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U.S. Tax-Equity Partnerships: How They Influence Credit Quality

Many renewable energy developers in the U.S. often use tax-equity partnerships as a means of financing large renewable energy projects. In forming these partnerships, the project developer receives cash in exchange for portions of future tax benefits and cash flows associated with the respective project. In recent years, developers have raised tens of billions of dollars using this lever to finance many project builds. We anticipate continued use of tax-equity partnerships in the coming years, given ambitious renewable growth plans and an increasingly mature financing regime. In general, S&P Global Ratings has treated most of these U.S. tax-equity partnerships as a sale of assets and not as debt-like, and views these partnerships as supporting the credit quality of a company growing its renewable energy asset base.

Why Do Companies Enter Into Tax-Equity Arrangements?

Unlike in Europe, where countries use feed-in tariffs (policy-driven long-term contracts that ensure cost recovery at an above-market price for renewable energy producers) to spur investments in renewables, the U.S. federally subsidizes many new renewable investments through tax incentives. As such, the tax benefits associated with renewable energy projects in the U.S. typically represent about half of the returns that these projects produce and enable these projects to remain more competitive with other energy sources. This is primarily because in addition to the depreciation on these renewable assets that lowers taxable income, renewable projects can also benefit from tax credits. In particular, investment tax credits, largely intended for solar and offshore wind projects, provide a tax credit for a percentage of the investment cost at the start of the project while production tax credits provide a tax credit for onshore wind per kilowatt-hour generated for the first 10 years of the project's life. However, the near-term benefit of these tax credits can only improve a company's cash flow to the extent that the company has sufficient taxable income.

Many renewable energy project developers and corporations do not have sufficient taxable income to fully benefit from these tax credits in the first years of the project and it is therefore advantageous for renewable energy companies to sell these tax benefits to another entity (usually a bank) with high taxable income, which can immediately fully benefit from the tax credits.

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Under tax-equity partnerships, the tax-equity investor invests in the project in exchange for a large portion of the associated tax benefits plus some of the cash distributions of the project (at least initially). The project developer retains operational control of the project, receives much of the cash distributions, a small portion of the tax benefits, and is paid a fee for its management of the projects. In this structure, the developer is able to better optimize its returns on its invested capital, while the investor also earns a return mostly through the tax benefits of the project. We expect tax-equity partnerships to remain a viable use of financing for the renewable energy industry over the near to medium term. Should the tax rate increase, we expect that the number of tax-equity investors would also likely increase, broadening the market. Furthermore, the U.S. Congress has remained supportive of renewable projects through continued approval of tax incentives. In late 2020 it extended the production and investment tax credits for onshore renewable projects and introduced an investment tax credit for offshore wind projects constructed between 2017 and 2025.

Details Of A Tax-Equity Partnership

The most popular tax-equity structure in the U.S. that is usually synonymous with tax equity is the partnership flip structure. Although this structure has many variations, it is most broadly understood as a tax-equity investor investing capital in a project in exchange for large portions of the project's associated tax benefits and some cash distributions. The project developer retains operational control, receiving the vast majority of the cash distributions, and a small portion of the tax benefits. Please note the actual mechanics of this partnership are usually complex, relying on a sophisticated understanding of U.S. tax and partnership laws.

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In almost all structures we have analyzed, the distributions to the tax-equity investor, whether from tax benefits, income, or cash distributions, are not fixed and vary depending on the economics of the project. This is particularly the case for internal rate of return (IRR)-based partnership flips where a target IRR must be reached before the distribution of tax benefits and cash distributions to the developer and investor changes. Only in rare cases have we seen structures with a portion of the return to the investor that is a fixed contractual amount, as is seen more for calendar-based flips where the distribution flip occurs on a set date.

How We Treat U.S. Tax-Equity Financings

While we view each tax-equity partnership on its individual terms, in general, S&P Global Ratings treats U.S. tax-equity partnerships as similar to an asset sale as opposed to debt-like because the benefits of tax equity are not regenerated in the ordinary course of business, the risks and rewards are shared with the tax-equity investor, and there is no need for there to be financing on an ongoing basis. We base our analysis on the following:

  • The percentage returns from these projects are agreed upon upfront; however, the actual tax-equity return distributions are largely variable, depending on the economics of the project and federal tax policies--the tax-equity investor takes on this risk.
  • Although tax equity has been extensively used within the industry, we generally don't view tax equity as a necessary arrangement to fund existing operations. In other words, developers have other options and we don't believe tax equity is necessary for the continuation of the renewable business.
  • Tax equity relies on federal policy initiatives, which are largely out of a company's control and therefore not viewed as in the ordinary course of business.
  • The particular renewable assets of a company typically represent a small percentage of a larger company and are therefore usually not an integral part of a company's operations.
  • The developer is not likely to support the tax-equity investor even through moral recourse, which is the likelihood of company's support despite not being legally obliged to do so.
  • The developer neither assumes contingent or indirect liabilities resulting from the transaction nor any repayment acceleration following the target return not being met.
  • The developer does not retain any of the associated finance or tax risks assumed by the tax-equity investor and any claims made against the partnership are nonrecourse to the developer.

