Clean energy capital is getting pricier

Tax equity deals have long been a linchpin in clean energy project finance. 

However, rules governing the United States’ implementation of the international banking regulations known as Basel III, introduced last July, stand to make that financing more expensive. The rules, which have a proposed implementation date of 2025, have sent the industry into something of a limbo.

• The top line: Regulations slated to take effect in 2025 will require that banks conducting tax equity investments maintain a 400% financial cushion for each deal. In other words, banks will soon need to set aside more money for every deal they sign — four times more than they do today. For every dollar that a bank invests in tax equity, it must show it has $4 in liquid assets. That means backing clean energy projects could get a lot more expensive.
• The market grounding: The vast majority of the U.S. solar market relies on tax equity financing. Quadrupling the amount of money banks need to keep on hand for such deals has the potential to seriously hamper renewable energy projects’ ability to get up-front capital, and industry stakeholders are hoping to convince federal regulators to reverse their stance.‍
• The impact: The looming regulation change has injected complexity into negotiations between big banks and clean energy developers. In this relatively uncertain climate, risk allocation is becoming a sticking point in dealmaking. And hybrid deal structures — in which investors retain the right to sell tax credits — are surging.‍
• The current take: Tax equity financing is a “very elegant way to get projects built,” said Katherine Hamilton, chair of 38 North Solutions. But it shouldn’t require that banks hold the same financial cushion as they must for private equity deals. “It’s just different,” she said. “Tax equity is more like a loan — it’s not hard equity, it’s not a risky product, it’s just like a loan because you know you’re going to get the tax benefit. It’s going to come back to you.”

Industry groups including the American Council on Renewable Energy, are urging the Federal Reserve, the OCC, and the FDIC to amend the proposed rules to keep tax equity for renewables at its current risk weight. 

The proposed 400% risk weight would make it “prohibitively expensive for the banks to extend tax equity financing,” the group said in a letter, and could result in an up to 90% decrease in annual tax equity investments in clean energy.

“When you think about how clean energy companies have been able to lower their costs and get strong financing to build, it’s because of the tax code and the investment tax credit,” said Hamilton. 

In 2023, the vast majority of solar projects leveraged investment tax credits, said Keith Martin, co-head of projects at Norton Rose Fulbright.

And this isn’t just about solar: the IRA expanded tax credits to things like microgrids, storage, and geothermal, which means the Basel III rule could impact a wide range of energy transition industries, Hamilton added. This potential impact has prompted “a big push” against the proposed risk weighting, including via a widely-signed letter from members of Congress.)

“I do think that probably the regulators will try to work it out,” Hamilton said.

But in the meantime, the uncertainty could have a big impact on the ability of the industry to move forward on projects.

“You don’t want any uncertainty out there as to what the risk factor would be,” Hamilton said. “The banks need that certainty to provide tax equity.”

Deal structures are already shifting

The standard model of raising tax equity — used by almost all wind projects and around 80% of the solar market — involves contracts that allocate a project’s tax benefits (and, usually, a sizable share of depreciation deductions) to an investor who then shares ownership of the project. 

Those agreements are for a set number of years, Martin explained, after which the tax equity investor’s interest in the project typically drops to around 5%, and the developer has the option to buy out the investor.

Basel III was introduced in the wake of the global financial crisis in the early 2000s, with the goal of protecting consumers from bad banking practices. However, it still hasn’t been fully implemented. The so-called “Basel III endgame” rules are the final step, governing how much capital banks must have against credit. 

Because of this impending change, Martin said he’s already seeing a shift in the way tax equity partnerships are structured. And those shifts are having knock-on effects for the tax credit sale market.

That market is ramping up, and fast. Martin said his team had closed 14 large-scale tax credit sales through the end of 2023, and today they have 20 in the contract documentation phase. 

“Equity investors do not have to compete internally for regulatory capital if they’re just buying tax credits,” Martin explained. “We’ve seen a lot of JPMorgan and Bank of America in the tax credit purchase market, because it just avoids these problems.”

But the tax credit sale market isn’t a complete replacement for traditional tax equity, because it leaves depreciation on the table, Martin said, which is why “almost every tax equity partnership has converted to a hybrid transaction.” In that type of deal, the tax equity investors retain the rights to sell tax credits and also monetize depreciation.

At the same time, tax equity negotiations are also facing a new sticking point: Banks, worried that transactions they enter into in 2024 may be caught up by the 400% capitalization requirement in 2025, want an additional safeguard.

“We’re seeing in almost every set of tax equity papers now a bank regulatory out, where if they get caught up in these requirements they have the ability to just drop out of the partnership,” Martin said. 

Whether or not a project developer should have to make the bank whole in that instance has become a key issue in negotiations, he added.