Ahead of Basel III final rule, renewable financing already feeling the chill

Tax equity dealmaking for renewable energy has slowed as developers and financiers wait for US federal regulators to clarify whether proposed capital requirements for large banks will include a 400% capital weighting for tax equity, according to developers and financiers.

But even if the Federal Reserve and the Federal Deposit Insurance Corp. adjust the final rule to address tax equity's credit-like risk profile, industry experts still expect project finance costs to increase.

The Basel III global banking standards would require banks to hold $4 in reserves for every dollar of tax equity for clean energy projects that they provide, compared to $1 under current rules.

The American Council on Renewable Energy (ACORE) estimated in a December 2023 letter that implementing the standards in the current proposal could shrink available tax equity by 80% to 90%.

Sounding the alarm

Quadrupling that risk weight is "basically saying tax equity is riskier than shares that trade every second on the New York Stock Exchange, which to me doesn't seem grounded in any reality whatsoever," Julian Torres, chief investment officer at Warburg Pincus & Co. portfolio company Scale Microgrid Solutions LLC, said in an interview with S&P Global Commodity Insights.

"If the insurance markets are willing to underwrite that [tax credit recapture] risk for 3%, why should Basel III require banks to hold 400% of the at-risk capital?" Torres added.

Regulators hope to finalize the Basel III endgame proposal as soon as possible in 2024.

Wells Fargo & Co. Executive Vice President and CFO Michael Santomassimo told investors and analysts on the bank's third-quarter 2023 earnings call that under the risk weighting proposed for tax equity, "the math just doesn't make sense from a return perspective, and so we'll probably do less."

The bank helped finance several deals in 2023, including a $1.2 billion package for the Vineyard Offshore Wind Project under construction by Avangrid Inc. and Copenhagen Infrastructure Partners P/S.

Forcing developers to seek alternative, more expensive financing "will also, in turn, increase the cost of the clean energy produced by these projects for all electricity consumers," Invenergy LLC Senior Vice President for Federal Affairs Andrew Wills wrote in a Jan. 3 statement.

Commodity Insights Climate and Cleantech Executive Director Peter Gardett disagreed that the worst-case scenario is a foregone conclusion if regulators keep the draft rule intact.

"Depending on how you read it, it could have anywhere from a cooling and capping effect to a completely disastrous elimination of the market, but there's a lot of wiggle room between those two views," Gardett said in an interview.

The tax equity market has also likely maxed out at the $20 billion banks invested in 2023, with the most growth in future financing availability coming from private markets and tax credit transfers, Gardett added.

Hitting the brakes

Still, banks are exercising caution.

"In closed-door sessions, I've heard the banks explain to representatives in Congress that ... 'hey, we're pencils down in new deals right now,'" Scale Microgrid's Torres said.

Torres' comment echoed concern expressed by Rubiao Song, managing director and head of energy investments at JPMorgan Chase & Co., that if there is no resolution to the "elephant in the room" by midyear, major bank investors will likely pause issuing new production tax credit commitments.

Some banks that are doing new deals have chosen to include terms providing for a 400% risk weighting.

"I have seen some parties insisting on language to address risk associated with this," Hilary Lefko, renewable energy and project finance tax attorney at Norton Rose Fulbright, said in an interview. "It's more of a protective measure, the parties deciding who's going to bear the risk if the final rule doesn't give an exclusion."

The nascent tax credit transfer market, which Gardett estimates has "grown from zero to four billion-plus in the last 12 months," is somewhat offsetting investors' hesitation.

"It has helped pick up what would have been a much larger slowdown in the tax equity market," Marathon Capital LLC Managing Director Matt Shanahan said in an interview.

Many projects are also opting for hybrid structures that combine tax equity and tax credit transfers from the beginning, Shanahan added.

Waiting game

Trade groups including ACORE and the Solar Energy Industries Association are teaming up with members of Congress such as Rep. Sean Casten (D-Ill.) to pressure regulators to rethink the draft rule, which has also drawn criticism from consumer groups and the insurance industry.

Casten and 105 other Democratic lawmakers in Congress wrote a letter to the Federal Reserve and the FDIC in December 2023 that urged them to "consider alternatives that accurately reflect the risk profiles of tax equity investments."

"There's an understanding among regulators that when a bank provides debt it has a certain risk profile, it has a certain seniority in the capital stack, it has a certain predictability of income," Casten said in an interview.

"What I think happened is the regulators saw this as looking more like a venture capital or private equity stake and not like tax equity, which for all practical purposes really just looks like debt," he added.

Casten described himself as "cautiously pretty optimistic" that tax equity will not be subject to a 400% risk weighting.

"In all the conversations we've had with regulators, everybody has qualitatively agreed with the concerns that we raised ... but it's not across the goal line yet," he said.

Norton Rose Fulbright's Lefko agreed that all signals point to a fix.

"When it first came out, everyone looked at it as catastrophic," Lefko said. "We wrote a blog article that said as much and now I think after hearing from the government, parties are getting more comfortable that a fix is coming, it's just that the sitting on our hands waiting is making it difficult."

Torres said that even though he would like to see regulators issue a statement that they made a mistake and will amend the final rule accordingly, he understands that "they can't issue an interim rule."

"In the meantime, we have this sort of shadow," Torres continued. "There's no indication that there is even a grandfathering or safe harboring for assets that were invested in prior to this ruling being contemplated."

Production tax credits at stake

Marathon Capital's Shanahan said the final rule will likely increase tax equity's risk weighting to just 200%, which "won't be devastating."

But banks will still have to pass greater capital costs on to project owners, which will have consequences.

"You won't see banks investing competitively" in production tax credit tax equity deals, Shanahan warned. "The yield that the tax equity charges has a very big impact on returns to the sponsor, much more so than with an [investment tax credit] deal."

The production tax credit provides a base credit rate of 0.3 cents/kWh that can be claimed annually for the first 10 years of a project's operation, while the investment tax credit provides a base rate of 6% for a project upfront.

Higher capital requirements for tax equity deals are likely coming "given the trajectory of bank regulation," Commodity Insights' Gardett said. "That will ultimately have a kind of capping effect."