The Inflation Reduction Act of 2022 transforms the US tax equity and renewables market

The enhanced tax incentives in the Inflation Reduction Act of 2022 (IRA) is a remarkable legislative effort to encourage clean energy investments in the US. It will unavoidably transform the tax equity market for renewable energy

The IRA, signed into law by U.S. President Joe Biden on 16 August [2022], could considerably broaden tax credit incentives in the clean energy sector and could restructure the associated tax equity market. inspiratia examines how the IRA favors the expansion of tax credit incentives to foster a wider range of renewable energy resources.

Improved tax credit structure grows appeal for the clean energy sector

Within the act, the production tax credits (PTCs) and investment tax credits (ITCs) regimes are expanded, and new direct pay and tax credit transfer systems are being introduced. Starting in 2023, they will create a durable clean energy tax platform.

The US tax code distinguishes two traditional tax credits for the renewables industry. ITC is a one-year credit reliant on the construction cost of projects. PTC is a longer tax credit stream that depends on the quantity of renewable energy produced and sold to an unrelated party over a 10-year period. PTCs have now been retroactively prolonged for various clean energy projects (including wind and hydropower). Both ITCs and PTCs will generally be available until at least 2032.

The IRA's extension of ITCs and PTCs provides renewable companies with the stability they need to do business by facilitating coordination of engineers, contractors and manufacturers for project development.

Timing and cost allocations play a role in how much (and which) tax credits a project might qualify for. A notable tax upgrade is that solar, a sector historically tied down to ITCs, is now a PTC-eligible technology. PTCs may be a more attractive credit to large-scale solar projects due to the relatively constant amount of electricity they are able to generate over 10 years. Washington-based tax and energy partner at global law firm, Orrick, Scott Cockerham, expects "many utility-scale solar developers to consider shifting to a PTC financing regime".

These incentives also reinforce previous, albeit smaller-scale and resource-specific, efforts to develop the home-grown clean energy industry. For instance, inspiratia reported on a 30% tax credit that was introduced in January 2021, for domestic construction investments into offshore projects entering construction between 2017 and 2025. After a period when the value of US wind was phasing down, expanding tax credits greatly dynamised the offshore wind industry – and it will certainly do so for other clean energy resources from 2023 onwards.

The new tax credit structure functions as a two-tiered system in which bonuses can be added on top of the full rate when certain conditions are met. Each resource depends on a defined base rate that can receive a 5x multiplier if the project satisfies the requirements. Bonuses can then be added on top of the full rate credit. The required equity to build a project may shrink, thus increasing the competitivity of such clean energy technologies.

Direct pay and selling credits might be game changers

The act further stimulates the clean energy industry by introducing direct pay to non-profit and governmental entities. Traditionally, tax credit translates into institutions like JP Morgan buying equity in renewable projects in exchange for tax credits. With this new feature, domestic tax-exempt actors also enter the clean energy equity game.

Direct pay allows parties to monetise tax credits more easily by enabling certain taxpayers to receive a cash payment from the United States Treasury, essentially mimicking a tax refund. Its access is limited to certain tax-exempt entities (including municipalities and other state and local governmental entities), except for projects involving clean hydrogen PTCs (section 45V of the tax code), carbon capture (section 45Q) or advanced manufacturing (section 45X) where all tax-paying entities can also benefit. US investors are the only actors that can directly benefit from tax credits, but any foreign developer can potentially monetise the credit by selling it. These new features "could potentially significantly broaden the market" according to Cockerham.

Before the IRA, tax credits were often extended on a yearly basis by Congress (and applied to fewer clean energy resources); this translated into more inflexibility and risk-taking for developers and investors. The new tax credit options now mitigate the end-of-year rush that companies could experience as they scrambled to get projects completed, leading to an increase in prices. The act replaces this inefficient system and offers instead "increased monetization alternatives to tax equity", claims Cockerham. Well-known technologies like solar and wind will continue to expand, and projects deemed riskier in the eyes of investors, such as hydrogen and carbon capture storage will be able to take off.

What should investors' first concern be?

The far-reaching piece of legislation is a significant step forward in federal efforts to incentivize the deployment of clean energy.

The opening up of the market to tax-exempt entities could stimulate greater public sector involvement. As tax credits make clean energy investments cheaper, demand will grow rapidly, and the supply side of things will have to catch up.

The IRA is meant to be comprehensive, bringing together over 50 different tax credit policies that each benefits a clear constituency. Each policy is set out to attract specific developers who can move forward with their projects, rather than having a single tool which developers in different sub-sectors would have to compete for. It is set out to create economic benefits across the country and thus designed to be politically durable.

Now that the bill has passed, it could be thought that people in the clean energy sector need to build projects as fast as they can. However, the ambiguity of certain tax credit features creates weird dynamics in the industry; with developers being very happy in principle about expanded tax credits, but investors wary to go ahead with projects in due of the practical uncertainties of claiming the tax credits and complying with aspects of the new rules.

It is unlikely that the sector sees a near-term speeding up of project development, unlike what could have been expected with the passing of the bill. These obstacles are inevitable because they are imbedded in a tax system that has grown incredibly complex over the past few decades, but they do not cancel the incredible step forward this policy represents for the decarbonisation of North America.

The difficulty to navigate the tax credit market has historically come from three things: it was illiquid, unregulated and complex. The number of experienced investors was limited and experience with the monetisation of tax credit restricted to a handful of actors. Newcomers will need to become comfortable with the often arcane rules applying to such tax credits.

The restructuring of the tax credit system cements the market as a critical pillar of renewable energy investment and has the scope to make new clean energy technologies more economically appealing. However, the IRA should still be regarded as a framework with binding rules to be erected in the future.

The IRA provides tax incentives for clean energy projects to be built from 2023 and at least until 2032, opening an area of unprecedented visibility for the sector, and likely creating a welcome investment boom.