Below are soundbites from panel discussions at Solar Power International on September 25 and 26 in Anaheim, California. Overall the conference was well-attended and the panelists and audience seemed optimistic regarding current and future opportunities.
The soundbites are organized by topic, rather than presented chronologically. The soundbites were prepared without the benefit of a recording or a transcript and have been edited for clarity.
Topics covered include tax equity, the solar start of construction rules, the investment tax credit (“ITC”) and tax basis risk after the Federal Circuit’s opinion in Alta Wind, the inverted lease structure, back-leverage debt, storage, community solar and merchant projects.
Macroeconomic Factors for Solar and Tax Equity
“Rising corporate profits have caused more tax equity to enter the market. That has shifted the negotiating leverage to the sponsors.” Managing Director, Money Center Bank
“Tax equity always needs to fund around 40 percent of the capital stack in order to use the tax benefits efficiently.” Managing Director, Money Center Bank “Equipment costs continue to come down. Module prices are back to where they were before the tariffs at 30 to 40 cents a Watt.” President, Diversified Solar Services Company
“There are greater economies of scale for utility scale solar than for residential or C&I. As module prices drop faster than that customer acquisition costs, utility scale will become a larger portion of the market.” President, Diversified Solar Services Company
“I am very bullish on next year. This has been the best year ever from a volume perspective, not from an income perspective, because the market is causing us to charge less.” Managing Director, Regional Bank
“Falling electricity prices aren’t leading to sponsors raising less capital, because sponsors have been beating down lenders and service providers.” Managing Director, Regional Bank
“Capital providers are taking more risk for less return.” Managing Director, Regional Bank
“Residential solar debt has become an accepted asset class.” Managing Director, Regional Bank
“Soft costs, such as marketing, legal, accounting and tax advice, are five to seven percent of a solar project’s cost in Europe and Asia; they are 35 percent of solar project’s cost here; we need to attack that.” President, Solar Developer
“Start of Construction” of Solar Projects to Qualify for the Full 30 Percent ITC after 2019
To qualify for a full 30 percent ITC, a solar project must “start construction” before the end of 2019 and be “placed in service” before the end of 2022. The IRS has published guidance as to what it means to start construction. The guidance provide two means to do that (i) a safe-harbor that requires “incurring” five percent of the ultimate tax basis of the project prior to the end of 2019 or (ii) starting “significant physical work,” which if performed by a third-party must be pursuant to a “binding written contract.” The out-of-pocket cost of significant physical work is much less than the five percent safe harbor, but it has more uncertainty. We discuss this guidance in detail in our Legal Update.
“The money is out there for the five percent safe-harbor [to finance your purchase]. It is just a question of what that money costs. I say spend the money on the five percent safe-harbor; if you don’t use the five percent safe harbor, the tax equity is going to require a higher yield and your construction lender is going to charge more.” Managing Director, Regional Bank
“My advice is use the five percent safe-harbor ([rather than, significant physical work)]; it will serve you better in the long term with respect to the reaction you will get from the tax equity market.” Managing Director, Money Center Bank
“If I have the choice between two deals and one uses the five percent safe-harbor and the other uses significant physical work, I’m going to go with the five percent safe-harbor deal.” Managing Director, Money Center Bank
“Buying solar panels and steel posts is a good mix for the five percent safe-harbor. But with steel tariffs, you don’t want to go long buying steel. So buying panels is probably the better bet.” Senior Vice President, Captive YieldCo
“Tariffs make it difficult to know where to put your money for the five percent safe-harbor.” Senior Vice President, Captive YieldCo
Tax Equity Preferences Among Solar Asset Classes
“My bank will only be doing residential (“resi”) tax equity in the solar tax equity market this year because that is only space where we can get the returns we want. We won’t do any utility scale solar this year.” Managing Director, Money Center Bank
“A 300 bp [premium relative to utility scale solar] for [residential] solar tax equity is a mystery to me because with resi solar you have a pool of assets that are less risky on a diversified basis.” Managing Director, Boutique Investment Bank
“Residential projects have a margin to support that [higher] cost of capital.” Managing Director, Money Center Bank
“Commercial and industrial (C&I) solar has even more expensive tax equity than residential.” President, Diversified Solar Services Company
Insurance for Tax Equity and Tax Basis Risk
In recent years, particularly in financings of residential solar portfolios, it has become common for the sponsor to procure an insurance policy that insures the risk that the IRS successfully challenges the value of the project that is ITC eligible. Sometimes the insurance is required by back-leverage lenders who are concerned about an unpaid tax indemnity reducing the cash available to pay back-leverage debt service; sometimes it is required by the tax equity investor, and sometimes it is purchased by the sponsor or the cash-equity investor (who may or may not have assumed some portion of the related indemnity risk) in order to sleep better at night.
