Drive to Reduce the Cost of Capital (Special Update)
Renewable energy companies and the Obama administration are looking for ways to reduce the cost of capital for renewable energy projects in the United States.
Attention is focused “yield cos,” “synthetic MLPs,” REITs, true MLPs, foreign asset income trusts and securitizations, among other strategies.
The efforts should be seen in a larger context.
Project developers draw funding from up to six tiers of capital from cheapest to most expensive.
The six tiers are Treasury cash grants, government-enhanced debt, straight debt, tax equity, back-levered debt and true equity. Chief financial officers looking at ways to finance projects try to raise as much capital as possible from the cheapest source before moving up to the next tier.
Each of the new strategies is an effort to raise straight debt more cheaply or to raise true equity at a cost that is closer to the cost of straight debt.
The cheapest source of capital is Treasury cash grants that cover 30% of project cost and are free money. However, the only projects that still qualify for grants are those that were under construction by December 2011.
Next cheapest is government-enhanced debt: loans guaranteed by the US Department of Energy or the US Department of Agriculture, cheap financing from export credit agencies eager to support sales of equipment manufactured in their home countries and debt supported by new markets tax credits. The Department of Energy loan guarantee program is winding down. The US Department of Agriculture still has a loan guarantee program that allows debt to be raised at 12.5 basis points above Treasury yields for projects that supply electricity to customers in rural areas. Export credit agency support might include support in theory from the US Export-Import Bank, which has authority to counter efforts by foreign ECAs to promote sales of foreign equipment over US-made equipment, although the agency has declined to use the authority to date.
Tax equity remains a core financing tool for renewable energy companies that are large enough to be in a position to raise it. Federal tax benefits on wind, solar and geothermal projects amount to 56¢ per dollar of capital cost. A tax equity transaction can raise anywhere from 9% to 85% or more of project value, depending on the form of tax equity transaction and the type of project. Tax equity looks at first glance like it costs more than straight debt, but the developer is using a currency — tax benefits that he or she is not in a position to use efficiently — to repay part of the financing, so it requires a more complicated analysis.
“Yield cos” are corporations listed on a US or Canadian stock exchange that hold operating assets. The idea is to move operating assets under a publicly-traded vehicle, allowing equity to be raised at a higher multiple to earnings. The assets have been de-risked and throw off predictable cash flow. Investors pay a premium as well for the ability to trade their ownership positions in a liquid market. If, in addition, the publicly-traded entity is not subject to income taxes on its earnings, then the investors will pay a higher multiple still. The developer keeps its pipeline of projects under development in a separate entity. The yield co has an option to purchase each new project as it enters or ends construction.
Most renewable energy projects do not start generating taxable income until three or four years after they have been in operation. The projects are depreciated largely over five years on an accelerated basis. The depreciation exceeds revenue from electricity sales for the first several years. The excess depreciation can be carried forward for up to 20 years and, if used solely to shelter earnings from the project, can usually shelter earnings for up to nine years.
Thus, a yield co should be able to go for an extended period without any income taxes at the entity level. In this sense, it is like a “synthetic MLP.” An MLP, or master limited partnership, is a large partnership whose units are traded on a stock exchange. Because it is a partnership, there is no tax at the partnership level; the earnings are taxed to the partners or investors directly.
There will be no taxes on earnings initially at the investor level, either, if the yield co can spread out its depreciation to more closely match the pattern of electricity revenues. Cash distributions by a corporation are considered taxable dividends to shareholders to the extent the corporation has either undistributed accumulated “earnings and profits” or current-year earnings and profits. If it has neither, then the cash distributions are considered nontaxable returns of capital to shareholders until the shareholders get their capital back. (After that, the distributions are reported as capital gains.) A corporation with a large net operating loss carryforward due to depreciation may not have to pay any corporate income taxes, but would still be treated as paying dividends if it has current-year earnings. Therefore, the key is to avoid current-year earnings and profits over roughly the same nine-year period that the corporation is not expected to have to pay any income taxes. It helps that even though wind, solar and geothermal projects are depreciated for tax purposes on an accelerated basis over five years, depreciation for calculating earnings and profits is taken over 12 years on a straight-line basis.
First Wind did a forerunner of a yield co, but without a publicly-traded entity, in 2012. It sold a 49% interest in a portfolio of operating wind farms in New England and New York to a US subsidiary of Emera, a Canadian utility holding company. The joint venture may acquire other projects that are currently under development as the projects reach construction.
