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Improving tax incentives for wind energy production: the case for a refundable production tax credit.


Despite heated discussions in the media and on Capitol Hill, one climate change debate appears to be reaching a consensus: over ninety-seven percent of climate scientists now believe the world's climate is warming as a result of human activity. (1) In reaching an international agreement on climate change in Paris late last year, the United Nations called climate change "an urgent and potentially irreversible threat to human societies and the planet." (2) The Intergovernmental Panel on Climate Change has concluded that continued human interference with climate systems will increase the likelihood of "severe, pervasive, and irreversible impacts," including substantial species extinction, significant risks to food security, and temperature and humidity changes that may threaten normal human activity. (3) In the United States, a recent White House report asserted that climate change caused by emissions of greenhouse gases--and carbon dioxide in particular--is to blame for increasingly frequent and intense heat waves in the West and downpours in the Midwest and Northeast (4)

Growing concern about climate change has been used to rally support for government subsidies for renewable energy investment. (5) Two important tax credits have been available to help subsidize renewable energy projects: the investment tax credit (6) and the production tax credit. (7) The two credits, which are mutually exclusive, serve similar roles in the renewable energy industry and face similar challenges. This Article, however, will focus on the more controversial of the two: the production tax credit, which was recently extended by Congress. (8) This Article argues that the production tax credit should be amended to make the credit refundable. As explained below, a refundable version of the production tax credit would make it more effective and better able to promote market efficiency and fight climate change by eliminating the need for costly transactions currently used to monetize the credit.

The production tax credit was introduced as part of the Energy Policy Act of 1992, (9) which marked the first time that Congress "acted affirmatively to address the issue of global climate change." (10) The credit provides a dollar -for-dollar tax benefit to the owners of eligible renewable energy facilities, including certain wind farms, based on the amount of electricity produced and subsequently sold to unrelated persons. (11) The amount of the credit available to wind projects for any taxable year is 2.3 cents per kilowatt-hour ("kWh") of electricity generated: (12) the amount of energy required to power a 100-watt light bulb for ten hours. (13) In 2010, 246 claimants claimed a total of $1.7 billion in production tax credits, an average of roughly $6.9 million per claimant. (14) Eligible taxpayers can claim the credit during the first ten years after the renewable energy project began generating electricity. (15)

Like most tax credits, the production tax credit is a nonrefundable credit that delivers economic value to taxpayers solely by offsetting their tax liability. (16) In other words, taxpayers can apply the credits to achieve dollar-for-dollar reductions to their tax bills. (17) In general, these tax credits are the economic equivalent of delivering a direct subsidy to a taxpayer in the form of a check; (18) however, because the taxpayer receives a reduction in taxes owed instead of a check, the "subsidy" delivered via a nonrefundable credit is limited by the amount of taxes owed. Nevertheless, because the production tax credit can be understood as a spending program administered through the tax system, this Article at times refers to the production tax credit as a subsidy for wind energy producers. The production tax credit, which is subject to periodic sunset provisions, was allowed to expire at the end of 2014. (19) Efforts to reinstate the credit were resisted by Republican lawmakers, who gained control of Congress in 2015, but the credit was ultimately extended along with several other expired tax provisions as part of a budget deal approved by Congress in December 2015. Given the widespread concerns about climate change--not to mention energy independence--it is safe to assume that legislators will continue to face questions about whether, and how, to encourage renewable energy production. Continued government involvement in renewable energy, whether through direct regulation or through the tax system, should be expected. Policymakers should revisit the traditional approach to incentivizing renewable energy through the production tax credit and seek ways to improve the credit.

The purpose of this Article is to further our understanding of how the production tax credit works and does not work as a tax incentive to promote investment in renewable energy and to fight climate change. For reasons to be discussed, the tax incentives traditionally available present a number of transaction costs and limitations that make them less effective than alternative incentives. Specifically, this Article looks at the way the production tax credit is employed in the context of wind farm development. Because similar tax incentives and market conditions are relevant to other renewable energy industries, such as the solar energy industry, the wind industry was chosen as a representative case study within this context. (20) Though the production tax credit has been important for encouraging growth throughout the renewable energy industry, it has been especially important in the context of wind energy. (21)

Wind farms, which use wind turbines to convert natural wind into mechanical energy and then electricity, (22) have been "the fastest growing energy technology worldwide, achieving an annual growth rate of over 30%" in total installed capacity. (23) Wind energy capacity, which is the amount of power that could be supplied if it were possible to run all wind turbines continuously at full-load, is measured in megawatts ("MW"). (24) One megawatt is roughly the amount of energy produced by ten automobile engines, and one megawatt-hour is enough energy to power about 330 homes for one hour. (25) From 2009 to 2014, U.S. wind energy capacity grew from 25,000 MW to over 61,000 MW. (26) The amount of electricity generated from these turbines grew 200% during that period, an increase the American Wind Energy Association attributes to "technological innovation and operational improvements, which [have] effectively driven down the costs and allowed development to occur in lower wind speed regions." (27)