Alta Wind, a recent Federal Circuit case, holds that it possible for a solar project when sold to a tax equity investment vehicle to have intangible value, such as goodwill or going concern value, even if the project has not been placed in service yet (i.e., has not yet operated as a business). The case was remanded to the trial court for a factual finding as to whether any such intangible value was indeed present. You can read more about the case in our analysis.
“After Alta, the appraiser’s job got more complicated because any intangible associated with the project does not qualify for ITC.” Managing Director, Money Center Bank
“Will insurers take ITC fair market value risk after Alta?” Managing Director, Money Center Bank
“To trust the appraiser on tax basis risk is not where we want to be. The insurers have stepped in to take that risk.” Managing Director, Money Center Bank
“Tax basis risk is incremental, not binary. You have to multiply [the benefit of a higher ITC amount] by the probability that you get hit with that risk [(i.e., lose an IRS audit)], but you can’t go crazy with basis.” President, Diversified Solar Services Company
“We now know how to not overstep our bounds on tax basis: look at true third party costs and have a reasonable markup with none of it tied to an intangible. [However,] we have no outright cap on the markup.” Managing Director, Money Center Bank
“We are going to look at all three methods of valuation” (i.e., income (discounted cash flow), replacement cost and market comparables). Managing Director, Money Center Bank
The Inverted Lease Tax Equity Structure
The inverted lease structure is a nuanced structure that uses an election in Section 50(d)(5) of the Internal Revenue Code (through a cross-reference to a provision of a prior iteration of the Internal Revenue Code) that allows a lessor to pass through the ITC to the lessee, and for the ITC to be based on the fair market value of the project (even though no party may have actually paid that amount). In one popular version of the structure, the lessee is a flip partnership between the tax equity investor and the sponsor, and the lessor is a partnership between the lessee and the sponsor.
“We like the inverted lease structure because it enables us to optimize the capital stack.” President, Diversified Solar Services Company
“I have no idea, but my guess is that the inverted lease is 20 percent of the solar tax equity market, but very few tax equity investors use that structure.” President, Diversified Solar Services Company
“We use only the partnership flip structure the solar industry” (i.e., we don’t use the inverted lease). Managing Director, Money Center Bank
“There’s less phantom income [(i.e., tax gain that is not matched by third-party cash proceeds)] in an inverted lease than a partnership flip.” President, Diversified Solar Services Company
“We can also use special allocations in an inverted lease.” President, Diversified Solar Services Company
Explanation: the IRS is of the view that “electricity” is a good that is subject to the inventory method of accounting. See, e.g., CCA 20062801F (citing PLR 200152012). Accordingly, depreciation and other expenses must be capitalized into “cost of goods sold” (“COGS”), which effectively means the depreciation must be allocated among the partners that own the project in the same manner as the revenue. For instance, Partner A cannot be allocated 45 percent of the depreciation and ten percent of the revenue, rather Partner A must be allocated a percentage of bottom line income or loss. In an inverted lease, the lessor is leasing the solar project, rather than selling electricity; accordingly, a partner of the lessor could be allocated, let’s say 49% of the depreciation deductions and 5% of the revenue.
Estimated Useful Life of Solar Projects
The estimated useful life of solar projects is important for purposes of modeling the cash flows the project can potentially generate for financing purposes, valuing the project and in transactions involving a lease of a project applying the “true lease” tax test in Revenue Procedure 2001-28 that compares the useful life to the lease term.
