Samuel Egendorf | Senior Manager, Capital Markets, EDPR NA Distributed Generation
Over the past few weeks, a large number of friends, family members and colleagues in clean energy have asked for my take on the Inflation Reduction Act (“IRA”). I answer their question with one of my own: how much time do you have? As an energy professional focused primarily on tax equity financing of distributed generation solar projects, I have a lot to say on the topic. And the IRA itself is a massive and complex piece of legislation. But I’ve discovered that not everyone is interested in an hour’s long lecture on the nuances of clean energy finance. What follows is the shorter version I’ve had to use to prevent people’s eyes from glazing over, covering my take on the IRA, some background on tax equity and a few features of the IRA which I find particularly interesting.
After decades of congressional stagnation, the passage of the IRA on August 16 marks a sea change in our country’s approach to the energy transition. I join my colleagues and the global community of climate advocates in hailing this historic legislative achievement and applauding the tireless efforts of the countless policymakers, staffers and industry advocates who made this happen. The IRA is not immune to criticism, of course, but it is the boldest climate action ever taken by the federal government and it represents a meaningful step towards finally bringing our energy policy into alignment with our climate goals. Indeed, the commitment of $370 billion for climate and energy programs is historic by any measure, and it sends a powerful message to both the U.S. energy industry as well as the broader international community.
But in the midst of widespread joy and enthusiasm, those of us in clean energy finance are likely experiencing a bit of trepidation as well. The IRA promises to upend a regulatory landscape which has remained relatively stable for nearly 20 years. Those of us tasked with transforming these government incentives into operational renewable energy projects are now scrambling to understand the law’s practical consequences. The next six months in particular will be crucial as we work to develop fluency with a new set of rules and rethink our approach to building and financing clean energy infrastructure. This is, admittedly, a “good problem to have,” but the magic of this moment makes the task ahead no less daunting in light of the hundreds of pages of dense legislative text and forthcoming agency regulations that we must digest and then translate into actionable strategies for clean energy investment.
With the news media focusing on the $370 billion sticker price of the IRA’s energy provisions, casual observers and even some industry insiders would be forgiven for thinking that Uncle Sam will be writing checks to companies like ours to hasten the deployment of clean energy. In rare cases (primarily municipality-backed projects), this is not far off. But for commercial sponsors, who comprise the vast majority of the market, reality is much more complex.
Following the approach of the IRA’s predecessor, the Energy Policy Act of 2005, the IRA’s energy incentives eschew direct payment of subsidies for a series of tax credits that can be used by project owners to offset tax liabilities they would otherwise pay to the IRS. This approach is crucial for both political reasons (since direct subsidies fall prey to accusations of rent-seeking and market manipulation) as well as legal reasons (as Congress has plenary constitutional authority to regulate via the tax code); it also means that the portion of that $370 billion price tag which is aimed at spurring the growth of our clean energy infrastructure does not represent government expenditures but rather an estimate of future reductions in federal tax revenue. In effect, the government is outsourcing to the private sector the task of, and the financial risk associated with, implementing the energy transition by dangling a carrot in the form of a tax break when projects are successful.
At the heart of clean energy finance is the fact that sponsors and independent power producers do not come close to generating enough revenue to capture the value of the tax credits their projects create. In fact, most projects operate at a loss for many years post commissioning —$0 in taxable income means $0 in tax liability. Therefore, we must use one of a variety of complex financing structures, grouped under the heading of “tax equity,” to convert the tax break into clean energy capex. In solar, we call this “monetizing the ITC” and it requires transferring much of the tax ownership of the project to a third-party investor in exchange for a capital contribution. Tax equity investors are typically large banks, insurance companies or other high-revenue-generating enterprises with sizable tax bills; by virtue of becoming a project owner for tax purposes, they can claim the tax credits on their income statement and significantly reduce their liability when filing their annual tax return.1
So what does this mean in the context of the IRA? Most obviously for solar, the availability of the investment tax credit (or “ITC”) at the highest level (i.e., 30% of eligible cost) has been extended into the 2030’s, providing much needed certainty and better returns for the industry over the medium term. This means more projects will get built. And it is especially impactful because the percentage had been ratcheting down since 2019, heading towards 10% by 2024. Because the loss of just a few percentage points of ITC can mean the difference between a viable project and a dead one, there can be no doubt that the IRA has breathed new life into a crucial and highly-specialized segment of the clean energy industry that was otherwise expecting to be rendered largely obsolete in less than 2 years.
