Disappearing tax equity
Tax equity is emerging as a potential major choke point for the US renewable energy market. Many developers are having difficulty finding it this year. Without it, some projects that would have been built this year will be delayed. Large bank loan loss provisions and tax credit carryforwards are making it tough for banks, which are the dominant tax equity investors, to forecast tax capacity not only for this year, but also for 2021.
Tax equity investors from five banks talked during a conference call in late July about the condition of the US tax equity market. The investors are Robert Capps, managing director for tax equity origination for SunTrust, Eric Cohen, group head of renewable energy finance for Fifth Third Bank, Eric Heintz, director of energy financing for M&T Bank, Scott McClain, executive vice president and head of equipment finance for First Horizon Bank, and Yonette Chung McLean, a managing director on the tax equity desk at RBC Capital Markets. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
Still Doing Deals?
MR. MARTIN: This is the third in a series of calls since late March on the condition of the tax equity market. One problem with these calls has been the impression given that it is largely business as usual for tax equity this year, when clearly it is not. Many developers are having trouble this year raising tax equity.
We start this call with someone who is currently out of the market. Robert Capps from SunTrust, what is the story there?
MR. CAPPS: SunTrust and BB&T merged late in 2019. In early Q2, when we began formulating a forecast for the combined company and adding in the COVID impact on the economy, that led to a fairly conservative forecast of what our tax capacity might be going forward.
We also had to take into account some one-time expenses of the merger and the current very low interest rate environment. When we put those two dampening effects on tax capacity into our model, we ended up projecting significant tax credit carryforwards.
Such carryforwards are fine economically, but they were adversely affecting our CCAR, or bank stress case test, which is a problem for any bank. When we combine that with the fact that we had very strong deal origination at the end of 2019 and into early 2020, leading to a fairly large increase in full-year 2020 volume over 2019, we came to the reasonable conclusion that it probably made sense to take a pause until we can get a little more clarity around COVID.
MR. MARTIN: Do you have any indication yet what 2021 tax capacity will be?
MR. CAPPS: We do not. I think we need a little more of COVID in our rear-view mirror instead of our windshield before we will have a better sense of what it will be. We will probably take another shot at a forecast in late Q3.
MR. MARTIN: Is anyone else currently out of the market?
MR. MCCLAIN: First Horizon is finished taking new opportunities for the remainder of this year basically for the same reasons that Robert mentioned — the impact of COVID, as well as the merger between Iberiabank and First Horizon Bank that closed on July 1. Until we have a better feel for our tax position, we are focused on filling out 2021 and, at this point, we are getting close to all the 2021 deals to which we are prepared to commit at this time.
MR. MARTIN: What about others? Fifth Third?
MR. COHEN: Our goal is to remain in the market this year and to look for opportunities for both 2020 and 2021. We do not have a fully formed view yet from a solar or bank perspective about how much tax capacity we have to use next year.
MR. MARTIN: Eric Heintz, is M&T Bank still in the market?
MR. HEINTZ: We are in the market, but are slowing down. We hope to do one more 2020 deal and are likely to commit to a 2021 opportunity in short order, but we will be relatively quiet thereafter until we have more certainty about potential outcomes in the economy and public policy.
One of the big questions for banks is how much of our loan loss provisions will ultimately be realized in charge-offs. This makes forecasting our tax capacity in 2021 and 2022 particularly difficult.
MR. MARTIN: Yonette Chung McLean, what about RBC Capital Markets? Are you in the market?
MS. MCLEAN: Yes. For some context, RBC is a syndicator of tax credits. Our investor clients tend to be regional and super-regional banks, insurance companies and corporate investors. We have seen a couple investors pull back, but most of our investors continue to look at deals.
We will write tax equity checks for a couple more deals in 2020, but our focus is largely on 2021 at this point. There is a fair amount of activity within our platform.
MR. MARTIN: For those of you still in the market, let's drill down into what that means. Eric Heintz, you said you will do one more 2020 deal. Have you already signed the term sheet for it?
MR. HEINTZ: No, but we expect to do so in the next couple weeks after we reach agreement on pricing.
MR. MARTIN: Eric Cohen, you said the goal at Fifth Third is to look for more 2020 and 2021 deals, but you do not have a fully formed view yet about your tax capacity. What does that mean in terms of what you are actually doing?
MR. COHEN: To clarify, we do not yet have a fully formed forecast of 2021 tax capacity. We know what we have left for 2020. We have a decent amount of 2020 tax capacity. We are looking to use it on strategic opportunities.
