By Fred Greguras, Charles Purcell

In his inaugural speech on January 3, 2011, Governor Jerry Brown stated his goal of 20,000 megawatts of renewable energy generation for California by 2020. This may result in greater incentives in future years. In 2011, however, it will be the extension of the Section 1603 cash grant program and 100% bonus depreciation at the federal level that will stimulate investment in renewable energy projects in California. The cash grant program was extended through 2011 as part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which was signed into law on December 17, 2010 (the 2010 Tax Act). The cash grant was the most important policy for driving renewable energy growth in California and the United States during 2009 and 2010. The 2010 Tax Act also enacted 100% bonus depreciation for property placed in service after September 8, 2010 and before January 1, 2012, another important incentive for renewable energy project finance.

The cash grant extension will strengthen job creation in the construction and operation of renewable energy projects in California, and the availability of bonus depreciation could cause significant investment in manufacturing plants in a number of business sectors, which could also result in many new jobs in California.

Extension of Section 1603 Cash Grant in Lieu of Investment Tax Credit Program

The Section 1603 program was established in the American Recovery and Reinvestment Tax Act of 2009 (ARRA) to provide cash payments for the implementation of renewable energy projects. Prior to that time, the principal incentive for solar projects was the incentive tax credit or ITC. By 2009, however, many taxpayers did not have a tax liability against which the ITC could be applied. Thus, Congress enacted the cash grant program. The cash grant can be obtained from Treasury relatively quickly and simply as compared to other ARRA incentives and is not taxable at the federal level.

The cash grant amount is 30% of the qualified project costs for solar, wind, biomass, geothermal, landfill gas, waste energy, hydropower, marine and fuel cell power projects and 10% of the project costs for microturbines, geothermal heat pump systems and combined heat and power cogeneration systems. Prior to the extension, a taxpayer would have needed to either place the project in service before the end of 2010, or begin substantial construction of the project before the end of 2010 to obtain the grant. Many project developers raced against the clock to begin construction of renewable energy projects.

The 2010 Tax Act authorized a one-year extension for the cash grant; there were no changes to the requirements for the program. As extended, a project developer must either place the renewable energy project into service by the end of 2011, or begin construction of the project before the end of 2011 and place the project in service before the applicable tax credit termination date (i.e., by the end of 2012 for wind farms; the end of 2013 for biomass, geothermal, landfill gas, waste energy, hydropower and marine; and the end of 2016 for solar, microturbines, geothermal heat pump systems, fuel cell and combined heat and power cogeneration systems).

The cash grant has supported total investment of more than US$19 billion in renewable energy projects in the United States based on the over US$5.8 billion of payments under the program. As of November 22, 2010, over 85% of the funding had been for wind projects, and about 7% (over US$416 million) had helped finance almost 1,200 solar projects. In comparison, a total of 209 wind projects and 77 other types of renewable energy projects had received funding. As of that date, California solar projects had received the most cash grants with US$143,651,129 for 178 projects followed by New Jersey, with US$72,183,816 for 164 projects, and Florida, with US$70,710,898 for 112 projects. California continues to be the top state for solar jobs.

Bonus Depreciation for 2011

The 2010 Tax Act enacted 100% bonus depreciation which is available for new qualified property acquired and placed in service after September 8, 2010 and prior to January 1, 2012. Essentially, this allows a taxpayer who places in service certain types of property (including alternative energy facilities) to claim an immediate deduction against income of all or (in the case of property on which the cash grant or a tax credit has been claimed) 85% of the cost of the property. Depreciation is a deduction against income, so the taxpayer must have sufficient income in order to fully utilize this incentive. (Equipment which uses solar or wind energy to generate electricity would normally be depreciated over five years.) As a result of this incentive, project developers placing new solar or wind energy equipment in service during this period may immediately expense the cost of such equipment. This means the entire capitalized cost of a solar generation facility in 2011 may be written off in one year instead of over a 5-year period. This benefit applies only to new property and not to used equipment. The law also provides for bonus depreciation in 2012 but at a lower rate of 50%. Bonus depreciation can create a net operating loss (NOL), which may be carried back to the two prior tax years and provide an immediate tax refund. An NOL may also be carried forward for twenty years.

