Outlook for US renewable energy projects following COVID-19 - Baker McKenzie
Wind turbines at work. Author: Nick Cross. License: Creative Commons, Attribution-NoDerivs 2.0 Generic.
The US renewable energy sector is battling uncertainty on multiple fronts. The outbreak of COVID-19 is disrupting key supply chains across the industry, heavily utilised tax incentives are ratcheting down and soon may disappear, and the project financing landscape is shifting. Yet, given the structural benefits renewable energy can bring in terms of economic development and job creation, public and investor focus on environmental, social, and governance (ESG) criteria as an investment standard, as well as the push to transition to clean energy sources, the industry is well positioned to help lead the country out of the current economic slump.
IMPACT OF COVID-19 ON RENEWABLE ENERGY SUPPLY CHAINS
The coronavirus pandemic is disrupting supply chains across industries worldwide. With few exceptions, companies in every market are facing unprecedented challenges obtaining key components for their businesses. The impact of this disruption varies depending on the industry, the market, and the scope of the underlying supply network. For industries like renewable energy that rely on specialised supply chains, the immediate impact is severe.
The global renewable energy sector is highly dependent on imports from China. China is a major manufacturer of photovoltaic component parts, including solar panels, inverters, and racks. While the wind industry is less reliant on China for components—many of which are manufactured in Europe—the sudden outbreak of the coronavirus has dramatically slowed production in China and Europe alike, threatening equipment delivery schedules worldwide. As it relates to solar projects, even though factories are beginning to reopen in China, production rates are expected to remain significantly lower for the near future as preventative lockdown measures and stringent social distancing policies remain in place.
There are few, if any, viable alternatives. While the tariffs on Chinese imports imposed by President Trump in 2018 and 2019 may have led US solar developers to reduce their reliance on China somewhat, currently available alternatives, including US-manufactured panels, significantly increase development costs, in some instances lowering returns to unfinanceable levels. Similarly, developers in the rest of the world also depend mostly on China for solar components. And even though, in response to the tariffs, many US developers look to pivot their supply chains to more cost-effective markets—namely, Southeast Asian nations such as Vietnam and Malaysia—those countries are heavily dependent on China for their own equipment and raw materials. Moreover, such alternatives are, on the whole, not yet able to match China’s manufacturing capacity and infrastructure, resulting in production and installation delays. As such, for now, China remains an integral link in the renewable energy supply chain.
In response to these pandemic-related supply chain disruptions, suppliers who are unable to fulfil purchase orders have begun issuing force majeure notices, leaving developers scrambling. Depending on the terms of the specific supply contract, a developer who receives a force majeure notice may have little recourse, and in some cases may still be contractually obligated to pay for all or a portion of the undelivered goods. Even in the unlikely event a developer has access to a secondary supplier, the developer may not have sufficient additional capital to buy from an alternative source.
Supply chain disruptions also jeopardise contractual and legal deadlines for projects under development. As global lockdown measures continue to hinder production at key manufacturing facilities, significant delivery and construction delays are occurring worldwide. In turn, these delays are forcing projects to postpone their commercial operation date—the date on which the project achieves “commercial operation” and is capable of delivering power (COD).
COD is a critical milestone in the project development lifecycle. Many contracts that are fundamental to a project’s success—including interconnection agreements, power purchase agreements, and certain financing agreements—cannot be performed unless and until the project reaches COD. Moreover, the failure to reach COD within a specified timeframe may trigger economic penalties or constitute an event of default under one or all of the above-referenced agreements. Thus, any delay in achieving commercial operation, however brief, could potentially derail an entire project.
FEDERAL TAX CREDITS FOR US PROJECTS Tax Credits Generally
In addition to the supply chain issues affecting the renewables industry worldwide, US projects are facing a unique obstacle that could potentially undermine project financing: the inability to qualify for time-sensitive tax credits.
Federal tax credits play a critical role in financing US renewable energy projects. The investment tax credit (ITC), primarily utilised in solar developments, allows the owner of a renewable energy system to deduct a percentage of the cost of installing the system from its federal tax liability. The production tax credit (PTC), used predominantly for wind developments, provides a similar reduction in tax liability based on the amount of energy generated by the project over time. Both credits are intended to subsidise investment in and production of renewable energy, and both are heavily utilised in the industry.
Eligibility for both the PTC and ITC is based on a “commence construction” standard. In order to qualify for the credit, the owner of a renewable energy system must prove that it either commenced physical work of a significant nature on the facility (the “Physical Work Test”) or incurred at least five percent of the total cost of the system (the “Five Percent Safe Harbor”) prior to the statutory deadline. Both methods require that the owner make continuous progress toward completion of the project once construction has begun (the “Continuity Requirement”). Notably, the Continuity Requirement will be deemed satisfied if the project is placed in service by the end of the fourth calendar year after the year in which construction began (recently extended to the fifth calendar year for projects that began construction in 2016 or 2017, as discussed further below) (the “Continuity Safe Harbor”). Otherwise, satisfaction of the Continuity Requirement is determined by the relevant facts and circumstances.
