Tax credit sales
The Inflation Reduction Act lets companies sell nine types of federal tax credits to other companies for cash. The window opened on such sales on January 1. Many people have been interested in how quickly the market will develop and at what prices tax credits will trade. Five market veterans discussed these and other questions during a live podcast at the end of April.
The panelists are Jack Cargas, managing director and head of tax equity origination for Bank of America, Rubiao Song, managing director and head of energy investments for JPMorgan, Ted Brandt, CEO of Marathon Capital, Jamie Stahle, senior managing director of the CCA Group, and Billy Lee, president of Reunion, which is one of several digital platforms to match tax credit sellers with buyers. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
MR. MARTIN: Jack Cargas, how would you characterize the tax credit sales market? Are deals closing? Is there strong interest, or is it just getting started?
MR. CARGAS: The market is really just getting started. There are a few deals that have closed, including by Bank of America, but many market participants continue to await guidance from the Treasury. There is strong interest in the concept of tax credit transfers, as indicated by the size of your audience. But at this early juncture, that interest is coming more from prospective sellers than from prospective buyers.
MR. MARTIN: Rubiao Song, same question.
Mr. SONG: It has been a slow start, but that should not be a surprise. We are still waiting for Treasury guidance. Potential buyers and sellers are still in the price discovery phase. We see a lot of letters of intent being signed and due diligence documentation underway, but there is no actual cash changing hands. That will have to wait until the guidance comes out.
MR. MARTIN: Ted Brandt, what is your sense of the market?
MR. BRANDT: We have been focused on trying to expand the market by finding additional investors, particularly around section 45Q tax credits for carbon capture where we are seeing acute shortages of supply versus demand. It is very early, and everybody is waiting for guidance. We have seen some incumbent investors trying innovative new structures. We are hearing lots of talk. We have not seen a lot of closings.
MR. MARTIN: Jamie Stahle, your view?
MR. STAHLE: No large-scale transactions have closed yet. A number are in various stages of diligence or LOI execution. Everyone is waiting for guidance. The good news is there is a lot of forward activity from a number of players that have an interest in in developing this market.
Some of the issues that are probably limiting the activity currently, at least among bank and insurance company buyers, is figuring out what the regulatory or capital requirements are going to be for this type of product. Sellers are still trying to assess how tax credit sales compare to other possible transactions.
MR. MARTIN: Billy Lee, how do you view the market?
MR. LEE: We are seeing strong interest on both the buy side and sell side. We are actively working on documenting a few transactions and have a number of term sheets outstanding. The market is young, but developing rapidly. We are super excited to be part of it.
MR. MARTIN: We are seeing prices mainly in the 90¢ to 92¢ range per dollar of tax credit, but there are some deals in the 80¢ range and we are seeing some creep higher, like 93¢. Billy Lee, where are you seeing prices settle?
MR. LEE: The 90¢ to 92¢ range is generally what we are seeing currently for projects that are placed in service in 2023.
MR. MARTIN: Ted Brandt, do you agree?
MR. BRANDT: Yes.
MR. MARTIN: Many people believe prices will go up over time as more buyers come into the market. Where do you think they will settle ultimately?
MR. BRANDT: It is really important to bring duration into the conservation. A credit is worth a certain amount from the settlement date until the next quarterly estimated tax payment date when the credit will be used. The other variable besides duration is the creditworthiness of the seller. For ITCs, the sale is a one-time transaction. For PTCs, sales occur over time and sponsors will probably want to borrow against the future payment stream. Borrowing against a future payment steam requires an investment-grade buyer. Both duration and creditworthiness will affect pricing.
MR. MARTIN: Does anyone else want to weigh in on pricing?
MR. STAHLE: We agree about the current price range of 90¢ to 92¢, although it depends on when the seller will receive the proceeds. There is still some question around whether the actual payments will be made in the current year or the following year. That has a bearing on the present value of the purchase price payments.
