Will tax equity deals really drive US storage?

• Inflation Reduction Act opened door for tax equity investment in standalone storage
• ‍But setting up tax equity deals can be expensive for small developers, costing up to $1m
• Only a handful of tax equity investment providers operating in the market
• Corporates may enter tax equity market via syndications

One of the benefits of the US Inflation Reduction Act (IRA) – which was introduced last year – was the creation of an investment tax credit (ITC) for standalone energy storage projects. Prior to the enactment of the IRA, the Section 48 investment tax credit (ITC) did not apply to standalone storage projects – storage projects could only claim the ITC if they were installed in connection with a new solar generation facility, and then only if the energy storage project was charged at least 80 per cent by the solar facility. The IRA changed the landscape, however, by extending the Section 48 ITC to standalone storage.

Storage market observers have lauded the legal change, saying it will provide a much-needed new source of capital for standalone storage projects in the form of the tax equity investor. What is a tax equity investor? They are usually large financial institutions – such as banks and insurance firms – that have substantial tax obligations and therefore want the tax credits, while also seeing the typical yield of 6% to 8% as an attractive return. 

Tax equity investments: The lowdown

How exactly does a tax equity investment work? An investment of this type could be structured in one of a number of ways, but the most frequently used mechanism is the ‘partnership-flip’. This involves a tax equity investor investing capital into a special purpose vehicle (SPV), which is set up by the project developer and treated as a partnership for federal income tax purposes. The main objective of the SPV is developing, owning and operating one or more energy storage assets.

In return for making the investment, the tax equity investor is issued shares in the partnership that mean it is entitled to almost all of the partnerships tax items and an agreed proportion of its cash distributions. At some point in the future, the tax equity investor will have received enough tax items and cash to reach a negotiated internal rate of return on its investment, a time which is usually described as the ‘flip date’. Now, the percentage allocations of tax items and cash flow ‘flip’ with the result that most company tax items and cash flows are subsequently allocated and distributed to the developer rather than the investor.

Eolian: First beneficiary of tax equity investment in standalone storage

It's undoubtedly a handy new source of financing for some standalone storage projects and, in February this year, Eolian – a portfolio company of Global Infrastructure Partners – announced that it had closed what it described as a first-of-its-kind tax equity investment in two standalone utility-scale battery storage projects located in Mission, Texas. The Madero and Ignacio projects are interconnected battery storage facilities located on a single site with a combined operating capacity of 200MW. “This pioneering financing is the first use of the Investment Tax Credit (ITC) structure by a standalone utility-scale battery energy storage system and is possible due to passage of the Inflation Reduction Act of 2022,” an Eolian statement said. The tax equity investment in the projects was provided by a fund managed by Churchill Stateside Group, LLC. 

Tax equity deals can cost $1 million

But there is scepticism about whether tax equity financing will be as widely used to fund standalone storage projects as is hoped. To begin with, the amount of tax equity investment available is limited. For example, during the period 2020 to 2021, more than 50 per cent of the $20 billion tax equity market’s investment supply came from just two large banks: JP Morgan and Bank of America. There are other major players – such as Wells Fargo, US Bank and Credit Suisse, but the field is small because participants not only must have big enough tax obligations to desire tax breaks, but also have the capacity to set up and manage what is an extremely complex instrument. Indeed, the fact that tax equity investment is so complex means that it also acts as a deterrent for smaller energy storage developers – senior executives at storage companies have lamented the fact that arranging tax equity financing is much more difficult than securing project finance. It’s also very expensive to arrange tax equity financing, which consequently puts it out of the reach of many storage developers. Such deals often incur costs exceeding $1 million, with even the simplest structures costing more than $250,000 to set up.

Will tax equity provide ESG boost?

Will the number of tax equity providers increase? Possibly – it’s been mooted that more corporates could enter the fray, particularly those already backing clean energy projects via power purchase agreements. For example, in March this year, Nestlé agreed a deal with Enel North America that saw the food and drink company become the sole tax equity investor in Enel's 208 MWdc Ganado solar-plus-storage project in Jackson County, Texas. Amazon, Google and Toyota are among other big-name corporates that have made tax equity investments in the renewable energy sector. Indeed, there is speculation that, with the pressure on corporates to minimise their carbon footprint increasing, from an environmental, social and governance (ESG) perspective, tax equity investment could be a way for companies to demonstrate ‘additionality’, that is, a positive impact or outcome that would not have otherwise occurred without additional resources or capital investment.

That said, there are doubts that the provision of tax equity investment by corporates – as opposed to large financial institutions – will take off in a big way. The plain truth is that only a handful of corporates have seen fit to get involved in tax equity deals up to now.
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Tax equity investors will get more comfortable ‍

Yet tax equity deals are expected to become a more prominent feature in the energy storage sector. A report published last week by the law firm Troutman Pepper – entitled Taking Charge: Inside the U.S. Battery Boom – highlighted that the biggest challenge for battery owners and tax equity investors is that standalone batteries are not generating assets like solar or wind farms, where tax equity is linked to project cashflow from energy production. “Batteries have different revenue streams that will pose a challenge for the market,” the report concluded. Yet the report said that it is anticipated that projects where the power output is fully sold will “get to a stage where tax equity investors are comfortable underwriting those projects using traditional tax equity structures”. However, merchant storage projects are more likely to use transfer mechanisms, as they rely more on fluctuating demand and pricing of energy. Troutman Pepper has also stated that developers now looking at standalone storage projects will have to find the right mix of merchant exposure and contracted offtake to attract tax equity investors without diminishing overall returns.

Credit transferability will entice more tax equity investors

At present, sources of tax equity investment are limited and consequently the number of storage projects that are financed using this mechanism in the short term will amount to a trickle rather than a flow. The cost of setting up tax equity structures can be prohibitive for developers of smaller storage projects and the fact that so few institutions are offering this type of investment means they will be very careful about which projects they choose to back.

But the outlook could change. With regard to certain clean energy tax credits, for tax years beginning after December 31, 2022, the IRA allows for transferability – wherein a tax credit can be transferred or sold to another taxpayer or tax-paying entity for cash, a mechanism often used to incentivise businesses to invest in a certain area or industry, like renewable energy. The expectation is that this will likely bring more tax equity investors into the market and increase competition. In addition, there is a view that more corporates will begin deploying tax equity investments via syndications, which Cohn Reznick Capital has highlighted as an “easy avenue for new entrants, particularly corporations”.

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