Tax credits can be a very attractive financial investment - as the large banks have enjoyed for multiple years via the tax equity market.
In principle, tax credits can provide very attractive (even “infinite”) returns with very limited risk, while helping unlock cash for clean energy projects (and, in some cases, low income communities) and driving developments - almost a “trifecta”.
How to think about the return/yield:
Tax credits are a dollar-for-dollar reduction in taxes, and they are purchased at a discount (e.g., 90 cents on the dollar) versus their face value (i.e., the amount of taxes that can be reduced). For example, a buyer may pay $900 for $1,000 of tax credits.
In the example provided above, the buyer receives a 10% discount and $100 in net savings. The return on investment (ROI) is slightly higher though: 11.1%. The math would be that with $900 of investment, $1,000 of value has been obtained: $1,000/$900 = 11.1%.
Moreover, the timing of those returns is important - it is not the same to receive 11.1% in a year than in two months. This is where yields can become quite substantial: the closer that the investment is made to the date that taxes are “saved”, the higher the yield. For example, if tax credits are purchased 3 months before filing taxes, the simple annualized yield would be 44.4%. Quite high, right?
In a way, the “floor” or minimum yield would almost be 11.1% if credits are acquired at the beginning of the year and taxes are only filed once per year. That being said, most C-Corps file quarterly estimates, which would mean that the "floor" would be 44.4%, and the closer to the filing date, the higher (e.g., 121.2% if acquired one month before). Very few financial products provide these returns with the level of risk of tax credits. Again, this would be for a 10% discount - we are seeing the market around these discounts without tax recapture insurance (even higher discounts) and a bit less discount with insurance (although with virtually no risk in this case).
“The infinite return”
It can get even more interesting - the Inflation Reduction Act states that corporates can adjust their estimated tax filings with their expected tax credit purchases. This means that the returns could be collected even before the investment is made, leading to “infinite” yields.
To use an example, a corporate could reach an agreement in February to purchase $1,000 of tax credits in May for $900. In its quarterly estimated filings in March, it could cash in the $1,000 by paying less taxes and then make a $900 investment in May with part of the savings. At no point did the corporate need to set cash aside to invest in the tax credits.
What are the risks then?
In summary, tax credits have very limited risks (e.g., recapture events are very rare) and they can be mitigated via diligence and diversification. Furthermore, if desired, buyers can virtually eliminate the risks by adding “tax recapture insurance” that would cover the risks involved in the transaction.
As a result, buyers can choose a slightly higher return with some risk exposure or a slightly lower risk with virtually no risk, as it will be protected via insurance. Our advice to buyers is to leverage insurance until they grow comfortable with the risks and the counterpart.
That being said, to be exhaustive, the risk of tax credits being recaptured (partially or fully) can be bucketed into three main groups:
- Structure: if the transaction was not properly executed (e.g., documentation was done properly, the buyer was not eligible, etc.) - in our view, by involving third-party experts (as we do at Concentro) this risk should almost be non-existent. Moreover, it is fixable (e.g., tax filings can be amended).
- Qualification: if the amount claimed for the tax credit exceeded the eligible amount (e.g., non-eligible costs included, excessive step-up of the cost basis) or if the requirements for the base tax credit or the adders claimed are not met (e.g., wage & apprenticeship requirements) - again, by leveraging expert input and performing a thorough diligence process (as we do at Concentro), these risks should become almost negligible. Moreover, smaller projects do not have wage & apprenticeship requirements which virtually eliminates the qualification risk.
- Recapture: after the project becomes operational, there is a window of five years during which the IRS could recapture (partially or fully) the tax credit. The main sources of recapture are a transfer of ownership, a foreclosure or a project not being operational - these situations should not be common in projects and can be protected via indemnities (as well as via insurance, of course), but this would present the main source of risk. Lastly, recapture risk is “vested”: each year, the amount that can be recaptured is reduced by 20%.
Considering all of this, our view is that, with a proper diligence process, the returns described before clearly outweigh the risks - said another way, the risk-return profile is attractive. Moreover, by acquiring tax credits from different projects, risks can be diversified.
Still, as indicated before, there is an extra tool in case corporates do not want to assume the risk: tax recapture insurance. Tax recapture insurance protects buyers against all of the risks described above, except for those in which there is a willful event with a breach of contract (e.g., the buyer elects to transfer the property) - cases in which indemnities should be easy to claim, as there would be a liquidity event. Tax recapture insurance should come at a 3-4% cost depending on multiple factors.
Rewinding a bit, if a tax credit is purchased for a 10% discount, the buyer could virtually elect to get an 11.1% return (much higher yield) with some risk, or forfeit 3% of the discount, and get a 7.5% return (lower yield). If this is executed 3 months from filing taxes (“the floor case”) it would be a choice between a 44.4% return with limited risk or a 30% return with almost no risk.
Why are smaller projects more attractive?
Smaller projects provide an interesting arbitrage: with fewer liquidity options available, they are willing to accept larger discounts (e.g., 10-15%) which lead to higher returns. On the risk side, if they are under 1 MW, they do not have to meet the only requirement to claim the base tax credit, the prevailing wage & apprenticeship requirements. Additionally, most of these projects claim the tax credits on a “cost” basis (straightforward and objective) while most of the large projects do it on a “fair market value” basis and add “step-ups” to the costs (subjective). Therefore, they can provide higher returns with lower risks.
What's the catch? You need to do more transactions to get to the same total amount. At Concentro we absorb all the complexity and costs involved in these transactions so, for our buyers, it just results in a higher diversification - we charge a flat fee on transaction volume, not number of transactions, and we take care of all the costs and work.
How should I think about it from a Corporate Sustainability angle?
The truth is that not all tax credits will come with the RECs (“the green attribute”) - in fact, most tax credits most likely will not come with these attributes. Therefore, from a regulatory perspective, it may not count towards decarbonization metrics.
That being said, tax credit transfers allow projects to happen. As a result, from an “additionality” perspective, investing in tax credits will result in more clean energy projects being developed and a substantial impact on the energy transition. We are seeing it with our clients - for some projects, it makes all the difference.
Furthermore, many of these projects will have a strong community and social impact. In fact, the IRA provides an extra 10-20% bonus tax credits for Low Income Communities, to contritbute to "climate justice". As a result, channeling funds to these projects may have a "double" ESG impact, helping from an environment and social perspective.
So, when corporates think about how to channel funds into clean energy, we believe that tax credits should be one of the main options as they can have a significant impact (also social), while also being very attractive investments from a risk-return perspective.
Final thoughts:
In summary, tax credits can present a very attractive investment opportunity for corporates that could outperform most asset classes, while also providing much-needed capital for clean energy developments. Moreover, tax recapture insurance further sweetens the deal by virtually eliminating almost all risks. Still, it is a very new market and it will be important to leverage expert input to make sure that transactions are executed properly and that projects are vetted.
At Concentro we help buyers find vetted clean energy projects, we execute a thorough diligence with the help of expert CPA and tax counsel, and we provide tax recapture insurance solutions. Additionally, most of the work we do is with smaller projects, which have fewer requirements to claim tax credits and offer stronger diversification opportunities.
Please reach out to us if you would be interested in learning more.
