Who Monetizes Investment Tax Credits?

There is a deep market for U.S. Federal investment tax credits sought by highly profitable, usually non-capital-intensive service companies. Since the mechanism for transferring the benefit of these credits from a user of capital equipment (which is unable to use the tax credit) to an owner (which seeks tax credits to reduce its Federal income tax liability) typically takes the form of a true lease, it is no surprise that financial institutions are the primary investors in these transactions.

Types of True Lease Structures
These leases are usually structured in one of two ways:

• a direct lease between a single financial institution acting as lessor, and a user of the equipment, acting as lessee; or
• a tax equity transaction in which a partnership consisting of one or more financial institutions and a developer acts as lessor.

In either case, the lessor acquires ownership of the equipment for which the tax credit is to be monetized, and leases the equipment to a user that is unable to benefit from the investment tax credit because it has insufficient or no current or past taxable income. The lessor passes the benefit of the investment tax credit to the lessee in the form of a reduction in the rental payments otherwise due under the lease.

Lease Economics

In the case of the current 26% investment tax credit, the aggregate rent in such a lease can be as low as 70% of equipment cost resulting in negative implicit rate (i.e., IRR) in the lease. In other words, the lease payments do not return the Lessor’s original investment in equipment cost as a substantial portion of Lessor’s cash flow and yield return is provided by the investment tax credit.

Who Are these Financial Institutions?

There are at least 3-4 dozen major financial institutions—both U.S. based and the U.S. subsidiaries of Canadian and E.U. institutions—that are active in the direct lease market. There is little uniformity in the way that the investors document these transactions which raises their complexity and the difficulty of execution—especially if multiple investors need to be employed to finance the requirements of a single user/lessee.

Lessors will typically step up for $15-25 million investment in equipment cost in a first-time transaction with cumulative outstanding exposures to a single Lessee building to as much as $250-300 million over time for the larger institutions. Aggregate outstanding exposure to any one user/lessee is determined by the creditworthiness of that company unless external means are used to provide collateral support for the lessor.

What Determines Which Lease Structure is Appropriate

The lease structure normally used for smaller transactions—usually in the range of several million to $25 million of equipment cost financed each with a separate user, equipment configuration and documentation—is a direct lease with a single lessor and a single lessee.

The lease structure used for large transactions—usually in the range of $50 – $300+ million of equipment cost financed—especially utility-scale projects with a single, very creditworthy lessee like a utility, energy company, etc., is usually a tax-equity partnership. This structure allows for (a) multiple tax equity investors, (b) debt leverage, and (c) reallocation of membership interests between Lessors and the developer once all the available tax benefits—principally the investment tax credit and depreciation deductions—have been vested .

Estimated Market Capacity

According to Norton Rose Fulbright, a major international law firm heavily involved in renewable energy financings, the estimated size of the renewable energy tax equity market was a $12 to $13 billion in 2019 and was $17 to $18 billion in 2020. Two banks – JPMorgan and Bank of America – accounted in both years for more than half the market (https://www.greenbiz.com/article/why-jpmorgan-chase-committed-200-billion-clean-financing, https://newrepublic.com/article/162444/wall-street-profiting-clean-energy-tax-credits).

In addition to the usual suspects, the tax equity market is also populated by a number of highly profitable tech companies that are seeking both to virtue signal and simultaneously shelter their not-insubstantial income. They also happen to be major users of electrical power for their data centers. These investors include, among others, Alphabet, Inc., Facebook, Inc., Microsoft Corporation, etc.

We estimate the annual capacity for the direct lease market to be $5- $10 billion per annum (in terms of equipment cost financed). It appears that the dominant equipment type being financed under these structures is solar, following by wind and a newcomer, hydrogen fuel cells.

Risk Vs. Return

Although the yields on the tax equity partnerships are higher than what is available for the direct leases, the partnership transactions usually involve longer lease terms (and therefore greater credit and funding risk) and may involve higher tax risk due to the higher profile of the transactions (and therefore audit).

Some financial institutions invest in both direct leases and partnership leases; others invest in one or the other. We have found that some of the largest institutions will only invest in the partnership transactions most likely chasing their higher yields and the ability to deploy substantial amounts of capital with fewer investments and staff.