The US renewable energy market is entering a period of potentially rapid growth, but with a great deal of short-term uncertainty. The sources of uncertainty include supply-chain difficulties, a potential rewrite of federal tax incentives for clean energy, inflation, import tariffs and domestic and international political tensions.
More than 3,400 people registered to attend the CLEANPOWER 2021 convention in Salt Lake City in early December. A panel of two tax equity investors and two lenders talked about the current state of the market. The panelists are Jordan Newman, managing director with Wells Fargo, Steve Schauer, managing director with KeyBanc Capital Markets, Mark Williams, managing director with PNC Bank, and Dave James, managing director with CoBank. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
MR. MARTIN: Mark Williams, how are supply-chain difficulties affecting transactions?
MR. WILLIAMS: They are introducing a large delay factor and some uncertainties. About 60% to 70% of the deals on which we are working and that were scheduled to close in the fourth quarter this year have slipped, at least partially, from 2021 to 2022. I could give you a better answer in three weeks as to how many have slipped, but that is how I would handicap it today.
Fortunately, all the deals for which we provided tax equity that were scheduled to close during the first half this year closed successfully with minimal delays. These earlier deals represented most of our volume for the year.
MR. MARTIN: Steve Schauer?
MR. SCHAUER: We like to have a buffer between when the tax equity funds to pay down the construction debt and the drop-dead dates for funding and for when the project is in danger of losing the power purchase agreement for failure to be completed in time. Those time periods are really contracting. This is a big concern.
MR. MARTIN: How common is it in deals today that projects are backing up against the deadline in the power contract to be in commercial operation or the tax equity investor’s outside commitment date to fund?
MR. SCHAUER: It was happening before COVID. Supply-chain issues have been affecting deliveries of both solar panels and batteries. We are seeing a lot higher demand and a lot more projects. This would have been a challenge even before container ships started backing up at US ports.
MR. MARTIN: Mark Williams said 60% to 70% of the fourth-quarter deals on which PNC is working have slipped from this year to next. Do you have a percentage?
MR. SCHAUER: Right now we are laser-focused on getting closed. We have some 30 deals that we are trying to close between November 1 and year end. Are some of those going to slip? No one is telling me that. We are just working hard.
MR. MARTIN: You said 30 deals.
MR. SCHAUER: We are having a record year. We hope to have closed some 60 project finance deals this year and put something like $3 billion in new capital to work.
MR. MARTIN: Dave James, how have supply-chain difficulties affected your deals?
MR. JAMES: The schedules are getting pushed out and maybe up against PPA deadlines, and sponsors are having to approach offtakers in some cases to ask for more time. Whether equipment is arriving on time or getting stuck in port is definitely affecting closing schedules.
MR. MARTIN: What percentage of your deals have slipped into next year?
MR. JAMES: It is hard to say. Maybe 30%.
MR. MARTIN: Jordan Newman?
MR. NEWMAN: We certainly have had to extend commitments a number of times for a number of different deals this year as projects were running up against PPA deadlines or up against construction debt deadlines. We are probably looking at 20% of the volume that we might have expected to do in 2021 slipping into 2022. It may be just luck of the draw. We saw a significant amount of volume slip from 2020 into 2021. We are also seeing deals on which we are working toward funding commitments in 2022 already being pushed into 2023 because of supply-chain issues.
MR. MARTIN: Slipping into 2023, not 2022?
MR. NEWMAN: Correct. They would have been 2022 deals, but it is already clear that delays will push them into 2023.
MR. MARTIN: So the supply-chain issues are not a short-term problem that will work itself out by next summer?
MR. NEWMAN: It certainly doesn’t seem that way from where I sit.
MR. MARTIN: Mark Williams, the “Build Back Better” plan that is being debated in Congress would increase the tax credits back at least to their full rates and, in some cases, push the ITC as high as 50% for projects placed in service in 2022 or later. Do you see developers delaying placing projects in service until next year in order to qualify potentially for higher tax credits?
MR. WILLIAMS: You would theoretically get higher tax equity investments if there are higher tax credits, but I don’t see a lot of negotiation and planning around that yet.
