Tuesday, August 30, 2011

Energy Tax Subsidies for "Fat Cats" (Part Four)

My fourth and final post on the U.S. energy sector. I'm finally getting around to the topic that motivated this series of posts: U.S. tax subsidies to encourage the development of renewable energy.

In my last post, I described a hypothetical wind farm development in Iowa. Wind and solar are currently "non-economic" without some type of government subsidization. In other words, the returns to an investor in a renewable energy project do not justify the risk associated with the investment.

In typical fashion, Congress decided to "solve" the economic obstacles to renewable energy development through the tax code. Investors in qualified renewable energy projects are entitled to two types of tax subsidies. The first type of tax subsidy involves tax credits linked to electricity generation by qualified facilities (wind farms, solar projects, etc.). The second type of tax subsidy involves accelerated tax depreciation for equipment deployed in qualified facilities.

As I described in my last post, the tax subsidies may convert an otherwise non-economic project into a project that will attract private financing.

In a logical world, we would assume that Congress would want to maximize the amount of private capital that would flow into renewable energy projects. After all, new renewable energy facilities require construction activities before COD (jobs), and operations/maintenance activities after COD (jobs) (jobs, jobs, jobs). In fact, there would be a sort-of multiplier effect; we would need to upgrade the nation's outdated transmission "grid" to accommodate more wind and solar power. Moreover, renewable energy provides obvious benefits by reducing pollution, improving air quality, etc.

Unfortunately, Congress isn't subject to the constraints of a logical world. Instead of providing broad eligibility to use credits (and depreciation) against taxable income, Congress effectively limited participation to corporate taxpayers. By limiting participation to corporate taxpayers, Congress kept individual investors (taxpayers) out of the market. This decision may have been predicated on a political judgment that uber-wealthy individuals would create "blowback" by using energy tax subsidies to shelter income. However, it starved the renewable energy developers of one source of capital following the 2007 financial meltdown (as discussed below).

Let's get back to my Iowa wind-farm development. Our developer friend needs $100 million, for a project that is not economic unless the developer can "monetize" the tax subsidies available to the project. The developer cannot reach out to individuals; only corporations can use the tax subsidies in practice. Which corporations are providing "tax equity" to these projects?

There are currently 15 tax equity investors active in renewable energy development. The list is a "who's who" of TARP recipients. Bank of America, JP Morgan, GE Capital, Citi, Wells Fargo, Northern Trust. In addition, at least one insurance company is participating in the sector (MetLife). The only non-financial institution on the list is Google, which has recently entered the sector with a couple high-profile investments.

As you can see, most "tax equity" for renewable energy is provided by financial institutions (banks and, to a lesser extent, insurance companies). Financial institutions are logical participants in the sector. They generate steady taxable income from U.S. sources, and thus can offset U.S. tax liabilities with tax subsidies from renewable energy projects. They are also in the business of underwriting loans to borrowers, i.e., evaluating the quality of a borrower's income stream in determining whether to advance cash to the borrower.

Unfortunately, Congress built the tax subsidies for renewable energy with Wall Street in mind. During the "boom boom" years of the real estate bubble, financial institutions were flush with profits and taxable income, and they surged into the renewable development space. The surge of capital pushed down the cost of "tax equity" into a range of 6-7%, promoting development. As we all know, the real estate bubble burst with devastating consequences on the economy at large, and concentrated pain within the banking sector. Financial institutions updated their business models to reflect lower profits and lower taxable income (or tax losses). The surge of capital into the renewable energy sector became a trickle and then a drought. Under current market conditions, the cost of "tax equity" has climbed into a range of 10-15% (depending on type of project, among other things).

I keep expecting other corporate taxpayers to join the party. In fact, the reluctance of non-financial institutions to commit "tax equity" to renewable energy projects leaves me scratching my head. (Again, the mad geniuses at Google are a notable exception.) I understand that industrial and technology and service-oriented businesses do not have the same underwriting experience as the large banks. However, many of these companies have large cash stockpiles, and "tax equity" investors are seeing pre-tax returns of 20-25%. Industry sources tell me that, notwithstanding the economics, CFOs get hung up on the fact that "tax equity" investments are non-core activities.

Why has Google decided to be a trailblazer, where others dare not tread? I don't have a good theory. I'm surprised that other large corporate taxpayers are not taking advantage of the rich "tax equity" yields to invest in the space. I'm guessing that the marketing advantages for "going green and socially responsible" would tend to outweigh the benefit of the tax subsidies.

So where does that leave our wind farm developer? Maybe Google will be interested; more likely, the developer will join the line of developers seeking capital from the TARP recipients.

Where does that leave us as electricity consumers (ratepayers)? No surprise here. The cost of renewable energy development has increased, and utilities pass through costs to consumers. We'll be paying higher electricity costs as utilities source more electricity from (higher cost) renewable facilities. Unless other corporate taxpayers start participating in the "tax equity" market, electricity consumers (ratepayers) and taxpayers will pitch in to repair the balance sheets of the financial institutions participating in the market. But you probably won't see this story in the New York Times.

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