This is an extract from a recent CohnReznick Capital report titled “Opportunity and Complexity: U.S. Clean Energy Financing in 2023”
The U.S. renewable energy market is poised for unprecedented growth. The passage of the Inflation Reduction Act (IRA) in August 2022 presents many opportunities for developers and investors. The IRA contains $369 billion in investments to boost clean energy and curb greenhouse gas emissions. One of the biggest wins is the IRA’s long-term extension and expansion of federal tax credits. As a result, the U.S. should accelerate the deployment of wind, solar, energy storage, electrified transportation, and carbon-capture projects.
The war in Ukraine has sparked a global energy crisis that has reinforced the need for energy security in the form of homegrown clean energy. The International Energy Agency forecasts that the world will add as much renewable power in the next five years as it did in the past two decades.
This forward movement is not without speed bumps, however. In 2022, global supply-chain disruptions were an acute problem, and they will remain an issue in 2023. These supply-chain issues have forced renewables developers to change their suppliers and rethink how to hedge supply risk. Permitting and interconnection queues are another hurdle. And, while not insurmountable, inflation has made financing projects more difficult across the board.
However provisions in the IRA, in conjunction with state-level policy incentives for clean energy and corporations’ increasing focus on environmental, social, and governance (ESG), provide tailwinds that will help the renewable energy market flourish.
Global M&A steadies and prices rise
Throughout 2020 and 2021, platform M&A for U.S. renewables surged. Valuations for platforms, which include portfolios of projects and the teams that manage them, reached all-time highs. With rising rates for capital, there is now a shift to minority investments. Investors are providing growth capital in the form of a minority stake, often receiving preferred equity in a company that has the potential to grow and expand in the post-IRA world, in which company value could increase substantially over the next few years.
Despite inflation and the rising cost of capital, M&A continues There is a robust trend of international players acquiring experienced U.S. developers with strong project portfolios. This trend shows no sign of abating in 2023; here’s why:
- Foreign independent power producers and infrastructure funds see acquisition as an efficient tool to enter or expand their presence in the growing North American market.
- Before the IRA passed, the Investment Tax Credit and Production Tax Credit were either being stepped down or phased out. As a result, potential acquirers were focused on a short development window. Now that the ITC and PTC have been extended for projects that begin construction before 2034, independent power producers and infrastructure funds are looking to access a much larger project pipeline through acquisition.
- Corporate M&A activity that provides development experience and a portfolio of projects in key U.S. markets delivers scale and transaction efficiency that the acquisition of individual projects can’t match.
M&A asset activity will continue to focus on solar and wind companies and projects. However, the vital role of storage in
a renewables-dominated power system, along with a new ITC for stand-alone storage, will also drive more M&A activity.
In 2022, the cost of power-purchase agreements for renewable energy projects continued to rise. Marketplace operator LevelTen’s PPA price index found that solar and wind prices increased almost 10% between the second and third quarter of 2022, and were up 34% year-over-year.
The reasons for these price increases are well known and include a mix of supply-chain constraints, record-high commodity and labor inflation, and increasing demand for clean energy. CohnReznick Capital’s analysis shows that average PPA prices will remain elevated due to high capex costs and high overall merchant prices. As long as labor and component costs remain high, compounded by supply-chain disruptions, PPA prices should also remain high.
Transferability will bring new market stakeholders
Developers of some types of clean energy projects will be allowed to make a one-time sale of tax credits to an unrelated party in exchange for cash starting in 2023. The cash earned from the sale is federally tax-exempt, and the purchaser cannot resell the tax credits. In traditional tax equity, the tax credits, depreciation, cash flow, and losses associated with the clean energy project are allocated to a tax equity investor in exchange for a capital contribution. In contrast, the sale of tax credits for cash means that the tax depreciation, and other benefits and liabilities, remain with the owner of the asset. With guidance from the U.S. Treasury on the transfer of credits, the first indicative pricing and term sheets for the transfer of tax credits will be available in early 2023.
