Renewable Energy and Tax Reform: The Impact on Renewable Developers An Interview with Keith Martin, Co-Head of Project Finance at Chadbourne & Park

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______________________________________________________________________________

Eric Selmon Hugh Wynne

Office: +1-646-843-7200 Office: +1-917-999-8556

Email: eselmon@ssrllc.com Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

______________________________________________________________________________

January 17, 2017

Renewable Energy and Tax Reform: The Impact on Renewable Developers

An Interview with Keith Martin, Co-Head of Project Finance at Chadbourne & Park

On January 9th, we hosted a conference call for investors during which we interviewed Keith Martin, a partner at the law firm of Chadbourne & Park and co-head of the firm’s project finance group, on the subject of tax reform and its impact on renewable developers. We provide below a transcript of that call.

Portfolio Manager’s Summary of Keith Martin’s Comments:

  • There is high probability of tax legislation being passed in the current Congress (2017-2018).
  • As to its content, the only certainty is corporate tax reduction; beyond that “it’s anybody’s guess.”
    • It’s not clear yet whether it will be a full tax reform package, or just piecemeal tax changes.
  • The treatment of renewable tax credits depends on whether the legislation is bipartisan or not.
    • Under the budget reconciliation process, a bill could be passed with a simple majority, allowing the GOP to make more radical changes to the tax credits. But changes to the tax code passed under budget reconciliation bills are not permanent and expire within 10 years.
    • A bipartisan effort would more likely preserve the current schedule to phase out tax credits.
  • The availability of tax equity will not fall as much as the cut in tax rates would imply, as most of the big tax equity investors are limited more by their risk tolerance than their tax appetite.
    • However, tax reform will likely cause a “pause” in the tax equity market from the date a real proposal is released until the law is passed.
    • Large developers will have an advantage obtaining tax equity should there be a shortfall.
  • Owners of existing projects could be hurt by the impact of tax reform on tax equity investors.
    • Most tax equity investors refuse to fund bonus depreciation. Projects that do not elect bonus depreciation have longer depreciation schedules, whose value to tax equity investors would fall at lower tax rates.
    • Generally, developers must make up any shortfall in tax equity investors’ returns.
      • Note: We estimate that in 2018, any project brought online in 2014 and later that did not elect to use bonus depreciation could see a shortfall for tax equity investors. For projects that used bonus depreciation there is no risk of shortfalls in any year.
  • The transition to renewables should continue regardless of tax reform due to the continuing improvement in the economics of renewable energy, and particularly for solar PV.
    • Even wind may have a strong future because technological improvements exist to bring down the cost and, once the tax credits expire, more investors may be willing to try them.

Conference Call Transcript:

Please find below a transcript of our January 9th investor conference call. The call begins with a

summary of SSR’s views as to the impact of tax reform on renewables and continues, starting on page

10, with a interview of Keith Martin, co-head of Chadbourne & Park’s project finance group, in which

he presents his contrasting views.

Hugh Wynne: Good morning, and thank you all for dialing in. With us today is Keith Martin, who is a partner at the law firm of Chadbourne & Parke, where he is co-head of the firm’s project finance group. Keith also edits Chadbourne’s monthly Project Finance newsletter, which I would recommend to anyone interested in renewable energy. Most importantly for us, Keith has been centrally involved in the major tax equity transactions of recent years and thus has his finger on the pulse of market developments in this area. Keith, thanks for joining us today.

Keith Martin: My pleasure.

Hugh Wynne: So, I will begin today’s call with a brief, five-minute summary of how we expect tax reform to affect the development of wind and solar energy in the United States. My partner, Eric Selmon, will then interview Keith to get his views on this critical issue [see pages 10 and following].

Let’s now look quickly at the deck and particularly the agenda on Exhibit 1. The questions we want to address are how will expected changes in the tax code affect the cost of wind and solar energy? And, second, what are the implications for the growth of these renewable resources going forward?

Exhibit 1: Agenda

Agenda

  • How will expected changes in the tax code affect the cost of wind and solar?
  • What are the implications for the growth of renewables going forward?
  • How do the Trump and House tax plans impact tax equity, and how will this affect the cost of renewables?
  • What are the implications of the border adjustment provision of the House tax plan?
  • Company impacts

Source: SSR analysis

Let’s move on to Exhibit 2, where we summarize the key elements of the tax reform proposals put forward by the Trump campaign and the House GOP leadership. These tax reform proposals would affect the cost of wind and solar energy in four principal ways:

  • first, through the elimination of renewable energy credits;
  • second, by a material reduction in corporate tax rates;
  • third, through the border adjustment provision of the House GOP plan, which would prohibit U.S. firms from deducting from their taxable income the cost of imports; and
  • fourth, through the House GOP proposal to allow immediate expensing for tax purposes of capital expenditures while disallowing the deductibility of new loans.

Exhibit 2: Key Elements of the Trump and House GOP Tax Plans

Source: www.donaldjtrump.com; Speaker of the House Paul Ryan, A Better Way: Our Vision for a Confident America

Let’s then move on to Exhibit 3, where we illustrate the importance of the elimination of renewable tax credits.