When you move away from some of the larger-scale, more mature projects to newer technologies and asset classes, you start to see some divergence in price based on the characteristics of the project or the counterparty. That is particularly true of PTC deals, because there is a lack of liquidity and investor depth in that market. It is harder in that market to get a real beat on where pricing will settle.
MR. MARTIN: Jack Cargas, we just heard that prices will vary by type of tax credit, by creditworthiness of the seller and by when the buyer must pay for the tax credits. Why should prices vary by type of tax credit?
MR. CARGAS: I think it depends on the buyer. Some buyers may find ITCs less attractive than PTCs due to recapture risk. PTCs are often financed on a pay-go basis, meaning purchased in arrears, so there is minimal tax-credit risk. ITCs, on the other hand, might be paid for in advance and remain subject to recapture risk over the next five years.
MR. MARTIN: Playing it out further, are all PTCs equivalent? For example, would you expect wind PTCs to price at the same level as carbon capture PTCs?
MR. CARGAS: Potentially, but the perceived creditworthiness of the seller is important. To the extent a seller is offering a legal conclusory representation backed by an indemnity, or perhaps a seller can provide strong evidence of the provenance of the tax credits, for example, to prove the PTCs emanated from that wind turbine with that serial number, the PTCs may be more attractive and command a slightly higher price.
MR. MARTIN: Rubiao Song, do you agree with what Jack just said about differences in pricing for different types of tax credits?
MR. SONG: Yes. Duration is a significant differentiating factor, such as whether you are talking about a 2023 tax credit or a five-year commitment.
The type of tax credit also matters as Jack mentioned: whether a PTC is from a certain wind farm that can be easily traced or whether it is a section 45Q or 45V tax credit. It will take some time to make investors comfortable with newer types of tax credits. There will not be as deep a market for them, and that will affect the price.
Another issue with ITCs besides recapture risk is tax basis risk.
New Asset Classes
MR. MARTIN: Jamie Stahle, do you expect much of a market for things like section 45Q credits for carbon capture, 45V for making clean hydrogen, 45Z for making clean transportation fuel, and 45X for manufacturers who make components for wind, solar or storage projects?
MR. STAHLE: In time. By the time many of those new types of projects are built, the market probably will have evolved and be better educated about them. The price depends on demand and supply. However, we expect wind and solar tax credits about which the market is already familiar to fetch better prices than the newer credits that sponsors will be trying to sell into a more shallow market.
MR. MARTIN: You are assuming that the buyer is exposed to audit risk. If a buyer of 2023 tax credits has an all-events indemnity and the IRS pursues solely the seller after an audit adjustment, should the buyer really care whether the tax credits are section 45, 48, 45Q, 45V, 45X or 45Z credits?
MR. STAHLE: Yes. The newer credits have added complications. That said, to the extent you have a creditworthy seller, that probably gets people to a point of comfort. This market will have to broaden beyond the universe of existing tax equity investors. The more complicated the risks are to understand, the more limited the universe will be of investors. Sellers will have to find a way to wrap all of the risks.
MR. SONG: Traditional tax equity investors will not fund into an indemnity. We will do at least part of — and in many cases most of — the same diligence we would do in a traditional tax equity deal.
MR. MARTIN: What if the Treasury ultimately says the person exposed to audit risk is the seller? I suppose it is hard to imagine the IRS will release buyers completely from audit risk.
MR. SONG: It is not expected and, even if it were, large corporations are usually not comfortable entering into transactions for tens of millions of dollars without careful diligence.
MR. MARTIN: Billy Lee, how much diligence do you expect buyers on your electronic platform to do?
MR. LEE: In the early days, I think there will still be diligence of the kind everyone has been talking about. Over time, we are trying to commoditize the tax credits and transactions.
I am more bullish than my fellow participants that a tax credit is a tax credit.
We are building a marketplace that facilitates trading of these credits. We see three critical pillars to have a successful marketplace.
One is having a deep supply of tax credit buyers. This will obviously be an education process.
Another is portfolio diversification. We need to offer projects from multiple sponsors and different technologies. When most people think tax credits, they think wind, solar and storage, but let's not forget biogas, carbon capture, hydrogen and so on.