That starts with existing clients with whom we already have a relationship and know can execute. We have been a lender to this market for the last eight years and a tax equity investor for the last 18 to 24 months. Tax equity is a newer product for us.
We have a strategic mindset. We are looking to use that tax capacity to reward clients of either our advisory team on the investment banking side or the lending team, or both. We feel like there is enough opportunity to fill our dance card with such companies or with companies with whom we have been talking for a while and want to get something going.
MR. MARTIN: You do only sale-leasebacks at this time, correct?
MR. COHEN: That is correct. We are evaluating a partnership flip product for 2021. Obviously a lot of that depends on what we think the market looks like for 2021. We would like to be able to offer both.
MR. MARTIN: Yonette Chung McLean, you said you are still signing new commitments for deals that will close this year.
MS. MCLEAN: Yes, we have capacity for two more deals this year. We are in term-sheet discussions. Our thought is to have those deals closed no later than mid-October.
MR. MARTIN: Give me a sense of whether this is a normal pattern for those of you who are still doing deals. Yonette, you said two more deals this year. Is that typical for a year at this stage?
MS. MCLEAN: No. We have tended in the past to see a few deals that pop up at the end of the year. They might get done if our investor-partners find that they have additional tax capacity after filing their tax returns in the summer.
We are seeing a fair amount of abnormality this year in the number of deal submissions. While the number of deals we do has been growing year over year, the challenge this year is processing the number of deals being sent to us every day. It feels like trying to drink out of a fire hose.
MR. MARTIN: To what do your attribute the increase in volume?
MS. MCLEAN: Developers are finding many doors closed as investors scramble to understand what effect COVID will have on tax capacity. There is a crush to get into any door that remains open.
Outlook for 2021
MR. MARTIN: So SunTrust is out of the market this year. First Horizon is not making any new investments. M&T is slowing down; it will do one more 2020 deal. RBC has capacity for two more deals. Fifth Third has tax capacity, but is reserving it for existing clients.
This does not sound like a very promising market for developers who are looking for tax equity. It explains some of the desperation developers are feeling.
Let me move to 2021. Some of you have already addressed this, but what is your sense currently about what 2021 will look like? Developers report that it is hard not only to secure 2020 tax equity commitments, but also that banks are reluctant to commit to 2021 deals because of uncertainty about the future direction of the economy. Eric Cohen, true or false?
MR. COHEN: True. Robert Capps did a nice job summing it up. We really do not know yet what loan losses will look like, and that will drive taxable income.
MR. MARTIN: Eric Heintz, same story for 2021?
MR. HEINTZ: Yes. Hopefully it will begin to improve as we move into the fourth quarter of this year and first quarter of next year, but actual charge-offs are hard to predict at this time. That applies to 2022 as well.
MR. MARTIN: The four biggest banks — JP Morgan, Wells Fargo, Bank of America and Citigroup – reported aggregate loan loss provisions of $33 billion as of the end of the second quarter.
Yonette Chung McLean, in a normal year would you already be writing commitments for the next year?
MS. MCLEAN: Yes. In fact, we are currently in close mode on a transaction that will fund in 2021. We closed a couple deals earlier this year as well that will fund in 2021.
The difference between my panel colleagues and our investors is we have banks, insurance companies and corporates. While the banks, RBC included, have some constraints, it is not exactly the same for insurance companies and corporates.
There are corporates that are doing well in the current economy and have the ability to do business not only this year, but also for 2021.
We are still doing 2021 deals. The only difference is we see investors being a little more selective in picking deals.
Overall 2020 Volume
MR. MARTIN: The tax equity market was roughly a $12 to $13 billion market last year for renewable energy. Many people expected it to hit $15 billion this year. Does that now seem unlikely? Robert Capps.
MR. CAPPS: Although we are out of the market, as I said earlier, we have had a record year in 2020 commitments. My sense is the market will still get to roughly $15 billion, even with the headwinds that it is facing.
Going back to your last question to Yonette about 2021, we made some 2021 commitments and closed already on those transactions. We will be funding 2021 deals. We are just taking a pause on new 2021 commitments.
MR. MARTIN: What about the rest of you? How does this year feel in terms of aggregate volume? Eric Cohen.
MR. COHEN: I don't think I have the best gauge on that as a relatively new entrant.
MR. MARTIN: Let me ask it in a different manner. What percentage of renewable energy deal volume do you expect to have done by the end of this year as compared to last year?
MR. CAPPS: A 200% increase.
MR. MARTIN: Eric Cohen?
MR. COHEN: We had a huge increase this year as we ramped up that product.
MR. MARTIN: Eric Heintz?