REITs or real estate investment trusts are another form of publicly-traded entity that could be used to raise capital at lower cost, but they are difficult to use and may create other complications.
REITs are corporations or trusts that do not have to pay income taxes on their earnings to the extent the earnings are distributed each year to shareholders.
Congress created REITs in 1960 as a way for small investors to invest in large-scale real estate projects. Small investors pool their investments in the REIT and are treated essentially as if they had invested in the real estate projects directly without a corporate-level tax being taken out along the way.
There are two kinds of REITs: equity REITs and mortgage REITs. Equity REITs own assets directly. Mortgage REITs make loans secured by mortgages over real property.
Either type of REIT must jump through three hoops to maintain qualification as a REIT. It must hold at least 75% “real estate assets” at the end of each quarter. Examples of such assets are land, site leases, buildings and mortgages secured by real property. At least 75% of the REIT’s gross income each year must come from such things as rents from real property and interest on mortgages secured by real property, and at least 95% must be rents from real property, interest, dividends and certain other forms of passive income.
A REIT cannot own an operating business. If it sells inventory, then it is subject to a 100% tax on the profits.
Thus, an equity REIT would have to own the portions of a wind, solar or other project that are considered “real property” and lease them to an operating company. The REIT’s income would be rent from real property. However, the REIT could not own the land underneath a wind farm, for example, and charge a rent for the use of the land that reflects the improvements, meaning the fact that the land has a wind farm on it, because part of the rent would have to be allocated to the equipment. The towers, distribution lines and other inert parts of the project may be real property, but machinery is not.
A least one REIT has asked the Internal Revenue Service for a private letter ruling that solar rooftop systems are real property. No ruling has been issued, and indications from the IRS to date have been that the agency is not prepared to treat solar panels as real property. REIT advocates argue that the panels are closer to transmission lines that the agency has already ruled privately are real property than to machinery, because the panels are an inert asset through which energy passes.
The tax committee of the Solar Energy Industries Association suggested to REIT advocates that they should be careful so as not to do harm to other tax positions the industry has taken.
There are four issues.
First, renewable energy companies have taken the position with the US Treasury the last four years that their projects are largely equipment in order to qualify for Treasury cash grants on the projects. REITs require pivoting to a position that the projects are partly or largely real property. Grants are only paid on equipment. There are differences in what is considered real property for cash grant and investment tax credit purposes and what is real property for REIT purposes. An asset can be real property for REIT purposes and still be equipment for the cash grant and investment credit if it is “inherently permanent,” meaning so fixed to land or a building that it is unlikely ever to be removed.
Second, treating solar rooftop panels as inherently permanent could make it harder for solar rooftop companies to raise tax equity. It is less likely to affect utility-scale projects. There have been at least three dozen large tax equity transactions done around portfolios of solar rooftop installations. These transactions rely on the ability of a third party to own the systems for tax purposes. Given the right facts, third-party tax ownership can be established, but it is harder to claim tax ownership of an asset that is bolted permanently to someone else’s roof, as it can be a little like claiming ownership of a chimney on someone else’s house.
Third, wind, solar and geothermal property is depreciated over five years. This depreciation is worth almost as much in tax savings as the Treasury cash grant or investment tax credit: the tax savings have a present value of roughly 26% of project cost at a 35% income tax rate using a 10% discount rate. Fiveyear depreciation is only available for “equipment” as opposed to “non-residential real property.”
Finally, the US renewable energy sector has attracted a large amount of foreign investment, including by prominent European utilities. The US does not tax foreigners on their gains from US investments, unless the investments are in US real property. Any tax in that case is levied under a statute called the Foreign Investment in Real Property Tax Act or FIRPTA. Most renewable energy companies take the position that their asset value is largely in equipment rather than real property. FIRPTA and the REIT statute use the same definition of “real property.” Foreign shareholders in a publicly-traded REIT are not subject to FIRPTA taxes as long as they have not held more than 5% of the REIT, but any decision that renewable energy projects are largely real property would be an unwelcome development for the offshore investment funds and European utilities invested in the sector.
Citigroup, GE Energy Financial Services and other financial institutions have been circling the energy efficiency sector trying to figure out how to finance retrofits to existing buildings so the buildings use energy more efficiently. Hannon Armstrong has solved the puzzle. The company has made a business of securitizing government payment obligations under energy savings performance contracts. These are contracts that private contractors like Honeywell and Johnson Controls sign with US military bases and government agencies to install solar panels, more efficient lighting, better windows and similar improvements in exchange for periodic payments that are a share of the energy savings. Hannon Armstrong filed a draft S-11 registration statement with the US Securities and Exchange Commission in February indicating that it plans to convert into a mortgage REIT. The REIT will issue shares on the New York Stock Exchange. The goal is to raise at least $100 million.