MR. MARTIN: The developer would be taking a chance in any event. The bill may not pass this year.
Jordan Newman, when a project ends up qualifying for higher tax credits than expected and the term sheet or deal papers have already been signed, do you increase the tax equity investment?
MR. NEWMAN: In short, yes. It is in everyone’s interest for the tax credit to be of higher value. It allows us to put more capital to work, it increases the economic pie for the sponsor and, generally speaking, a deal that has more tax benefits allows us to take less of the cash and still achieve our target return.
We have at least one example of a sponsor that was intending to place something in service this year and is going to hold out in hopes of higher tax credits next year for a PTC project. We have other examples where we structured our commitment to be flexible to allow for funding at the higher level should the tax credits increase.
MR. MARTIN: Let me toggle back and forth between the two tax equity investors for a moment. Mark Williams, as you know, the Build Back Better bill would also let developers get cash payments in place of tax credits. What happens when developers say to the tax equity investor, “I would like to do tax equity, but if I have the option of getting cash, then I would rather dispense with the tax equity and convert the tax credits into cash directly.” Does that work?
MR. WILLIAMS: We have not encountered that issue. I don’t think it would work for a deal to which we are being asked to commit and negotiate fully.
The refundable tax credit is an interesting idea and will generally help the market, but there is a lot of uncertainty about how it will be administered. If you recall the Treasury cash grant days, a number of developers thought they had been shortchanged by the government. There is still a lot of detail that needs to develop around exactly how the new program will function and how reliable it will be.
MR. MARTIN: Steve Schauer, will the lenders lend on a back- levered basis where there is a cash payment and the government could, I assume, have a tax lien over the project in the event the government is owed some of the money back? Does that have to be sorted out before the banks will feel comfortable lending?
MR. SCHAUER: Absolutely. As you know, we like to be first priority during construction with a first lien over all the assets. Post-construction, we have an agreement with the tax equity investor that gives us an assurance that cash flow can be distributed to the sponsor to pay debt service. The priority of the government claim if some of the cash payment were to have to be paid back will definitely have to be worked out.
MR. MARTIN: During the Treasury cash grant era, the Treasury was willing to take a back seat in terms of lien priority in order to facilitate bank financings.
Jordan Newman, what role will there be for tax equity if there is a direct cash payment option?
MR. NEWMAN: There should continue to be a role for tax equity, especially for PTC deals. If you think about the value that tax equity adds, it is not just the tax credits, but also the depreciation.
There are two ends of the spectrum.
At one end, you might have a wind repowering deal where both PTCs and bonus depreciation will be claimed. We are putting in 70% or even 80% of the capital. The depreciation is on the full tax basis without the basis reduction that would happen for a deal with an investment tax credit. That is a lot of value to leave on the table for most sponsors if they cannot otherwise use the depreciation.
At the other end of the spectrum is a solar project that the parties will have to depreciate over 12 years using straight-line depreciation because of DRO issues. We are only putting in 33% of the capital, and our tax basis is reduced by half the ITC. The tax equity is giving hardly any value for the depreciation. Those are the deals where perhaps the direct pay compares more favorably to raising tax equity.
Then there is everything in between.
So perhaps the mix of projects that will seek tax equity will be different than it has been, but we certainly think there is a role for tax equity, and we continue to talk actively with customers about tax equity deals into 2022 and 2023.
MR. MARTIN: Let me understand that. You are suggesting that there will be a greater role for tax equity in wind where tax equity is about 65% of the capital stack on average, plus or minus 10%, as opposed to solar where tax equity is around 35% on average, plus or minus 5%. Wouldn’t the depreciation be largely the same in either case? It is a little higher in wind because there is no reduction in depreciable basis when PTCs are claimed.
MR. NEWMAN: Yes. It is about how much tax basis does the tax equity investor have that allows depreciation to be truly monetized rather than ending up as a suspended loss.
It is true that the amount of depreciation available to the partnership is roughly the same, but the outside basis of the tax equity investor in its partnership interest is lower in a solar deal. The investor is really only giving value in its discounted after-tax cash flow to the tax benefits that it has enough outside basis to absorb. We are providing more value beyond just the tax credits in a wind deal where we start with a higher outside basis and are in a position to absorb more depreciation.