Opponents to the production tax credit assert that the wind industry has matured to the point that continued subsidies are no longer justified. Executives from traditional energy companies told Forbes magazine: "We believe the [production tax credit] has achieved its original purpose, namely shepherding a nascent industry to maturity, and any extension will cost taxpayers and electric consumers billions simply to benefit a handful of vested interests." (28) Conservative groups have opposed the renewable energy tax credits on the belief that the government should not interfere in the free market, arguing that "forcing new-energy companies to weather market forces is the best way to test their viability and strengthen the wider energy field." (29)

There is truth to the view that subsidies can distort market activity; somewhat ironically, historical subsidies for fossil-fuel producers have contributed to distortions in the energy sector that now disadvantage wind energy producers and drive the need for renewable energy subsidies. (30) For example, the oil and gas industry has long had the benefit of tax-favored Master Limited Partnerships to help finance extraction activities. (31) While some economists have proposed parity for renewable energy companies, (32) others have advocated for ending all energy subsidies, for both traditional and renewable energy producers, based on faith in the free market and distaste for distortions caused by economic incentives. (33) To the extent that energy subsidies distort the market, rather than respond to and correct existing market distortions, such proposals have merit.

However, the distortions in the energy sector exist apart from the historical fossil-fuel subsidies. First, University of Kansas School of Law environmental law professor Uma Outka has explained that "an implicit support structure for fossil energy is written into law in a range of areas, including environmental law, and ... statutory and regulatory concessions to fossil energy inevitably distort how the costs of bringing new energy technologies to scale are perceived." (34) These historical features of the energy industry continue to present significant barriers to newer players like wind energy producers. Second, and most importantly for this Article, traditional energy producers emit pollution, a negative externality that distorts prices in the energy industry to the detriment of clean energy producers. (35)

The production tax credit is a subsidy intended to counter these distortions in the energy sector by making wind energy projects more profitable. 36 For this purpose, the production tax credit works very well. The wind energy industry is highly sensitive to the availability of subsidies like the production tax credit, and observers have collected significant data that correlates slowed growth in the wind industry with periods of political uncertainty about the future availability of the credits. (37) The expiration of the production tax credit at the end of 2013 was blamed for a decrease in the number of new wind projects and lost jobs related to the wind industry. (38) This Article does not discuss whether the production tax credit delivers a meaningful economic benefit to the wind industry. (39) Rather, this Article seeks to contribute to the understanding of how the production tax credit works to promote a more efficient energy market, and it proposes changes to the credit that would not only make the production tax credit a more effective subsidy, but would also better align the credit with broader tax policy goals.

Part II begins by exploring the theoretical justification for the production tax credit as a Pigouvian subsidy intended to incentivize behaviors that produce positive externalities. The presence and effect of negative externalities in the energy sector are well documented, as pollution is a classic example of a negative externality responsible for market failure. (40) The positive externalities renewable energy companies generate when they displace traditional energy, however, are more nuanced. Yet, this context is essential to understand the justifications for the production tax credit.

This Article next describes the production tax credit in practice. As has been noted by others, design features of the production tax credit have led to complex financing structures with high transaction costs. (41) The most common tax equity investment structure requires wind developers to partner with passive investors who are willing and able to contribute capital in exchange for tax benefits. (42) The pool of so-called "tax equity investors" is limited to roughly eleven to twenty cash-rich corporations outside the energy industry that include household names like Google, MetLife, Bank of America, J.P. Morgan, Wells Fargo, and Morgan Stanley. (43) Anti-abuse provisions in the tax code operate to keep the pool of tax equity investors small, decreasing the availability of tax equity financing to wind developers. (44)

Part III of the Article takes a closer look at the legal environment in which tax equity investment transactions take place and asks how legal uncertainty may further discourage new entrants to the tax equity investment market. The first major area of legal uncertainty surrounding the production tax credit stems from sunset provisions that threaten the availability of the credit. (45) The sunset provisions have already received significant attention in academic literature and, therefore, are addressed only briefly in this Article. (46) The second potential source of uncertainty, which has received considerably less attention in academic literature, dates back to a 2012 court case over rehabilitation tax credits. In Historic Boardwalk Hall, LLC v. Commissioner, the U.S. Court of Appeals for the Third Circuit denied a tax equity investor the benefit of rehabilitation tax credits based on a substance-over-form analysis that recast the tax equity partnership as a prohibited sale of the tax credits. (47)

The Internal Revenue Service ("IRS") responded to the Historic Boardwalk case with agency guidance specific to rehabilitation tax credit transactions. (48) That guidance, which was watched closely by the renewable energy industry, differed in several respects from the safe harbor guidance on which wind energy tax equity investors have typically relied. (49) Though the existing tax equity investment market continues to take comfort in the wind safe harbor, the recent legal uncertainty in broader tax equity investment markets highlights the fine line between legitimate tax equity financings and abusive transactions. At least some potential investors have probably chosen to shy away from tax equity transactions in favor of more traditional deals. Thus, this Article argues that continued reliance on costly tax equity investment transactions is bad for the wind industry because it depends upon a limited pool of capital that is unlikely to grow significantly.

