Title: Optimizing Investments in Energy Storage
Speakers: John Leonti and Anne Loomis
John Leonti (00:07):
Thanks for doing this. I think this is going to be a good conversation. Obviously with the Inflation Reduction Act passed, there’s a lot of buzz in our industry on what’s going on and I think you and I want to just have a conversation on battery storage today.
Anne Loomis (00:21):
That sounds great.
John Leonti (00:22):
So let’s start there.
Anne Loomis (00:25):
So what are the differences between doing tax equity for storage and doing tax equity for generation?
John Leonti (00:33):
Well, other than the asset itself — obviously a battery can charge and discharge, and solar relies on the sun and a wind farm relies on the wind blowing — the battery is where it gets really interesting, and that’s on the off-take arrangements. In the solar and wind space historically we’ve done bus bar PPAs, we’ve done corporate PPAs, we’ve done all different sorts of hedges that have been out there. But with batteries, particularly in places like ERCOT, lots of sponsors really would prefer to run their projects on a merchant basis. However, for tax equity investors, that presents a challenge. They really look to finance contracted revenues. They look for long-term contracts anywhere from seven years and up — in some cases, seven years is too short for them. On the flip side, a lot of the sponsors’ investment committees are also uncomfortable with fully merchant assets.
Not all, but some. And so that has been driving the market to figure out how they can get tax equity financing and also get contracted revenue while the projects still look very attractive from an economic standpoint. And so there have been some products developing out there — some fixed shape hedges, some insurance products. And then of course you have more traditional agreements like a tolling agreement and items like that. The trick is going to be to find how you can run a battery on a quasi-merchant basis, and I think the commodities market is going to have to help with that. But I’ll turn it back to you. I think also one thing that could help is if sponsors don’t have to raise traditional tax equity and they can take advantage of this transferability market.
I’d love to hear from you how you think that’s going to develop over the next several years.
Anne Loomis (02:23):
Yeah, absolutely. So the IRA gave us this great new tool in our monetization toolkit for tax credits — the ability to sell tax credits to a third party for cash consideration. And that really opens up some great opportunities for storage projects, standalone storage in particular, where you can sell your tax credit without needing to worry about the investor looking for that revenue profile that they’re so used to that you described. So you can monetize your tax credit with an investor who can be indifferent to the revenue profile. And that’s a great benefit from the IRA. There are of course some disadvantages to that compared to traditional tax equity. In particular, you don’t get a chance to monetize the tax depreciation. So that could be a big difference between how those projects end up economically viable versus the traditional wind and solar.
John Leonti (03:17):
Do you lose the depreciation fully, or would the sponsor need to be able to take the benefit?
Anne Loomis (03:26):
The sponsor would keep the tax depreciation, but of course if they don’t have the ability to utilize it because they have a lot of net operating losses that they’re carrying forward — which is quite common in renewables given that all of the renewable technologies get accelerated depreciation and we’ve been in a bonus depreciation scenario for several years — and batteries now as a result of the IRA get that accelerated five-year depreciation.
John Leonti (03:53):
Right. So we would be in a situation where if I place my battery in service, I can sell off the investment tax credit and that buyer is just a buyer of tax credits and will have no say in how I run my project. So if I want to run my project on a merchant basis, I can just do that and still be able to monetize the ITC, maybe having to leave the depreciation unmonetized — or perhaps the sponsor can monetize it themselves.
Anne Loomis (04:22):
Yes. And perhaps they’d have to carry it forward into the future and monetize it a few years down the road, which makes it slightly less valuable, but still an important tax benefit.
John Leonti (04:32):
Right. And the other interesting thing about that is if you do a transferability deal, it gives you the ability to do term debt at the project level rather than having to do these traditional back leverage deals, because you’ll just have a tax credit buyer. They won’t be in a partnership with the sponsor — they’re just a buyer — and then we can go ahead and call it front leverage at the project level, which also could be attractive because the lenders are closer to the asset. We know that lenders are allowing for fully merchant portfolios of batteries to be financed. And so that could also be another attractive tool as a result of this transferability. So you get some of the tax benefits and you get a fully merchant project that is debt financed.
Anne Loomis (05:18):
Now we do need the tax credit transfer market to develop and there are a few things that are holding that up right now. Part of that is the statute allowing for the secretary to put some procedures in place to prevent duplication. And we don’t yet know what those procedures are going to be. So until we get guidance from the IRS, I think a lot of the potential players in the tax credit market are sitting on the sidelines waiting to see how onerous those procedures are going to be. But once those come out, I think we’ll start to see people move into the tax credit transfer market. There will of course be a discount on the tax credits, so that’s another downside versus tax equity. But it does create tremendous opportunities with these things we’ve been talking about here, particularly for standalone storage.
John Leonti (06:06):
And if I’m a buyer of the tax credit, will it just be as simple as on my return saying that I’ve bought a tax credit from project X, Y, or Z?
Anne Loomis (06:16):
We don’t know yet. But we expect that there will be a fairly straightforward reporting process for that tax credit and probably some system for tracking from the seller to the buyer.
John Leonti (06:30):
So in a transferability deal where you transfer the tax credit as opposed to a third party tax equity deal, one of the things I’ve been thinking about is whether there’s an ability to step up the tax basis in these transactions. If I just do a direct transfer, am I stepping up the basis in that scenario?
Anne Loomis (06:50):
No. And we’re used to in tax equity having to do a development company and operating company structure so that there can be a sale that steps up the basis and unlocks all of the value that’s inherent in that property. And we do need that in the tax setting to create basis — we need a realization event that steps up the basis. And if we’re just selling from the party that has generated the tax credit to the party that is going to own the tax credit and utilize it, we don’t have that sale that is unlocking that value. So in just a straight transfer, it would not be stepping up the basis. There are probably ways we could structure to step up the basis, like using a cash equity investor on the seller side.
But that brings us back to many of the issues that you were talking about before in the revenue profile and getting an investor comfortable with those sorts of issues.
John Leonti (07:48):
Right. And so if you’re looking to step up the basis, you’re probably looking at some other form of partnership on the other side, assuming you also want to be a long-term owner of the asset. There is probably some other type of partnership involved, and obviously if you’re entering into a partnership with a cash equity investor or a tax equity investor, that brings everything along with that in terms of voting rights and just managing the asset.
Anne Loomis (08:11):
That’s right. You need two different regarded taxpayers to be able to have a sale that steps up the basis. So that means we need to be introducing those third parties into the mix.
John Leonti (08:21):
And probably not the end of the world. We have quite a few sponsor clients that do sell down a portion of their cash equity interest in the deal anyway. So maybe it’s just reinventing a structure that’s been tried and true for several years. But it’s an important point because if you’re not stepping up the basis for an ITC deal and you’re also not monetizing depreciation, you really need a pretty strong purchase price on the transferability credit to probably make them pencil out the same way.
Anne Loomis (08:53):
That’s right. You’re leaving some value on the table there, so you need to make sure that you’re getting the most bang for your buck with transferring the tax credit.
John Leonti (09:00):
Well, this has been a great conversation. I appreciate it and truly enjoyed it.
Anne Loomis (09:05):
Me too. Thanks.
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