Currently, solar developers are allowed to credit against their taxes 30% of the cost of their new solar projects. Wind

developers enjoy a production tax credit of $23 per megawatt hour, which is equivalent to approximately 50% of the

unsubsidized cost of energy from new wind projects. Clearly the elimination of these credits, which is contemplated

by the current tax code as well as the Trump and House GOP tax reform proposals, will have a critical impact on the

economics of wind and solar going forward.

Exhibit 3: The Loss of Tax Credits Will Force PPA Prices Higher

Source: Internal Revenue Service; Consolidated Appropriations Act, 2016

Now, on Exhibit 4, we make the point that we think that the negative impact from the loss of the solar investment tax credit will be offset by a continuing decline in the installed cost of utility scale solar. We expect the installed cost per Watt of utility scale solar to drop by about 6% per annum over 2018 to 2024, which perhaps is a bit conservative in light of the more rapid decline that’s been realized since 2010. As a result of that 6% compounded decline through 2024, we anticipate that by that year the cost per watt of solar will be some 40% lower than in 2016, which in real terms that would be equivalent to a reduction of about half. By contrast, the installed cost of wind appears to have plateaued, as we illustrated in the chart on the bottom of Exhibit 4. So, the loss of the production tax credit, which, as I pointed out, is equivalent to about half the unsubsidized cost of wind today, will have no offset in the reduction in the installed cost of new wind projects.

Exhibit 4: Solar Will Continue to Benefit from Rapidly Falling Installed Costs

Source: National Renewable Energy Laboratory, U.S. Solar Photovoltaic System Cost Benchmark Q1 2016 Report; Lawrence Berkeley National Laboratory, Wind Technologies Report, 2011-2015; SSR estimates and analysis

So, what are the implications of these two changes? If you look at Exhibit 5, we estimate for you that the PPA price of solar in 2018, 2020 and 2024 under the current tax code and under the Trump and House GOP tax reform proposals, and we compare those estimates to the PPA price of solar energy in 2016 in the column on the left. There are two key points to be made here. One is that there is a continuing decline in the PPA price of solar, reflecting the decline in the installed cost of solar capacity. If the Trump or House GOP tax reform proposals were to be implemented, that decline would be slower but it would still persist, and over the period through 2024, it would still be very dramatic.

The second key point we’d like to make is that despite that decline in the installed cost of solar, the PPA prices of solar will remain, by our estimate, well above on-peak wholesale prices for power in the sunniest regions of the country. Consequently, developers of new solar projects will continue to require above-market PPAs to render their investments economic.

In our view, then, the proposed tax reforms will not bring about a fundamental changed with respect to utility scale solar. We still see costs declining. We still see PPA prices remaining above wholesale power prices, and we therefore still see a critical role for PPAs in the development of new solar resources.

Exhibit 5: Solar Can Thus Absorb the Loss of Tax Credits with No Fundamental Change

Source: Lawrence Berkeley National Laboratory, Utility Scale Solar 2015; SSR estimates and analysis

Let’s move on to Exhibit 6. As you can see there, when it comes to wind we do see a material adverse change in the outlook for new wind development. This reflects the fact that with the loss of the production tax credit for wind, and no offsetting reduction in the cost of new installed wind capacity, we believe that the PPA prices for wind will be on an upward trajectory through 2024. And that upward trajectory will be slightly worse if the House or Trump tax reform proposals are implemented.

The second key point we would make is that today the PPA prices for wind are increasingly competitive with wholesale around-the-clock prices in the windiest regions of the country, particularly the Great Plains states. As PPA prices rise over time with the phase-out of the PTC, however, we believe that the PPA price of new wind projects will come to exceed the around-the-clock price of power in wholesale markets. And therefore the prospect for more rapid growth, as wind was adopted for economic reasons, could now disappear. We would return to a situation where the growth of wind is once again contingent upon above-market PPAs from utilities operating in states with renewable portfolio standards. So, this, to our way of thinking, is a critical change.

Exhibit 6: The Cost of Wind Will Rise Materially, Eroding Its Competitive Advantage

Source: Lawrence Berkeley National Laboratory, Wind Technologies Market Report, 2011-2015; SNL; SSR estimates and analysis

Let’s move on to Exhibit 7. The point we want to make here is that we see the competitive position of wind being materially eroded over time vis-a-vis solar. The columns on this chart show you our estimated PPA prices for wind and solar — wind in blue and solar in orange — in 2018, 2020 and 2024. You can see how the expected PPA price for solar declines, the expected PPA price for wind rises, and the ratio between the two rises dramatically. Wind today is about half the cost of solar. We expect that the cost advantage will fall to only 15% by 2024. So, even in the context of RFPs [requests for proposals] for new PPAs, we think that wind will see its competitive advantage eroded in regions where both wind and solar resources are abundant. This loss of competitiveness would also occur in the context of RFPs where the procuring utility can rely on renewable energy credits and therefore is not particularly sensitive to the location of the renewable resource with which it contacts.