Here, this Article departs from existing scholarship by arguing that a subsidy that relies heavily on tax equity investment transactions reflects poor tax policy because the subsidy is poorly targeted to reach its intended recipients. For this reason and others, this Part challenges the premise of recent commentators whose proposals would have considered how the production tax credit could be redesigned to help expand the supply of tax equity investment financing. (50) Part IV shows that tax equity investment transactions misdirect part of the subsidy's value away from wind projects through investment returns and advisor fees. The analysis demonstrates that tax equity investment is more costly than traditional commercial financing that would be more readily available if the production tax credit were refundable. This Part argues that a better proposal would eliminate the need for tax equity finance transactions by making the production tax credit refundable.

The discussion below shows that a refundable production tax credit would constitute a more effective, better targeted subsidy than the nonrefundable version, largely because it would eliminate the need for tax equity financing. This proposal would not only improve the efficacy of the production tax credit in practice, but it would also be consistent with broader tax policy goals such as efficiency and simplicity. Accordingly, Part V concludes that the production tax credit should be amended to make the credit refundable.


A. The Wind Energy Production Tax Credit and Positive Externalities

At the outset, the argument in favor of the production tax credit can be stated normatively in terms of the government's obligation to protect its citizens and their general welfare by promoting clean energy. Specifically, the government should act to protect the populace from the dangers presented by climate change, including harms to health, property, and the country's physical landscape. Support for clean energy tends to fall along political party lines, however, and the ethical arguments in favor of subsidizing wind energy production often result in political gridlock. Perhaps for this reason, modern tax scholarship has acknowledged that ethical arguments play a role in policy choices, (51) but it has generally drawn more heavily from economic theory. (52)

Economic theory is based on the premise that, in a perfectly efficient free market, the price of a good will equal its marginal cost. Social welfare theorists further argue that at this price, supply and demand would reflect the socially optimal level of a good, which is the amount of the good required to maximize social wellbeing. (53) Certain real-world problems can prevent markets from functioning efficiently, however. As a result, the price may not equal the marginal cost, and the quantity of the good supplied may not be the socially optimal amount. (54) In such instances, the market is said to be inefficient --or in a state of market failure--due to the oversupply or undersupply of a good. One problem that can lead to market failure is the existence of externalities. (55) Externalities describe costs, or benefits, that are not taken into account in the price of an item because consumers do not fully internalize that cost or benefit. (56)

The classic example of a negative externality, described by British economist Arthur C. Pigou in the 1920s, is pollution. (57) Pigou described a factory emitting smoke that harms consumers, observing that the smoke "inflicts a heavy uncharged loss on the community, in injury to buildings and vegetables, expenses for washing clothes and cleaning rooms, expenses for the provision of extra artificial lights, and in many other ways." (58) In other words, pollution is a negative externality because the full cost of the pollution associated with the factory's output is not included in the price of the goods it produces.

In theory, when traditional energy producers engage in pollution-causing activities without internalizing the social costs of pollution--the costs of which typically are passed on to purchasers--the price they charge consumers will be artificially low, and the amount paid by consumers cannot adequately compensate for the harms inflicted on society. (59) The artificially low price of traditional energy thus renders more appropriately priced competitors, including clean energy companies like wind farms, unable to fully compete. (60) This circumstance can result in an undersupply of the competing good, which in this case is wind energy.

Stated more directly, the theory of negative externalities suggests that even if all regulatory distortions in the energy industry are ignored, the price of carbon emitting traditional energy sources is artificially low and leads to an oversupply of fossil fuels and a corresponding lack of demand for alternative sources of energy. 61 As a result, the wind industry will be unable to fully compete with traditional energy because demand for wind energy will always be suppressed relative to traditional energy due to the role of negative externalities in the energy industry.

Existing law and policy literature in support of taxing traditional energy or subsidizing renewable energy has relied on the existence of these negative externalities as sufficient justification for policy intervention. (62) Most academic observers have agreed that a well-designed corrective tax on the greenhouse gas carbon dioxide, which is a negative externality associated with fossil fuels, would be a more efficient and effective policy choice for controlling emissions than tax subsidies. (63) Nevertheless, tax subsidies for renewable energy have enjoyed more political support than the carbon tax. (64) A subsidy like the production tax credit does not force traditional energy producers to internalize negative externalities in the same way that a carbon tax might, (65) but it does have a related externalities-driven purpose. The production tax credit is properly understood as a Pigouvian subsidy to correct positive externalities.

A Pigouvian subsidy on positive externalities, which is the complement of a Pigouvian tax on negative externalities, (66) compensates producers for externalities that confer a benefit on society that is not reflected in the price. (67) At first blush, it seems reasonable enough to conclude that the production tax credit is justified because an increase in clean renewable energy from wind energy generation would have a corresponding beneficial decrease in harmful carbon emissions; however, it is worth considering the fact that, absent a substitution effect, renewable energy does not actively reduce pollution.

