Dozens of institutional investors in U.S. renewable energy projects pulled out of the market when the nation’s liquidity reserves dried up late last year. Some left the renewable market sector in search of more lucrative investment opportunities. Others found themselves unable to take advantage of the attractive tax credits because they themselves lacked profits against which to use the credits. The American Recovery and Reinvestment Act of 2009, approved February 13, changed the investor ground rules — again.

The American Recovery and Reinvestment Act of 2009 (ARRA) gives investors, owners, operators, and financiers a choice of government credits that may help push forward renewable projects that otherwise might be turned down. The purpose of this article is to provide a summary of the ARRA as it affects federal support for renewable energy projects as well as an explanation of how the renewable investment rules of the road have changed with the stimulus incentive package.

Large insurance companies and investment banks that engage with project developers provide the bulk of renewable energy project financing. The ARRA offers to those financiers a number of very useful incentives for renewable energy projects that can be tailored to individual project needs. By using complex financial models and structures that are designed to leverage the federal government’s support for renewable technologies, investors can use accelerated depreciation and tax credits to offset tax liabilities. Now, with the expanded variety of production tax credits (PTC), investment tax credits (ITC), and cash grants to choose from, investors must consider the benefits of each incentive for their respective projects (see sidebar).

Good News for Renewables

The ARRA has several finance-based provisions that renewable stakeholders can now consider. These changes will influence how financing decisions are made on both qualitative and quantitative issues. The key changes include these:

  • The PTC in-service deadline is extended through 2012 for wind projects and through 2013 for open- and closed-loop biomass, geothermal, municipal solid waste, qualified hydroelectric, and marine hydrokinetic facilities.

  • Project financiers may now elect the ITC in lieu of the PTC. The ARRA allows PTC-qualified facilities installed in 2009 through 2013 (2009 through 2012 in the case of wind) to elect a 30% ITC in lieu of the PTC. If the ITC is chosen, the election is irrevocable and requires the depreciable basis of the property to be reduced by one-half the amount of the ITC.

  • Project financiers may also elect a cash grant in lieu of the ITC. This new program provides grants that cover up to 30% of the cost basis of qualified renewable energy projects that are in service in 2009 – 2010 or that commence construction during 2009 – 2010 and are in service prior to 2013 for wind, 2017 for solar, and 2014 for other qualified technologies. The grant is excluded from gross income, and the depreciable basis of the property must be reduced by one-half of the grant amount.

  • The ITC-subsidized energy financing penalty is removed, allowing projects that elect the ITC to also utilize "subsidized energy financing" (such as tax-exempt bonds or low-interest loan programs) without suffering a corresponding tax credit basis reduction. This provision also applies to the new cash grant option.

  • Bonus depreciation of 50% is extended (that is, the ability to write off 50% of the depreciable basis in the first year, with the remaining basis depreciated as normal, according to the applicable schedules) to qualified renewable energy projects acquired and placed in service in 2009.

  • The loss carrryback period is extended from two to five years for small businesses (those with average annual gross receipts of $15 million or less over the most recent three-year period). This carryback extension can only be applied to a single tax year, which must either begin or end in 2008.

  • ITC dollar caps are removed, eliminating the preexisting maximum dollar caps on residential small wind, solar hot water, and geothermal heat pump ITCs. The dollar cap on the commercial small wind 30% ITC is also eliminated, and credits may be claimed against the Alternative Minimum Tax.

  • The existing loan guarantee programs to cover commercial projects are expanded to include support of up to $60 billion to $100 billion in loans, depending on the risk profiles of the underlying projects.

  • Clean renewable energy bonds (CREB) get more funding: $1.6 billion in new CREBs is added for eligible technologies owned by governmental and tribal entities, municipal utilities, and cooperatives. Combined with the $800 million of new CREB funding added in October 2008, new CREB funding totals $2.4 billion.

Pick Your Poison

Cash flow model studies funded by the Department of Energy have been developed to help quantify the benefit of PTC and ITC incentives. Given installed project costs and expected capacity factors — along with assumed federal and state tax rates — the models calculate the present value of the ITC, PTC, and cash grant at nominal discount rates of 5%, 7.5%, and 10%. Depending on the project type and constraints, your tradeoff choice between the federal incentives may be clear or marginal.