The IRS issued Hannon Armstrong a private letter ruling last fall confirming that the security it plans to take back for its loans qualifies as a mortgage on real property. Redacted copies of private letter rulings are normally made public three months after the ruling is received by the taxpayer, but Hannon Armstrong appears to have asked for an additional delay to allow time to be the first mover on its strategy. IRS rules allow another three-month delay for this purpose and, under certain circumstances, may allow the period to be extended by another six months.
Meanwhile, the REIT community has been watching the expansion of what can be put into a REIT with some trepidation for fear that the expansion will eventually lead to a backlash in Congress. In the last year, the IRS has ruled that signs permanently attached to buildings, offshore oil and gas platforms, boat slips and data center buildings are real property. In November 2012, casino owner Penn National Gaming, Inc. announced plans to do a tax-free spinoff of its casino facilities into a REIT, and the REIT would lease them back to the operating company. Penn National said that it has a private letter ruling from the IRS approving certain aspects of the transaction and the qualification of the new company as a REIT.
A push continues in Congress to allow renewable energy companies to reorganize themselves as master limited partnerships.
MLPs require a statutory change by Congress. An MLP is a partnership that raises capital by listing units on a stock exchange. There is no income tax at the partnership level. The investors are taxed directly on their shares of earnings. The liquidity, or the ability to exit the investment in a public market, and the fact that earnings are only taxed once mean that equity can be raised at a higher multiple to earnings. The MLP units also provide a currency that can be used to make acquisitions.
Minerals and natural resources companies can already operate as MLPs. Renewable energy companies generally cannot, field portion of a geothermal project can be put in an MLP. Senator Chris Coons (D.-Delaware) is proving an effective advocate for allowing renewable energy companies to operate as MLPs, but the proposal still faces long odds. At the end of the day, the issue is how many additional industries Congress will allow to operate without having to pay corporate income taxes. Standalone tax bills do not pass Congress. The proposal is unlikely to be taken up until it can be considered as part of a larger debate about corporate tax reform. Most lobbyists do not expect Congressional action on corporate tax reform before 2014 at the earliest, although the timetable could accelerate if President Obama and Congressional Republicans can reach a grand bargain on the federal budget deficits this summer. Congress will have to increase the federal debt ceiling by late July or August or the government will run out of money to fund operations.
There is a split within the renewable energy community about whether it is enough to amend the US tax code to allow renewable energy companies to operate as MLPs or whether one would have to go farther and also relax at least two other tax rules that make it difficult for individual investors to share in tax benefits from renewable energy projects.
One advantage of operating as a partnership is tax benefits pass through to the partners. Renewable energy projects generally throw off more tax benefits than income for the first three or four years of operation. When wind companies first started advocating for MLPs in 2005, the idea was to open the tax equity market to a larger pool of potential investors in the hope that increasing the supply of tax equity would bring down the cost. However, “passive loss” and “at-risk” rules limit the ability of individuals, S corporations and closely-held C corporations (corporations in which five or fewer individuals own more than half the stock) to use the tax benefits from any wind or other renewable energy project. Such investors would be limited to using them solely as shelter for income from the project and other passive investments and then only to the extent of the equity the investor has at risk in the particular project. The passive loss and at-risk rules make limited exceptions for investments in oil and gas and low-income housing projects, but not renewable energy.
The industry appears to be moving gradually to the view that it is enough merely to have permission to operate as an MLP. In that case, MLPs would be used to raise money from large corporations.
Operating as a partnership creates challenges. Pension trusts, university endowments and other tax-exempt investors (and private equity funds with any such investors) would have to invest through “blocker” corporations to avoid partial loss of tax benefits on the projects. A project owned partly by an entity that does not pay taxes is not entitled to full tax benefits. A 50% or more change in ownership within a 12-month period could cause the partnership to terminate for tax purposes, leading to a time-value loss in depreciation. Solar and other projects on which investment tax credits are claimed would face an additional challenge. Any partner who is allocated an investment tax credit would suffer full or partial recapture of the credit if he sells his interest within five years.
The existing MLP market has been made up principally of yield investors who are looking for predictable cash flow.