The way that wind farms reduce greenhouse gases stands in stark contrast to more textbook examples of positive externalities. Among the most traditional examples of positive externalities are research and development activities that benefit firms other than those that invest in the activities. (68) A more interesting example, however, is found in beer breweries located along the James River in Richmond, Virginia. (69) The breweries' wastewater releases carbon into the James, which helps remove dangerous nitrogen from the river, thereby improving water quality and saving the city money by reducing clean-up costs. (70) In recognition of this clear positive externality, the city gave the breweries a break on their utility bills. (71)

Wind farms differ from both the beer breweries and the classic example of research and development activities. First, wind farms are different from the beer breweries because wind farms do not reduce existing carbon levels simply by operating. (72) Second, unlike in the research and development context, wind farm developers do not avoid investing in new wind projects due to fear that their returns will be diminished by competitors who will benefit from their investments. (73) Rather, they avoid investing in new wind projects because wind farms cannot out-compete traditional energy producers, which can sell their energy at artificially low prices. (74)

Rather, wind farms' potential benefit to the environment--a social benefit that should be considered an uncompensated positive externality--is realized when wind energy displaces traditional energy (the "substitution effect") and causes a corresponding offset to carbon emissions. Washington University in St. Louis economist Joseph Cullen developed an economic model to estimate the environmental contribution of wind power resulting from this substitution effect. (75) Cullen's study of a large electricity grid in Texas confirmed that wind power subsidies do result in displacement of fossil fuel energy, but it also showed that the effect of this substitution effect on mitigation of emissions varies greatly depending on the type of generator displaced. (76) Cullen's results, though based on a discrete case study, highlight the fact that the distribution of positive externalities across wind energy producers would be hard to assess: "When low marginal cost wind-generated electricity enters the grid, higher marginal cost fossil fuel generators will reduce their output. However, emission rates of fossil fuel generators vary greatly by generator. Thus, the quantity of emissions offset by wind power will depend crucially on which generators reduce their output." (77)

An efficient production tax credit would subsidize wind farm development so that the market price for wind energy would reflect its full social value, which is the private value of wind energy to consumers plus the value of offset carbon emissions. (78)

A production tax credit that achieves this result would be considered optimal. (79) In reality, however, policymakers are limited in their ability to set the production tax credit to the correct level to restore market efficiency. First, the government would have to know the correct amount of wind development that would result in the optimal amount of carbon reduction, which may be impossible, especially in light of Cullen's observations. (80) Second, the government would have to know the economic value of carbon reduction, which may also be impossible. (81)

Even without knowing the optimal size of the subsidy, however, it is reasonable to conclude that if the full subsidy does not reach its intended recipients, then the tax will not be as effective as it would be otherwise. As the next Part shows, in practice, certain features of the production tax credit have hindered the delivery of the subsidy and led to the widespread use of transactions that drive the subsidy away from wind farms. These transactions misdirect part of the subsidy away from wind developers, resulting in a poorly targeted subsidy that is less effective than it could be if it were amended to be a refundable credit.

B. The Wind Energy Production Tax Credit in Practice: An Ineffective Subsidy

1. Restrictions on Wind Developers' Ability to Use the Wind Energy Production Tax Credit

The production tax credit is available to eligible wind energy companies during their first ten years of generating electricity. (82) This timing has a significant consequence: because the production tax credit is not available until a wind farm begins generating energy, (83) wind projects in the development phase cannot earn the credit because they are not yet producing energy. (84) Tying the subsidy amount to actual wind energy generation makes sense if the goal is to encourage greater quantities of wind energy production in order to displace traditional energy; this benefit is undermined, however, to the extent that wind projects require significant financing during the earlier development stages before the credit is available. (85) In fact, capital expenditures on turbines account for approximately eighty percent of development costs for new wind farms, (86) and many wind projects need subsidized financing during that stage.

Two additional features of the production tax credit significantly affect the way the credit is used in practice. First, like all tax credits, the production tax credit can only be claimed by a taxable entity, which means only corporations or individuals can use the credit. (87) The partnerships and limited liability companies ("LLCs") that typically own eligible wind projects--and earn the credits--are not eligible to claim the credits at the operating company level because these forms of business organizations are pass-through entities under the existing tax system. (88) In addition, as discussed below, individuals are limited in their ability to use the production tax credit due to certain anti-abuse rules in the tax code. (89) Second, the production tax credit is not refundable, which means only taxpayers with projected tax liabilities can use the credit. (90) Because a credit is a dollar-for-dollar offset against taxes otherwise due, if a taxpayer has no tax liability, then the credit will have limited value to that taxpayer. Wind developers typically have no tax liability in the early years because their expenses far outpace revenues, and as a result, the credit has no immediate value to them. (91)

Because of these limitations, the wind industry has implemented complex financing structures designed to monetize the production tax credit to help fund wind developers' initial investments in wind projects. (92) The most straightforward of these structures is to finance the wind project through a "flip partnership." Before describing the flip partnership structure, however, it is instructive to understand the general structure of wind project financing The simplest financing structure for new wind projects is an all-equity structure pursuant to which a wind developer contributes all needed capital. (93) The developer wholly owns the project without any supplemental debt financing, and all project risks and returns, including any tax benefits, inure to the developer. (94) This all-equity structure is most readily available to a small number of cash-rich developers with the ability to use the tax credits. (95)