MR. MARTIN: Mark Williams, do you agree with that? There may be less tax equity in the solar market if there is a direct cash payment than there will be in the wind market?
MR. WILLIAMS: The depreciation is still valuable whether the deal is solar or wind.
We are no longer in the very early innings of the industry. There are a lot of major sponsors that have deal papers in place with tax equity investors so that they can do repeat business easily and with little execution risk. Those players will continue to use third-party tax equity.
I agree that sponsors that have struggled to raise tax equity will avail themselves of the direct-pay option and forego the depreciation just to get a deal done.
MR. NEWMAN: I am not suggesting that there will not be tax equity ITC deals. I was just trying to draw the mathematical distinction between the two ends of the spectrum when it comes to monetization of depreciation. There are other ways in which tax equity adds value for ITC projects. For example, the tax credits are higher if the project can be financed in a way that steps up the tax basis as happens when the project company is sold to a tax equity partnership.
MR. MARTIN: Dave James, some solar developers have told us that as many as 30% of PPAs for solar projects still in development have been cancelled because the developers are no longer able to deliver the electricity for the original prices offered. Supply-chain difficulties and inflation are driving up project costs. Have you seen this?
MR. JAMES: I don’t think so. If the deal is in financing, then the developer has already locked in a profitable spread between a fixed price in the PPA and construction costs.
MR. MARTIN: Steve Schauer, have you seen any distressed power contracts in the deals you considered financing?
MR. SCHAUER: What we see, particularly in solar, is that PPA prices have gotten so low that there is usually very little room for back leverage. Most of the back leverage and debt financing in general is in smaller-scale solar. We are lending to a lot more distributed solar projects under 20 megawatts.
MR. MARTIN: Mark Williams, inflation in November was running at a 6.2% annual rate. How, if at all, does that affect tax equity yields?
MR. WILLIAMS: It hasn’t affected them yet. It is likely to affect them in the future. Both Janet Yellen and Jerome Powell said “transitory” is no longer an appropriate word to describe inflation. We see bond spreads and investment-grade bond deals getting wider. The bank market is typically lagging. If inflation persists, then bank spreads will widen, and tax equity yields and debt pricing will increase.
MR. MARTIN: Will they go up opportunistically? Or is it simply that a higher cost of funding will have to be passed through?
MR. WILLIAMS: The cost of funds will increase. As the Fed reins in bond purchases, interest rates will increase.
MR. MARTIN: Dave James, what other effects has inflation had on debt or tax equity?
MR. JAMES: Banks will be scrutinizing cost line items in the financial model with an eye to whether the project will generate enough free cash to cover debt service.
We have not seen any widening of the LIBOR spreads in our deals due to inflation, but it could be coming.
MR. MARTIN: Steve Schauer, where are interest rate spreads currently in the debt market?
MR. SCHAUER: We are seeing interest rates on back-levered term debt in solar projects that are down the middle of the fairway in terms of risk at 125 or maybe 137.5 basis points.
MR. MARTIN: Above LIBOR?
MR. SCHAUER: Yes. For SOFR, you would add another 12.5 basis points. SOFR spreads have not been worked out yet. SOFR is more trouble to swap because the full range of debt tenors is not available yet. For small-scale solar, we see LIBOR spreads in the 150- to 200-basis-point range.
MR. MARTIN: How do you define small-scale solar? Twenty megawatts?
MR. SCHAUER: Portfolios of solar projects that are under five megawatts each. We have probably closed seven of those transactions this year for various sponsors, both big and small.
MR. MARTIN: So interest rates basically have not moved this year. At the start of the year, if I had asked you what the LIBOR spread is on utility-scale solar debt, you would have said 125 to 137.5 basis points.
I was looking at a loan agreement yesterday. It will use a SOFR rate, and the spread is 100 basis points higher than the LIBOR spread. Why? You said it difficulty swapping. Is there more to it?