Exhibit 7: Even in RPS States, Wind’s Cost Advantage versus Solar Will be Much Eroded

Source: Lawrence Berkeley National Laboratory, Wind Technologies Market Report, 2011-2015; National Renewable Energy Laboratory, U.S. Solar Photovoltaic System Cost Benchmark Q1 2016 Report; SSR estimates and analysis

So, finally, let’s move on to the issue of the impact of tax reform on tax equity on Exhibit 8. Here, the key point is that the corporate tax rate would be cut from 35% today to 20% under the House GOP plan and 15% under the Trump plan. We anticipate that those cuts would materially reduce the capacity of tax equity providers. If tax liabilities fall commensurately with the cut in tax rates, we would see a 40% drop in the appetite of tax equity providers under the House plan, and about a 55% drop under the Trump plan. By contrast, we do not anticipate the demand for tax equity among project developers to decline significantly, certainly not until the ITC and PTC are fully phased out in 2020 and 2022, respectively. So, absent a significant increase in the income of tax equity investors, we expect the supply of tax equity to fall relative to demand, and we expect the cost of tax equity to rise.

The key issue here will be the difficulty that developers may face in securing tax equity. Developers that cannot monetize their renewable tax credits could face much higher cash costs for their projects. Specifically, developers who are unable to procure tax equity or to monetize available tax credits internally will be forced, by our calculation, to increase their PPA prices for solar by 35% to 40%, and for wind by 70% to 80%. These could be prohibitively large increases in PPA prices, crowding these developers out of the market. Consequently, we think that the limited availability of tax equity could create a significant cost advantage for firms that can absorb the tax benefits for renewable projects internally, such as AEP and Southern, as well as large developers that have the strongest relationship with tax equity providers, firms like NextEra Energy, Southern and Duke.

Exhibit 8: The Impact on the Availability of Tax Equity

  • The House tax plan would cut corporate tax rates from 35% to 20%, the Trump plan to 15%
  • The capacity of tax equity providers could fall commensurately, by ~40% under the House plan and by ~55% under the Trump plan
  • By contrast, demand for tax equity among project developers will not decline significantly until the ITC and PTC are fully phased out in 2020 and 2022, respectively
  • Absent a significant increase in taxable income at existing tax equity investors, the supply of tax equity may fall relative to demand and its cost rise
  • Developers unable to secure tax equity, or to monetize available tax credits internally, will face much higher cash costs
  • These developers would be forced to increase their PPA prices for solar by 35-40% and for wind by 70-80%
  • The limited availability of tax equity could create a significant cost advantage for large developers with the strongest relationships with tax equity providers (e.g., NEE, SO and DUK), and developers able to absorb the tax benefits of renewable projects internally (e.g., AEP and SO)

Source: SSR estimates and analysis

Let’s move on to Exhibit 9. A key element of the House GOP tax plan that could have a very detrimental impact on the outlook for both wind and solar is the border adjustment provision. This would prohibit firms from deducting the cost of imports from taxable income, although it would exempt export revenues from taxation. We have not included this border adjustment in our analysis of the House plan because the provision is highly controversial and because developers can mitigate its impact by increasing their purchases of U.S. components. However, if we were to assume that imports account for about half the cost of new wind and solar projects, on average, the border adjustment provision would increase the PPA prices required for wind and solar by about 12%, relative to our base case estimate for the House plan, and by 20% versus the current tax regime. Those increases are large enough in our view to slow the growth of solar, and they would certainly add a further headwind to the already unfavorable prospects for wind, putting company growth plans at risk.

Exhibit 9: The Border Adjustment Provision of the House GOP Tax Plan

  • The House GOP plan would prohibit firms from deducting the cost of imports from taxable income and exempt export revenues from taxes (border adjustment)
  • We have not included border adjustment in our analysis of the House plan, both because the provision is highly controversial and because developers may mitigate its impact by increasing their purchases of U.S. components
  • If we assume that imports account for 50% of wind and solar project costs, border adjustment would increase the required PPA prices for wind and solar by:
      • ~12% relative to our base case estimate of PPA prices under the House plan &
      • ~20% versus the current tax regime
  • Such a large increase in PPA prices would slow the growth of solar and add a further headwind to the already unfavorable prospects for wind, putting company growth plans at risk

Source: SSR estimates and analysis

Let’s move on to Exhibit 10, where we look at who will bear the fallout from the proposed tax reforms, and the consequent potential for the development of renewable resources to slow. NRG and NextEra plan the largest development of unregulated renewable generation over the next few years, followed by Avangrid and Southern. The average annual cost of the renewable capacity additions planned by NRG is equivalent to almost 10% of NRG’s market cap. Similarly, the average annual investment planned by NextEra is in excess of 5% market cap, and the corresponding numbers for Avangrid and Southern are between 3% and 4%. We note, however, that while the growth of renewable energy may slow through the end of the decade as the availability of tax equity declines, it is precisely companies like NextEra and Southern that are best positioned to access the tax equity that remains.