Finally, we need a robust technology, meaning a platform that not only standardizes diligence but also organizes and increases the velocity of transactions and achieves risk diversification that you can't achieve in purely bilateral transactions. That type of portfolio diversification takes some of the pressure off individual transactions and reliance on indemnities from creditworthy sponsors.
Our vision is to run regular auctions that settle based on buyer bids and seller asks for both spot and forward contracts. Ultimately, we are trying to provide liquidity, efficiency and transparency in pricing.
MR. MARTIN: Ted Brandt, coming back to you, will PTCs be sold on a year-by-year basis or do you expect forward sales?
MR. BRANDT: We expect a combination, but a lot depends on how the projects are financed. There is no real secondary market for tax credits today, even if the PTCs are separable, because the full 10 years of tax credits are spoken for in a tax equity transaction.
The big question is whether new structures will emerge that allow the financing to occur in such a way that there will be some flexibility as to when sales occur. We are working on a model that would convert PTCs into a quarterly-in-arrears sale, and we think there will be some buyers that will want 40 quarters and some buyers that will want two quarters.
MR. MARTIN: Jack Cargas, do you agree with that and, if so, will buyers in forward sales be willing to pay upfront as in a tax equity deal or only over time as the tax credits are claimed?
MR. CARGAS: I think we will see three approaches.
One is on a year-by-year basis in arrears. That could be where a company is just looking to manage its effective tax rate. I think we will also see PTCs sold on a forward basis for maybe five or 10 years where the buyer pays a stated discounted price up front to purchase of all of the projected PTCs from a particular project. Then possibly we will see tax credits trade on a hybrid basis where the purchaser pays at the outset a portion of the overall projected value of the PTCs and then commits to buy any excess PTCS above that upfront portion on a pay-go basis, probably paying those amounts in arrears after the PTCs are actually earned.
MR. STAHLE: I agree with Jack. There will also be capital providers that want to staple together different pieces of capital with a PTC transaction.
There may also be investors with long-term liabilities that are willing basically to commit to tax credit transfers in exchange for being able to apply different forms of capital — term loans or what have you — to the transaction that acts as a surrogate for filling the capital gap that needs to be filled with a prepayment. Jack mentioned a variation on that theme, but there are various ways you can structure it to adapt to different investors who are looking to add assets to their balance sheets.
MR. MARTIN: Many people listening will wonder why have the two biggest tax equity investors on this call. Aren't they competing against tax credit sales? But in point of fact, you two have been major buyers of tax credits as the market starts to take off, or at least you are negotiating such purchases. Why buy tax credits rather than do traditional tax equity deals?
MR. SONG: We are still primarily a tax equity provider, but the ability to buy tax credits directly gives us another tool to help clients on certain projects. The diligence is a little lighter than in a full tax equity deal. It is less resource-intensive for our clients.
MR. MARTIN: Jack Cargas, I know you are both investing tax equity and buying tax credits. Why do one or the other?
MR. CARGAS: We plan to continue to do both. We are building a strong inter-disciplinary team to tackle all of this. We want to be a major participant in this market for years to come.
We can imagine circumstances where we enter into a tax equity partnership where perhaps we keep 50% of the tax credits and the partnership sells the other 50% to a corporate buyer.
We are also seeing transactions where sponsors choose simply to sell tax credits and not do a tax equity deal. We think we can help make that market. An example is a merchant project that is not a good fit for tax equity, but the sponsor can't use the tax benefits.
There could also be cases where the sponsor has enough tax capacity itself to use the depreciation, but doesn't have enough to use the tax credits. We want to be able to make that market, too.
MR. MARTIN: The ability to sell also gives the parties more time to syndicate the tax equity position.
MR. MARTIN: Billy Lee, what sort of indemnities will your buyers expect?
MR. LEE: For now, anything in the control of the developer will need to be indemnified. For ITCs, tax basis and recapture risk will have to be indemnified by the developer. Obviously, the developer will also have to agree to post-closing covenants against major renovations that could trigger ITC recapture.
