An effort to cut corporate taxes may ultimately shrink the pool of capital seeking to monetize renewable energy tax credits, potentially challenging the financial conventions that have long governed the investor appeal and competitive nature of renewable energy projects.
Both the Trump administration and congressional Republicans have signaled their intention to push corporate tax reform as one legislative priority in 2017, offering dueling proposals that would cut the corporate tax rate to 15% or 20%, respectively, down from the current statutory rate of 35%, which has been in place for nearly the past three decades.
On the political spectrum, tax reform rates below repealing the healthcare law, a Supreme Court nomination, immigration reform, debt ceiling authorization and budget finalization, Washington, D.C.-based research firm ClearView Energy Partners pointed out in a note Jan. 17.
But if Republicans exit these efforts without "exhausting their political capital," ClearView sees one path by which the House and Senate can pass a tax reform bill on a strictly partisan, majority basis in both chambers, before sending it to President Donald Trump.
"Republicans’ 241-194 House majority appears sufficient for party-line passage in the lower chamber, but the 52-48 GOP Senate majority leaves room for only two defections," ClearView said. "Vice President-elect Mike Pence would break a 50-50 tie, assuming the White House supports the bill."
The timeline for tax reform could take shape toward the end of this year in anticipation of midterm elections next year.
"We believe that we could see the corporate tax rate change as early as 2018, and would not be surprised if the Republicans in control of the House and Senate were looking to pass legislation lowering taxes going into the midterm elections in November 2018," Jefferies LLC analysts noted in their 2017 outlook.
A lower corporate tax rate on its own could free up more cash across corporate balance sheets, and likewise have the primary effect of trimming a firm's total tax liability, but having the equal and opposite effect of shrinking its appetite for tax credits that would otherwise be viewed as "free money" when applied toward a higher tax burden.
While the outright rollback of renewable energy tax credits appears unlikely on its own, given existing step-down schedules, the prospect of shrinking tax equity base could create major financing gaps, in view of how prominently tax equity features in capitalization of renewable energy projects.
Major tax equity investors at Bank of America Corp. and JPMorgan Chase & Co. on Jan. 17 observed that tax equity typically supplies between 50% and 60% of total capital required to back a given wind project, with solar sitting between 40% and 50%.
Total tax equity capacity available from traditional tax equity providers could fall between 40% and 55% under the House and Trump tax plans, respectively, according to independent research firm SSR LLC on Jan. 4. That could further carve away at the roughly $11 billion in tax equity investments that were made in 2016, down already from $15 billion in 2015, according to an estimate offered by JP Morgan.
With tax equity comprising roughly half the capital stack for most renewable projects, analysts provided a glimpse into how the economics of wind and solar investments could change, given lower tax rates.
Marathon Capital, a renewable energy investment bank, suggested in its own analysis that a lower corporate tax rate could have the effect of lowering project returns between 40 and 60 basis points on a wind project in a 25% tax rate scenario, and a loss of 80 to 120 basis points in the 15% tax scenario.
The short-term saving grace could be claiming accelerated depreciation immediately on new projects as a deduction on expenses, but project fundamentals, moreover, would still require declines in construction costs of about 8% lower than present day, or conversely, a 10% to 15% increase in the price paid by purchasers of renewable project’s output to remain competitive, Marathon suggested.
SSR was more bearish, suggesting that wind power purchase agreement prices would have to increase as much as 80% to compensate for the lower tax equity investment, with solar PPA prices having to boost as much as 40%. Building costs on their own seem to suggest that wind could be more challenged than solar, particularly in the absence of tax credits altogether.
"Solar can absorb the loss of the ITC because installation costs per watt are falling, but wind cannot adsorb such a loss, because there is a flatter decline in the cost curve and smaller efficiency increases," Hugh Wynne, co-head of utilities and renewable energy at SSR, said on a call.
Though as tax reform language is crafted behind the scenes, the possibility that solar is also threatened, on a building cost basis, could also manifest in the event that legislation includes a border tax adjustment such that solar imported solar equipment becomes more expensive, pressuring solar firms like SunPower Corp. and First Solar Inc.
"We see risk of a greater tax burden for US sales, which represent the majority of both First Solar and SunPower's revenues," Morgan Stanley Research said Jan. 17, potentially disrupting the competitive prices offered by both residential and utility-scale projects. "Some of the incremental cost would likely be passed to customers in the way of higher panel prices, system prices, and PPA and lease rates."
Nevertheless, renewable investors are optimistic that the industry and its investors will continue to evolve, particularly as President Trump’s appeal resonates in Republican states with the most renewable resources, both ClearView and Morgan Stanley said.
"The marketplace needs to evolve in order to accommodate political uncertainties," Bank of America Merrill Lynch managing director Jack Cargas said on a Jan. 17 call with law firm Chadbourne & Parke. "We are hopeful and confident the marketplace will continue to exhibit the adaptability necessary to finance these assets."