This being said, we analyze these arrangements thoroughly for features that may be unique to each arrangement that could make the structure more debt-like. Our analysis considers the financial policies and growth strategy of the developers that enter into these type of transactions, and whether or not they are expanding their business by entering into these type of partnerships in lieu of borrowing. This could be the case if the tax-equity investor has a put option, in which they could sell their interest back to the developer for cash, or if terms in the partnership encourage the developer to buyout the tax-equity investor's share in the project with cash.

Though we haven't necessarily seen put option or buyout terms employed in tax-equity transactions, we have seen similar mechanisms in partnership arrangements, such as is the case for NextEra Energy Partners L.P. (NEP). In this instance, we make an additive adjustment to debt for some of NEP's partnerships with KKR and BlackRock Inc., as we believe the terms of the partnerships incentivize NEP to buy out its partners, a portion of which could be funded with cash, as the partnership is obligated to disproportionately increase the proportion of its paid out cash dividends to the investors after the buyout date.

Regarding the distribution and amortization characteristics of tax-equity partnerships, we have viewed the non-cash nature of the distributions and balance amortization of tax-equity partnerships as also differentiating these types of financings from most of our debt adjustments. Typically, what we have seen is that the vast majority of the distributions to the investor are non-cash before the distribution flip kicks in, and when that happens almost all of cash distributions typically goes to the developer. In almost all cases, the tax benefits that are distributed to the investor are of limited-to-no use for the developer over the near to medium term, thus not materially affecting our earnings or operating cash flow forecasts. Furthermore, the reported balance of the tax-equity investor's investment in the partnership typically gets amortized by the non-cash distributions.

Evaluating Tax-Equity Financings
Credit considerations for tax-equity financings Features of tax-equity financings that support not treating as debt-like
Are returns to the investor fixed or variable? Returns are generally variable, depend on the economics of the project, and are not mandatorily repayable in cash if the target return is not met.
Does the developer guarantee a return to the investor within a specified time period? Typically, the developer does not guarantee a return to the investor within a specified time period.
Are the tax benefits regenerated in the ordinary course of business and is there a recurring need to finance project builds through the securitization of these benefits? Typically, we do not consider these benefits to be regenerated in the ordinary course of business in most cases and are likely not to presume that a developer has a recurring need to finance project builds through the securitization of these benefits or use these type of arrangements in lieu of borrowing.
Are the returns to the investor paid in cash? Although a very small portion of the return to the investor is a cash distribution from the project, the vast majority of the returns are by way of tax benefits that are non-cash.
Is there repayment acceleration if a target return is not met? No terms indicate repayment acceleration if the target return is not met.
Is the developer obligated to compensate the investor for the fair value of its investment once its return objectives are met? Though the developer may have a call option to purchase from the investor for the fair value of its investment once its return objectives are met, it is not obligated to do so.
Source: S&P Global Ratings.

Largely A Codified Opportunistic Way To Obtain Capital Based On Current U.S. Tax Policy

Though each partnership flip structure is unique, standard terms that we have seen, for the most part, are not harmful for developers' credit quality. Furthermore, these structures are enshrined in U.S. federal tax policy as a way to further promote development of renewable energy and are ways for a company to grow its asset base and make more efficient use of its tax benefits while receiving capital that is generally at a cheaper cost than common equity (though more expensive than debt). This being said, we will continue to evaluate each company's tax-equity arrangements when adjusting our debt figures for features that may be unique to said structure.

This report does not constitute a rating action.

Primary Credit Analysts:Sloan Millman, CFA, New York + 1 (212) 438 2146;
sloan.millman@spglobal.com
Shripad J Joshi, CPA, CA, New York + 1 (212) 438 4069;
shripad.joshi@spglobal.com
Gabe Grosberg, New York + 1 (212) 438 6043;
gabe.grosberg@spglobal.com

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