But that’s just the start. There is a wide array of other exciting changes on the horizon—too numerous to recount here—but a few of which stand out for me personally and I think should be of interest for energy professionals and laypeople alike: namely, the prevailing wage and apprenticeship requirements and the forthcoming transition to “tech neutral” tax credits.
Prevailing Wage and Apprenticeship
To qualify a project for the 30% ITC, sponsors must now demonstrate that laborers are paid a “prevailing wage” (i.e., generally equivalent to union pay in the area) and that a specified portion of them are “qualified apprentices.” The regulations that will define the contours of these requirements have not even been issued yet, but the world of clean energy finance is already preparing itself to get educated very quickly on the various labor law questions these rules will generate and developing strategies to ensure compliance. Thanks to the IRA, it will soon be my job, that is, the job of the investment and capital markets teams, to make sure our contractors receive the required level of compensation, as failure to do so now constitutes a material financial risk. It’s almost ironic: prior to the new law, paying contractors less improved project returns. The incentives have essentially flipped.
But to put this in context, recall that the ITC has been sunsetting for the last 3 years. I’ve spent countless hours during this time learning an arcane set of rules arising from treasury regulations and IRS guidance to qualify projects for higher ITC wherever possible. And even more time has been spent demonstrating to the satisfaction of tax equity investors that the rules have been followed correctly, which has meant pouring over piles of procurement documentation, bills of lading, purchase orders and manifests. Those days are over now. Instead, we’ll be sharing a different set of documents with investors: pay statements, employment forms and others which have yet to be defined. If my investor’s return is predicated on prevailing wage payment, you can be sure those wages will get paid.
Simply put, I find this highly gratifying. Like many of my colleagues, I didn’t pursue a career in this industry for purely financial reasons; I wanted to be a part of the energy transition and to see my efforts make an impact, both in terms of renewable energy deployment and new economic opportunities. Frankly, it feels good to know that my projects are creating good jobs.
Transition to “Tech Neutral” Tax Credits
Finally, I’d like to point out one other feature of the IRA which has flown under the radar in popular news coverage: the transition to “tech neutral” tax credits that will take place in 2025. Under current law, and for the next 2 – 3 years, tax credits are available only for specifically enumerated energy technologies. That is, the tax code expressly defines solar photovoltaics (so long as, curiously, they’re not used to heat a swimming pool), wind turbines and a few other energy sources as technologies for which tax credits are available. But this will change suddenly on January 1, 2025, when references to specific types of technology will effectively be struck from the tax credit provisions and replaced with a single overarching criterion: whether the energy source is carbon neutral.
This puts the entire energy industry on equal footing. That is, even traditional thermal generators using fossil fuels are technically eligible for energy subsidization via the IRA, they just have to demonstrate carbon neutrality (via carbon capture or similar means). In my view, the implication is that renewable energy, and wind and solar in particular, are no longer niche technologies that must be guided through infancy, but mature market participants that have outgrown tailored federal support. Instead, it’s our energy infrastructure as a whole that must modernized and expanded. Congress doesn’t care how we get there, but their assistance is contingent on keeping your carbon emissions in check. If sponsors want to build carbon intensive projects, they may do so, but at a slightly higher cost of capital. This strikes me as both appropriate and as good policy: carbon intensive projects should be more costly to build, as this reflects the costs their emissions impose on society. In economics parlance, we might say that the IRA takes a large step towards “internalizing the externality” of carbon emissions, a long-term goal of many climate advocates.
I stated at the outset that the IRA has allowed us to finally bring our energy policy into alignment with our climate goals. I highlighted these two examples, prevailing wage and “tech neutral” credits, because I think they are two areas that demonstrate this alignment. We indeed have exciting times ahead of us.