partnerships
- Real Estate Investment Trusts
- Green Banks, at the state level.
Master Limited Partnerships (MLPs)
MLPs are used to finance energy and natural resource projects with stable cash flow profiles. Over $270 bn of assets are held in MLPs, over 60% of which has gone into oil and gas pipeline projects. The MLP Parity Act is a simple 200-word amendment to existing law to include renewable energy and fuels in the definition of qualifying assets. For more background on the Act, please see MLP Parity Act on Senator Coons’ website.
MLPs are taxed like partnerships, but trade in public markets like corporations and offer steady cash distributions (current average dividend is 6%). The combination of liquidity and yield widens the pool of potential investors and lower the cost of capital. For purposes of tax law, all income is attributed to the partners (investors) and taxed at the investor level at ordinary income rates.
Renewable energy MLPs would be most appropriate for mature portfolios once the tax credits have been used up, because of a tax law provision that prevents investors in the partnership from taking advantage of those tax benefits. For example, from 2013-2017 over 10,000 MW of wind capacity are slated to use up their production tax credits. Wind developers who want to focus on their development business, rather than be long term owners of assets, could elect to sell these mature portfolios into an MLP, generating proceeds for further development. There will undoubtedly be financial innovation around MLPs, to facilitate holding projects in multiple phases.
Real Estate Investment Trusts (REITs)
REITs have long been a vehicle for financing real estate. The US REIT industry has a market cap of $450 billion.
REITs are attractive to investors looking for cash flow, as they are required to pay out 90% of their taxable income. They are regularly marketed to individual (retail) investors. The fact that a REIT is a taxable entity (unlike an MLP, which is a pass-through) expands the investor universe to include tax-exempt and foreign entities for whom the partnership structure is disadvantageous. Because a REIT is a taxable entity, it is also able to take greater advantage of tax benefits.
A series of complex asset and income tests must be satisfied to qualify for REIT treatment; at the core, these are based on the determination of whether the assets constitute “real property” or “real estate related income”. To be real property, a system must be inherently permanent (affixed to real property) and passive (not an accessory to operation of a business). In addition, for the entire system (rather than component parts) to be considered real property, it must be functionally interdependent. These determinations are made by US Treasury ruling on a case by case basis, pursuant to existing regulation. For an explanation of the application of these rules to wind projects please see a paper on Wind REITs prepared by Skadden Arps.
The National Renewable Energy Lab has just released a paper on The Technical Qualifications for Treating Photovoltaic Assets as Real Property by Real Estate Investment Trusts (REITs) , with the intention of providing the technical analysis to assist the US Treasury in its decisionmaking process. NREL concludes that “based on this initial examination, it would appear that PV systems have many of the qualities associated with inherently permanent assets…[and] the majority of the assets that make up a PV system would appear to meet the “integrated as a system” characteristic given the limited viability of these individual components to function independent of one another. However, NREL defers to the Treasury to rule on the matter, and points out that “the reclassification of PV as realty has the potential to disrupt current financing practices in the solar market today.”
Green Banks
For the past four years, there have been efforts to establish a ‘clean energy bank’, ‘green bank’ or ‘infrastructure bank’ at the federal level. With action in Washington blocked, those efforts have shifted to the states. Connecticut established the first in 2011. The Clean Energy Finance and Investment Authority (CEFIA) is a quasi-public entity funded by ratepayer electric charges and RGGI, and also has authority to issue bonds, seek Federal grants, accept philanthropy and raise capital. California is now considering the application of AB32 auction proceeds to establish an infrastructure bank that would provide low cost debt for energy efficiency and renewable projects. The concept is also being explored in New York State and others.
The ‘green bank’ concept aims at accelerating deployment of renewable energy and energy efficiency by lowering the cost of financing. It takes advantage of the fact that many states, like Connecticut, are already collecting ratepayer charges for renewable energy and efficiency programs, but redirects those funds away from direct investment and grants towards loans, in order to expand the pool of financial resources. The intent is to create self-sustaining entities that operate on commercial credit principles. There are many questions around the green bank concept, which remain to be resolved on a state by state basis. Among these: Would the bank only finance mature technology, or would it reserve some capital for innovation? How would the bank use its credit capacity to stimulate lending by the private sector (eg. co-participation, loan guarantees, first loss provisions)? Would the bank be housed within an existing governmental agency, or would it be a newly created free-standing entity (possibly facilitating access to private capital)?
A role for E2
E2 is committed to accelerating the development and deployment of clean energy. There are three elements to that equation – technology, demand, financing – operating within a macro framework set by markets and policy. The price of renewable energy has dropped as technology has matured and demand has been grown; the next area for bringing down costs and scaling up volume lies in the finance realm. Given federal budget austerity, we will have to depend more on market mechanisms to finance mature technologies. Yet even that shift will require targeted policy measures (such as the MLP Parity Act) and select market intervention (like creation of state green banks).
E2 has been working with NRDC’s Center for Market Innovation on the detail of several of these proposals. We encourage those of you with experience or interest in this topic to let us know, so we can include you in the dialogue around how best to structure and advance the financing piece of the equation.
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