“We used to think 25 years, now we’re talking about 40 years.” Senior Vice President, Captive YieldCo
“We have assets now that we think have 40 year lives.” Managing Director, Boutique Investment Bank
“People are talking about re-powering solar that is less than ten years old.” Senior Vice President, Captive YieldCo
“Two or three years ago the pricing difference between back leverage [(i.e., the lender is only secured by the sponsor’s interest in the tax equity partnership that owns the project)] and front leverage (i.e., the lender has a senior mortgage over the project itself) was eliminated. So there is no reason for sponsors to select front leverage.” Managing Director, Regional Bank
“Pretty close to 100 percent of levered deals are back levered. I haven’t done a front levered deal in over four years.” Managing Director, Regional Bank
There are some front levered deals are in the market. They typically include a forbearance agreement for the five year ITC recapture period, so the tax equity investor can be comfortable that a debt default will not result in the lender foreclosing on the project, which is a sale for tax purposes and would trigger ITC recapture. Typically, the lenders in such transactions are not the European, Asian and New York banks that dominate project finance lending generally, and the tax equity investor is using a time-based (as opposed to yield-based) partnership flip structure.
“LIBOR plus 150 bps is typical for utility scale solar debt. The best sponsors get LIBOR plus 137.5 bps.” Managing Director, Regional Bank
“Large projects almost always use back leverage at the rates [quoted above], but distributed generation solar is different.” President, Diversified Solar Services Company
“The amount of debt that a sponsor can raise is based on a debt service coverage ratio that is the lesser of (i) 1.3 x P50 and (ii) 1.0 x P99.” Managing Director, Regional Bank
The “P” refers to how probable the production estimate is to be exceeded in any given year – in other words, it is a confidence interval. There is less cash generated from production in “P99” than “P50,” as P99 is the production estimate that the parties expect will be exceeded 99 percent of the time, while “P50” is the production estimate that the parties expect will be exceeded only 50 percent of the time.
“Bullet debt is fine [(i.e., a loan with all of the principal due in lump sum)], but [the lender] still [has to be able to re-paid] over the [power] contract [term]. If a loan has a five-year bullet and a 20-year PPA, we may take all of the cash [otherwise distributable to the sponsor] over the last 15-years if [the sponsor] doesn’t refi [at year five to pay the bullet].” Managing Director, Regional Bank
“Institutional lenders [(i.e., insurance companies and pension funds)] are more receptive to bullet amortization than banks.” Managing Director, Regional Bank
“If we don’t do storage, the industry is not going to grow the way want it to.” President, Diversified Solar Services Company
“We limit the number of batteries we allow into our tax equity portfolio. Our primary due diligence for batteries is making sure the batteries are not going to blow up. As we see a track record, we will allow more.” Managing Director, Money Center Bank
Community solar has become a fourth segment of the solar market: there are now utility scale, C&I, residential and community solar market segments. Community solar is something of a hybrid segment of the market as it is typically a utility scale size project but either purely residential subscribers or a mix of residential and C&I subscribers, and some are contracted with only C&I subscribers.