We expect over time that many tax credit buyers will not have had experience with renewable energy. We need to be able to offer as low-risk a proposition as possible to expand the number of tax credit buyers.
MR. MARTIN: What you described sounds like an indemnity for breach of representations and warranties as opposed to an all-events indemnity.
MR. LEE: I am not sure exactly how the market will develop, but those are the primary risks in an ITC transaction that will have to be borne by the seller. Also, we don't have structural risks to worry about as with a full tax equity partnership transaction, meaning the risks that the transaction has been properly structured to transfer tax benefits.
MR. MARTIN: Jamie Stahle, in the term sheets on which you are working, how are the indemnities structured? Are they reps-and-warranties or all-events indemnities?
MR. STAHLE: It depends on the buyer. The traditional tax equity investors will want indemnities that look like they get in their current tax equity deals. Pure tax credit buyers with little understanding of renewable energy probably need something broader.
MR. MARTIN: Ted Brandt, will smaller companies that are less creditworthy have a tough time selling tax credits and will they need an insurance policy to stand behind the tax indemnities?
MR. BRANDT: Time will tell. I hope Billy's optimism turns out to be warranted. We at Marathon expect insurance to be required. We think there needs to be the equivalent of title insurance to cover risk that the tax credit was fraudulent or otherwise deficient. All of a sudden, the buyer has some explaining to do internally and will need to get its money back, probably grossed up for all the additional expenses.
MR. MARTIN: Jack Cargas, will Bank of America as a tax credit buyer routinely require tax insurance?
MR. CARGAS: Not routinely. It depends on the seller. If the seller is a long-time, experienced and trusted operator, we may be comfortable with standard fact-based representations and indemnities. If it is a new asset class to the market or the seller, then we will need indemnities more like what Ted described.
MR. MARTIN: Rubiao Song, you said earlier that deals are being signed, but the Treasury will have to issue guidance before people actually make payments. What guidance do you feel the Treasury needs to issue to conclude deals?
MR. SONG: Mostly on procedural questions. An example is what documents have to be given to the IRS before the actual tax credit transfer can happen. Other questions are whether the tax credits can be transferred to multiple transferees, how the partnership capital accounts will be credited or debited in cases where a partnership owns the project, and whether transferred tax credits can be used to offset current-year estimated tax liabilities.
The Joint Committee on Taxation answered other questions in a document it released last week. It answered questions about imputed interest and whether buyers have to report the discount they receive to the full credit amount as taxable income.
MR. MARTIN: Our experience is deals are moving forward anyway, although there are some questions people want answered.
MR. STAHLE: Another big question is whether PTCs on projects that were already in operation before 2023 can be sold. There is a high confidence that they are, but the market would appreciate confirmation. The answer has a pretty big bearing on the volume of PTCs that would be available.
MR. MARTIN: Billy Lee, how complicated do you think tax credit sales on your electronic platform will be to document?
MR. LEE: Putting aside whether the sale is on our electronic platform or in a bilateral transaction, I think it will be far less complicated than tax equity. I have done many tax equity deals in my career. There are no partnership or equity capital contribution agreements to negotiate. The buyer is not making an equity investment into a project.
That said, it will be a lot more complicated than a short as-is purchase agreement. If you are talking to a seller about buying tax credits and you get a two-page purchase agreement, buyer beware. There should be a host of representations and warranties, pre- and post-closing covenants, conditions precedent, indemnities, and so on.
MR. MARTIN: I should say I have seen term sheets anywhere from three pages to 31 pages, so there has been a wide range of approaches as the market evolves. Jack Cargas, will buyers like you require tax opinions?
MR. CARGAS: Yes. Buyers are going to want an expert to confirm they will be entitled to claim the tax credits.
MR. MARTIN: Rubiao Song, large tax equity investors like JPMorgan and Bank of America have been capping the basis step-ups they will accept in tax equity transactions involving investment tax credits at 15% or 20% above construction costs. What happens in tax credit sales?
MR. SONG: We will enforce the same policy.
