∫ Solar Project Finance – Part II

The Pieces of the Financing Puzzle

In the last installment, we explored why solar project finance is necessary, and how homeowners and commercial real estate owners make payments through leases and PPAs. Where matters get messy is in examining how project financiers earn a return on their investment.

Don’t they simply make money by lending the solar equipment (a lease) or selling the solar energy (a PPA)? Unfortunately, no. The revenues from solar equipment leases or from solar energy sales – that is, the cash that the building owner pays every month to the bank – are insufficiently attractive to financial lenders. Government incentives provide the additional cash flows necessary to make a project profitable for solar financiers. What are these incentives?

Let’s begin with the easiest to understand: Feed-in-Tariff. Though it sounds a bit like a run-down diner, a feed-in-tariff simply means the owner of the solar panels is paid per kWh of electricity that her solar panels provide (feed-in) to the grid. For example, if the panels produce 2,000 kWh per year and the feed-in tariff is $0.50/kWh, the owner receives $1,000 annually from the utility. The utility pays $0.50/kWh instead of what they pay power plants for regular electricity rates – closer to $0.10/kWh – because the government requires them to do so (up to a cap). So the owner sells power to the utility, and the utility buys it at an inflated price. This increases the solar panel’s return. Pretty straightforward, right?

Good, because that’s not how it works in the United States. Instead, a jumble of federal and state incentives provide the crucial drivers of solar project finance. These incentives are an alphabet soup: the ITC, MACRS, PBI, SRECs, and rebates. Let’s take them one sip at a time.

The Investment Tax Credit (ITC) is the bedrock solar incentive. The federal government provides a tax credit worth 30% of the cost of your system. So if your solar project costs $1,000,000, you receive a tax credit worth $300,000. To use it you must have “tax appetite,” that is, owe at least $300,000 in federal taxes. To owe $300,000 in taxes, you need to have a very sizeable income. That’s why large companies are the ones who own the solar projects. For 2009 and 2010, the ITC became a cash grant instead of a credit, so you didn’t need to be hungry for tax credits. But the grant program ends in 2012.

Accelerated depreciation (MACRS) is the second most important solar incentive. It provides value worth about another 25% of the system cost. Depreciation is an accounting method to adjust for the fact that assets become less valuable over time. A pencil is not depreciated, because it assumed to have used up all its value the moment you buy it. A computer, however, will last about five years. So a “straight-line” depreciation will reduce the value of that $2500 computer by 20% ($500) every year until it is, for accounting purposes, worthless. (The computer may in fact run for several more years, but “on the books” it is worthless).

Why is depreciation important? Because it is a taxable expense. For example, if your corporation had $150,000 in revenue last year and $50,000 in expenses, it earned $100,000 and owes $34,000 in taxes. However, if your company accounts for the fact that its 20 computers are now worth $500 less each – that is they have each depreciated by $500 – then your expenses would go up by another $10,000 (20 x $500). Your income would drop from $100,000 to $90,000 and you would owe about $30,000 in taxes instead. The depreciation “write off” saved you $4,000 in taxes.

The government gives solar panels a depreciation timeline of 5 years. That’s odd, you say, I thought they last for 30 to 40 years? You are right. But as an incentive, the IRS permits solar projects to be accounted for using a 5-years MACRS depreciation, so that the full value of the tax deduction is accounted for in the first 5 years. This boosts the returns on the solar investment: you get more money back early on (see chart).

Those are the major federal incentives. They are completely tax dependent. The result is that companies and banks with large “tax appetites” are critical to solar project finance. These entities are often referred to as “tax equity” partners, since they are essentially putting money into the solar project in order to obtain tax benefits.

State level incentives are sometimes tax-related, but generally not. A common state level incentive is the Performance Based Incentive (PBI), in which the system owner receives a payment for every kWh of electricity produced by the solar panels. This incentive is very similar to a feed-in-tariff, though logistically a bit more complex.

A second major state-level inventive is the SREC or Solar Renewable Energy Certificate. Pioneered by the Garden State, SRECs are issued to solar facility owners for every kWh of electricity they produce. Instead of receiving a fixed payment per kWh, however, as is the case for PBI and feed-in-tariffs, the solar owner sells the SREC at a market price.

What is the price? It depends. In New Jersey, Maryland, and other SREC markets, state law requires all power plants to generate a certain percentage of their electricity from solar resources or else they must purchase SRECs to fill the deficit. The penalties for failing to meet a solar energy requirement can be very steep, as high as $0.68/kWh. This creates automatic demand for SRECs, often at favorable prices to solar project owners.

Rebates are often used for residential projects. Installing a solar array may cost you $6 per Watt (Watt is a unit of power). Depending upon your location, you might receive a rebate anywhere from $0.50/Watt to $3/Watt. Rebates are rare for commercial-scale projects because state programs run out of money quickly.

If you’ve made it this far, congratulations. The world of incentives is an alphabet soup or a marsh. Either metaphor you choose, it’s wet and messy. Thankfully, innovative legal and financing structures have been developed to tap into these incentives and make solar project finance a reality. The question then is with these structures in place, why isn’t solar everywhere? Alas, there are critical pitfalls to solar development, which we will discuss another day.

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