Is It Time For Renewable Energy MLPs?

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On June 13, U.S. Rep. Ron Estes, R-Kan., and Mike Thompson, D-Calif., together with U.S. Sens. Chris Coons, D-Del., and Jerry Moran, R-Kan., re-introduced legislation, the Financing Our Energy Future Act, that would allow renewable energy producers to utilize the master limited partnership (MLP) structure.

Coons has sponsored the bill, previously named the MLP Parity Act, several times since 2012. Although the acts represent bipartisan efforts to provide support to the renewable energy industry, the MLP Parity Act never advanced, and it remains to be seen whether the Financing Our Energy Future Act will fare any better.

If enacted, the Financing Our Energy Future Act could provide renewable energy producers access to a broader range of investors and the lower-cost capital that an MLP can provide. (Note: Due to the tax efficiency of the structure, MLPs generally have a lower cost of capital relative to corporations. In the current environment, MLPs are facing headwinds due to the perceived complexities of their structure and other governance and regulatory factors, all resulting in a sometimes higher cost of capital relative to a corporation.)

What is an MLP?

Simply put, an MLP is an investment vehicle created though the Internal Revenue Code (IRC) to promote the development of energy infrastructure throughout the U.S. MLPs are formed by a “sponsor” and have publicly traded limited partner interests called common units. The common units allow MLPs to access the liquid public equity markets in the same manner as publicly traded corporations. 

However, MLPs engaged in certain activities specified by statute also have a significant structural advantage over corporations – these MLPs are taxed as partnerships for U.S. federal income tax purposes and are not required to pay entity-level income tax. 

Instead, all taxable income is passed through to the MLP’s unitholders. As a result, MLP unitholders are not subject to the double taxation that stockholders of a corporation face. Even with the reduction in the corporate tax rate to 21%, MLPs continue to be the most tax-efficient public company model available to investors — the effective tax rate on income of a corporation distributed to its shareholders is 36.8%, and the effective tax rate on income of an MLP is currently 29.6%. (Note: Effective tax rates do not take into account the 3.8% Medicare tax. The maximum individual tax rate is 37%, and individual MLP unitholders are allowed a deduction under Section 199A of the IRC generally equal to 20% of the unitholder’s share of the MLP’s domestic income and 20% of any recapture income of an MLP unitholder on the sale of an MLP unit. The Section 199A deduction is scheduled to sunset at the end of 2025.)

The diagram below illustrates the organizational structure of a traditional MLP:

Is It Time For Renewable Energy MLPs?

In order for an MLP to be taxed as a partnership, the MLP must comply with the exception in Section 7704(d)(1)(E) of the IRC, which requires that at least 90% of the MLP’s gross income be “qualifying income.” If a partnership does not meet this test, it will be taxed as a corporation for U.S. federal income tax purposes if it becomes publicly traded. 

In 1981, Apache Petroleum Co. introduced the investment vehicle known as the MLP. Other oil and gas MLPs followed, as did an assortment of operating businesses. Between 1981 and 1987, there were more than 100 MLP IPOs, including cable television (Falcon Cable Systems Co.), hotels (La Quinta Motor Inns Limited Partnership/Aircoa Hotel Partners L.P.), amusement parks (Cedar Fair L.P.), casinos (Sahara Casino Partners L.P.) and even professional sports teams (Boston Celtics Limited Partnership).

Congress, concerned about the disincorporation of America and the long-term erosion of the corporate tax base, enacted Section 7704 in 1987 to restrict the growth of MLPs. In the case of certain natural resource activities, however, the tax-created competitive advantage afforded to publicly traded partnerships at that time was deemed to be less significant because Congress considered the disruption of practices in such activities was inadvisable due to general economic conditions in these industries at the time (H.R. Rep. No. 100-391 [1987]). 

Thus, the so-called “natural resource exception” was created, allowing MLPs to engage in the exploration, development, production, mining, refining, marketing and transportation of depletable minerals and natural resources, such as crude oil, natural gas and coal. In the decades since then, MLPs have financed the expansion of the nation’s vital domestic energy infrastructure. There are approximately 75 MLPs on the market today, the majority of which are in industries related to natural resources and investments in energy infrastructure. 

The Financing Our Energy Future Act

The Financing Our Energy Future Act would expand the definition of qualifying income to include income from renewable energy sources.  New eligible energy resources would include solar, wind, marine and hydrokinetic energy, fuel cells, energy storage, combine heat and power biomass, waste heat to power, renewable fuels, biorefineries, energy efficient buildings, and carbon capture/utilization/storage.  

