The word on the street is that completion risk heading into the scheduled, dreaded investment tax credit (ITC) step down is already becoming an issue for solar developers. In short, there is a general fear on the part of market participants that solar projects currently in development won’t meet the IRS’s qualifications for being placed in service before the end of 2016, when the ITC is scheduled to decline from 30% to 10%. This would make many projects in the current environment economically unviable.
For debt and sponsor investors, making the wrong bet on renewable projects would amount to incurring an opportunity cost as commitments to failed projects would foreclose capital deployment elsewhere. There would be a similar story for tax equity investors – perhaps compounded by the fact that tax equity is more ephemeral in nature than other sources.
Unlike debt and sponsor investors who could, short of some other restriction, redeploy capital in the new year; tax equity investors have limited opportunity to play around with tax periods thanks the ITC step down, and may lose undeployed tax liability or at least find it difficult to shift that liability to another project. For developers, this ITC story is perhaps most catastrophic as they depend on asset sales to recoup development costs and overhead, hopefully with a margin on top. Most asset buyers are incredibly weary of taking on the risk described above. Anecdotally, this has meant that large projects without permitting completion are already, over a full year before the ITC step down, facing a bit of an uphill battle to get financed. It can be expected that larger commercial and industrial projects will face similar obstacles over the next few quarters, if they haven’t already.
As the last round of tax equity of this current great wave of solar projects tries to find a home, some developers may intend to place completion risk bets intentionally and aggressively by holding fire sales at the end of the year. However the laws of supply and demand would seem to dictate that, in most cases, the opposite story will be the more prevalent one – that tax equity dollars will have the pick of the litter with respect to projects. While returns could be maximized by a few, it seems more likely that a game of high stakes musical chairs will leave some developers with this strategy without a tax equity capital source – or perhaps with offers far below their return thresholds.
Even a distressed market scenario is far from a sure bet. While plain vanilla investment theory tells us that everything has a price, that doesn’t always play out in real life, particularly in the solar development world. Recent events in Puerto Rico lend support to this exception to the rule as orphaned projects there in the wake of repayment shenanigans by the government have made it clear that some risks cannot be overcome, even at cut rate prices. It is unclear whether completion risk will be viewed the same way as credit risk, but the situation in that undercapitalized territory does provide a stark guidepost.
Developers need to be taking steps now to avoid the pain described above later. In many cases, they will need to be ready to provide completion guarantees to buyers, which need to be backed by real balance sheets – whether their own or that of an EPC backstop. Insurance products could provide another solution. Some may need to accept higher soft costs in the form of legal and tax opinions on placed-in-service dates. This will be the case even if, or maybe especially if, lawmakers shift the ITC to a ‘start of construction’ type regime to mirror what has been done to extend the usefulness of the production tax credit (PTC) in the wind space.
To ensure maximized returns, developers should therefore use all haste in ensuring that key components of their projects are done – and done right. Permits need to be pulled as soon as possible, interconnection costs need to be finalized, land needs to be secured and offtakers must be signed. It also increasingly looks like it will mean addressing the supply disruptions that may already be occurring. It finally means avoiding gaps and utilizing market-ready document suites for all counterparty agreements. All of this is true, even if it means deploying more speculative capital than most are used to.
Special thanks to Morgan Gerard who assisted in the preparation of this post.