The current legislation governing renewable energy tax credits provides for an incremental phase down of both the ITC and the PTC based on the year in which construction of the project begins. As such, to determine whether a project qualifies for a particular credit and the percentage that is applicable, the date on which the project is deemed to have commenced construction is crucial.
The PTC, which began phasing down in 2017, was set to expire at the end of 2019 until Congress extended the credit by one year in December 2019. Absent the extension, the credit would not have been available to projects that commenced construction in 2020 or after. Under the extended schedule, so long as a project meets either of the two “commence construction” tests (i.e., qualifies for the PTC) before the end of 2020 and satisfies the Continuity Safe Harbor, it will be eligible for at least a portion of the PTC, as follows:
The ITC, currently 30% for projects that commenced construction in 2019, steps down according to the following schedule (and expires for residential systems after December 31, 2021):
2022 or after
0% (utility and commercial projects only)
Given the eligibility framework discussed above, supply chain delays of even a few months can have a significant effect on a project’s tax credit strategy. For projects already under construction, delays at the supplier level could disrupt the project’s “continuous progress” and thus threaten the project’s ability to satisfy the Continuity Safe Harbor. As a result, those projects may not be able to secure the maximum amount of available tax credit. For projects scheduled to begin construction in 2020, supply chain delays could push the start of construction to 2021. If this occurs, wind projects hoping to secure the PTC would be unable to qualify for the expiring tax credit, and solar projects would see their ITC reduced from 26% to 22%, significantly lowering expected returns. In each case, the failure to satisfy either “commence construction” test in 2020 may threaten the project’s underlying economics.
Extension of Continuity Safe Harbor
Fortunately, projects that began construction in either 2016 or 2017 now have an additional year to come online and still qualify for their expected tax credit amount. On May 27, 2020, the Internal Revenue Service (IRS), citing expected development and construction delays caused by the coronavirus pandemic, issued a notice extending the Continuity Safe Harbor from four to five calendar years for projects that began construction in 2016 or 2017. The notice provides significant relief to wind developers facing 2020 or 2021 placed-inservice deadlines. Developers of wind projects that commenced construction in 2016 now have until the end of 2021 to complete their projects and still claim the full PTC. Likewise, wind projects that began construction in 2017 now have until the end of 2022 to come online and secure an 80% PTC. Thus, while these projects may still face near-term development challenges posed by COVID-19, the IRS notice should give developers comfort that these challenges will not immediately jeopardise their tax credit strategies.
On top of the immediate threat posed by the scheduled phase down of the tax credits, uncertainty surrounding the viability of tax equity and other financing sources raises an additional layer of concern for US developers.
Unlike federal tax credits for most other activities—which must be claimed directly by the party engaged in the activity targeted by the subsidy—renewable energy tax credits are transferable and thus encourage the intended beneficiary of the subsidy (i.e., a project developer) to partner with a third party to use the tax incentive. Under this structure, referred to as a “tax equity” transaction, a developer transfers the right to claim the credit to an investor in exchange for an equity investment in the project. By monetizing the tax credit in this way, developers receive access to capital that can immediately be put toward project development.
Unfortunately, the global economic downturn may limit the availability of tax equity financing. The structure of these tax credits requires developers to rely on investors that have sufficient tax burdens to offset. At a time when many financial institutions and other potential investors are facing unprecedented financial hardships and revenue declines, the appetite for tax equity is likely to shrink.
Moreover, from a risk-management perspective, tax equity investors are analyzing projects differently in light of probable development delays. The value of a tax equity investment depends entirely on the underlying project meeting strict development milestones; if a certain milestone is not met, the project may not qualify for the highest available tax credit. Thus, any delay in meeting those milestones could put the whole investment at risk. As long as the potential for pandemic-induced construction delays remains, so too will investors’ concerns about their ability to utilise the tax credit program.
The current economic uncertainty also affects the availability of senior debt. As global financial markets struggle to cope with the coronavirus, financing in general is becoming more risk averse. As such, traditional debt lenders may view a renewable energy project today as too risky compared to other financing opportunities available on the market. This will likely make debt financing more expensive in the near term, and will restrict financing availability for new market entrants. In a conservative financing market, both tax equity investors and debt lenders will likely not be as open to working with new developers and sponsors, and instead will focus on the proven industry players with whom they have existing relationships.
The risk of supply and construction delays has altogether frozen tax equity, and financing generally, for projects other than those already in the pipeline or new projects from tried and tested developers and sponsors. Thus, for projects expected to enter the finance market in the coming months, the outlook remains highly uncertain.
The renewable energy sector is poised to be a leading contributor in the eventual economic recovery. According to the American Council on Renewable Energy, the sector has invested over USD 50 billion annually in the US economy over each of the past five years, making it one of the country’s most important economic drivers. Renewable energy is also becoming increasingly cheaper to produce than carbon-based sources, further supporting the industry’s economic appeal. And while COVID-19 has reduced energy demand across the board, the effect on clean energy is less pronounced. Unlike demand for fossil fuels, demand for renewable energy is tied to broader decarbonisation and sustainability goals. As investors push businesses to prioritise environmental, social, and governance considerations, and as long-term pressure to transition to clean energy continues to gain momentum, the demand for renewables will only increase.