Notably, the renewable energy industry as we know it today did not exist in the 1980s. From the late 1800s until today, fossil fuels have been the major sources of energy. Hydropower and solid biomass were the most used renewable energy resources until the 1990s. Since then, the shares of U.S. energy consumption from biofuels, solar and wind energy have increased. In 2018, about 63% of total U.S. electricity generation was from fossil fuels, and about 17% was from renewable energy sources. 

Many of the same rationales that applied to traditional energy sources in 1987 – the need to increase domestic energy production and achieve energy independence – also apply to renewable energy sources. In fact, in 2008, Congress expanded Section 7704 – for the first time since its enactment – to allow MLPs to earn income from the storage and transportation of alternative fuels. Moreover, the 2008 amendment also provided that certain income associated with industrial-source carbon dioxide generates qualifying income. Further extending the MLP structure to the renewable energy sector could provide the renewable energy industry access to the capital it needs to build and grow at a lower cost.

Impact

Proponents of the proposed legislation believe that it could unleash significant private capital for renewable energy projects and create more jobs. Whether renewable energy projects could successfully operate in MLP form is not certain, and at the very least, it will require additional analysis by the industry to make it work.

Currently, investments in renewable energy projects are largely financially feasible only as a result of federal and state taxes and other incentives. The federally mandated tax credits, which are being phased down or are set to expire beginning in 2020 for certain technologies, include production tax credits (based on the production and sale of energy produced from specified renewable resources) and investment tax credits (based on the cost of certain energy property placed into service). Additional incentives come in the form of depreciation deductions.

Together, these tax incentives can significantly decrease the cost of producing renewable energy. However, tax incentives are useful only to those producers with positive taxable income. Renewable energy projects by themselves typically do not generate enough positive taxable income to use all of the available tax incentives. In order to monetize the tax incentives, renewable energy producers oftentimes enter into arrangements with an investor that can use tax credits, losses (or depreciation deductions) or both. In these arrangements, within certain limits, the tax credits and losses are allocated to the investor, who then uses them to offset other income. 

Current rules under the IRC make it difficult for individuals, a significant investor base for MLPs, to use the tax benefits generated by their MLP investments. Individual investors in an MLP are subject to “passive activity loss” and “at risk” rules that would limit the use by the unitholder of their share of the MLP’s tax credits and losses to their investment in or income from the MLP. In other words, an individual MLP investor would not be able to offset his other income with tax credits and losses generated from a renewable energy MLP.

This hurdle is not insurmountable, though. Potential solutions include amending the specific MLP passive loss activity rules through additional legislation or combining renewable projects with other income generating businesses within the same MLP.

Furthermore, MLPs have historically been measured largely by the stability and predictability of their cash flows. MLPs are marketed to the public based on their stated intention to pay a minimum distribution each quarter to each unitholder. The MLP is required to distribute all of its “available cash” to its unitholders, and its sponsor is incentivized to grow the MLP and increase its quarterly distributions over time. These cash distributions directly affect the market valuation of the MLP. Thus, in order for a business to be suitable for a traditional MLP, the business needs to generate sufficiently steady and predictable distributable cash flow to support payment of the minimum quarterly and increasing distributions over time. 

It is unclear whether renewable energy MLPs could fit the traditional MLP cash model. The performance history of renewable energy investments is limited, and performance data are, to a large extent, private.

However, another avenue may exist — the variable distribution MLP, which typically includes businesses that have substantial and unpredictable fluctuations in their cash flows (i.e., businesses that are not suitable for the traditional MLP model of steady and predictable cash flows), such as businesses that own oil and gas mineral interests or refining assets. Instead of promising their investors steady and increasing cash distributions per unit, variable distribution MLPs tell their investors that they will focus on optimizing their business results and maximizing total distributions, rather than attempting to manage results with a focus on minimum distributions. Distributions are expected to vary and fluctuate significantly from quarter to quarter (and may be zero) based upon fluctuations in the cash generated by the MLP. 

While the passage of the Financing Our Energy Future Act could be a game-changer for the renewable energy industry, leveling the playing field for projects by enhancing the industry’s access to capital while maintaining a tax-efficient structure, additional work will be needed to get there, starting with the passing of this legislation. Fifth time is a charm!

Based in the Houston office of Sidley Austin LLP, Angela T. Richards is a partner advising MLPs and other clients on tax matters. Jon W. Daly is a partner advising MLPs and other entities on capital markets transactions, mergers and acquisitions, private-equity investments, and other transactional matters. They can be reached at arichards@sidley.com and jdaly@sidley.com, respectively.

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