Finally, we believe the phase out of the production tax credit implies that wind will cease to be competitive with wholesale power prices and will come to depend, like solar, on above market PPAs with utilities in states that have renewable portfolio standards. The diminished growth prospects for wind should be negative for wind turbine suppliers such as Vestas and TPI Composites. Moreover, in solicitations for renewable PPAs, the marked cost advantage of wind over solar will erode over time. Relatively speaking, solar module manufacturers such as Canadian Solar, First Solar and SunPower, should fare better as a result

Exhibit 10: Company Impacts

  • NRG and NextEra plan the largest development of unregulated renewable generation capacity over the next few years, followed by Avangrid and Southern
    • Through 2018, the average annual cost of planned renewable capacity additions equals 9.7% of market cap for NRG and 5.4% for NextEra
    • Through 2020, planned annual investments in renewables by Avangrid and Southern average 3.8% and 3.1% of market cap, respectively
  • Among publicly traded renewable companies, the module manufacturers have the greatest exposure to utility-scale solar development.
    • This is particularly true of those with development arms, such as Canadian Solar, First Solar and SunPower
    • TPI Composites and Vestas are among the most exposed to utility-scale wind development

Source: SSR estimates and analysis

So those are our views on the subject, but let’s turn now to the expert, Keith Martin, and get his perspective. Eric, I think you’ve got some questions prepared.

Eric Selmon: So, just to start, a brief question on the IRS and its start of construction guidance. Is there any update from the IRS regarding the allowed construction period for new solar projects? There is concern that under the Trump administration it may not be as favorable as the four years given to wind.

Keith Martin: I have not heard an update since early November. They were trying to get it out by

year-end. I don’t know if they will get something out by January 20, when Trump takes office.

Eric Selmon: Okay. Next, what do you think the probability and likely content of tax reform

legislation might be? What’s the likelihood of it actually occurring, first of all?

Keith Martin: On the likelihood, I think chances are good, that something called tax reform will

happen in this Congress. Whether it happens in 2017 is harder to say. This Congress runs through the end

of next year.

Eric Selmon: Right. Which elements do you think are most likely to show up in tax reform?

Keith Martin: I think one is a certainty, and that is a corporate tax rate reduction, since that has

been so heavily advertised and both parties seem to be in favor of it. Beyond that I think it’s anybody’s guess,

but let’s look at the elements one at a time. The expensing of capex is a surprising addition to the list,

because recent tax reform proposals — the most recent being Dave Camp’s comprehensive bill that he

released in the last Congress — would have made depreciation slower. Depreciation was viewed as a toggle

switch to help pay for the corporate rate reductions, so it’s surprising to see it moving in the other direction.

On the border adjustment, I think there is a lot of interest in that among Republicans. It’s a new concept.

Alan Auerbach, Douglas Holtz-Eakin, who have been circulating a paper about it, are respected economists.

Auerbach has been in this field for a long time. So, I think people will wait and see how the details work out

before forming a judgment. It is politically difficult. It would increase prices for consumers unless you

think the dollar is likely to appreciate enough to offset the tax on imported equipment.

On the other big element, no interest deductions, I think that is more likely to survive if this whole package

holds together. If the package starts being picked apart, then I think you go back to something with a rate

reduction and a less meaningful tax reform.

Eric Selmon: Do you think there is much risk of the renewable tax credits ending

immediately or are they more likely to let them sunset as currently planned?

Keith Martin: I think that depends on the process that Congress uses to put the bill through. If

Congress uses the budget reconciliation process so that the bill can go through with just 51 votes in the

Senate, then the tax credits are at greater risk. If Congress doesn’t use the budget reconciliation process and

tries a more bipartisan approach — the Senate Finance Committee has always tried to do that — then I think

the renewable credits are much safer. Even if they use the budget process, it’s hard to see how Congress

would cut short the wind credits, since it’s already being phased out. It has a transition rule of sorts. The

solar construction start deadlines are a little bit more at risk, and certainly the 10% permanent solar credit one

would think has to go as part of corporate tax reform.

Eric Selmon: If they use the budget reconciliation, my understanding is that means that anything

they do is limited to a 10-year impact?

Keith Martin: That’s correct, and that is one of the downsides of the budget process as a means to

put through tax reform.

Eric Selmon: So let’s assume we get tax reform and a corporate rate reduction. Under the House

plan, the corporate tax rate would fall from 35% today to 20%. The tax liabilities of the big tax equity

investors could fall commensurately. If so, that would mean as much as a 40% cut in the tax appetite of tax

equity investors. Under the Trump tax plan, the tax rate would be cut from 35% to 15%, which would be

consistent with a 60% cut in the tax appetite of tax equity investors. But it seems like demand for tax equity

would remain high as long as the tax credits aren’t phased out immediately. So, first, what percentage of

current projects are using tax equity financing?

Keith Martin: It depends on the sector, but I don’t have a figure yet for 2016. In 2015, tax equity

for wind and solar was about $13 billion. And if you look at investment in 2015, it was $30.2 billion for

domestic investment in solar. The solar tax equity piece of the $13 billion was $6.8 billion, so that’s

equivalent to 22.5% of domestic investment in solar. That probably overstates the percentage, because a lot

of solar goes below the radar screen. And then, on the other hand, pushing in the other direction, some of

that solar investment is by homeowners in rooftop systems they own. They get a separate tax credit that isn’t

part of this tax equity equation.