MR. MARTIN: Step ups will be less common when a developer is just selling the tax credits, unless the step up is done by combining a traditional tax equity structure with a tax credit sale.
Another question: if a tax equity partnership sells tax credits for 90¢ on the dollar, what gets credited against the tax equity investor's yield? Is it the full dollar tax credit or only 90¢?
MR. SONG: That is a negotiated point, but we think the right answer is only 90¢ gets credited rather than the full amount of the credit.
MR. MARTIN: Jack Cargas, what is your view?
MR. CARGAS: The tax equity investor would prefer to credit only the 90¢, but the sponsor is going to want a credit of the full dollar, especially if the flip date gets delayed solely because the tax equity investor directed the partnership to sell part of the tax credits.
It is one of the most interesting questions in the market. It will have to be answered on a deal-by-deal basis. Opinions differ as to how it will play out. It matters what kind of a deal you negotiated with the seller, what size deal it is, and maybe what the tax credit pricing is. If the tax credits are sold for 99.5¢, then it will not be a big negotiation, but if they are sold for 90¢, that could be a pretty significant negotiation.
MR. MARTIN: Ted Brandt, are depreciation-only tax equity deals feasible?
MR. BRANDT: We have not seen demand for them on the investor side. In the various tax-credit-sale structures on which we have been focused, the glaring deficiency is the depreciation does not get monetized. Our initial conclusion is that on the higher net-capacity-factor PTC deals, selling tax credits is still worthwhile, despite being unable to monetize the depreciation. The answer may be different if the project has a low capacity factor.
This is a rapidly developing area. Who knows where the market will land. If this market takes off, there will certainly be a huge amount of stranded depreciation left on sponsors' balance sheets. We should all pray that an investor base will develop that will monetize depreciation.
MR. MARTIN: Jamie Stahle, what other issues are you seeing in tax credit sales?
MR. STAHLE: On the depreciation question, some hybrid structures are being used where the project is sold to a tax equity partnership to monetize the depreciation, and the partnership sells the tax credits. That is probably the solution for dealing with stranded depreciation.
MR. MARTIN: Are there other issues anyone else wants to mention that are coming up in transactions?
MR. SONG: Insurance is in short supply, particularly when it comes to buying storm or hurricane insurance. That is an issue in ITC sales where the tax credits could be recaptured after a casualty affecting the project and in forward PTC sales if a large share of the purchase price is paid up front.
MR. CARGAS: Another issue is the 15% global minimum tax, otherwise called Pillar 2. Other countries could impose a top-up tax on large multinationals to the extent they use tax credits to reduce their US tax bills. Treasury has been working with the other OECD countries, but there is no clear solution in terms of exemption for US renewables credits.
MR. STAHLE: Another issue is the challenge for corporations to be able to forecast future tax liabilities. It is an execution risk.
MR. MARTIN: Rubiao Song, you, Jack and I were on a cost of capital outlook call in January. Both of you said then you expect the tax equity market to be $20 to $21 billion this year. That's not tax credit sales. It is traditional tax equity deals. Is that still your expectation four months into the year.
MR. SONG: It still looks good. There are a lot of constraints in terms of tax and regulatory capital capacity. However, some tax equity investors who sat on the sidelines for a couple years are now coming back. We also see some new entrants, particularly from corporations who are very much ITC focused. There was also a good development on accounting for tax credits. Adoption of proportional amortization would solve a lot of issues for PTC investors. We are seeing a robust tax equity market this year.
MR. MARTIN: So it sounds like, if anything, we will be on the more optimistic end of the estimated range. Jack Cargas, do you agree?
MR. CARGAS: Twenty billion remains our best estimate. We are already seeing a few deals slip over year end.
Your real question may be whether we think tax credit transfers will take deals away from the tax equity market. We see tax credit sales as additive and even complementary in some transactions.
As for how large the combined tax equity and tax credit sales markets may be this year, there is obviously a lot of speculation. The Joint Committee on Taxation estimated the price tag of the climate bill would be $369 billion over 10 years. We saw one respected market observer state that it foresees an annual tax credit transfer market alone of $60 billion within a few years. Assuming that is accurate, you might be talking about a tax equity plus tax credit transfer market of $70 to $80 billion a year within five or six years. That may be overly optimistic, but my overall point is that we expect tax credit sales to be additive.