The most prominent example of a developer that has used the all-equity structure is FPL Energy. (96) At the close of 2013, FPL Energy was the largest wind power company in North America and the owner of roughly seventeen percent of wind power capacity in the United States and Canada. (97) In contrast, smaller wind energy developers are not well positioned to use the all-equity structure, particularly if they need the production tax credit to subsidize the transaction. Historically, developers who lacked the ability to use the credits were forced to sell the project after the construction phase to a larger company with capacity to use the credits. (98) In the absence of advanced financing structures designed to monetize the tax credits, a Berkeley Lab report explains:

   [U]p until about 2003, one of the few options available to such
   developers was to develop a project up to the point of construction
   and then sell it to a larger entity (e.g., FPL Energy) with not
   only access to the capital required to build the project, but also
   a tax base large enough to efficiently use the project's Tax
   Benefits. (99)

Over the past decade, market growth in the wind industry has demanded increasing amounts of capital to sustain growth and more elaborate financing structures have evolved to meet this need. (100)

To the extent that a wind developer is able to access debt financing, a wind developer may also choose to incorporate borrowing through the use of project finance structures. In the most basic project finance structure, a wind developer would form a new, wholly-owned subsidiary that directly owns the wind project. (101) This new subsidiary, called the "Project Company," is a pass-through entity like a limited liability company ("LLC"), which means the Project Company is not a taxable entity. (102) Instead, all taxes incurred at the Project Company level, as well as tax benefits earned, pass through to its owner, the wind developer, who then reports such taxes on its own tax return. (103)

In order to finance the project, the wind developer would cause the Project Company to borrow a limited recourse construction loan from project finance lenders. (104) The project finance lenders would secure the loan by taking as collateral all the project assets--for instance, the turbines or power purchase agreements--and all future cash flow of the Project Company. (105) After the wind farm is built and begins operating, the construction loan will convert to a term loan, and the Project Company will begin repaying the project finance lenders. (106) Any profits left over after the debt payments will belong to the wind developer. (107)

If the size of the project finance loan is insufficient to fund development, or if the developer does not anticipate sufficient returns on the investment, then the wind project will not be built. One purpose of the production tax credit is to encourage wind farm development by responding to these challenges. (108) Unfortunately, however, under this financing structure, the production tax credit cannot adequately respond to either concern.

Insofar as a wind developer's decision about whether to proceed with a new wind project turns on its ability to access sufficient debt financing, the production tax credit does not immediately solve this problem. First, the lenders cannot take the tax credits as collateral because, as non-equity holders, the lenders are ineligible to claim the tax credits directly. (109) Second, the lenders' lien on the Project Company's cash flows will not reach the value of the tax credit because the credit will never generate any cash flow at that level because the Project Company is not a taxable entity. (110) For these reasons, the anticipated tax credits are unavailable as additional collateral to support a larger loan at the Project Company level. (111) The wind developer similarly cannot use anticipated cash flows from the production tax credit as collateral for loans at the developer level if the developer lacks the tax liability necessary to use the credit. (112) The wind developer's ability to build a new wind farm, therefore, continues to be limited by the size of the loan it is able to secure through traditional project financing, an amount that ignores the potential value of the tax credit.

The production tax credit is similarly limited, under traditional financing structures, to encourage investment by increasing the wind developer's expected rate of return on its investment. (113) The credits that will be earned by the Project Company after it begins generating energy are only valuable insofar as the owners expect to receive economic benefit from those tax credits. (114) If the wind developer does not expect to be able to use the credits until a date in the distant future, then the credits may not increase its expected rate of return enough to make a particular wind project viable. (115) If the credits could be used to increase the amount of available project financing, then the wind developer may be able to increase its rate of return by adding additional leverage at the Project Company level; for the reasons explained above, however, the production tax credit cannot be used for this purpose.

The limitations described in this Part place meaningful restrictions on wind developers' ability to use the production tax credit and decrease its effectiveness as a subsidy to wind energy companies. As is explained in the next Part, this problem has given rise to complex, costly tax equity financing structures used to monetize the tax credits. Unfortunately, such structures are an imperfect solution because they misdirect part of the subsidy's value away from wind projects.

2. Monetizing the Wind Energy Production Tax Credit Through Tax Equity Investment

Due to the constraints on its use, the production tax credit does not immediately respond to the wind developer's barriers to investment. The wind developer will either forgo the wind project entirely to pursue other projects with greater expected returns, or it will limit the size of the project to a level that can be financed solely with a combination of equity and project financing. In either case, the production tax credit will fail to incentivize the development of wind projects unless wind developers are able to monetize the tax credits. To solve this problem, complex financing structures have been designed to make the production tax credit valuable to wind developers who are otherwise unable to use the tax credits. The most straightforward of these structures is the flip partnership structure.