As for wind, investment in U.S. wind farms in 2015 totaled $11.6 billion. The amount of tax equity for wind

was $6.4 billion, or 55% of the total invested. It’s not surprising that a larger percentage of wind farms get

tax equity because the tax equity market gravitates toward the larger developers, and the wind developers tend

to be larger.

Eric Selmon: Now, just to try and understand those numbers, you’re saying that $6.8 billion out

of the $30 billion invested in solar was the amount of tax equity. So, if maybe half of the project costs can be

funded by tax equity, then about 40% of solar projects would have been using tax equity?

Keith Martin: Well, that’s a good question, Eric. This is the total cost of solar, $30.2 billion in

2015; tax equity was $6.8 billion, so that’s about 22.5%. Is the right way to view that number, that it’s the

percentage of cost covered by tax equity? Probably. Is that the equivalent of saying 22% of solar projects get

tax equity? Probably not. So, I don’t have a better metric.

Eric Selmon: Okay. And what are the current terms of tax equity? Where are the target returns

for tax equity and do they differ materially for wind and solar and by size of project?

Keith Martin: It depends. For wind, the larger developers are paying around 8%, maybe a tad

under for unleveraged. These are after-tax yields. For solar utility scale, you can see tax equity in the low 7%

range. But once you get into rooftop solar, even the top three residential solar developers who account for

90% of the tax equity to that sector, they’re still paying maybe a little below 9%.

I stopped counting the number of tax equity investors in the summer of 2015, when we had reached 35,

because it seemed after that, with corporate profits rising, that every three or four weeks you’d find a new tax

equity investor maybe doing one or two deals, but not more active than that. One thing that happens when

you get a lot more players in is that the market is a little bit harder to discern. It’s a less transparent market.

Eric Selmon: Absent tax reform, do you see the cost of tax equity changing much, or is it kind of

flat?

Keith Martin: Well, it’s been flat really since the tax equity market revived in the summer of 2009.

It trended down a little bit in the last year, maybe a little longer. It was trending down, but then the tax equity

investors were making up part of the downward drift through additional fees. On a net basis it seems like the

rates really haven’t moved that much. The one area where things have moved is where you have leverage.

The tax equity requires a yield premium if the debt is ahead of it in the capital structure, and that used to be

on the order of 250 basis points. In the last few years it’s been more like 500, and you don’t see much

leverage. As a consequence, most of it is back-leveraged behind the tax equity.

Eric Selmon: Right.

Keith Martin: I think most of the action in the market lately, since the election, has been a focus

on the effects of tax reform, and that is starting to play into negotiations about who takes the risk of tax

reform and how that risk is mitigated.

Eric Selmon: So, now looking at tax reform, first, do you expect that with the lower tax rates

there would be a significant drop in the supply of tax equity, or is there a lot of untapped demand or capacity

for tax equity out there?

Keith Martin: I don’t think it’s as great as you’d think at first glance, and that’s because the

principal tax equity players are banks and insurance companies for whom an 8% yield is very attractive

compared to the alternative of lending at a lower rate. And so I think that will continue. It’s also hard to

figure out to what extent these large banks are constrained by tax base. Their constraints are probably more

just on risk diversification.

Eric Selmon: So, therefore they’d be able to continue to invest a similar amount and you don’t see

the supply of tax equity being constraint for the renewables developers after tax reform?

Keith Martin: Well, all I can say is it can’t be a good thing. There has to be some reduction in

supply, and the cost of tax equity is a function of demand and supply for a scarce resource, which is tax

capacity. The bigger factor is not really tax reform; it’s what direction you think the economy will take. This

expansion is pretty elderly compared to most post-war expansions. That will be the more significant factor.

Eric Selmon: Okay. So, if there is a decrease either due to tax reform or because a weakening of

the economy, it sounds like you think that would drive up the cost of tax equity, so we would expect yields to

go up in that case?

Keith Martin: If demand remains as strong. But one of the things you guys have projected is that

wind and solar will be less competitive and therefore you’d see less demand, one would think. I think it’s a

little hard to say.

Eric Selmon: I guess we might also see less demand for tax equity because the value of the

depreciation deduction is less at lower tax rates.

Keith Martin: I think what will happen this year is there will be a pause in the tax equity market

when the details come out about tax reform. It’s not clear when this happens. All eyes at the moment are on

the House Republican bill draft. The House Ways and Means staff is converting the 35-page blueprint that

was released last June into bill language, and there is speculation that that could come out as early as

inauguration day, it could come out in the spring, or it could wait until the House tax committee is ready

to vote on it. If you look at past practice, nobody releases a list of pay-fors until they’re about to vote. It’s

just too inviting a target for lobbyists to pick over. So, that will be a key issue. Once that happens, I suspect

you’ll see a pause in the tax equity market while people digest the effect.

I don’t think the tax equity investors will exit the market. I think you have dedicated

shops. These people, this is what they do for a living. They’ll find a way to continue offering this product. It

may not raise as much of the capital stack required for renewables projects as before, but the product will

remain. The decision will be on the sponsor side, because for deals that are already out, to the extent the

depreciation is less valuable, then the investor will have to have its yield made up with more cash. That’s

more burdensome for the sponsors. As you guys point out in your slides, the cost to buy out the back end of

the tax equity investor’s remaining interest will increase. For new deals, though, I think all this will just come

out in the pricing.

