Financing Strategies for Renewable Energy Projects Southwest Renewable Energy Conference 2010
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Financing Strategies for Renewable Energy ProjectsSouthwest Renewable Energy Conference 2010 Office: 414.225.2752 Cell: 414.588.2948 Email: email@example.comLinkedIn: http://www.linkedin.com/in/geoffreymorganTwitter: Geoff_MorganGeoffrey R. Morgan Michael Best & Friedrich LLP100 East Wisconsin AvenueSuite 3300Milwaukee, WI 53202michaelbest.com/grmorgan
IntroductionArranging finance for a renewable energy project is not a task to be underestimated by developers, especially those with no previous experience in raising finance or establishing successful power generation projects. It is important that developers bear in mind the following:
Introduction (contd)Process of arranging financing is time consuming.Technical, contractual and consent aspects of a project all affect the financing.No template problems will emerge that require determination and, often, ingenuity to overcome.
Introduction (contd)Small projects (less than $30 million) may be difficult to attract the attention of lenders or investors. A developer may believe that the project will sell itself based on its own merits, but in reality the developer will have to adhere to the strict terms and conditions applied to project financing.Identification and use of tax incentives has become critical.Grants and loan guarantees helpful but difficult to procure.In summary, the technical difficulties of a project, which in themselves may appear daunting, are often exceeded by the complexities of raising the necessary finance.
Financing AlternativesMost projects are highly capital-intensive and will require the developer to raise large amounts of finance well in advance of the start of operations. Although every project is different, and a variety of means have been used to date, there are generally four possible routes for financing a project:
Financing Alternatives (contd)1.Use of internal company or personal reserves, or obtaining funds from friends and business associates. Except for the smallest renewable energy projects, it is unlikely that sufficient personal reserves would be available to meet the total cost of the project. It may not be suitable to use company reserves and hence one of the alternative routes will need to be considered.
Financing Alternatives (contd)2.Use of bank loans secured against other parts of the developers business or major assets (on-balance sheet finance) or personal guarantees often linked to property owned by the developer.3.Co-development of the project with a financially strong joint-venture partner who is more readily able to raise the necessary finance.4.Limited recourse project financing, whereby bank loans are secured largely against future cash flows rather than just physical assets, and involving a series of complex contractual arrangements.
Factors Which Affect the Financing DecisionAt an early stage in the projects development, the developer and sponsors should therefore consider whether to finance a project on a limited recourse basis or on an on balance sheet basis by addressing the following questions:
Factors Which Affect the Financing Decision (contd)Do the developers/sponsors have the financial wherewithal to provide the full financing requirement from within their own resources, and do they wish to use them for the project?Is the magnitude of the potential financial obligations such that, if the project were a failure, there would be serious damage to the financial health of the developer?Are there specific project risks with which the developer is not comfortable and desires to see laid off, i.e., technology risk in a structured manner to third parties?
Factors Which Affect the Financing Decision (contd)Is the project in a non-core business segment for the developer, where the shareholders and financial markets would expect the companys exposure to be limited?Is the size of the financing requirement too small to attract the interest of project finance lenders, who are unlikely to consider a transaction where the debt component is less than about $10-20 million, unless there are special factors which affect the banks decision such as loan guaranteesDOADOEBIA
The Project ContractsThe commercial contracts form the basis of the security structure which creates the project cash flow and hence underpins a project financing. For renewable energy projects, the typical principal contracts are:Power purchase agreementEngineering, Procurement and Construction Agreement (may be separated into more than one agreement)Fuel or waste supply contract (if required)Operating AgreementShareholders (or joint-venture) agreement
Summary of Tax IncentivesInvestment Tax CreditProduction Tax Credit1603 Treasury GrantTax Credits vs. 1603 GrantMonetizing the ITCTax-Exempt Use Property IssuesNew Markets Tax Credits
ITCThe investment tax credit (ITC) is a federal income tax credit equal to 30% of the tax basis of property which generates electricity from certain renewable sources. IRC 48.No cap on amount of credit.100% of the ITC is claimed in the tax year that the property is placed in service (i.e., when property is producing electricity).
