Solar project development is often financed with solar tax equity. The term refers to pairing a solar project that qualifies for tax incentives, but can’t use them, with an equity investor who has a tax liability and wants to invest in solar energy.
A tax equity investor will usually invest 40%1 of the equity in a solar project in return for 100% of the tax benefits, plus additional cash proceeds, over a period of around 5 years.
The result is reduced tax liabilities and a nice return on investment for the tax equity investor and a profitable solar project generating renewable energy for a customer who buys it from the solar developer.
The tax equity investor may be an individual, business or corporation with significant “tax appetite“… Tax appetite means that the investor owes – or will owe – taxes and would like to reduce the amount of tax they otherwise would have to pay by investing in a commercial solar project that qualifies for federal tax incentives.
Because many solar developers (aka “sponsors”) do not have enough of a tax liability to be able to utilize the federal incentives, the solar developer will assign the rights to the tax credits to the tax equity investor in return for a financial investment in the solar project.
The federal government offers three tax incentives for commercial solar development that solar developers can assign to tax equity investors, including:
- The solar investment tax credit currently at 26%
- Bonus depreciation currently at 100%
- MACRS accelerated depreciation
All of these federal tax incentives and project cash flows over the life of the investment are available to the solar tax equity investor who invests in the solar project.
The internal rate of return (IRR) on a typical solar tax equity investment is in the 15% range.
Once a tax equity investor has achieved a certain target return on investment, the sponsor will buy back the project from the investor. The tax equity investor would also then receive a buyout payment at the end of the project.
Institutional solar tax equity investors often purchase tax liability insurance to protect themselves from an unfavorable tax ruling by tax authorities, such as the IRS.
How Is A Solar Tax Equity Deal Structured?
If a solar developer does not have sufficient tax liability to take advantage of the tax incentives, the developer will seek out a tax equity investor.
The tax equity investor and the developer will negotiate the amount of money to be invested, the cost of the tax credits, the deal structure and the timing of payments to each party.
There are three types of deal structures that a solar developer is likely to use:
- Partnership flip: In a partnership flip, the tax equity investor owns 99% of the project until their internal rate of return is met. After that point a “flip” occurs where majority ownership of the project changes to the solar developer.
- Sale leaseback: In a sale leaseback, the solar developer sells 100% of the solar project to the tax equity investor who then leases it back to the solar developer.
- Inverted lease: In an inverted lease, the tax equity investor and the developer form two partnerships, a tenancy partnership and project LLC partnership. The tax equity investor leases the project from the solar developer and realizes the tax incentives through nature of the LLC.
Depending on the structure, the tax equity investor and the developer will agree on a minimum IRR for the investor.
Once an agreement is set, a limited liability company is formed that will own the solar project.
Tax Equity Partnership Flip Structure
The partnership flip is one of the most common solar tax equity deal structures for developers without tax appetite.
This is because the partnership flip structure provides flexibility for developers in assigning ownership of tax credits, losses and any income streams.
The partnership flip accommodates both the short-term tax incentive and IRR requirements of the tax equity investor and the long-term investment goals of the developer/sponsor.2
My cartoonish diagram above shows an oversimplification of the partnership flip process:
- Solar Developer: The solar developer identifies and forms the solar project opportunity and finds a tax equity investor.
- Tax Equity Investor: The tax equity investor contributes capital to the solar project in return for 100% of the tax incentives from the project.
- Solar Contractor: The solar project gets built by a solar contractor.
- Solar Offtaker: The solar project is brought online and the renewable energy is purchased by a customer (aka an “offtaker“) who uses the electricity.
After a period of 4, 5 or 6 years, once the solar tax equity investor has achieved the desired IRR, the investor is bought out by the solar developer.
The partnership flip deal structure allows the partners to allocate income, gains, losses, tax credits and/or deductions and cash distributions according to the terms of the partnership agreement.
An example would be a solar tax equity investor paying 90 cents on the dollar for each $1.00 of tax credits. In this case, the tax equity investor receives an 11.1% return on their money ($100,000/$900,000 = 11.1%), before any additional income streams from the solar project. The IRR of a partnership flip is usually in the 15% range.