Right now the typical windfarm is raising somewhere between 40% and 50% of its capital stack in the tax

equity market. Solar is a tad lower. So, maybe it will be less tax equity; the developers will have to find the

missing capital somewhere else, probably more back-leveraged debt. The cost of capital will go up slightly.

It’s a little hard to compare tax equity to cost to debt because the developers are using a currency to repay tax

equity that they can’t use efficiently. They can use it eventually, it has a value to them, but they’re not as

efficient as the tax equity investors. So, I think this will just come out in the wash. The capital stack will

change.

Eric Selmon: Right. Do you see any limit to the appetite in the project finance market for

funding that need for additional back leverage on the projects?

Keith Martin: I don’t, and here’s why I say that. Number one is, we’ve seen a dramatic increase in

the number of banks playing in the North American project finance market through the end of 2015. The

2016 data will be interesting. Toward the end of the year we saw some project finance shops starting to shut

down, they weren’t getting traction. We’ve also seen banks more interested in doing merchant deals or quasi-

merchant deals. That’s a sure sign of difficulty in finding projects to finance. So, I think the demand on the

bank side has been strong. We’re seeing rates go up a little bit, but I think it still remains strong.

Eric Selmon: For utility scale solar and large wind projects, where is the project financing pricing

right now, and what are the usual terms? How long can they get?

Keith Martin: Well, Chadbourne’s going to have a cost of capital call on Tuesday next week with

the 2016 data; it just hasn’t been assembled yet. But just to give you a sense of where things were in 2015, the

spreads above LIBOR started at 175 for construction debt. We were seeing spreads of 175 to 275 above

LIBOR for better projects, with back-levered debt having a premium to construction spreads of anywhere

from 20 to 50 basis points. In some cases as much as 100, but 25 to 50 was more common. The tenors were

all over the map. The debt service coverage ratios were on the order of 1.45 for wind — this is just

generalizing — and 1.35 for solar. Those are at P50 [probability of 50%] output numbers. For P99

[probability of 99%] the coverage ratio would be 1.0 or 1.1 for projects.

Eric Selmon: Do you see a risk to existing projects or existing tax equity from tax reform?

Keith Martin: The only risk I see is in the corporate rate reduction. It depends on what the parties

negotiated about who took the risk of a change in corporate tax rates. In most deals over the last three years,

the sponsor takes the rate risk. And so in deals other than US Bank’s fixed flip structure, that would mean,

depending on when the reduction in the corporate tax rate occurs in the life of the deal, it could be a negative

or a positive. The earlier it occurs in the life of the deal the more likely it is to be a negative and therefore the

more cash the sponsor would have to end up giving to the tax equity to get him to his target yield. That’s a

bigger burden on sponsors. There is no way really to protect against that. US Bank has a fixed flip structure,

where tax rate change is irrelevant. They flip on a particular date. And I’ve noticed lately US Bank has now

been trying to add to the cash waterfall a provision where it would get more cash to make up for the hit due

to rate reduction.

Eric Selmon: It’s interesting. When we were looking at this we found that because of bonus

depreciation, almost no projects really suffered a negative impact from tax reform, assuming the tax reform

came into effect tin 2018. Because we were finding that, particularly for solar —

Keith Martin: The depreciation was all gone.

Eric Selmon: Yeah, it’s all gone. You’re a taxpayer by year four.

Keith Martin: But it’s not very common to find bonus depreciation taken in these deals. Most tax

equity investors refuse to take it. The reason is they want to spread their scarce tax capacity over a larger

number of deals.

Eric Selmon: Interesting, okay. So, most of the utility-scaled tax equity is not taking bonus

depreciation?

Keith Martin: Correct.

Eric Selmon: So, that actually does leave some risk, and then it’s a matter of how soon the lower

tax rates come in?

Keith Martin: That’s correct.

Eric Selmon: That is a very useful fact. I know tax risk is a big issue for the tax equity. When you

speak to developers about their plans, what have they been expressing as concerns? Have you heard much

discussion? How do you think this affects the developers’ economics and their plans?

Keith Martin: I think this is playing out in the following way. First, the developers’ pipelines of

new projects had thinned out considerably at the start of 2016 because almost everybody thought the market

would be over at the end of 2016. So, at the start of last year you saw CEOs from the wind and solar

companies showing up at industry conferences for the first time in several years. They’re trying to assess

whether to dive back into the development game. I think a lot of them did. We saw a lot of activity last year,

particularly as the year went on, of wind companies signing up contracts to buy turbine equipment so that

their projects would be considered under construction in time to qualify for full PTCs. We didn’t see so

much of that activity in solar just because their first construction start deadline is not until 2019.

Eric Selmon: Right.

Keith Martin: I think what’s happened as a result is that the wind folks have locked themselves

into a significant pipeline that will play out over the next four years. It’s not just new projects, it’s also

repowering of existing projects. But then, as I said, you’ll start to see a pause in the tax equity market while

people digest the details once they come out.