In the meantime, there is a “self-help” MLP structure that can be used without waiting for Congress to amend the statute. The MLP forms a corporate subsidiary to hold assets that do not throw off the right type of income to be included in an MLP. At least 90% of the gross income of the MLP each year must be dividends, interest, rent from real estate, certain other forms of passive income or income and gains from “the exploration, development, mining or production, processing, refining, transportation . . . or the marketing” of any minerals and natural resources. Assets that do not throw off this kind of income are put in the corporate subsidiary. The MLP raises capital in the public markets and injects part of it into the corporate subsidiary partly as debt and partly as equity. Earnings move up to the MLP from the corporate subsidiary partly as interest. The interest can be deducted by the corporate subsidiary. The presence of the corporate subsidiary in the ownership chain has the effect of converting bad income (revenue from electricity sales) into good income (interest and dividends) when received by the MLP. Both Fortress and Blackstone used this structure when they converted to MLPs in 2007.
Canadian Income Trusts
Some US energy companies are tapping foreign asset income trusts, also known as cross-border income trusts, in Canada to raise cheaper capital.
An income trust is a trust formed in Canada that raises money in the capital markets and pools it for investment. Trust units are traded on a stock exchange. The trust is not subject to income taxes in Canada. Rather, its earnings are taxed to the investors directly. A large percentage of the trust units may be held through tax-deferred retirement funds with the result that the earnings are often not taxed immediately at the investor level either.
Income trusts saw a phenomenal growth in Canada at the start of the last decade through 2006 when the Canadian government took steps to shut them down. There were 256 income funds in Canada by 2006 with a combined market capitalization of C$256 billion. Canada faced the prospect of mass de-corporatization as Canadian companies rushed to convert into income trusts. Because of the tax advantage, the typical trust could return at least 27% more cash to Canadian investors than would a similar investment directly in corporate shares.
Private equity firms used this math to turn large profits. For example, Kohlberg Kravis Roberts & Co. and the Ontario Teachers’ Pension Plan Board together acquired 90% of the Yellow Pages business in Canada from Bell Canada in November 2002 for C$900 million and then resold a 25% interest in the business in the summer 2003 through an income trust for C$935 million. American Industrial Partners achieved similar alchemy by acquiring Great Lakes Carbon — a US-based producer of calcined petroleum coke for making aluminum — in 1998 and then selling down the investment to a Canadian trust in 2003.
The Canadian government introduced so-called SIFT rules in 2007 that required income trusts essentially to start paying income tax on pre-dividend earnings, just like a corporation. The trust structure was revived starting in late 2010, but this time focusing solely on investments outside Canada. Such investments are not subject to the SIFT rules as long as the trust does not own any assets that are used in carrying on a business in Canada.
Five foreign asset income trusts are now listed on the Toronto Stock Exchange. Four are focused on energy investments in the United States. The Eagle Energy Trust raised C$169 million in November 2010 to acquire a 73% working interest in the Salt Flat light oil field in south central Texas. Parallel Energy Trust raised C$393 million in April 2011 to acquire a 59% working interest in the West Panhandle natural gas field in northern Texas. Argent Energy Trust raised C$212 million in August 2012 and used the funds to acquire oil and gas wells in Texas and Oklahoma.
The Crius Energy Trust went public in November 2012 and raised C$100 million that it used largely to buy two subsidiaries of Crius Energy, LLC in Connecticut, as well as a 27% interest in the parent company. Crius Energy serves more than 400,000 residential and commercial customers in 12 eastern US states and the District of Columbia. It markets electricity and natural gas directly to customers.
A fifth foreign asset income trust, Dundee International REIT, was launched in 2011 and makes real estate investments in Germany.
The combined market capitalization of the five such trusts is C$2.03 billion.
The offerings have had a mixed reception from investors. Two foreign asset income trusts that attempted to go public in 2011 had to cancel the offerings. One, Argent, succeeded a year later. Another, the North American Oil Trust, was rumored to have raised only a tenth of the C$375 million it was seeking before cancelling the offering. Newspaper reports that as many as another six trusts would list by the end of 2012 proved unfounded. Three of the five existing trusts are trading at reduced unit prices to the initial offering. In early April, Eagle was trading at 68.9% of the original unit price, Parallel at only 42.7% and Crius at 68.7%. Argent was at 104.2% and Dundee at 106.9%. The trusts pay high cash-on-cash payouts. Current dividend yields are 15.24% for Eagle, 14.02% for Parallel, 10.08% for Argent, 14.49% for Crius and 7.52% for Dundee.