A detailed overview of the partnership flip can be viewed in the video below by Edward Bodmer.
Reducing Risk In Tax Equity Investment
Insurance is a necessary part of any solar investment plan. Solar projects need to be thoroughly insured throughout the process from initial concept to NTP3.
Indeed, projects may need insurance and bonding well into their operations, maintenance and ultimate decommissioning.
Contracts between the the parties should be reviewed by your insurance broker to ensure proper risk transfer and risk management for the life of the project.
Your insurance broker should be fluent in the language and risks associated with solar projects and collaborate with your legal team to ensure documentation prevents problems in the investment process.
Below are the main insurance elements both solar developers and solar tax equity investors should consider to protect against unforeseen risks to financial performance:
- General Liability Insurance: General liability protects your solar project from claims of bodily injury and property damage to third parties. This coverage is important because of the sheer size of many solar projects. Some projects may be on roofs or expansive ground mount systems covering many acres. If an employee, subcontractor or independent contractor, or even a trespasser is injured on-site, your general liability policy covers you.
- Solar Offtaker Insurance: Solar offtaker insurance is a form of credit enhancement similar to a bond or letter of credit. Solar offtaker insurance protects both the solar developer and project financier (lender, investor or tax equity) against the risk of payment default by an non-credit rated offtaker, or one with below investment-grade credit. The insurance transforms the below investment-grade credit offtaker into investment grade by substituting the insurance company’s Standard & Poor’s AA- rated credit in place of the offtaker’s credit, guaranteeing the payments for up to 10 years into the future. Policies may be renewed as needed.
- Property Insurance: Solar systems need to be insured. For solar project owners, or solar developers with equity in their solar projects, solar property insurance protects the solar system itself (the solar panels, inverters, racking and hardware, etc.) from perils of wind, hail, fire, storms and other perils that can cause physical damage. Solar property insurance also protects against loss of business income if the system fails to operate, providing income protection in the event of business interruption.
- 3rd Party Solar Contractor Insurance: Solar project developers and tax equity investors need to work with solar contractors who are properly insured. Many times solar developers rely on certificates of insurance (COIs) from their sub-contractors and do not verify the nature of the coverage. This can leave the general contractor (the solar developer or sponsor) exposed in the event of a claim. A solar contractor insurance program can address all of these risk transfer requirements.
- Solar Production Insurance: For solar tax equity investment portfolios greater than 5MW, insurance is available to protect against shortfall in solar production. Solar production insurance is paired with solar property insurance on a “special” aka “All Risks” form.
- Cyber Liability and Errors & Omissions: Community solar projects require additional insurance to protect customer financial data, online billing systems and renewable energy. This is because community solar projects require managing consumer data that must be protected from breaches and cyber crime.
- Directors and Officers Insurance: Do you need directors and officers insurance aka “D&O”? If you’re raising money from limited partners, or have outside or passive investors, you should consider D&O insurance. As the manager or general partner of a solar tax equity fund, you should have directors and officers insurance in place. This protects your business (and your personal assets) from a lawsuit by a LP, investor or employee for breach of fiduciary duty, among other potential claims. Other types of claims that may be protected by D&O include anti-trust, unfair trade practices and regulatory coverage. D&O may also be packaged with employment practices liability (EPLI), fiduciary and crime coverage in a full management liability insurance plan.
- Performance, payment and decommissioning bonds: Solar bonds are often required by state agencies or by developers or general contractors. Bonds may include payment and performance bonds, interconnection bonds and decommissioning bonds.
Understanding both the right type of tax equity financial structure, and having the necessary insurance in place, ensures that your solar tax equity investment will be a home run financially and a success for the future of renewable energy.
- The amount of the investment as a percentage of the total cost of the project is often affected by the amount of tax incentives available. The solar investment tax credit recently dropped from 30% to 26%. This may also reduce the percentage of tax equity investment as a percentage of the whole project. A 26% federal tax credit for the ITC may translate to a tax equity investment closer to 34.5%, as opposed to 40%.
- A detailed description of the tax and capital account implications of the partnership flip is available from Woodlawn Associates.
- Notice to proceed