Transferability will provide a backstop to tax credit pricing in the U.S. One goal of transferability is to provide small companies and those with little clean energy finance experience access to financing when they can’t afford or fail to meet the criteria for tax equity financing. For example, corporate entities can purchase credits to simultaneously reduce their tax liability and achieve ambitious ESG goals without the due diligence necessary in traditional tax equity deals. The transferability provision is just one more way the IRA will bring an influx of new entrants into the market.
The transferability provision may also encourage corporations’ direct ownership of clean energy assets and could incentivize real estate investment trusts (REITs) to invest in on-site clean energy. Starting in 2023, REITs can invest in clean energy technology at their properties and then sell the tax credits while still taking advantage of the depreciation.
A new choice for solar: PTC or ITC?
A significant number of solar projects were paused in the weeks after the IRA passed. That’s because the new law allows solar developers to use either the solar ITC or the PTC, which incentivizes power production over 10 years. As the costs of solar projects decline, the potential of the PTC to be more financially advantageous was enough to prompt some developers to halt projects and assess their options.
In many cases, the PTC is preferable to the ITC for large-scale projects. Solar projects with lower dollar-per-watt capital costs will tend to favor the PTC, making it more likely that utility-scale projects will elect the PTC and that residential and commercial projects will elect the ITC. Allowing renewable developers to choose between the ITC and PTC would result in up to eight times as much reduction in emissions by 2031 compared with a straight 10-year extension of the previous tax credit rules, according to an analysis from the Rhodium Group.
Also, some investor-owned utilities are subject to tax normalization rules that require the tax credits to be realized over the life of the solar assets. The PTC, however, is not subject to the normalization rules, which is another benefit for those utilities.
Projects with higher net capacity factors will also favor the PTC over the ITC, meaning that projects in sunnier parts of the U.S., such as California and Texas, will be more likely to elect the PTC than those in regions such as the Northeast.
However, the devil is in the details, and every project needs to be assessed individually to determine whether the PTC or the ITC would provide greater returns. For instance, tax equity investors may prefer one credit’s economic and accounting profile over the other. The ITC is determined upfront and may give investors more certainty around tax planning and exit timing.
The outlook for energy storage and carbon capture
The IRA finally made the long-discussed possibility of a tax credit to support stand-alone energy storage a reality. Not surprisingly, market forecasts for U.S. storage installations are robust. According to American Clean Power and Wood Mackenzie, the U.S. will add nearly 60 gigawatts of new energy storage capacity by 2026, and dozens of stand-alone large-scale storage projects are now in development.
The surge in new energy storage projects will require investors to grow their knowledge of merchant power prices and various revenue streams available to energy storage projects. As the market expands, more complex revenue models will be required to remain competitive. The investors that understand the nuances and complexity of these revenue models will be the ones best situated to capture opportunities in the energy storage market. As the market expands, M&A activity is poised to rise.
In particular, the stand-alone storage ITC is a significant change likely to accelerate utility deployments.
In the past, some regulated utilities leveraging the ITC were required to retain a portion of the ITC’s financial benefits exclusively for their shareholders. Because of this tax normalization requirement, those utilities could not pass along the ITC’s full cost savings to their customers in the form of lower prices.
Utilities can now opt out of tax normalization for stand-alone storage projects, which should drive significant investments. The improved economics of storage should also accelerate M&A activity, particularly for companies with development experience and a portfolio of existing projects.
Potential for a banner year
More funding is available than ever before, demand for renewables is at an all-time high, and competition for new business may be fierce. There is no denying that 2023 and the next five years will most likely be banner years for renewable power.
The headwinds of the volatile global economy, inflation, supply-chain disruptions, tariff threats, permitting delays, and transmission bottlenecks are likely to persist. Companies that can keep risk low but maximize returns on investment in an increasingly complex environment of tax incentives and revenue structures will come out ahead in the market. The winners will be those that can successfully mitigate the risk faced in the current market and adapt to changing conditions.
The complete report can be accessed here