MR. HEINTZ: We will be pretty consistent in volume this year over last year.
MR. MARTIN: Scott McClain, how will your volume this year compare to last year?
MR. MCCLAIN: Last year, we did not execute any tax equity transactions due to a different merger. That is a long story, but our tax position was not advantageous last year. So our year-over-year increase is basically infinite. We will do a significant amount of tax equity investment, whereas last year we did a lot of debt financings. Our overall volume will be the same, but it will be shifting to tax equity from debt.
MR. MARTIN: I think two of you — Fifth Third and First Horizon — are doing only sale-leasebacks at the moment. Fifth Third is seeking permission to do partnership flips. Is First Horizon also looking for that permission?
MR. MCCLAIN: Not yet. It is something that I looked at previously at a predecessor organization, and coming to Iberiabank, we just did not have the tax base to justify the product. Now that we have merged, the bank has gone from $32 billion to $83 billion in assets. Taking COVID out of the picture,
I would probably be looking to offer that product. With COVID and all the uncertainty around it, I don't know when will be the right time to introduce it. It is in our minds as a future offering.
MR. MARTIN: Yonette, how does volume this year compare to last year?
MS. MCLEAN: About double.
MR. COHEN: One thing to add is we may end up taking on deals for 2021 that generate tax benefits that can be carried back into 2020 if it looks in the second half of 2020 like we will end up with additional 2020 tax capacity.
If things are better in 2020 than expected or meet current forecasts, we may pick up some incremental capacity in 2021 even if 2021 is a down year. That is another piece of the puzzle. We will know more as the year progresses.
MR. MARTIN: There seems to be a disconnect here. Some of you are out of the market in terms of capacity to do additional 2020 deals. Two of you are down to one or two more 2020 deals. And yet the volumes you expect this year are in some cases double what you did last year. How do you reconcile that?
MR. CAPPS: It depends on whether the focus is on funding existing commitments or writing new commitments. I was speaking mainly to funding in 2020 of existing commitments.
It was a very robust last quarter of 2019 and a very robust first quarter of 2020, which is the reason for our large increase in tax equity funded this year even though we are not issuing new commitments. At this point in a normal year, we would be focusing on the next year ahead.
MR. MARTIN: So double the funding this year, but in terms of closing new deals in 2020, the number may be down.
MR. CAPPS: It is probably flat.
Other Market Shifts
MR. MARTIN: It seems like spreads had widened by about 50 basis points in April and May compared to the start of the year. Where would you say they are today?
MR. MCCLAIN: About the same.
MS. MCLEAN: They are at least 50 basis points wider at this point.
MR. COHEN: I concur with that. Yields have moved north, particularly for anyone looking to secure remaining 2020 capacity. The 2021 supply has also shrunk, and it is affecting 2021 yields as well.
MR. MARTIN: Are tax equity deals taking longer to close this year because of COVID?
MS. MCLEAN: I don't think so.
MR. HEINTZ: I don't see any difference either.
MR. COHEN: I think the biggest difference is around getting the third-party deliverables lined up. To the extent those are in order and moving efficiently, we have not seen any delays. To the extent that the independent engineers or other consultants are backlogged due to COVID, that has caused some delays. That is really the only thing that we have noticed.
MR. MARTIN: Is creditworthiness of corporate offtakers becoming a concern?
MR. MCCLAIN: It is always a concern for us with the sale-leaseback product. Sale-leasebacks are long-term structures, so the offtaker credit and industry profiles are of the highest importance to us.
MR. CAPPS: I agree. We do the sale-leaseback product as well, which is more long dated. Even before our pause, when we were looking at some distributed generation portfolios, we were probably tightening the minimum credit standards. There has definitely been a tightening there.
MR. MARTIN: What about COVID delays pushing 2020 projects into 2021? Is that happening?
MS. MCLEAN: That is one of the biggest reasons why we see investors being a little tentative about 2020 commitments. Having a number of projects in the pipeline that are supposed to be placed in service in 2020, but that could slip into 2021, obviously could affect investor tax strategies.
Our sponsors have to be proactive in managing this risk and to get ahead of any supply-chain or construction-site issues early.
Communication with our sponsors has been terrific. They have been giving us construction-progress reports and letting us know where they see issues so that we can help them to pivot or find solutions, such as helping to find a new equipment supplier. So far we have not had a deal slip because we are watching this closely, but I think most of us are thinking some slippage is very likely to happen.
MR. MARTIN: What happens if you have a deal slip? If you think slippage is a big risk, do you not do that deal in the first place? Do you just reduce the pricing if it slips?
