New Structures for Selling Tax Credits Can Fund Clean Energy

In this article for Bloomberg Tax, partners Sam Kamyans and Roald Nashi discuss how companies can enter into bankable revenue contracts for energy transition projects that have a 2050 net-zero emissions goal.

The Inflation Reduction Act has made federal income tax credits available for a wide array of green technologies. The 2022 tax-and-climate law also enables the sale of tax credits to help achieve its green energy policy goals. As a result, banks, sponsors, and fund managers have a unique opportunity to use transferability provisions to finance energy transition projects.
 
In this article, we consider the tax credit transferability contractual framework that creates a revenue stream against which banks can provide project financing as well as how funds can use pooling arrangements to optimize such financings.
 
New Structuring Opportunities
 
At a high level, project financing in a transferability context involves buyers that purchase tax credits; banks that provides debt capital; funds through which buyers receive tax credits; managers that arrange transactions between sponsors and tax credit buyers; and sponsors that control development, construction, and commercial operation of an asset, tax credits, and related environmental attributes.
 
Before the tax-and-climate law, sponsors monetized tax credits through a partnership where capital was invested in exchange for tax credits, tax benefits such as accelerated depreciation, and operating cash flow. Banks provided construction financing that was backstopped by the tax investor’s commitment to fund the project at certain milestones.
 
The new law allows direct sales of tax credits, including to partnerships that allocate the credits to their partners. In addition, sponsors may sell attributes—such as carbon dioxide removals or regulated cap-and-trade credits—through the same partnership or through separate contracts, and they may retain the cash generated from those sales.
 
As tax credit sales, carbon dioxide removals, and regulated attribute carbon markets develop, there may be opportunities to enter into revenue contracts for these attributes (separate from tax credits) and secure debt financing relying on those contracts.
 
Because a sponsor can sell tax credits and attributes, a pooling arrangement using traditional fund architecture allows for financing projects without a direct investment from a tax investor into a project company. Moreover, a sponsor can sell tax credits from the same project to multiple buyers, or from multiple projects that it owns to a single fund.
 
Using a fund structure allows a manager to form a single vehicle that buys a mixture of attributes from multiple sponsors and projects and allocates those items to tax credit and attribute buyers according to their economic arrangement.
 
Tax credits can only be sold once; a sale to a fund partnership that allocates tax credits generally qualifies as a single sale. Attributes other than tax credits generally aren’t subject to resale restrictions. Alongside forward commitments, the fund will receive capital commitments from tax credit and attribute buyers that will be funded as attributes become available.
 
For investment tax credits, a buyer is likely to provide funding simultaneous with the tax credit transfer, while production tax credits may require monthly, quarterly, or other periodic fundings. Attributes other than tax credits don’t have a time value component, enabling timing flexibility.
 
Lending and Project Finance
 
Once the tax credit or environmental attribute forward commitments are in place, a lender can make a loan to the fund, relying on the buyers funding their capital commitments to service the debt. This allows a lender to diversify risk across projects and attribute buyers, analogous to a securitization.
 
More specifically, lenders finance the revenue stream from the tax credits monetized through the fund and take the fund’s credit risk as opposed to a special purpose vehicle project company. The fund can loan the proceeds to one or more sponsors or make an advance payment on a forward sale of the attributes.
 
A lender may want rights under the credit agreement to compel attribute buyers to fund their commitments. This way, if they fail to do so, the lender can foreclose on the environmental attributes and assign the tax credit forward sale agreements.
 
Such rights cause additional complexities under the financing documents because granting a lender indirect privity against attribute buyers may not be well received from those buyers. Negotiating and structuring this arrangement may complicate the overall structure.
 
Alternatively, a lender can lend directly to the sponsor, secured by the cash from the tax credit sales agreements, thereby relying on the credit profile of the tax credit purchaser. This construct is similar to a tax equity bridge loan that a lender provides based on the tax equity investor’s commitment.
 
The lender can secure the loan with a pledge from sponsor of the project company’s equity, allowing the lender to take the asset, place it in service, and sell the tax credits arising from that project.
 
The manager can create several revenue streams. For one, it can arbitrage the attributes. Tax credits can be sold at a discount per $1 of credit—for example, the manager can arrange for the purchase of tax credits at 90 cents from the project and charge the attribute buyers 95 cents, keeping the difference. The same can be done with environmental attributes. The manager also can charge a management fee as a percentage of capital commitments (whether funded or unfunded).
 
An alternative structure is for a sponsor to partner with an “attribute sponsor” that agrees to fund the project in exchange for the right to monetize the attributes. This structure is a variation on traditional tax equity structures.
 
An attribute sponsor contributes capital to a company into which the sponsor contributes the project, and has the exclusive right to sell the attributes; it can take an allocation of tax credits if it has the capacity. Similar to a tax equity investor, the attribute sponsor will have a cash sweep to secure its return targets and may back-leverage its capital contribution.
 
In conclusion, the new transfer provisions enable variations on traditional fund and tax equity structures, which are a welcome development to fulfill the tax-and-climate law’s goals of enabling the energy transition.