Tax credits — the $1.7 trillion opportunity in climate investing
Following Illuminate’s previous deep dives into the voluntary carbon markets and evaluation of physical risk, in this post we will continue to dig into new opportunities to finance the climate transition. The next exciting evolution of this theme? Transferable tax credits.
The Big Picture: The Inflation Reduction Act creates “uncapped” and transferable tax credits
Last year’s Inflation Reduction Act (IRA) included a $374 billion budget to spend on clean energy and climate resilience projects over the next 10 years. However, many of the IRA’s most important provisions, such as its incentives for electric vehicles and zero-carbon electricity, are “uncapped” tax credits.
This surge in federal spending is expected to unleash a monumental $1.7 trillion influx of private investments in the sector over the next decade.
To capitalize on this trend, we see significant opportunity to:
- Increase access to data and investible insights,
- Create market structures for project developers, investors, and corporates to participate in the tax credit market, and
- Manage investment portfolios of this new asset class and subsequent financed emissions.
Project finance is best poised to capitalize on renewable energy tax credits
Project finance is a form of financing used for large-scale infrastructure and development projects. It is a segment of the industry that is best positioned to reap the benefits of these renewable energy tax credits.
Equity and debt investors stand to benefit
The major players within project finance include developers, tax equity investors and debt investors. Each represent a certain percentage of the capital structure of a project finance deal, and can benefit from the IRA’s new tax credits in the following ways:
Project Sponsors / Developers — Project developers are responsible for driving project initiation, development, and execution and typically represent 20–40% of the capital structure. Federal tax credits and rebates, renewable energy certificates (RECs), and managing the offtake agreement are all revenue sources for these renewable energy projects.
Tax Equity Investors — Renewable energy projects are eligible for tax incentives, but developers may not have sufficient tax liability to fully utilize them. As a result, tax equity investors, usually financial institutions or corporations, provide upfront capital in exchange for the allocated tax benefits. Tax equity typically represents 40–50% of the capital structure, although this percentage can vary depending on the project type.
In 2022, tax equity accounted for ~$18B of financing for projects, yet >80% of the demand was concentrated in just 10 corporate tax investors. JP Morgan and Bank of America alone have made up more than half of those investments in recent years. Other large players include Wells Fargo, US Bank, and Credit Suisse.
According to S&P Global, tax equity financing for renewable energy projects is expected to reach $20–21 billion in 2023.
Debt Investors — Debt investors, including commercial banks, development banks, and institutional investors, provide loans between 20–40% of the project’s capital requirements. Lenders evaluate the project’s feasibility and profit potential as well as the creditworthiness of the offtake providers, receivers of renewable energy.
Tax credit have been historically underutilized
Since the Energy Policy Act of 2005, federal tax credits for renewable energy projects were non-transferable, meaning only the project owner could claim them. The two main tax credits historically are Investment Tax Credits (ITC) and Production Tax Credits (PTC).
Because these credits were non-fungible, sellable, or transferable, this led to complicated structures for tax equity deals that limited the number of players able to capitalize on this market, leading to more than $400B in underutilized tax liability.
Unlocking profits through tax credit transferability
Effective January 1, 2023, the IRA introduced “transferability” — the ability for project developers to sell credits to unrelated third parties for cash. This milestone allows for the transfer and monetization of nine distinct types of clean energy tax credits, creating a wealth of new opportunities for renewable energy project developers.
What does this mean?
With the passing of the IRA, infrastructure projects that deal with innovative, yet unproven technologies such as clean hydrogen & carbon capture will finally receive the funding they require, largely due to the lucrative incentivization structures unlocking the ability to transfer tax credits.
The availability of tax credit transferability creates additional avenues for new investors and corporates to enter the market, while creating opportunities to better evaluate, underwrite, and manage credit portfolios across all parties.
New market participants
Monetizing tax credits can boost demand by expanding the range of eligible buyers beyond those directly involved in project development. Previously, only investors with substantial tax appetite (over $25 million) could engage in tax equity transactions.
