As reaffirmed by the 2022 Inflation Reduction Act (IRA), the federal government will continue to offer a significant incentive to invest in solar energy through the next decade via a mechanism called the Investment Tax Credit (ITC). It represents 30% of the value of the full investment cost of the solar power plant, when key conditions are met, and it is a direct credit for past or future taxes owed (subject to time limits). There are also possibilities of receiving additional tax credits for meeting specific individual criteria.
A specific user market
Many companies in the US cannot take advantage of these tax incentives, either because they are in a balance sheet situation which prevents access to them, or because their non-profit tax status (i.e.501-c-) makes them ineligible to receive those benefits (private schools, HOA’s, churches, country clubs, charities, etc). The latter scenario has benefited from IRA’s offering of a “Direct Pay” of the ITC, but that has mechanism has some challenges of its own (discussed in a separate blog). An example of the former scenario might be a privately held corporation that is highly leveraged, and which has no tax equity appetite. In both scenarios, a typical solar project would be a small to medium size installation (30 to 500 kW DC).
This substantial segment of the potential solar market has historically been the most underserved for tax-based financing of solar energy.
As a result, those in this broad commercial segment can get orphaned from the solar opportunity, even if they have a real desire to generate their own clean energy. They are not candidates for most existing lease or Power Purchase Agreement (PPA) programs because they have difficulty getting the 20-year credit implied by these solar financing mechanisms, yet they find “full retail” solar cost to be a prohibitive investment from a rate-of-return standpoint.
The cash-backed (or “pre-paid”) Operating Lease/PPA
A simple alteration of the Power Purchase Agreement (“PPA”) mechanism, the Op Lease is a long-term contract to the use of a solar power plant with a pre-agreed minimum yield, priced by the anticipated capacity of the system. A PPA, by contrast, is a direct sale of the yield or kilowatt-hour production from that system. These mechanisms are best used when the user of that power (the “off-taker”) does not have the credit rating required for a typical 20 to 25-year term, or perhaps the size of the solar system needed for the off-taker is not large enough to sustain the legal and other professional costs associated with the contract construct designed to minimize “risk” to the investor. A cash deposit against that future energy off-take significantly reduces that risk and creates interest from investors seeking the tax benefits of the transaction.
Whether an Op Lease or a PPA is used, the pre-paid structure is created by a tax specialty company which forms a Special Purpose Entity (SPE) that will own the solar project. The SPE offers a 20-year (or more) contract to deliver solar energy to the off-taker according to system design specifications. The SPE is funded with tax equity, which will represent the tax investor’s portion of the solar installation contract cost.
The tax partner’s contribution will offset approximately 20% (at the time of this writing – but the market is dynamic) of the solar system installation cost (the remainder of the tax benefits accrue to the tax investor, and are used to off-set their risk). On larger systems, a larger contribution can be made. The remainder of the solar installation cost is funded into the SPE via the cash prepayment of the contract by the off-taker.
In some structures, there is an automatic transfer of ownership and operational responsibility to the Off-Taker at year 6 of the contract, specifically stipulated in the Operating Lease agreement.
Key to the attractiveness of these structures for the off-taker are three characteristics of the scenario:
– A third party helps pay for the solar system while the Off-Taker enjoys 100% of its yield.
– Responsibility for Operation & Maintenance of the system is that of the owning SPE until it turns over its operation back to the off-taker who then becomes owner of the power plant;
– Off-Taker has that opportunity to eventually own the system, and possibly receive additional depreciation benefits at the federal or even state level (subject to review by the party’s CPA or CFO).
Financing the deposit
How the Off-Taker secures the funds necessary to make the deposit on the Operating Lease is completely independent of the transaction. The funds can be brought in from cash reserves, a bank loan, a PACE assessment, a capital lease, a gift or a grant, or any other method. The SPE will not be created until both of these conditions exist: 1. the tax equity partner is ready to fund the SPE and 2.the off-taker is ready to pay the deposit in full.
Once the pre-payment is made, the Off-Taker will have no additional payment to make to the SPE, nor to any other entity for the power used from the solar system for the life of the agreement, unless specifically stipulated otherwise in the Agreement.
The source of the deposit capital may associate a debt requiring servicing, such as a loan or an assessment (or, in the case of cash, an “opportunity cost”). In such case, the annual value of those payments can be looked at as the cost of the energy for that year. Financiers compare that cost against the “avoided cost” of the energy not supplied from the previous utility source; if the Off-Taker saves money by financing the loan over sourcing the energy from the utility over the term of the loan, the investment is said to be cash-flow positive.
The mechanics of a pre-paid or “deposit” Operating Lease
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For more information on the various ways to finance energy improvements for buildings, consult the DoE’s Better Buildings website’s Financing Navigator.