We expect the market to grow after the Treasury guidance is issued. We expect there to be interest in many of the new tax credits. Nine new credits were created.
MR. MARTIN: Jamie Stahle, what types of entities are the current buyers?
MR. STAHLE: The buyers are both new entrants and existing tax equity investors. Some new entrants are focused on managing their tax positions. They may be subject to the new book minimum tax or have high effective tax rates. Some have an ESG focus and want to encourage renewable energy.
Then there is a third group, which is investors that are offering other capital and have tax capacity that they can use to win deals. Examples are life insurance companies and non-US companies with active subsidiaries here who want to add assets to their balance sheets.
MR. MARTIN: Billy Lee, do you expect all of the above on your electronic platform? Do you expect other types of buyers beyond what Jamie Stahle described?
MR. LEE: A lot of the focus on this call has been on large corporates with large tax bills. That is obviously a very interesting sector, but let's not overlook the medium-sized corporations that have some tax liability and maybe have even participated in tax equity deals before. The tax equity market has struggled for years to attract new corporate tax equity investors, because the transactions have been too complicated, too far from these companies' core businesses, and the deals have had unattractive GAAP treatment. The fact that the tax credits were always on the verge of expiring did not help. Transferability and the IRA solve all these problems.
Lots of medium-sized companies pay significant taxes and have treasury departments that look at tax credit purchases as just another tool in the toolbox to do short-term treasury planning. We are really excited about them.
Another category is corporate purchasers of renewable energy. They should emerge over time as buyers of tax credits. Over time, chief sustainability officers will think more about using tax credit purchases as a tool in their overall company sustainability impact goals. That is another focus of ours in terms of educating the market.
MR. MARTIN: We have a couple hundred audience questions. Yesterday, the House passed a debt ceiling bill that basically repealed most of the Inflation Reduction Act. It is not expected to pass the Senate. Is the House vote to repeal having any effect on the market?
MR. CARGAS: Keith, I usually look to you on these matters, so this is a role reversal. It is hard to tell what can happen in gridlocked Washington. I personally don't think the vote will affect the market.
MR. MARTIN: Several listeners are asking about wage and apprentice requirements and what sort of substantiation tax credit buyers will require that those requirements have been met or that the project is exempted. Rubiao Song, what is the answer?
MR. SONG: Still developing. Most of the projects we are working on today are exempted from the wage and apprentice requirements.
MR. MARTIN: Ted Brandt, several listeners are asking about the availability of bridge debt. If you have 10 years of PTCs to sell, will a lender provide bridge debt to convert the 10 years of tax credits into current cash?
MR. BRANDT: Our survey is we don't think lenders are willing to take unguaranteed PTC price risk. There probably needs to be some type of an insurance policy that will take that risk, and we are working on a solution. Even the mezzanine lenders are saying that they would probably not take that risk on a pure nonrecourse basis.
MR. MARTIN: We heard from some lenders who say they are negotiating bridge loans. We saw a proposed advance rate of 50% in one deal. Others are still in negotiation.
MR. BRANDT: I don't think 50% will be attractive to the sponsors, but we are all getting educated.
MR. MARTIN: A lot of listeners are asking about tax basis step ups in tax credit sales. That is a little too complicated a subject for the last two minutes of this call. Here is another question multiple listeners are asking: will lenders be allowed to have a first lien on project assets in cases where the tax credits are sold?
MR. BRANDT: The premise on which we have been working is that there can be traditional senior debt combined with insurance.
MR. SONG: The ability to take a first lien of the assets is not a foregone conclusion. In an ITC deal, if the lenders foreclose, it could trigger ITC recapture. If there is insurance, great. If not, the lenders are going to have to agree to forebear from foreclosing in a manner that would trigger ITC recapture. In most tax credit sales deals at which we are looking today, there is no senior debt at the project level.