MR. SCHAUER: They should come talk to us. We are not charging anywhere near 100 basis points more.
MR. JAMES: Any new deals signed obviously have to be documented in SOFR. We have not really gotten into what the impact of that is on pricing.
MR. MARTIN: Why would the spread be higher? Is it because SOFR is a more volatile metric?
MR. WILLIAMS: It an inherently risk-free type rate. It does not build in a credit risk, so you have to build in a margin above SOFR, and the market has not really settled on what that is.
There have been suggestions for three-month SOFR that it is around 25 or 26 basis points, but my observations are—and these are my observations, not necessarily PNC Bank’s opinion—that there are a lot of administrative, logistical and regulatory issues that need to be worked out before we have smooth sailing in terms of the LIBOR transition.
MR. MARTIN: Steve Schauer, what is the current advance rate for construction debt on utility-scale projects? Eighty-five percent? 90%, 95%?
MR. SCHAUER: We see a wide range. On solar, you mentioned that tax equity accounts typically for 35% of the capital stack. We will advance 95% to 98% of the expected tax equity investment.
Term loans are all over the map. We will make a construction loan for 100% of what the project can support as a term loan. How much debt the project can support turns on the electricity price in the PPA. It would typically be 80%, but it could be as high as 90% or as low as 70%. We see a fairly wide range of construction loan advance rates.
MR. MARTIN: Mark Williams, do you see the same thing?
MR. WILLIAMS: We see around 90% for the construction loan and around 98% for the tax equity bridge loan in plain-vanilla transactions with top-tier sponsors, top-tier EPC contractors and an investment-grade tax equity investor.
MR. MARTIN: Jordan Newman, where are current flip yields for partnership flips?
MR. NEWMAN: Tax equity is always reticent about giving specific yield figures publicly. I will say that they have been remarkably stable this year after ticking up a notch at the beginning of the pandemic.
MR. MARTIN: I would put them in the 6% to 8% range, although we have seen some a little below six.
MR. NEWMAN: That is a fairly wide range, so I would describe that as accurate.
New Asset Classes
MR. MARTIN: The Build Back Better plan would create a new tax credit for standalone storage. It would create another new tax credit of up to $3 a kilogram for making clean hydrogen. There would also be enhanced credits for carbon capture. Are all of you interested in financing these types of projects?
MR. JAMES: Most still have new technology risk. One type of storage—pumped-storage hydro—is pretty limited by geography. There are not very many of those deals. In anaerobic digestion projects, it is hard to predict what P50 production will be and, therefore, what the cash flow is that you can reliably lend against. We are seeing more and more of these deals being proposed. Lots of people are interested in renewable natural gas. I think those projects can get done.
MR. MARTIN: So for hydrogen, some types of standalone storage and carbon capture, not yet?
MR. JAMES: Clean hydrogen is not really far enough along. Some types of projects may not qualify for construction debt and may have to be financed in portfolios of projects to spread the risk of a single bad project, again to reduce the risk.
MR. MARTIN: Renewable natural gas seems to be a fancy new name for what used to be called methane from cow manure. [Laughter] Jordan Newman?
MR. NEWMAN: We are very interested in all the new asset classes that either have potential new tax credits offered or, like offshore wind and carbon capture, have had recently enhanced tax credits, but the transactions are just starting to take form.
Each new asset class presents its own set of challenges. For carbon capture, for example, we have to wrap our heads around an entirely different type of technical analysis that is very different from renewable energy. We have to think about feedstock risk in a way that we have not had to think about with renewable energy.
We are out in the market talking with sponsors of carbon capture projects now, and we will probably be doing our first commitments for carbon capture in 2022, with capital going out the door after that.
MR. MARTIN: Are you aware of any tax equity deals that have closed involving section 45Q tax credits?
MR. NEWMAN: I am not aware of any, certainly not any deal that has funded.
As you expand out to the other asset classes, we are definitely interested.
MR. MARTIN: We are down to less than 10 minutes. Let me do a quick lightning round.
US Customs is blocking a lot of solar panels. One Chinese vendor told us as many as 80% of Chinese branded equipment is not getting into the US. How is this risk being handled in financings?