In a flip partnership, the wind developer partners with a third party, called a "tax equity investor," that has the ability to use the production tax credit. (116) When this structure was first introduced, the tax equity investors were often strategic investors with knowledge of and interest in owning and operating wind projects. (117) This has become less common over time, and today, institutional investors without expertise in wind energy development are the more typical tax equity investors. (118)

Institutional investors have special knowledge in tax reduction strategies and seek investments like wind projects that will allow them to offset tax liabilities attributable to other sources of income. (119) Practically speaking, the tax equity investor is always a cash-rich corporate entity. In fact, the market of tax equity investors has generally been limited to a group of roughly eleven to twenty investment banks and, more recently, a handful of public companies that have made tax equity investment a routine part of their tax reduction strategy. (120) The field of tax equity investors includes, among others: Google, MetLife, Bank of America, J.P. Morgan, Wells Fargo, and Morgan Stanley. (121)

Once a tax equity investor has been selected, the wind developer and the tax equity investor partner to own the Project Company. (122) Depending on how the transaction is structured, the tax equity investor will either contribute cash to the Project Company in exchange for a passive equity interest in the project entity, which is typically an LLC, or the investor will purchase a share of the developer's membership interests. (123) As discussed below, the tax equity investor will negotiate a target internal rate of return ("IRR") and will size the initial investment based on that target IRR. (124) The IRR is calculated by setting the initial investment as a negative value--cash outflow--and adding the present value of expected future cash flows until the number becomes positive and the required return is reached. (125) The relevant future cash flows may include not only the production tax credits the tax equity investor will receive, but also cash it will receive--either from operating income or from a future sale of the equity interest upon exit--its anticipated cash savings from depreciation, and interest deductions. (126)

The relationship between the tax equity investor and the wind developer is documented in the project company's operating agreement, which describes the rights and obligations of the members. (127) Because operating agreements are not public records, tax equity investment documentation is not typically available for review by researchers. (128) A search of the U.S. Securities and Exchange Commission through the Edgar database yielded just one example of a wind energy tax equity investment operating agreement: J.P. Morgan's investment in the Kaheawa Wind Power I project developed by First Wind Holdings, Inc. ("First Wind") in Hawaii. (129)

First Wind had formed a limited liability company named UPC Hawaii Wind Partners, LLC ("UPC Hawaii"), which indirectly owned the project company, Kaheawa Wind Power, LLC. (130) The project company operated a 30 MW wind farm on the island of Maui in Hawaii, which had already reached commercial operation. (131) This wind project was called the "Kaheawa project." (132) The Kaheawa project was financed using a flip partnership tax equity investment structure and is, therefore, a useful example for the purpose of this Article. (133) The extent to which the transaction is representative in the market, however, can be assessed only based on anecdotal descriptions of typical transactions, as described by practitioners and other commentators.

In its public filings, First Wind explained its use of tax equity investment as follows:

   In these transactions, we receive up-front payments, and our tax
   equity investors receive most of the operating cash flow and
   substantially all of the PTCs and taxable income or loss generated
   by the project until they achieve their targeted investment returns
   and return of capital, which we typically expect to occur in ten
   years. As a result, a tax equity financing substantially reduces
   the cash distributions from the applicable project available to us
   for other uses. Also, the period during which the tax equity
   investors receive most of the cash distributions from electricity
   sales and related hedging activities may last longer than expected
   if our wind energy projects perform below our expectations. (134)

To consummate the tax equity investment transaction, First Wind caused UPC Hawaii to divide the membership interests of UPC Hawaii Wind Partners II ("the Company") into Class A and Class B membership interests and sold all of the Class B membership interests to J.P. Morgan. (135) The Company directly owned the project company. (136) A tax equity investment transaction may follow this model, in which a developer and tax equity investor become co-owners of an entity that owns a project company, or the parties could partner to own the project company directly.

Like most tax equity investment transactions, the Class B membership interests purchased by J.P. Morgan were primarily passive membership interests that gave J.P. Morgan little control over the operations of the project company. (137) The management of the Company was governed by a separate Management Services Agreement ("MSA") between UPC Hawaii and an affiliate ("the Manager"), which was incorporated by reference in the tax equity investment operating agreement. (138) The performance of the Manager under the MSA was to be supervised by the managing member of the Company, which under the operating agreement, was UPC Hawaii. (139)

Further, under the operating agreement, no member other than the managing member had "any right, power or authority to take part in the management or control of the business of, or transact any business for, the Company, to sign for or on behalf of the Company or to bind the Company in any way." (140) J.P. Morgan, as the Class B member, further agreed not to exercise any authority otherwise available to it under the Delaware Limited Liability Company Act to bind or commit the Company to agreements or transactions, or to hold itself out as an agent of the Company. (141)

Finally, the day-to-day operations and management of the project company itself were governed by two operation and maintenance agreements between the project company and General Electric International, Inc. and UPC Wind O&M, LLC--another affiliate of the developer--respectively. (142) J.P. Morgan's membership interest did carry voting rights, particularly with respect to certain "major decisions," such as sales of the Company; however, as a practical matter, its membership interest conferred very little ability to control or manage the day-to-day activities of either the Company or the wind project owned by the Company. J.P. Morgan's passive interest in the wind project is typical of tax equity investments.