Promoters of the structure took comfort from the March 2013 federal budget that another change in tax policy affecting the trusts is unlikely. The budget included a long list of anti-taxavoidance measures that appeared to be a “thorough house cleaning,” according to one Canadian law firm, without any proposals to curtail use of cross-border trusts.
There are two main structures.
In one, a “mutual fund trust” is formed in Canada. It raises money through an initial public offering and injects the money partly as debt and partly as equity into a subsidiary commercial trust, also in Canada. The subsidiary trust then owns a US limited partnership (for investments in Texas to avoid the state margin tax) or another US passthrough entity that owns the projects or other assets. This trust-on-trust-on-partnership structure was used by Parallel Energy Trust.
In the other structure, a mutual fund trust is formed in Canada. It raises money through an initial public offering and injects the money as equity into a subsidiary corporation in Canada. The Canadian subsidiary then injects the money partly as debt and partly as equity into a US subsidiary corporation that owns the projects or other assets. The Canadian subsidiary then distributes the note from the US subsidiary to the Canadian parent trust. This trust-on-corporation-on-corporation structure was used by Argent Energy Trust.
There is no tax in Canada at the level of either Canadian entity. The income flows through to the unitholders.
In the US, the Canadian subsidiary is treated as a corporation for US tax purposes under both structures. A US corporate income tax must be paid in theory on the lowest entity treated as a corporation in each structure — the Canadian subsidiary trust in the first structure and the US subsidiary corporation in the second structure — but taxable income at the level of these entities is largely offset by the interest payments on the intercompany debt and by deductions for depreciation, depletion and intangible drilling costs. The result is that a small regular US corporate income tax or alternative minimum tax is paid at the entity level. The US normally also collects a withholding tax at the border on payments by a US taxpayer to someone outside the country, but the withholding tax in this case is avoided under either a “portfolio interest exemption” or the US-Canadian income tax treaty.
The United States has earnings-stripping rules that limit the extent to which a foreign parent company can capitalize a subsidiary that is a US taxpayer with debt and then “strip” the earnings from the subsidiary by withdrawing them as deductible interest payments to the parent. When the rules apply, interest deductions are disallowed. At least two things must be true for the rules to apply. The subsidiary paying the interest must have a high debt-to-equity ratio — it does — and the interest must be paid to a related party. It is not in this case as long as the parent mutual fund trust is ignored for US tax purposes so that the interest is considered paid to each unitholder individually.
Several solar rooftop companies are exploring the concept of pooling lots of customer payment obligations in a trust or limited liability company and then “securitizing” or converting the future payment streams into current cash by selling securities in the trust in the institutional debt market.
Such transactions usually require the customer paper be rated by two rating agencies. A developer using such assetbacked securities can usually borrow more cheaply than straight bank debt.
The Obama administration is eager to help facilitate such transactions. There are three main impediments: lack of industry form agreements with customers, lack of data on customer default rates and lack of accepted back-up servicing companies in whom the asset-backed securities market has confidence can provide the customer services required to earn the revenue over time. The home mortgage, student loan and other markets, where securitizations are common, use pre-printed agreements with customers.
Despite the obstacles, many people expect the first deal later this year.
The National Renewable Energy Laboratory, which is an arm of the US Department of Energy, is spearheading an effort to address the obstacles in the solar residential and commercial markets. A group of solar companies, rating agencies, law firms and other advisers has been meeting in person and on conference calls to work through the various issues while NREL also polls solar companies for customer default data. The group is about to move to a mock transaction that can then be rated by the rating agencies as a trial run.
A separate effort through the Rocky Mountain Institute is focused on the commercial and industrial rooftop market.
One of the challenges will be how to marry the structures with tax equity. The trust or LLC issuing securitized debt would normally be expected to hold the customer agreements that generate the revenue, but the tax equity vehicle needs to rely on the same revenue. The challenge is how to marry two financings around the same revenue-generating assets. One approach may be to have the securitization trust act essentially as a conduit to raise money that it relends into the tax equity vehicle. The marriage may not work with some types of tax equity structures. For example, in an inverted lease where the developer assigns the customer agreements to a tax equity investor and leases it the solar equipment, the customer revenue is received by the developer in the form of rent after passing through the lessee. Any debt would be expected to come in at the lessor level. The customer agreements may be too far removed and the revenue may be considered too much at risk. The developer has ongoing obligations to the lessee tied to representations and covenants that, if breached, would require an indemnity be paid to the lessee that would offset rent.