MS. MCLEAN: These issues are negotiated up front. Delays are not necessarily new to us because of COVID. Delays happen for many reasons. We try to be realistic in our projections.
We focus less when doing deals on how to adjust pricing if the deal slips. It is hard to predict future pricing. The appropriate thing is to make sure we structure the deal with a realistic timetable.
MR. MARTIN: What else has changed this year compared to where the market was before the economic shutdowns in March?
MR. HEINTZ: One thing we have been tracking is the hardening of the property and casualty insurance markets. That has required additional analysis by our risk and credit folks. We have been seeing more limits on certain catastrophic risk in property and casualty coverage.
MR. COHEN: The difficulty finding tax equity using partnership-flip and inverted-lease structures is driving some developers to take a closer look at sale-leasebacks.
MR. MCLAIN: We are seeing people that in the past have not considered a sale-leaseback also take another look at it.
MR. MARTIN: Sale-leasebacks do not work for projects — like wind farms — on which production tax credits will be claimed, but they work for solar and fuel cell projects with investment tax credits. In which solar market segments are you seeing growing interest in sale-leasebacks?
MR. MCLAIN: We have been doing both utility-scale and the larger distributed solar-type projects. I see the distributed sector definitely taking a fresh look at sale-leasebacks. On the utility-scale side, the projects that work best have long power purchase agreements, especially if the PPA price escalates over time. We can be pretty competitive with the partnership-flip product structures with those types of PPAs.
Possible Changes in Law
MR. MARTIN: I am going to roll through a series of remaining questions quickly.
The US Comptroller of the Currency asked for comments in late June about whether national banks should be prohibited from providing tax equity in partnership-flip structures for residential and C&I solar projects. Of course, not all banks invest as the regulated bank. If they are investing through a bank holding company or non-bank affiliate using merchant banking authority, they would not be affected. What are you hearing from your bank regulatory people? Could this affect the availability of tax equity for the rooftop solar market?
MR. HEINTZ: Most of our bank-level investing has been limited to utility and municipal utility types of transactions. We read the notice to say the Comptroller is considering more flexibility than it has shown to date on these asset classes. So this could lead to more tax equity for rooftop solar.
MR. MARTIN: So possibly a favorable development.
Next item: the US Chamber of Commerce, the National Association of Manufacturers and a coalition of individual companies are pushing for a tax credit refund proposal in Congress as part of the next economic stimulus bill. Tax credits claimed in 2019 or 2020 — or carried from as far back as 20 years ago into those two years — would be refunded by the IRS in cash. Would this put any tax equity investors back into the market this year? How significant a proposal is it?
MR. CAPPS: It could be significant. It might change our view about the need for a pause in further investments. It is the potential tax credit carryforwards that impact the CCAR. If we did not have to carry tax credits forward, that could very well put us back in the market.
MR. MARTIN: I should note that the proposal did not make the cut last night in the bill that the Senate Republican leadership released. However, there could be several weeks of negotiations.
MR. MCCLAIN: I agree with Robert. It would have a significant impact on our outlook.
MR. MARTIN: The renewable energy trade associations have been pushing a more narrowly-targeted proposal. The government would refund 85% of tax credits on renewable energy projects put into service after the proposal is enacted. There would be no time limit. Would you expect banks that are having tax capacity problems to come back into the market if they can bridge a refund and claim depreciation?
MR. HEINTZ: It would add additional capacity to the market.
MR. MARTIN: During the Treasury cash grant era, there were quite a few banks that had no tax capacity, but were investing tax equity as a bridge to the refunds.
Next question: If the Democrats win in November, at least two tax law changes are likely. One is extensions of renewable energy tax credits. The other is an increase in the corporate tax rate, possibly to 28%. How do you expect these changes to affect the market?
MR. COHEN: They would make what we are developing rather late in the game — if you think about when the credits are set to sunset at this point — a lot more viable for us in the medium to long term. They would create more tax equity business.
MS. MCLEAN: I agree with that. Reducing the corporate tax rate to 21% led to a reduction in tax capacity after 2017.
MR. MARTIN: The Wall Street Journal reported this morning that the Biden campaign is proposing a 15% corporate minimum tax. Basically if a company has more book earnings than it reported in taxable income, it would have to pay 15% of the book earnings as an alternative minimum tax. How do you see such a tax affecting banks' appetite for tax equity if it is enacted?
MR. CAPPS: It just adds one more layer of analysis that the banks have to do to forecast tax capacity. It makes the exercise more complex.
MR. MARTIN: How are you seeing change-in-tax-law risk addressed in current deal papers?