For example, a wind project that uses a discount rate of 7.5%, costs $2,000/kW installed, and with an expected capacity factor of 30% results in a 1.3% net value advantage for using the ITC instead of the PTC. Using the same assumptions, but with a project cost of $1,700/kW and an expected capacity factor of 40%, yields a 10.4% increased value for the PTC.

Generally, wind projects with lower installed costs and higher capacity factors find that the PTC provides greater benefit than the ITC. Because a higher capacity factor results in more production, the PTC seems to have higher project value for projects that can operate near the plant’s rated output for more hours each year.

Consider another example of an open-loop biomass project, the same discount rate, a capacity factor between 60% and 90%, and a project installed cost ranging from $3,000/kW to $5,000/kW. Using these parameters and several other assumptions (depreciation schedules and PTC applicability to biomass projects), calculations show that the ITC produces more financial benefits for the project than the PTC.

More Details to Consider

The relative value of each federal credit is among the most important considerations when deciding among the PTC, ITC, and cash grant. However, there are other qualitative considerations that may affect a manager’s decision, such as those that follow, especially when the quantitative differences between the PTC and ITC are slim.

Subsidized Energy Financing. The stimulus package removed the "double-dipping" penalty for the ITC, but not for the PTC. As a result, any PTC-eligible project that can secure "subsidized energy financing" may be better off electing to take the ITC (or equivalent cash grant) rather than sticking with a diminished PTC. Prior to the stimulus bill, the values of both the ITC and the PTC were reduced proportionally (with the PTC reduction limited to a maximum of 50%) by the amount of a project’s installed costs that was financed using "subsidized energy financing" (such as government-sponsored low-interest loan programs).

Option to Elect Equivalent Cash Grant. The ARRA not only enables PTC-eligible projects to elect a 30% ITC, but it also allows projects eligible for a 30% ITC to elect a cash grant of equivalent value instead. The availability of a U.S. Treasury – backed cash source might drive some PTC-leaning projects toward the 30% cash grant option, even if the PTC promises a higher expected value.

Owner/Operator Requirement. The ITC does not require the owner and operator to be the same entity, which opens the door to a variety of leasing structures, including sale/leasebacks and inverted pass-through leases. With the exception of biomass projects, the project owner must also operate the project in order to claim the PTC.

Performance Risk. Receiving ITC or cash grants is not dependent on project performance, whereas the PTC is dependent on asset output. The certainty offered by the ITC over the performance risk inherent in the PTC — even if the PTC promises a higher expected value — may make the ITC more attractive.

Power Sale Requirement. The ITC does not impose a power sale requirement, making it a more widely applicable incentive. In order to be PTC eligible, the qualifying renewable power must be sold to an unrelated party.

Tax Credit Demand. Tax equity investors rely on having a tax base that can fully absorb all of a project’s tax benefits over the coming decade before they invest in a 10-year PTC project. Even though depreciation deductions still occur for a multi-year period, the ITC greatly reduces the need for future tax shelter because the full credit is realized in the project’s first year. This also means that to fully absorb the ITC, an investor must have a larger tax base (compared to the PTC) during the first year of the project. Should a project elect to take the 30% cash grant instead of the ITC, the importance of tax equity investors and the tax credit demand is reduced (though it may still be needed in order to maximize allowable depreciation deductions).

Liquidity. The fact that the ITC, or equivalent cash grant, is selected in the project’s first year leads to a relatively more illiquid investment. Potential buyers of the project no longer have access to the credit once the project owner realizes the ITC. Consequently, the ITC vests linearly over a five-year period, forcing the investor to hold on to the project for at least five years in order to fully realize the ITC value. With the PTC, credits are realized in real time over a 10-year period as the project generates power. The sale of a PTC project can then occur at virtually any time (ignoring the influence of depreciation recapture), whereupon any remaining PTCs transfer to the new owner.
—Norbert Richter (norbert.richter@duke.edu) is an industry consultant specializing in renewable energy project evaluation and finance.

For More Information

An excellent reference source on the American Recovery and Reinvestment Act of 2009 and the modeling techniques described in this article is found in "PTC, ITC, or Cash Grant? An Analysis of the Choice Facing Renewable Power Projects in the United States" published in March by Lawrence Berkeley National Laboratory and the National Renewable Energy Laboratory. The entire report is available at http://eetd.lbl.gov/EA/EMP/reports/lbnl-1642e.pdf.