One of the largest factors responsible for driving the renewable energy boom over the last fifteen or so years was tax credits. Indeed, high electricity prices improved the economics of renewable energy projects, but the other factor that drove renewable energy boom was the desire of firms with large tax bills to reduce their tax liabilities. By investing in a renewable energy project that earned tax credits, the investor could reduce its taxable income.
Until the recent legislation was passed the primary federal tax incentives were the Production Tax Credit (PTC) and the Investment Tax Credit (ITC). The PTC was initiated in 1992 and gives project owners a tax credit when the project generates revenue from selling its power. In 2008it was worth $21/MWh for wind, closed-loop biomass, and geothermal power projects. Other renewable generation projects like open-loop biomass, landfill gas, municipal solid waste, qualified hydropower, and wave & tidal power projects received a tax credit of $10/Mwh (note that solar projects do not benefit from the PTC).
The Investment Tax Credit (ITC) has been available for certain types of commercial energy projects for a while, but was strengthened by the Energy Policy Act of 2005. The credit provides a tax credit equal to 30% of qualifying costs for solar, fuel cell, and small wind projects. Geothermal, microturbines, and combined heat and power projects are eligible for a credit equal to 10% of the project’s qualifying costs. This tax credit is realized in the year that the project begins commercial operations, but it vests over five years. If the project owner sells the project before the end of the vesting period, then the remaining portion of the credit is forfeited.
When the economy and profits were strong these tax credits provided strong incentives to invest in renewable energy projects, but now there are far fewer companies making large profits. Many companies are just struggling to achieve and maintain profitability. Also, a lot of the investors in these projects were large financial institutions, many of which are now simply struggling to survive. So, as the economic conditions worsened, the pool of investors in renewable energy projects shrunk rapidly. The inability to use these tax credits combined with the decline in energy prices across the board (especially coal and natural gas) made the economics of renewable energy projects for investors look very bad.
The American Recovery and Reinvestment Act of 2009 that was passed by Congress and signed into law by President Obama in mid-February addressed this issue; it allocated $40 billion of the $787 billion to clean energy initiatives. The legislation also called for modifying existing clean energy tax incentives and creating new ones, which will cost another $20 billion. One of the changes called for in the Act gives projects that are eligible for the Production Tax Credit (PTC) the choice to use an Investment Tax Credit (ITC) instead. However, the biggest change is that in lieu of the ITC, project owners can now choose a new incentive that offers a cash grant of equivalent value to the ITC for qualified renewable energy projects that are placed in service in 2009-10 (so in effect, if the project is eligible for the PTC, the developer could choose the ITC or grant instead).
While it sounds like choosing the cash grant instead of the production or investment tax credit should be a no-brainer that is not necessarily the case. The decision is dependent on the cost of the project, the capacity factor (how much power the project actually generates compared to its total capacity), investors expected future tax burden, liquidity needs, investment time horizon, and other idiosyncratic needs or preferences of investors. However, the real question is will this new addition of the cash grant option and the improvements in the flexibility of the existing tax incentives actually stimulate the market for renewable energy projects?
I believe the answer is, “yes”. Even though the grant and the ITC provide, in theory, essentially the same amount of value the grant provides cash in a liquidity constrained environment. The fact that the government is promising cash payment should make it easier for a project developer to obtain additional project financing. Further, in the past, a project that relied upon the PTC faced the possibility of operational problems resulting in less power being generated than expected; this would result in smaller tax credits being generated than expected. Now, a project that would have previously relied on the PTC can elect for a cash grant that carries no ongoing operational risk. The project just has to generate power for five years and it will recover 30% of the capital cost; fluctuations in the amount of power generated over that time won’t change the value of the grant.
So, in short, the new provisions in the stimulus act reduce risk for investors and provide more options. Investors view more options as being more valuable, so in essence, the stimulus plan reduces risk and increases return. What investor doesn’t want that??