MS. MCLEAN: We have not changed anything. We already were forecasting that there might be more changes in tax laws.
MR. MARTIN: What does that mean in practice?
MS. MCLEAN: Tax rates are expected eventually to increase. This might work a little in favor of sponsors or investors. We are not taking a different approach in how we write our deal papers.
MR. MARTIN: In most deals, the tax rate floats anyway. So if the transaction has a yield-based flip and the tax rate increases early in the life of the deal, the deal might flip sooner. If the rate change comes later in the life of the deal, it will delay the flip date.
MS. MCLEAN: That's right.
MR. CAPPS: We are not taking a different approach. In the sale-leasebacks, the investor bears the brunt of risk the tax rate will change. That is a risk the investor takes.
MR. MARTIN: Is anyone putting in special provisions to deal with change-in-tax-law risk at this point? [Pause] I will take that as a "no."
MR. MCCLAIN: Our transaction papers make it a condition to funding that there has been no change in tax law. Other than that, we are doing nothing new at this point.
MR. MARTIN: Projects have to be under construction by a deadline to qualify for tax credits, but it seems the link between the construction effort and the project claiming the tax credits is becoming more and more attenuated.
Sponsors are doing less and less physical work to start construction. Transformers may be ordered, but delivered in three or four years. The developer may tell the manufacture not to do any more work after the construction-start deadline until it receives a notice to proceed. Some wind developers are relying on physical work on a single wind nacelle. Physical work on one project is being moved to a different one.
Are you financing projects that start construction under the physical work test, and if so, what lines are you drawing? Yonette McLean.
MS. MCLEAN: Thank you for that, Keith. We have done one deal that was greyish, I will call it. I would not want to view it as a precedent for what we might do in the future. It put a fair amount of strain on our tax advisers, including counsel.
We have seen the transformer strategy. It is acceptable given the right facts. However, the physical work test is a heavier lift and less than ideal.
MR. COHEN: We look at it on a case-by-case basis, but physical work cases require greater care.
This also comes up in cases where we are acting as a lender and bridging to the tax equity, in which case we will want to be conservative. The tax equity is our takeout. Banks are inherently risk averse in nature, so they tend to steer toward the more conservative side.
MR. MARTIN: The next question is for the three of you who are doing sale-leasebacks. Some companies may end up looking everywhere they can this year for cash. How much of a market do you think there is for depreciation-only sale-leasebacks of existing assets where the lessor claims a 100% depreciation bonus?
MR. MCCLAIN: We did one such deal last year. Since the structure works pretty efficiently, it really comes down to the sponsor's objectives.
MR. COHEN: Scott, we worked on that deal with you, and I think it worked well, partly because the sponsor was sophisticated and a strong credit. I think it is something that we will start to see more of as projects move beyond the initial financing or tax equity term.
MR. MARTIN: The rent is fully deductible, whereas the ability to deduct interest would be capped, so that may also steer people to this form of refinancing.
I have two more questions. How much appetite do you think there will be, once tax capacity recovers, for carbon capture projects?
MR. HEINTZ: For us, as long as we still have access to high-quality solar projects with investment tax credits, we are unlikely to do carbon capture.
MR. MARTIN: Why?
MR. HEINTZ: Part of it is the need to go through internal new-product approvals. Moving into new asset classes can be challenging. If we have enough pipeline by way of quality projects on the solar side, we are unlikely to venture into a different asset class.
MR. MARTIN: Does anyone have a different view?
MR. MCCLAIN: No. I feel Eric's pain about the new approval process. And my understanding is these projects throw off pre-tax losses. That would not be something of great interest to us. As long as we have good solar projects where we can get pre-tax income, carbon capture credits would not be of interest.
MS. MCLEAN: I don't think investors are completely uninterested. It is too early at the moment for them to get excited about it.
If the credit looks more like a PTC, that will probably reduce the investor interest. The current sentiment is there is so much solar ITC product right now that investors have no need to look at new products.
MR. MARTIN: Last question. As Scott said, carbon capture deals are likely to run pre-tax losses, so the accounting treatment is difficult.
They apparently do not work with the HLBV method of accounting and would work only with the proportional amortization method like the Financial Accounting Standards Board authorizes for low-income housing investments. At least, that is what some people are arguing. Do you have any view on whether the current accounting treatment is a killer for this type of deal?
MR. MCCLAIN: Unless the bank has a reason to want to do such a deal as part of an ESG initiative, we prefer deals that generate earnings on a pre-tax basis.
MR. CAPPS: We can handle pre-tax losses. They are not a deal killer, but we certainly have to manage this on an overall portfolio basis.