The availability of both the cash grant and bonus depreciation in 2011 should increase the number of tax equity investors in the market and reduce the cost of such investment because of the greater potential returns. Tax equity investors generally prefer the Section 1603 cash grant because it is cash and the recapture provisions are less likely to be triggered than under the ITC. Under the cash grant, unlike the ITC, there is no recapture of the benefit in the case of a disposition of the project during the 5-year holding period (other than a sale to a tax-exempt investor) and the project continues to be used for the same energy generation purpose.

While the cash grant is limited to energy generation projects, 100% bonus depreciation is also applicable to manufacturing and other types of equipment investments across multiple business sectors. This could help support investment in solar related manufacturing facilities particularly in states like Arizona where state tax incentives have already attracted solar equipment manufacturers. The economics of this incentive could be positive enough for Chinese and other Asian solar module companies to set up manufacturing facilities in California and elsewhere in the United States. The incentives for manufacturing are much more difficult to monetize for lenders and tax equity investors in comparison to a renewable energy generating facility with reliable revenue streams.

Solar Project Finance Transaction Example

Consider the impact of these incentives on the financing of a US$15 million distributed solar energy generation facility placed into service in 2011. Initially, the 30% cash grant amount will be US$4.5 million. The depreciable basis would be US$12.75 million, which is US$15 million-[(50%) * (US$4.5 million)], or 85% of US$15 million. The 100% bonus depreciation in 2011 would be US$12.75 million. The taxpayer may use these tax benefits or monetize both of them through a tax equity investor. For a corporate taxpayer with about a 35% federal tax rate, assuming it has income to offset, the federal tax savings in 2011 from the bonus depreciation would be approximately US$4.5 million. Of the US$15 million that needs to be financed, about US$9 million or 60% is recoverable in 2011. The amount of debt financing needed for a project in 2011 should be smaller because the tax equity investment portion should be larger. California does not allow a taxpayer to claim bonus depreciation for state tax purposes but does provide other incentives as described below.

California Revenue Streams

Successful project finance depends on obtaining a return on investment that may be calculated with a high degree of predictability. In 2011, the only predictable revenue stream for utility projects in California will be payments for electricity under long term power purchase agreements (PPAs). For 2011 commercial projects that have a reservation under the California Solar Initiative (CSI), the production based initiative will provide an additional revenue stream for five years at about US$0.05 per kWh. For non-residential projects that do not have a CSI reservation, there is a wait list for this incentive at Pacific Gas & Electric and San Diego Gas & Electric because they have reached their budgeted caps for non-residential installations.

Unfortunately renewable energy certificates (RECs), which are usually bundled with the energy in utility projects, will not be a predictable revenue source for any type of California solar project in 2011. The implementation of AB 32, the California Global Warming Solutions Act, will also not have any impact on financing California solar projects in 2011 even if there is no litigation over the impact of Proposition 26. Both of these incentives may help the financing numbers in future years but not in 2011.

California Renewables Portfolio Standard (RPS)

The California RPS was 20% from renewable energy sources by the end of 2010 and is 33% by the end of 2020. Renewable energy projects must actually produce electricity to satisfy the RPS. Signed contracts for the purchase of electricity do not count unless and until generation commences. The RPS primarily targets California’s investor-owned utilities (IOUs); Pacific Gas & Electric, Southern California Edison and San Diego Gas & Electric. The IOUs were at about 18% on an aggregate basis at the end of 2010. The purchase of RECs by the IOUs could have some impact on RPS compliance in late 2011. Factors that have delayed IOU use of RECs include uncertainty created by the CPUC’s protracted proceeding in Rulemaking 06-02-012 on whether, to what extent, and for how long, the IOUs may purchase RECs separately from the energy with which they are associated in order to comply with the RPS. A final decision has been expected for some time, but there are deep divisions on complex policy issues.