Yet the industry also faces significant pandemic-induced challenges in the near term. To overcome these challenges and establish a stable environment for growth, the industry needs effective policy support.
In recent months, the US renewable energy sector collectively has lobbied Congress to address the expiring tax credits that are essential to financing projects. In a March 19, 2020 letter to Congress, seven US-based renewable energy associations, writing on behalf of the industry at large, called for the “prompt repair and extension” of the renewable energy tax credits to help the industry overcome the current economic downturn. The group specifically advocated for an extension of the commence construction and safe harbour deadlines to mitigate the effects of COVID-19, and for a “direct pay” option that facilitates tax credit monetisation by offering developers the choice to receive cash from the government in lieu of tax credits. If enacted, each proposal would provide an immediate boost to developers.
Congress did not address the renewable energy sector in its recent string of coronavirus economic relief packages (although, as discussed above, the recent IRS notice extending the Continuity Safe Harbor provides short-term relief to developers of certain late-stage projects). There are now growing concerns among industry stakeholders that the tax credit program will be left to expire without a viable replacement, which would altogether eliminate tax equity financing. With tax equity out of the picture, developers will be forced to rely on more traditional financing sources that other segments of the energy industry utilise. In light of the constraints on debt financing availability discussed above, this may lead to an influx of private capital entering the renewable energy space (even more so than currently) to fill the gap between senior debt and equity. Because private equity investors typically have different priorities compared to other financing sources (e.g., accelerated exits and higher return hurdles for investment), developers will need to adjust their financing strategies to account for this changing landscape.
Clear policies that support the growth of renewable energy would give developers and investors certainty that they can continue expanding the country’s clean energy infrastructure after the COVID-19 crisis. But as the current environment illustrates, government incentives will not last forever. It is therefore incumbent on the industry to find economic sustainability without tax equity sooner rather than later, as it has continued to do for some time now.
The one-two punch of the coronavirus pandemic and the diminishing utility of federal tax incentives has created an unstable environment for the US renewable energy sector. As long as lockdown measures remain in place to combat the further spread of the coronavirus, supply chain issues will continue. And if the tax equity market falls off as expected, it will be increasingly difficult to secure project financing, particularly in light of the uncertainty surrounding the future of renewable energy tax credits.
Even so, the industry remains uniquely positioned to be an economic catalyst moving forward. Looking ahead, developers should consider the following measures as they plan for the future.
- Consider whether extensions are available for current projects. Delays in equipment deliveries and construction schedules can jeopardise critical deadlines under interconnection agreements and power purchase agreements. For projects currently under construction, developers should consider whether extensions are available under these contracts to mitigate the risk of pandemic-induced delays. Similarly, developers may need to negotiate or extend long-stop dates under existing credit facilities to avoid termination or an event of default.
- Understand force majeure implications. Suppliers and service providers across the renewable energy value chain are struggling to meet their contractual obligations in the current environment. As such, developers should carefully review their existing contracts to understand their rights and obligations with respect to force majeure events. Likewise, in negotiating future contracts, developers must pay close attention to force majeure clauses (which are often overlooked as boilerplate) to ensure they are fully prepared in the event they give or receive a force majeure notice.
- Diversify supplier base. Developers must make a concerted effort to diversify their supplier base and implement alternative procurement strategies. Relying on a single supplier—or region—exposes developers to unnecessary risk. By diversifying their supply sources, developers will be able to quickly adjust to unpredictable disruptions and minimise the impact on project development.
- Optimise supply chain design. In addition to diversifying their supplier bases, developers should consider new business strategies in designing future supply chains. While traditional metrics like cost and delivery speed are important, other factors, like the ability to effectively deploy new technology to increase productivity and efficiency, have become increasingly relevant. Developers need visibility to the factors that matter most. Engaging an independent logistics consultant to diligence a potential supplier can help validate the supplier’s capabilities and streamline decision-making.
- Develop alternative financing strategies. The economic downturn and uncertainty surrounding renewable energy tax credits have had a chilling effect on project finance. Investors are worried that supply and construction delays will undermine the value of their tax equity investments, and traditional lenders are unlikely to take on new borrowers in the current market. As such, developers should begin to cultivate relationships with other potential sources of capital as part of an overall strategy focused on long-term economic sustainability.
- Leverage ESG and energy diversification initiatives. Despite the uncertainty facing the renewable energy industry, the reality is that corporate boards and stakeholders will continue to focus on ESG criteria as an investment standard, particularly given the ongoing instability of global oil markets. Traditional oil and gas companies will continue to transition to diversified energy companies with expanded portfolios, and will look to renewable energy as one component of their diversification strategy. Developers should capitalise on the ESG and energy diversification initiatives and look for opportunities to engage with companies transitioning to clean energy.