Considering the unfathomable costs of unabated climate change, it stands to reason that even the most elementary investment thesis for the energy transition merits sincere consideration. And with the enormous sums of public and private capital committed these last few years toward the companies, technologies, and projects that promise to drive climate change mitigation and adaptation, it would appear that capital providers don’t need much convincing.
But the fate of economy-wide decarbonization, at least in the near term, is startingly uncertain.
Industry-agnostic disruptions, from the upward creeps of inflation and the benchmark interest rate to yawning labor shortages and persistent supply chain bottlenecks, are increasing production costs, delaying project delivery timelines, and otherwise weighing on the outlooks of firms at the heart of the energy transition. Debt and equity investors are adapting their risk appetites. Worse still, it’s likely that the recent failure of Silicon Valley Bank (SVB), oft-referred to as the “lender of choice” for venture-backed climate technology startups, and in many cases a significant provider of project finance and tax equity for growth-stage and mature energy transition companies, will complicate the decarbonization financing challenge.
Fortunately, a consensus is crystallizing that climate technology companies, across a range of industries and commercial maturity, will endure. The urgency and durability of the climate crisis will substantiate these companies’ value propositions for the foreseeable future. Moreover, pre-existing market trends, namely the mainstreaming of environmental, social, and governance (ESG) investment practices, augur well for these companies, as do the funding opportunities made available by the Inflation Reduction Act (IRA).
But successfully navigating the near-term energy transition financing challenges left in SVB’s wake, from depressed equity valuations to scarcer and stricter lending arrangements, requires a strategy. Across the board, prospective borrowers would do well to burnish their ESG credentials and, to the extent possible, maximize commitments of working capital and expected disbursements from established credit facilities toward initiation or completion of projects that qualify for the IRA’s transferable (and stackable) tax credits.
The case for strengthening the ESG disclosure process is fairly straightforward. For one, the integration of ESG-aligned investment approaches is increasingly entrenched across U.S. capital markets. In response to the expectations of their clients and regulatory trends, institutional investors of all stripes are racing to not only plus up the sustainability of their portfolios, but are seeking the improved risk-adjusted returns that this more holistic investment strategy promises.
ESG Risk Management
With energy transition companies that aren’t publicly traded, inclusive of those directly exposed to the SVB fiasco, achieving and disclosing evidence of healthy ESG risk management have their advantages, too.
ESG considerations are steadily making their way into private equity and venture capital transactions, from opportunity identification to due diligence in dealmaking and exits. The story with corporate M&A transactions, a potential lifeline for unsecured energy transition companies especially, is much the same. Prospective acquirers, particularly fossil energy firms, heavy industrial manufacturers, and other companies with inflexible ESG risks of their own, are increasing their appetites for acquisitions that could quickly help them mitigate their carbon intensities.
But securing the optimal capital structure needed to maintain and expand operations, buoy equity valuations, and continue delivering climate benefits at minimal risk will take more than an updated résumé. Energy transition businesses will need to strategically leverage the tax credit transferability and stackability opportunities afforded them by the IRA.
Indeed, the “transferability” provision available for the modified and extended renewable energy production and investment tax credits, their successor “technology neutral” credits for clean electricity-producing facilities, and a host of other funding mechanisms has been hailed as the unsung hero of the Inflation Reduction Act.
And it just might save the day.
To explain, tax equity financing is, historically, an alternative project financing mechanism, whereby a project developer (i.e., sponsors) puts up a nominal amount of capital toward a project, sources a partner for the lion’s share of the remainder, and agrees to transfer the rights to “monetize” the pertinent production or investment tax credit to the equity provider. And now, with the IRA-enabled transferability and stackability options, project sponsors are effectively granted access to a wider market of potential joint venture partners in this robust, low-risk venture, inclusive of banks, insurance companies, and non-financial corporates.
Irrespective of their commercial maturity or exposure to the SVB fallout, what’s most important for clean energy developers to know is that the combination of the transferability and stackability options equips them with a great deal of leverage. In short, they have discretion over the components of tax credits they tender in tax equity markets, meaning that a clean energy company can essentially pick and choose which funding opportunities to monetize for themselves, and which to sell to a third party.
This has clear advantages for mature developers of solar PV and wind power facilities. For example, they can stand-up projects that are sited in energy communities, that are comprised of a minimum amount of domestic content, or that are constructed with prevailing wage labor to qualify for the “bonus credits” to the modified and extended ITC and PTC, sell the rights to those credits to a third party, and claim the base credits for themselves.
Producers of low-carbon alternative fuels, manufacturers of advanced energy technologies, and other energy transition firms have similar options available. And it’s important they leverage tax credit transferability and stackability strategically; early-stage projects risk fetching discounted tax equity infusions as investors juggle capital constraints of their own.
Consider the developer of a commercial electric vehicle charging facility powered, in part, by an onsite solar plus storage installation. In the event they finance construction by borrowing against the value of the pertinent investment tax credit (Sect. 30C), or outright transfer that credit at a discount, then can still improve their balance sheet by either borrowing against, transferring, or claiming attendant bonus credits or separate credits, such as the clean electricity production and investment tax credits (i.e., Sects. 45Y & 48E).
At present, the IRA is yet to be completely implemented, leaving ambiguity with regard to certain tax credit eligibility criteria and, in turn, leaving the tax credit transfer marketplace in flux. And while Washington is poised to bring structure and order to this marketplace, it behooves energy transition companies to nevertheless use this unprecedented federal funding opportunity to plan and develop bankable projects.
—Mona Dajani is a partner in the Project Development & Finance practice with the global law firm Shearman & Sterling, where she is also the Global Head of Renewables, Global Head of Energy & Infrastructure, and Americas Head of the Hydrogen and Ammonia Practice.