 The RPS by itself does not enable financing because the consequences for failure to meet the standard are not strong enough. Only a tiny percentage of projects contracted for by the IOUs are actually delivering electricity. There are multiple reasons for this problem but a major reason is that PPA pricing has often been too low to make the projects financeable by lenders and other investors.

Even after the October 21, 2010 Federal Energy Regulatory Commission decision that permits greater flexibility in the calculation of avoided costs for a Feed-in Tariff (FiT) determination, California Public Utility Commission (CPUC) tariff pricing will develop slowly because of concern over ratepayer impact. The CPUC has moved aggressively to implement the reverse auction approach for PPA pricing by IOUs for solar projects. This competitive bidding process can result in PPAs being signed at prices that makes project financing very difficult or impossible, particularly for small projects where economies of scale can’t be applied.

Distributed solar generation projects (1-20 megawatts) can be completed faster and are less risky to investors but the amount of electricity generated from such projects won’t add up to satisfy RPS requirements. Because of the IOUs’ lower cost of capital, their right to use actual cost (as opposed to avoided cost) factors in cost determinations and the need to meet RPS requirements, there will be more utility financed and owned projects but the overall economic impact on ratepayers of too many IOU-financed facilities will likely cause the CPUC to force IOUs to continue to source renewable energy from independent producers.

The financeability of large utility scale projects will remain difficult in 2011 because of PPA pricing, the risk from the sheer size of such projects, transmission line improvement requirements, siting and technology risks and other factors. The best business model for California developers may be to build and own the facility and then sell it to a utility once the commercial operation date is visible.

As indicated, in his inaugural speech, Governor Brown stated his goal of 20,000 megawatts of renewable energy generation for California by 2020. He also said that he intended to meet the goal by the appointments he makes and the actions his appointees take. On his campaign web site, the governor stated that the CPUC or legislature “should implement a system of carefully calibrated renewable power payments (commonly called feed in tariffs) for distributed generation projects up to 20 megawatts in size.” Without legislative intervention to implement more financeable PPA tariffs, however, it seems unlikely that the CPUC appointee approach will have any positive impact in the foreseeable future. Trying to achieve this objective by control over appointments to the CPUC would take years to occur and perhaps never occur because of the slow and cumbersome way the CPUC operates. Legislative decision-making is needed to overcome these obstacles and to spur growth and create jobs in 2011.

Successful project finance depends on making the return on investment numbers work for lenders, tax equity and other investors with a high degree of predictability. The extension of the Section 1603 cash grant and 100% bonus depreciation for 2011 will drive investment in renewable energy projects and increase job creation in California.

A ‘carefully calibrated’ FiT aggressively backed by Governor Brown and enacted by the California legislature in 2011 could immediately impact the implementation of solar in our state and create many jobs. The California legislature could also help create jobs in 2011 by requiring more renewable energy projects to be sited in California in order to be eligible for RPS requirements and by establishing a state manufacturing tax credit similar to the successful program in Arizona.

Fred Greguras is a partner in the Palo Alto office of K&L Gates who focuses his practice on strategic issues for global clean technology companies. His practice includes renewable energy project financings, venture capital financings, M&A and a full range of other domestic and international transactions. During his 25-plus year tenure in the Silicon Valley, Greguras has also been a venture capitalist and a general counsel and CFO for a startup. He is a graduate of the University of Nebraska Law School

Charles H. Purcell is a partner in the international law firm of K&L Gates LLP, resident in its Seattle office. Purcell’s practice encompasses federal and international tax issues involving foreign and domestic clients. Purcell also works with developers and investors in alternative energy projects, including solar and wind energy facilities. He has written on tax issues application to project finance of solar facilities. Purcell is recognized by peer group publications, including Best Lawyers in America and Chambers USA, as leading lawyer in the areas of tax and private equity.