MR. JAMES: If the panels are not already in the United States, then the related construction funds will not be released. You might be mid-construction and US Customs holds up a shipment of panels, and you have a problem at that point. Lenders will take a hard look at whether to continue to fund. They will want a sponsor guarantee in some cases to ensure repayment.
MR. SCHAUER: I agree.
MR. MARTIN: The “pay fors” in the Build Back Better bill include a book minimum tax. Big companies with more than $1 billion a year in average financial statement income over the past three years would pay 15% of the current-year financial statement income to the extent it exceeds the regular corporate income tax. How will this affect the tax equity market?
MR. WILLIAMS: The effect is unclear at this point.
MR. MARTIN: Jordan Newman, has Wells Fargo done any analysis?
NEWMAN: Yes. The issue is the effect on monetization of depreciation. There is obviously some risk that there would be a loss in value from the depreciation. Tax depreciation is taken over five years on a front-loaded basis. Financial statement depreciation is straight-line over the useful life of the project.
Generally speaking, in the tax equity market, the ability of the tax equity investor to use the tax benefits has been borne by tax equity. It is one of the main risks that tax equity bears.
MR. MARTIN: Will that change?
MR. NEWMAN: I think when the BEAT tax was imposed in the tax bill at the end of 2017, a few investors tried to push that risk to sponsors. I think a few deals were done that way, but for the most part . . .
MR. MARTIN: Not many.
MR. NEWMAN: The book minimum tax feels to me like it is in the same bucket of the type of risk that tax equity has borne and will continue to bear.
MR. MARTIN: The Build Back Better bill would also require that the same “prevailing wages” that the federal government pays on its construction jobs be paid during construction, and also on alterations and repairs for five or 10 years after the project has been completed, to qualify for full tax credits. These wages do not have to be paid by the solar or wind company itself, but by the construction contractors and subcontractors who are hired to work on the project.
Is this starting to play a role in any deals on which you are working?
MR. WILLIAMS: I haven’t seen it come up yet. Tax equity investors will ask for an indemnity from the sponsor to cover any recapture risk.
MR. MARTIN: How does 2022 look to you in terms of deal volume? We talked earlier about projects slipping, some into 2022, some even into 2023. How will the deal volume be affected by whether the Build Back Better bill is enacted?
MR. SCHAUER: I mentioned that 2021 was very strong. We expect 2022 will remain strong. You have a whole series of wind projects that were built in the 2009 through 2012 time frame that are ready for repowering. Solar kicked in two or three years later, so we see a lot of potential repowering in solar as well.
There should be lots of demand for tax equity, bank financing and even institutional debt. Institutional lenders and the project bond market will be looking to do more ESG investments that promote clean energy. We closed our first institutional loan earlier this year for a small solar developer as a refinancing and recapitalization, single-B credit. We are seeing a wave of that type of financing starting to come to market.
MR. MARTIN: These are refinancings?
MR. SCHAUER: This was actually triple leverage. There was tax equity, back-levered debt and then a further subordinated loan at the holding company level. I think there will be more of this type of capital available to sponsors to fund projects. It is a form of term lending rather than construction debt.
MR. MARTIN: Does it matter if the Build Back Better bill is enacted? How would it change the forecast?
MR. SCHAUER: It would be phenomenal for our business.
MR. MARTIN: The market will feel like a treadmill turned up to warp speed.
MR. SCHAUER: Yes. We are hiring.
MR. MARTIN: How has the “great resignation” affected the ability of the market to close deals? Working 22 or 23 months from home has given all of us a chance to reflect on life. Six percent of the US workforce quit in just August and September this year.
MR. SCHAUER: Most of our young people are back in the office. Some people are already traveling a lot. There is a mix. As a new junior banker, some of them decide they don’t really like the business and move on to something else, but for the people who like it, it is a really powerful business to be in and . . .
MR. MARTIN: This is your speech to KeyBanc employees, right? [Laughter]
MR. SCHAUER: Not only that, it is to all of you out there and your sons and daughters. Banking is awesome. [Laughter]
MR. MARTIN: Stephanie Ruhl of MSNBC said to the younger people, “You need to come into the office because if you don’t establish relationships, you have a job, not a career.”
