The heated debate between developers and tax equity investors about the appropriate level of tax equity returns flared up at the recent Infocast Wind Power Finance & Investment Summit.
In 2014, four new tax equity investors made investments in wind projects, while there were no reports of any investors pulling out of the market. Further, in 2014 Bank of America surpassed JP Morgan and GE Energy Financial Services for wind tax equity volume in 2014, but not due to either JP Morgan's or GE's pulling back from the market. Therefore, there was a material increase in supply of tax equity in 2014; however, tax equity investors' after-tax returns held steady.
With respect to after-tax returns, Matthew Cammack of CCA Group stated, ‘The range of after-tax returns was between 7.35 percent and nine percent. The project that got 7.35 percent was a strong portfolio of projects with power purchase agreements (PPAs). The nine percent project was quite large and used a hedge rather than a power purchase agreement.’
These returns are similar to those of the market in 2013 and 2012, so the improved supply has not reduced the cost of tax equity. This led Megan Schultz of Invenergy to assert a view shared by many developers.
‘Returns should be six percent after tax. Returns are overpriced,’ she says. ‘The headline return rate has been unchanged even as there are more tax equity investors in the market and a longer history of the deals performing.’
However, what the developers may not appreciate is that a tax equity investment, unlike loans and common equity, is exposed to the risk of the investor's own profitability: If the tax equity investor is not profitable, it will not owe income tax. If the investor does not owe income tax, then it will delay when it uses the tax credits and tax deductions, greatly reducing its returns.
The tax benefits have a 20-year shelf life, so 20 years of no or low profitability could mean the tax benefits expire unused. In such a scenario, it is typical that the pre-tax cash from a tax equity investment will be less than its cash outlay.Â
Representatives of JP Morgan and Bank of America made the point that tax equity investors bear the risk of their own profitability. Yale Henderson of JP Morgan said, ‘We [tax equity investors] take the risk of having 10 years of tax capacity’ (i.e., the 10-year production tax credit period). And Jack Cargas of Bank of America added, ‘Much of the tax equity investor's return is from tax capacity, which is outside the transaction. The tax benefits have limited value to the sponsor. It is not a zero-sum game.’
Based on their financials, the risk of not having an appetite for the tax credits is quite real for some of the largest banks participating in the market. JP Morgan's 2014 10-K filing was released this week, and it shows its total U.S. federal net operating loss carryforwards edged up $1.6 billion from $1.5 billion last year.
The 10-K filings for Bank of America and Citibank are expected soon; but based on their 2013 10-K filings, each of those banks had large net operating losses for U.S. tax purposes. At the end of 2013, Bank of America calculated its U.S. federal income tax net operating loss at over $3 billion. Citi did not provide the granularity of the other two bank but calculated its ‘tax credit and net operating loss carry-forwards’ at over $26 billion; however, it is not clear as to how much of that is related to U.S. federal income taxes.
Once you take into account the fact that these banks will have to wait to use the tax benefits from new tax equity investments until they work their way through their stockpile of tax benefits, the after-tax returns are likely far closer to the 6% that Invenergy's Shultz suggested would be appropriate.
Author's note: David Burton is partner at Akin Gump Strauss Hauer & Feld. He can be reached at dburton@akingump.com.
