Feature: US IRA causing shifts to renewable energy tax equity market

US power market and tax experts have been observing changes to the renewable energy development tax equity market because of the US Inflation Reduction Act introducing a direct pay mechanism allowing more entities to participate.

And while the IRA provides some support to US offshore wind developers, headwinds remain, and the sector will likely remain dominated by large corporate players.

The IRA is opening the doors to renewable energy and battery storage development and making projects attractive in previously suboptimal areas.

The IRA, which President Joe Biden signed Aug. 16, 2022, allocated $369 billion to energy and climate change spending, which is four times more than the 2009 Recovery Act for climate spending but also provides uncapped tax credits which could potentially result in much higher spending.

Under the IRA, many tax credits are sellable, spurring more interest from entities for whom it was harder to avail themselves of traditional tax equity deals, Kristen Gray, EY Americas sustainability tax leader, said in a recent interviews.

That has been shifting to transferable credit deals and "there is so much funding available we are still seeing projects move forward," Gray said, adding that foreign direct Investment is also becoming available.

The IRA has two main levers: transferability, through which entities can sell tax credits to a third party, and direct pay, allowing investors and stakeholders who do not pay income taxes to receive tax credits from the federal government in the form of cash direct payments, which allows new entities to participate in the market, she said.

These entities include state, local and city governments that qualify and could benefit. Native American tribes are another non-taxable entity along with non-profits and other groups that do not pay an income tax who can now participate in the market for renewable energy investments "because even though they don't have income to offset with a tax credit, they can make an election with the IRS to receive that tax credit in the form of a check," Gray said.

"Those new monetization levers could result in a reduction in some of the tax equity investments that we've seen historically which have been driven in large part by some of the large domestic banks," she said, adding that the trend toward a potential reduction in the total volume of tax equity investments involves other factors like proposed Basel III rule changes for the banks that could impact the risk in capitalization ratios related to tax equity investments.

Basel III is a set of measures developed by the Basel Committee on Banking Supervision in response to the financial crisis of 2007-09, with the measures aimed at strengthening the regulation, supervision, and risk management of banks.

That is another development that may lead to a reduction in tax equity investments in the long term "as we see more stakeholders piling into the transferable credit market and also with direct pay," she said.

Stabilization rather than shrinkage

Peter Gardett, S&P Global Commodity Insights research and analysis executive director, said in a Sept. 15 email it is true that classic tax equity structures "that we got used to in the pre-IRA world appear to be capped in quantity, but that with both direct pay and the transfer market for credits there's been a significant amount of growth for renewable energy finance among private equity and debt funds in financing renewables."

They have been doing this either straight off their balance sheet, "so, they don't need to use the old complex and pricy tax equity structure to get the credits and then utilize them across their bigger portfolio," as well as renewable energy finance growth from firms that qualify for direct pay using that market, he said.

"So, I see more of a stabilization rather than a shrinkage when it comes to classic tax equity, and a significantly higher degree of financing using new post-IRA structures like balance sheet financing and direct pay," Gardett said.

US offshore wind sector

Regarding US offshore wind power development, Gray said EY talks about this with clients and they have some who have paused investments, but others are moving forward as the IRA derisked investment to some extent.

US offshore wind developers face mounting financial hurdles to meeting President Joe Biden's target of 30 GW of the resource by 2030, reflected most recently in Orsted saying it anticipates impairments worth up to $2.3 billion.

Private capital has flooded into the energy transition, taking a leading role in the cleantech investment landscape over the past year, but offshore wind has been a notable exception to this trend, Gardett said.

Instead, the budding offshore wind industry is likely to remain dominated by large energy firms that can manage offshore wind projects' high upfront costs, long and complex development timelines, shifting technologies, and financial uncertainty, he said.

"For many private equity funds, the 10-12 years before contracted power purchase agreement prices exceed offshore wind levelized cost of energy is well beyond their investment timeline," Gardett said.

Even "generous tax incentives" and revenue support that could push built projects into positive financial return territory require significant upfront investment capital, "which corporates are better placed to source on debt markets as part of normal business," he said.