In the meantime, we’re seeing the potential for tax reform play out as follows: The tax equity market has not

really slowed down; it’s still doing deals. The tax rate change risk has been borne by sponsors for the last

three years; that won’t change. Depreciation, how it’s calculated, that risk was borne by the tax equity

investors. We’ve seen a shift lately to where the sponsors are taking that. Then there is a big issue that’s

arisen where there are multiple fundings of tax equity, which is true particularly in the rooftop solar market.

There is a strong debate about at what point in the life of the tax equity facility can the tax equity stop

funding? At what point in the legislative process: once the House Republication bill comes out, once there is

a vote in the House Tax Committee, once something passes the House or Senate? At what point is this

meaningful enough that funding can stop?

As for the M&A deals in the market, people are feeling their way. But I suspect where the market will land is

there will be a one-time repricing after tax reform based on look back, because the parties won’t be able to

agree today on what’s an appropriate price.

Eric Selmon: So the pause essentially would be when we have the details or more firm action on

the tax reform, so a lot will depend on the timing of that. That will stop tax equity deals. What do you think

the impact that will have on development? Do you think we could see a pause in actual project construction

as people wait for the impacts, or do you think developers are planning on working through that and just

figuring out how to replace the tax equity financing?

Keith Martin: Well, first, developers, particularly in the wind market, have these pipelines that

they’ve locked in for construction start, and I think any transition relief that will come with tax reform will

protect these projects, is my guess. Solar, I think you’ll see solar companies, as tax reform approaches,

locking in their investments. The last time we had major corporate tax reform was 1986. There were just lots

of transition rules. There were general transition rules and then there were so-called rifle shots that protected

people who had basically committed to an investment before the first House tax committee vote. And those

transition rules protected, among others, for example, people who had power contracts that committed them

to build a project, where they had signed a binding construction contract or bought a lot of equipment. And

I expect you’ll see similar transition relief this time, so that people who got started in 2016 are okay. And

solar companies that just focus on the potential for tax reform and lock in investments will be okay as well,

regardless of whether remaining construction start deadlines are cut short.

Eric Selmon: How much do you think they would need to lock in for this, for them to be

grandfathered, protected by the transition rules?

Keith Martin: Well, this will lead to an interesting intersection between the construction start rules

the IRS has announced. There are five notices the IRS has issued, and how it works in tax reform, that will

have to play out. But if you look at the ’86 Tax Reform Act as the template, there if you had a binding

contract to build a project, or you had a binding offtake contract that committed you to build the project, you

could see that investment through. You had a period of time, I believe it was four years, but it actually

depended on the depreciable life, over which you had to finish the investment to get the benefits you

expected. The wildcard here is there are some economists in the Joint Committee staff who question

whether it’s fair to let people lock in the cost recovery but also give them the benefit of the lower rate

reduction. I’m not sure how that will play out.

Eric Selmon: So, you think there is a chance that for those that locked in these investments that

they could also have the former tax rate, the current 35% applied to their projects?

Keith Martin: I don’t see how you do that. So, I don’t know how this will work itself out. The

one point is that it’s unheard of for Congress to pull away a carrot that has been held out to induce people to

invest from people who have already committed to such an investment.

Eric Selmon: It sounds like you’re definitely more concerned about the risk of the solar ITC being

taken away earlier than 2020, if we get tax reform. You’re talking about the solar investors locking in

investment and trying essentially to make sure they get covered under transition rules.

Keith Martin: I’m less concerned if the process is the Senate votes through the regular order, not

the budget reconciliation. Even if this comes up through the budget, it’s a little hard to predict. It depends.

I’ve seen Kenny Marchant, for example, who is a senior Republican on the House Ways and Means

Committee, say that this shift to a destination-based cash flow tax would require a 10-year transition period.

So, it depends on what they think is normal transition. Solar may fit well within that period.

Hugh Wynne: Keith, I would be interested to get your general sense of the direction of wind and

solar development over the next five years — and maybe if you would be willing to do so, over the next 10

years, given the likely phase-out over time of the investment tax credits. Do you see a coming sea change in

the industry? Or do you think that renewable developers will overcome the loss of subsidies and that we will

continue to see material growth in renewable energy?

Keith Martin: I think it depends on a number of things. I think the next four years for wind, we

already have a pipeline of projects that will proceed unless the corporate tax reform bill for some reason

screws up the construction start rules. For solar, the cost has been coming down so rapidly that we’ve seen

solar winning auctions in places like Abu Dhabi, Mexico, and Argentina, just purely on economics. And

so assuming the costs continue to come down rapidly, the transition to renewables should continue, but

maybe not as rapidly as before.

The other factors are, this industry had expected the Clean Power Plan to be its bridge once the tax credits

expired, and that plan is now in doubt. Another factor is, if you think about the larger power sector, it

consists of three segments on the generation side. There are the regulated utilities that still do some

generation; there are independent power companies; and then there are the rooftop solar companies. They’re

all competing for their market share of the load.

The utilities have been suffering as the rooftop companies pick off customers, and they’ve been focused on

swatting away these rooftop companies by battling them over net metering but missing the larger picture.