In the prototypical example of a tax equity investment transaction, the partnership will allocate up to ninety-nine percent of its taxable income or loss and ninety-nine percent of the production tax credit earned by the project company to the tax equity investor during the period when the project company will be eligible for the credit. (143) The remaining one percent of the income, loss, and credits are allocated to the wind developer. (144) Any cash distributions, however, are made first to the wind developer until it receives a return on its equity investment, and then to the tax equity investor. (145) Despite the income and loss allocation, the tax equity investor would not expect to receive much pre-tax return on its investment; almost all of the economic return on tax equity investment is attributable to the value of the tax credits. (146) Figure A illustrates the initial, pre-flip stage of the flip partnership.

This prototypical example adheres closely to an IRS safe harbor issued on November 5, 2007. (147) As discussed in Part III.B.l below, the safe harbor assures taxpayers that the IRS will not challenge tax equity investment transactions as lacking substantial economic effect as long as the parties meet certain guidelines set forth by the IRS. Among the guidelines is the requirement that the developer maintain at minimum a one percent in each material item of partnership income, gain, loss, deduction, and credit at all times during the existence of the project company. (148)

As explained in Part IV.A below, the ninety-nine percent/one percent restriction imposed by the safe harbor guidelines limits the amount of financing available to the wind developer by reducing the amount of anticipated future cash flow from the production tax credit. In other words, due to this restriction, one percent of the production tax credit cannot be monetized through tax equity investment. The First Wind deal, however, was completed in August 2007, prior to the issuance of the IRS safe harbor. (149) Under the First Wind agreement, a full 100% of all items of the Company's income and loss, gain, deductions, and credits were to be allocated to J.P. Morgan during this initial period. (150) In this respect, the First Wind deal is no longer representative of a typical tax equity investment transaction because it is unlikely that many parties today would risk violating the IRS safe harbor. (151) Nevertheless, the First Wind deal remains an interesting example of how taxpayers may behave in the absence of the IRS safe harbor: the parties structured the deal so as to monetize the entire value of the production tax credit.

Importantly, these initial allocations generally do not reflect the proportionate economic investments of the parties. A tax equity investor is unlikely to contribute ninety-nine percent of the capital needed to finance a wind project, at least in part because tax equity investors do not intend to engage in the business of operating a wind farm or intend to tie their potential rate of return to the wind farm's general success as a business. (152) Rather, assuming a tax equity investor expects to receive all of the tax benefits of the project company, including depreciation and interest deductions in addition to tax credits, the tax equity investor may be willing to contribute up to sixty percent of capital. (153) This amount is far below the ninety-nine percent interest in tax attributes tax equity investors typically claim during the early years.

Though the actual amount of production tax benefits and other cash flows generated may differ from the amount anticipated by the parties' early models, the First Wind deal demonstrates how the parties may negotiate terms that help ensure that the tax equity investor will receive its negotiated rate of return. Rather than defining the initial period by reference to the years when the production tax credit or other tax items would be available, the operating agreement provided for the initial allocations to continue until J.P. Morgan achieved an IRR equal to or greater than a target IRR. (154) The parties' right to continue allocating income to the tax equity investor until the agreed after-tax IRR is achieved has been authorized by the IRS in the safe harbor guidelines described below. (155)

As of 2013, the after-tax return on a typical tax equity investment deals was seven to ten percent for unlevered transactions and as high as the mid-teens in deals with debt at the project company level. (156) This return is almost entirely due to tax savings; tax equity investors often do not expect to receive more than a two percent rate of return on a pre-tax basis. (157) Moreover, though tax equity investment has risks, tax equity investors generally do expect to receive their negotiated yield on their investment, and in this respect, the investment is more like debt than equity. (158) The debt-like character of tax equity financing is not lost on industry actors, who compare the cost of tax equity financing to financing from commercial bank debt, mezzanine debt, and project bond markets. (159)

After the initial period, which may be defined by reference to when the tax equity investor achieves its target IRR, the partners' interests in the Project Company will "flip." (160) The tax equity investor's interest in the Project Company will drop to as low as five percent, and the wind developer will often hold an option to buy out that remaining interest. (161) Assuming the wind developer exercises such an option, the tax equity investor will no longer have any rights in the Project Company, and all future profits will belong to the wind developer. (162) Figure B illustrates the post-flip stage of the flip partnership.

By using flip partnerships and similar structures, wind developers have been able to monetize otherwise unusable tax credits to help finance initial investments in new wind projects. The tax equity investment structure may be used either as a stand-alone financing structure, or in combination with traditional project financing or private equity contributions; (163) however, in the past, tax equity investors have required a premium in leveraged deals that raises their after-tax rate of return to as high as thirteen to fifteen percent. (164) JPMorgan Capital Corporation estimated that, in 2007, roughly seventy percent of the wind capacity installed in the United States was financed using tax equity from third-party investors. (165)

Among the clearest limitations of the tax equity investment structure is the small pool of potential investors. As mentioned, the number of active tax equity investors in the market is fewer than twenty, and in some years, has been fewer than a dozen. (166) Wind developers' ability to tap into tax equity financing is limited by the tax liabilities and available cash reserves of this small number of tax equity investors. (167) As the projected tax liability of this small group of investors drops, as it is likely to do in recession years, so too does the amount of money available for tax equity financing. (168) As a result, the supply of tax equity financing can be restricted, and not all wind developers will have access to the tax equity finance source.