ITC (contd)2009 Stimulus bill deleted provision reducing the ITC by the amount of grants, tax-exempt bonds and subsidized energy financing.Because the credit is calculated based on the tax basis of property, the credit would thus be reduced only by grants, etc. that are not taxable. See IRC 118; 362(c).
ITC (contd)5 year graduated recapture period. IRC 50(a)(1).
ITC (contd)Claiming the ITC results in a reduction in tax basis of renewable property equal to 50% of amount of grant (50% * 30%). IRC 50(c)(1) & (c)(3)(A).
PTCThe production tax credit (PTC) is a federal income tax credit of 2.1 (adjusted annually) per kilowatt hour of electricity produced over a 10 year period. IRC 45(a).PTC requires electricity be produced by the taxpayer (i.e., no leasing). IRC 45(a)(2)(A).PTC requires power to be sold to a third party. IRC 45(a)(2)(B). Notice 2008-60 looks to the ultimate buyer of electricity to determine who is the third party (i.e., a customer of a public utility rather than the utility itself).No such requirement for the ITC or the 1603 Grant, permitting net metering projects where the project owner uses the electricity.
PTC (contd)Reduction of credit for grants, tax-exempt bonds, subsidized energy financing and any other credit allowable with respect to any property part of the project. IRC 45(b)(3).Reduction is lesser of 50% or the ratio of the other financing to aggregate project costs.Likely causes a reduction of the tax basis of the project when the PTC is coupled with new market tax credit financing, loan guarantees or other programs resulting in financing terms better than market rates. See IRS Form 6497.
1603 Treasury GrantCreated under Section 1603 of the 2009 Stimulus Bill to be substantively similar to the ITC but paid as a grant.Federal grant equal to 30% of the tax basis of property which generates electricity from certain renewable sources. ARRA 1603(a) & (d).No cap on amount of grant.The grant can be claimed in lieu of either the ITC or the PTC. IRC 48(d)(1).
1603 Treasury Grant (contd)Not available for pass-through entities with a tax-exempt owner (including Indian tribal governments). IRC 54(j).Generally tracks terms of the ITC.5 year recapture. ARRA 1603(f); IRC 50(a)(1).Causes reduction in tax basis of renewable property equal to 50% of amount of grant (50% * 30%). ARRA 1603(f); IRC 50(c)(1) & (c)(3)(A).
1603 Treasury Grant (contd)Not taxable to the project. ARRA 1603Grant is paid within later of (a) 60 days of application or (b) the date the project is placed in service. ARRA 1603(c). Application must be submitted by October 1, 2011. ARRA 1603(j).Project must be placed in service by December 31, 2010. ARRA 1603(a)(2).
Monetizing the ITCQ: How can Project Developer monetize the ITC while ultimately owning the solar project?A: Partnership structure.
Monetizing the ITC (contd)The project is owned by an entity taxed as a partnership (i.e., an LLC).The LLC is initially owned by the developer.A tax credit investor purchases an equity interest in the LLC from the developer. The developer retains a minority interest in the LLC. LLC governing agreement provides 90%+ of tax items (including tax credits) which are allocated to the investor, with the remaining less than 10% interest allocated to the developer.
Monetizing the ITC (contd)The developer holds an option to acquire the interest of the tax credit investor. The option is exercisable after a period of time that is:necessary for the developer to obtain a negotiated return on investment andafter any tax credit recapture period expires.The option exercise price must be equal to the then-fair market value of the tax credit investors interest or else the IRS may recalculate the investors ownership percentage, jeopardizing the investors allocation of tax credits.
Tax-Exempt Use PropertySolar and wind equipment (i.e., electric generating equipment up to the transmission stage) generally is depreciated over a 5-year, double declining balance depreciation. IRC 168(e)(3)(B)(iv).When property is tax-exempt use property, such property is required to be depreciated using the straight line method over a 40 year useful life. IRC 168(g)(2).
Tax-Exempt Use Property (contd)All or a portion of property owned by a partnership with a tax-exempt partner may be tax-exempt use property. IRC 168(h)(6)(A). If allocations to the tax-exempt partner are qualified allocations, then property owned by the partnership will not be t