MR. SCHAUER: Totally true.
MR. MARTIN: Let me make sure we get in one more topic and that is casualty insurance premiums. They have gone up four and five times for solar projects. We have seen sponsors send notices to bankers and tax equity investors in deals that have already been financed that they cannot find casualty insurance at affordable premiums. What happens in that case?
MR. JAMES: You still need casualty insurance. It will cost more, so it will reduce the amount of debt the project can support.
MR. MARTIN: What if the project has already been financed?
MR. WILLIAMS: Most lenders and tax equity investors are loathe to go for an extended period without insurance. We have seen sponsors ask to have increased deductibles that go above and beyond what was in the documents. It has to fit within the budget. If it breaks the budget by more than 10%, then consent is required to spend the additional money. So far, things have been working out. Projects eventually find insurance.
MR. MARTIN: Are you seeing other effects from climate change? I know we have worked on projects that have been damaged by hailstorms, lightning strikes, flooding, hurricanes and wildfires.
MR. NEWMAN: Ice storms.
MR. MARTIN: Ice storms in Texas.
MR. NEWMAN: It certainly seems like one-in-500-year events are happening more than every 500 years. In addition to affecting insurance, it feels like there is more uncertainty around electricity output. For example, the wildfires in California put smoke in the air that reduced the output from solar modules.
MR. MARTIN: Output forecasts have been less reliable in certain parts of the country. What adjustments are financiers making to forecasts? Do you accept them? What do you do to them in the back room?
MR. SCHAUER: We are trying to hold the line on reducing coverage ratios.
MR. JAMES: I think that’s right. You want to sensitize a little more around production estimates, but I think the science of estimating solar resources is advancing, especially after we have seen industry wide that solar output has been maybe 6% on average below forecasts. Those types of revelations help the market become more efficient.
Other New Risks
MR. MARTIN: This is my last question. Are there other, new risks that have shown up in the renewable energy market this past year that we have not discussed?
MR. SCHAUER: I see one other issue involving offtake contract structures. We are seeing a lot shorter power contracts, especially on the east coast. We don’t see a lot of long-term contracts in PJM unless they are with corporate offtakers. The financing parties have to be nimble enough to deal with variations in offtake arrangements, from traditional utility PPAs all the way to New York feeder offtake agreements. Analyzing the different arrangements is taking a lot of time.
MR. NEWMAN: I echo that. It is not necessarily new, but the cash flows that we are being asked to underwrite have been substantially more volatile and less predictable.
This is especially true in markets like ERCOT and SPP, but really all over where you might have a project that has three different offtake arrangements that maybe only cover 80% of the capacity. All three of them are settled at a hub, so there is electricity basis risk and a merchant component, and there might be some kind of floor or upside sharing. There is a mix of different types of offtakers with different credit profiles. That puts a lot of stress on the downside scenarios.
MR. MARTIN: You must discount the cash flows in such cases when sizing the tax equity. How much of an adjustment do you make?
MR. NEWMAN: It is not so much a matter of adjusting the discounting as running downside scenarios and making sure that you are looking at a reasonable flip tenor, or even more fundamentally whether the project will have the liquidity to continue to operate and generate production tax credits. We are layering on top of the production downside curtailment, availability and basis risk. Having a large, geographically dispersed portfolio helps to diversify the risk.
MR. MARTIN: It requires a lot more intellectual capital to pull off these deals. Any other new risks?
MR. WILLIAMS: The new risk is the cumulative impact of all the factors we discussed. We haven’t had this level of uncertainty in terms of tax law, in terms of inflation, in terms of supply-chain difficulties and labor shortages, in terms of pricing, and all of that has contributed to a reluctance on the part of sponsors to lock in long-term offtake contracts because they think prices may be higher in a few months. That has contributed to more delay.
People are moving forward, but cautiously. There is an unusually large number of moving parts.
MR. MARTIN: That will be the last word. This may be a case of “May you live in interesting times.”