Moreover, the pool of eligible tax equity investors is further limited by features of the tax system designed to prevent abusive tax shelters. For example, passive activity loss rules limit the extent to which individual investors can use the credits. (169) The passive activity credit rules limit when certain taxpayers, including individuals, can apply tax credits earned from passive activities. (170) Generally, the sum of credits earned from passive activities are disallowed to the extent they exceed the regular tax liability of the taxpayer allocable to passive activities. (171) A "passive activity" is any activity that involves the conduct of a trade or business and in which the taxpayer does not materially participate. (172)

The IRS expressly stated in the safe harbor guidelines that the passive activity loss rules apply to tax equity investment transactions, and "only entities not subject to [the [section] 469 passive activity loss rules], and not individuals, will be able to offset non-project income with credits received as a passive investor in a partnership." (173) In other words, tax equity investors are passive investors that do not materially participate in the wind energy trade or business; therefore, the passive activity credit rules limit the amount of the production tax credit that can be used by natural-person tax equity investors.

Though a very wealthy individual--or, more likely, a pool of such individuals --could theoretically have enough passive activity income to make a tax equity investment in a wind project possible, as a practical matter, individuals usually cannot act as tax equity investors. This limitation effectively forecloses the possibility of a private equity fund raising significant capital from individual investors for the purposes of investing in wind energy. (174) As a result, the only investors who have been incentivized to invest in wind projects are a small number of banks and a handful of large public companies that have been willing to partner with wind developers for the development of large wind projects.

For the reasons discussed in this Part, the supply of tax equity financing is inadequate to meet the needs of all eligible wind energy companies. Moreover, the availability of tax equity financing is probably further depressed by legal uncertainties surrounding the production tax credit discussed in the next Part. Without access to some form of tax equity financing, wind developers have a limited ability to monetize the production tax credits and fund new wind projects, even in years when the production tax credit is otherwise available. A production tax credit that relies heavily on tax equity investment structures, therefore, is less effective than one that can always deliver the subsidy directly.


A. Sunset Provisions and Uncertainty About the Future of the Wind Energy Production Tax Credit

The legal uncertainty surrounding wind energy tax equity investment financing is owed to at least two sources. The first area of uncertainty, which has been widely commented upon by academics and other observers, and will be touched on only briefly in this Part, relates to sunset provisions. (175) Since the production tax credit was first introduced in 1992, the credit was subject to sunset provisions that require Congressional renewal to prevent the credit from expiring. (176) The production tax credit was allowed to expire three times between 1999 and 2004. (177) More recently, the production tax credit was allowed to sunset at the end of 2014. (178)

Many commentators have criticized the sunset features of the production tax credit. (179) Lewis & Clark Law School energy law professor Melissa Powers has observed that the unstable nature of the production tax credit has negatively affected the wind industry by creating instability in the labor force and disrupting manufacturing processes and supply chains. (180) Another legal scholar similarly advocated for a long-term extension of the production tax credit on the basis that "[t]he PTC helps to determine the feasibility of future wind projects; therefore, the industry's ability to rely on its availability is necessary for long-terms goals of increasing production." (181)

Industry members have similarly attacked the sunset provisions as harmful to the wind energy industry. One nonprofit advocacy group observed that the production tax credit's "'on-again/off-again' status has resulted in a boom-bust cycle of development. In the years following expiration, installations dropped between 76 and 93 percent, with corresponding job losses." (182) The American Wind and Energy Association says that the uncertainty over the continued availability of the credit "caused wind installations to drop 92 percent in 2013, causing a loss of $23 billion to our economy and nearly 30,000 well-paying jobs." (183)

Another observer noted that the production tax credit sunset provisions are counterproductive to any goal of promoting long-term investment in wind projects because "renewable energy projects are irreversible investments with long lead times, and therefore investors cannot easily retract their investments upon the expiration of the PTC." (184) In other words, because production credit tax equity investment deals depend on the wind project earning tax credits over a ten-year period, uncertainty over the availability of the credit likely discourages at least some investors from entering into these long-term deals. For this reason, the sunset provisions act to suppress the market for tax equity investors.

Notably, when Congress extended the production tax credit in December 2015, it introduced a phase-out schedule by which the credit will be phased out gradually until it sunsets completely at the end of 2020.185 The phase-out approach has been supported by members of the wind industry, who say it will provide greater stability to the industry and allow it to become cost-competitive. (186)
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Title Annotation:I. Introduction through III. Legal Uncertainty Surrounding Wind Tax Equity Investment Financing A. Sunset Provisions and Uncertainty About the Future of the Wind Energy Production Tax Credit, p. 453-483
Author:Layser, Michelle D.
Publication:Missouri Law Review
Date:Mar 22, 2016
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