However, with the introduction of transferability mechanisms, credits can now be acquired through simpler purchase and sale agreements, allowing a broader market of participants including smaller investors and corporate taxpayers.
Institutional investors: While tax equity will continue to be used widely, simplifying the process attracts entirely new classes of investors into the renewable energy and storage investment sector.
This increased competition has a knock-on effect to developers beyond increased project appetite. In traditional equity financing, a hypothetical developer could sell $1 of a tax credit and receive $0.85 back in cash. With increased competition, developers can raise more cash per dollar of tax credit, increasing margins as well.
“Bank of America wants to be relevant in this evolving market and as the entire market as a whole is tax equity constrained, these transferability trades really are going to take center stage.”
Corporate tax credit buyers: The introduction of transferability presents a significant opportunity for new buyers seeking tax liability write-offs and to achieve their sustainability goals. If estimates hold true and corporations monetize approximately $83 billion per year of tax credits, this would represent almost 16% of all corporate tax liabilities in 2031.
Corporates participating in direct tax equity investments is not new. Amazon, Google, Patagonia, and Toyota have served as a source of tax equity in similar clean energy project deals, however, participation represents less than 10% of the market to date.
Divisibility and Syndication
While credits can only be transferred once, they are more easily divisible and can be sold to many counterparties. Whether corporates elect to purchase credits directly from project developers, utilize traditional financial service players, or access new marketplaces, is yet to be seen. An emerging option for corporations looking to enter into the tax equity market is to work through aggregators or syndicates.
Limitations still exist…
The IRS released updated guidance on transferability in June 2023. Though the sentiment has been that the guidance was net positive, increasing flexibility around transferability, there are several limitations and outstanding questions to solve as the market develops.
One limitation is the time horizon of the credits, as a majority are available for approximately 10 years, ending either in 2031 or 2032. Additionally, transferable tax credits can only be exchanged for cash with unrelated parties and can only be transferred once, prohibiting resale of the credits. This retirement of tax credits is one characteristic that mirrors what we have seen and written about in the voluntary carbon markets and is something we will continue to monitor.
The opportunity
The market is evolving by the day. However, we believe there are several opportunities to participate.
- Market access: Demand to access these new asset types will come from corporates and investors alike. Early innovators looking to democratize access to these tax credits have been focused largely on marketplace models, including Atheva, Basis, Crux, Evergrow, Ever.green, and Reunion Infrastructure.
- Project management: Solutions will enable project developers to structure and take advantage of these tax benefits. New project developers for traditionally nascent technologies will now be able to come to market through this new revenue source. These project developers will not only need support in structuring these financing vehicles, but create avenues to monetize these tax credits. Companies such as Paces, Perl Street and Sequestr are building solutions to enable these project developers.
- Credit ratings and underwriting: Similar to the evolution of the carbon markets, the nuances across the nine different types of tax credits available will require more sophisticated underwriting as new investors enter the market. We are interested in solutions to enable financiers on both the equity and debt side to better evaluate these nascent projects and capitalize on tax equity through new channels, including syndication and secondary transfers to their corporate clients. Companies including Green Assets Wallet and Banyan Infrastructure are platforms for financing institutions to unleash sustainable finance.
- Portfolio management and insurance: As tax investors make decisions around sourcing of PTCs and ITCs, and the subsequent cash flow implications (reoccurring over the project lifetime versus one-time), investors will need to make decisions around managing and insuring these cash flows against credit risk.
We will share these findings with the climate tech community as we continue to refine our thinking, test our assumptions, and identify what a winner looks like in this space.
If you are a like minded investor or early stage company building at the intersection of finance and climate, we would love to chat with you. Feel free to reach out to me at ag@illuminatefinancial.com.
Illuminate Financial is a thesis-driven enterprise fintech venture capital fund looking to partner with companies building technology solutions for financial services.