“As of the end of 2017, there were 743 megawatts of total community solar capacity in the US and 387 of those megawatts were installed in the US in 2017. Community solar is four percent of the total solar capacity in US.” SEPA, Executive
“Community solar is a bigger portion of the market than I would have thought, but it is still small.” Senior Vice President, Captive YieldCo
“The community solar market is moving away from offering customers leases or power purchase agreements (“PPAs”) to a ‘subscription’ model. You get more bang for your buck with a subscriber based model. The earlier community solar programs were generally prepaid PPAs or leases.” SEPA, Executive
“As of the end of 2017, 228 utilities in 36 states have some sort of community solar program and 17 states have enabling policies. Community solar in the other 19 states is based on voluntary programs offered by utilities.” SEPA, Executive
“The greatest benefit for a lender [from community solar] is risk diversification. If Sears was the only offtaker on a regular project, I would not finance that project. But if Sears is a one percent subscriber in a community solar project, no problem.” Banker, Specialty Commercial Bank
“Just like we provide construction loans to apartment buildings and do not require the apartment building to be pre-leased, we don’t require any subscriptions to be committed in order to provide financing to a solar project.” Banker, Specialty Commercial Bank
“Power is the only industry that requires businesses to pre-sell their output. We don’t require that of businesses that sell hamburgers.” Managing Director, Regional Bank
“We’ve done one community solar tax equity deal. It was in Minnesota. We required it to be fully subscribed before we closed.” Managing Director, Money Center Bank
“Community solar is very time intensive and not an efficient use of our people time.” Managing Director, Money Center Bank
“We want to see enough committed subscribers to be comfortable that the construction loan will be converted to a term loan and that there is enough cash flow to service tax equity and the term debt.” Vice President, National Bank
“I have less concern about ITC recapture with respect to a community solar project than I do a regular project.” Vice President, National Bank
“For community solar, we do not have minimum or average FICO credit score requirements. There is a data out there that folks will always pay their utility bill and accordingly their community solar bill.” Banker, Specialty Commercial Bank
“We are proponents of LMI (low-to-moderate income) community solar. Just because you are LMI doesn’t mean you don’t pay your utility bill. People like saving money.” Banker, Specialty Commercial Bank
“LMI consumers are the most price sensitive [(i.e., their electric bill is larger percentage of their pay check)], so they get the most benefit from community solar.” Executive, SEPA
“Subscriber terminations have been 1/5th of our estimates. Most of the terminations have been due to death or moving.“ President, Solar Developer
“If you are comfortable with the sponsor’s ability to replace subscribers, that’s what you are underwriting.” President, Solar Developer
“The one thing consumers hate more than utilities is wholesale suppliers [who try to persuade them to change their electric supplier]. We have to make sure that community solar is not confused with wholesale suppliers.” President, Solar Developer
“There is no limit to how many C&I customers that we will allow a community solar project to have. The most important thing is to make sure all the subscription contracts are uniform. The more C&I customers a project has the longer the underwriting takes. We are happy to have the subscribers be 100 percent residential consumers. We want to see the subscription contracts in the money [(i.e., a kWh cost that is less than purchasing from the utility)], so the subscriber is motivated to pay his bill.” Vice President, National Bank
“A floating community solar rate [(e.g., the rate will always be 90 percent of the standard utility rate, which will vary over the life of the subscription agreement)] provides a customers a simple and secure value proposition, but it is a more complex for tax equity and lenders to underwrite. Perhaps a solution would be floating with a floor [(e.g., the customer’s rate is the higher of (i) 90 percent of the standard utility rate at any given time and (ii) 3 cents a kilowatt hour)].” Vice President, National Bank
“Customer acquisition costs are $600 to $1,000 per customer.” President, Solar Developer
“Net metering (i.e., the ability of consumers to sell power to the utility to the extent the system on site produces more power than the customer needs in any given time interval) is compensation for value provided. It is not a subsidy. The value provided is distributed generation solar replacing peak power and the health benefits of emissions free electricity. We should not accept the argument that net metering is a subsidy.” President, Solar Developer
Corporate Power Purchase Agreements
“Corporates want ten year PPAs.” Managing Director, Boutique Investment Bank
“A utility scale project with four or five corporate offtakers can be financed. We are seeing that trend.” Managing Director, Boutique Investment Bank
“We are seeing more creativity with respect to merchant structuring, whether for the post-contract period or for a portion of the project that is not contracted from the outset.” Managing Director, Boutique Investment Bank
“The market is saying bid to zero percent internal rate of return during the contracted period [(i.e., just recover your investment)] and make your profits from the residual” (i.e., the merchant period after the contracted period). Managing Director, Regional Bank
“The smaller the deal the longer the merchant tail [(i.e., the period after the base term of the offtake contract)] that is financeable because for a small deal you only have to find one bank to finance it.” Managing Director, Regional Bank