Many corporations struggle to align their operations with the green economy while optimizing financial performance. The Inflation Reduction Act, signed into law by the Biden administration in 2022, allows businesses to accomplish both goals by purchasing Investment Tax Credits (ITCs) from clean energy developers. However, ITC purchases require robust due diligence, structuring, and insurance to execute properly.
CFO Dive connected with Bellus Ventures, an environmental markets firm, and Powerline Risk Advisors, an insurance broker focused on structured risk transfer products for project investors and lenders, to learn how new ITC transfers can be evaluated, structured, and insured to mitigate risk.
What is IRS recapture?
In an ITC transfer, a developer of renewable energy projects sells a tax credit to a buyer, a corporation with taxable income. The seller receives a one-time up-front payment and the corporation reduces their tax liability. The transaction takes place at a discount to face value, providing a profit to the corporation.
The government issues the tax credit with the understanding that the renewable energy project will operate for at least five years. During these five years, the credit is subject to recapture, or the risk the government the government reverses or takes back the credit.
The Internal Revenue Service lists 11 reasons to recapture all or a portion of the credit, including project shutdown, change of control, or an IRS challenge to the project’s claimed cost basis. The ITC buyer is liable for recapture even though the ITC seller operates the project.
“Recapture is very rare, but it is an important risk that ITC buyers should mitigate,” said John Sinclair, Managing Director at Bellus Ventures. “Proper screening, structuring, and tax credit insurance are vital to de-risking ITC deals.”
The good news is that recapture risk can be covered by an insurance company, mitigating the risk for a corporate buyer. Insurance policies are sized to cover recapture as well as IRS interest, penalties, and contest costs. The cost of insurance is typically paid by the developer, reflected in the ITC sale price, and ranges from 2% to 4% of the notional value of the Investment Tax Credit.
“Tax Credit insurance is a well-established product with insurance carriers representing over one billion dollars of risk per project,” says Neil Derfler of Powerline Risk Advisors. “We work closely with developers and buyers to craft optimal policy terms and extract competitive pricing from the market.”
How ITC deals are screened
To confirm a project’s suitability and mitigate recapture risk, ITC deals require thorough screening. During this process, developers provide a background description of the project, ownership diagram, legal agreements, engineering plans, Power Purchase Agreements (PPAs), economic models, and other relevant materials to facilitate due diligence. Additional documentation is required if a project claims ITC adders, such as 10% ITC bonuses for using domestic content and building within an “Energy Community.”
“Every ITC deal starts with a long documentation checklist,” says Ian Clark, Advisor at Bellus Ventures. “Screening is lots of work, but it identifies issues early. Some projects aren’t a good fit for ITC transfers and are weeded out. In other cases, we can work together with the developer to mature projects. Most importantly, we wait until projects are fully ready before showing them to potential ITC buyers.”
Deal Structuring: Portfolios, step-ups, and PSAs
The structure of deals varies to ensure they are viable, marketable, and qualify for ITCs. Developers will often combine several small renewable projects into one portfolio to economize on deal costs and improve marketability. Pooling of projects, for example, is vital for residential solar rooftop installations where the average project may only generate a few thousand dollars of ITC. The diversification in the pooling of projects also leads to similar, if not lower risk, compared to ITCs generated from one large utility scale project and can be purchased at more compelling prices.
“Step-up” transactions are another essential structuring tool. With a step-up transaction, a developer sells the project to an arm’s length third party prior to commercial startup. The sale price, which must be based on fair market value, establishes a higher cost basis for earning more ITC.
Purchase and Sale Agreements (PSAs) are the last essential element of an ITC deal structure. PSAs contain important seller representations and warranties, indemnities, and restrictive covenants. This ensures that the buyer and seller of ITCs understand the transaction and each party’s roles and responsibilities in the event of recapture.
Tax Credit Insurance
As mentioned previously, IRS transferability regulations make ITC buyers liable for recapture risk, even though the buyer sits outside of the investment partnership, and responsibility for project operations remains with the seller. Tax Credit Insurance provides a remedy for the buyer’s exposure, acting as a backdrop to an IRS challenge.
How to get started
“While the risks of ITC transfers can be effectively mitigated, it takes experience to execute properly,” acknowledges Clark. “The Bellus value proposition is that we make the process easy. We have a deep bench of experienced professionals, a broad network of vetted developers, and we can structure the right deal for every buyer.”
For more information, contact Bellus Ventures at [email protected].