And that is the fact that the independent power companies, which are finding it hard to get utility contracts,

are going to the large corporates and contracting directly with them, and picking off 100- and 200-megawatt

loads. How much longer will they be able to continue doing that? If you can get a power contract, you can

finance a project. All this other stuff we’ve discussed doesn’t prevent that project from going forward.

The last factor is coal retirements. We live in a market where electricity demand is not growing, and so the

only way that new entrants get traction, that’s renewables, is by having retirements of existing generation.

And if coal retirements slow down, that would mean less opportunity for renewables to replace. I think these

are all factors in the mix.

The bottom line is, I think the transition will continue just purely on economic grounds. Everybody expects

to have to shift to less carbon-intensive forms of generation. The Trump administration is just four years,

maybe eight at most, but the longer-term trends are clear, and I think the transition will continue, maybe not

at the same pace.

Hugh Wynne: It sounds like you are more optimistic about the growth prospects for solar because

of its continuing decline in the costs.

Keith Martin: The costs have to come down faster, enough to replace the subsidies that disappear,

and so it’s just a race against time on the cost coming down.

Eric Selmon: On that note, when you speak to wind developers, post-2020, once they are past the

safe harbor for the start of construction and the PTC is really gone, do they sound optimistic when you speak

to them? With solar, we see the cost coming down fairly continually and dramatically, but what are the wind

developers saying about that?

Keith Martin: The only insight I have is, I moderated a panel discussion among CEOs of turbine

vendors, and their feeling is they have the technological improvements that can bring costs down more

rapidly than they have been. But they say their constraint is the market isn’t interested in financing new

technologies. I think if we can get past that, that would help wind. Wind isn’t facing quite as large a barrier

as one might think. That’s just an instinct. I have not yet heard wind CEOs talk this year about the outlook.

In fact, I haven’t heard any discussion among them since Trump was elected.

Eric Selmon: One question back on the tax equity. Between the large the large renewable

developers like NextEra and the smaller developers, is there a significant variation in the terms that the

developers get based on kind of their size or repeat business, or the strength of the parent company

relationship?

Keith Martin: For tax equity?

Eric Selmon: Yes, let’s start with tax equity. I guess I could ask the same question about project

financing as well.

Keith Martin: Well, I think the answer to both is yes. The tax equity investors all want to deal with

the same handful of well-known names, people they trust who can get the project built and deliver over time.

They have staying power. And smaller players have trouble getting financing.

Eric Selmon: So, if there were some constraints in the tax equity market, then we’d expect that the

bigger developers would still be able to secure the financing they need at reasonable terms?

Keith Martin: My guess, as I said, is tax equity will remain. It may be instead of 40% to 50% of

the capital stack for a windfarm it may be 35% to 45%. It’s just a calculation, you take the yield the tax equity

investor requires, and it’s already very high compared to debt, very high compared to debt, and you use that

as a discount rate to discount four things. One is the tax credits; second is the tax savings from depreciation;

third is the share of cash; and the fourth is a detriment, it’s the taxes that have to be paid. So, this tax reform

looks likely to swing two of those elements. One is, it would make the depreciation less valuable and in fact

eliminate it to the extent imported equipment is used. But then on the backside, taxes will be less

burdensome.

Eric Selmon: On that note about the imported equipment, what’s the discussion as to how solar

and wind address that? Because it is such a large portion of their equipment costs, the imported goods. Have

you heard much discussion about strategies to address border adjustment provision if it were to come

through?

Keith Martin: That’s an interesting question, because as people were pressing at year-end to sign

up turbine supply agreements, it was one of the questions that people raised. Because these manufacturers

were taking on so many orders, many of them will be unable to deliver on the timetables by delivering solely

U.S. equipment. But nothing really was done in the contracts I’m familiar with. People are just keeping their

fingers crossed and hoping they can get adequate transition relief. After all, these are investments that were

committed in 2016, before even the new Congress took office. Beyond that, I suspect for new turbine supply

agreements signed this year, the buyers will want some ability to get the equipment from a U.S. factory, if at

all possible. That’s what I would do if I were a buyer.

Eric Selmon: What about on the solar side, where there is so much less manufacturing capacity in

the U.S.?

Keith Martin: It should help Panasonic and Tesla with their New York plants; SunPower to the

extent it can manufacture in the U.S.; SolarWorld for U.S. manufacturing. I just think these people will have

an improved sales pitch. On the others, I think they’ll be before the Joint Tax Committee describing their

situations, where they have signed binding contracts in the hopes that transition relief will be provided.

There has to be a long transition period for such a significant adjustment. There are many questions that

haven’t been worked out yet on the border adjustment. For example, what is US-made equipment? How

does the border adjustment work? Does it work just like a VAT, where you bring in parts of the equipment

and you assemble or do some further manufacturing in the U.S.? Or do you take a trade treaty approach of

there is some tipping point where it’s US made? What about banks, where they take deposits from foreign

depositors? Is that an import or an export? There are just a host of questions that will have to be worked

out here and will take some time to do.

Eric Selmon: All right. We’re at the top of the hour. Your comments have been very helpful,

very insightful, and I hope the listeners found them to be so as well. Thanks again.

Keith Martin: Thank you.

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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