In this Perspective, we discuss four topics of current interest to both growing and established cleantech companies: 1603 update, clean energy investment, valuing and leasing solar energy, and investor interest.
1603 Update
Section 1603 of the American Recovery and Reinvestment Act (ARRA) gave the alternative energy industry an important opportunity to apply for grants from the U.S. Department of Treasury in lieu of taking advantage of an Investment Tax Credit for investments in qualified alternative energy property like solar, fuel cells, small wind, micro turbines, and combined heat and power. The ability to apply for and receive such a grant quickly became important to the feasibility of many investments in alternative energy property, primarily because such investments are often associated with start-up tax losses and several funding rounds, often resulting in limitations on the ability to utilize the investment tax credit to increase cash flow.
The ARRA’s Section 1603 grants were originally legislated only through the end of 2010. As year-end approached, numerous investments being considered were faced with having to meet the strict requirements for qualification as having “begun construction” before the end of 2010. Such requirements, somewhat nebulous despite a safe harbor based on 5% of the expenses of the project being paid or incurred before the end of 2010, created significant uncertainty for the alternative energy industry. Through the last quarter of 2010, such uncertainty limited the funding of many investments in alternative energy property.
With only weeks remaining in 2010, Congress passed, and President Obama signed, the Tax Relief Unemployment Insurance Reauthorization and Job Creation Act. Embedded in this legislation was an extension of Section 1603 grants for the 2011 calendar year. The extension was welcome news for the alternative energy industry, especially where investments were planned and construction was only beginning. However, it is inevitable that the uncertainty created as the expiration of the grants grew near, and the resulting negative impact on investment in alternative energy property, will return as the end of 2011 approaches. Though the industry now understands much more clearly what is necessary to qualify for Section 1603 grants, the likelihood of investment in alternative energy property in 2011 may in many cases depend, as it did in 2010, on legislative action to extend the availability of the grants.
Clean Energy is Still a Viable Investment
It is somewhat of a truism to say that we want sustainable economic growth, we want jobs, and we want them now. However, entrepreneurs must believe that the U.S. is serious about clean energy to take real risks and make sizeable investments.
According to an October 2010 Pew Research Center Poll, the majority of Americans support alternative energy policies. However, energy experts inform us that oil and gas reserves are larger than previously assumed. This is great news, but only renewables can achieve the other energy goals many Americans have, like reducing greenhouse gas emissions and achieving increased energy security. Americans also want more jobs.
In a study conducted by the Union of Concerned Scientists, researchers concluded that 185,000 new jobs would be created if 20% of the energy in the U.S. were produced from renewable sources by 2020. A 20% renewable portfolio standard would also generate $66.7 billion in new investment. The Apollo Alliance, a partnership between labor leaders and environmental experts, concluded from its studies that investments in clean energy produce 40% more jobs than investment in coal and oil resources. This is due to the fact that renewable energy production is more labor intensive.
The industry has suffered broad setbacks in the recent economic crisis, evidenced by a decrease in investment, because lower economic activity resulted in lower demand for energy. This trend is reversing as the recovery unfolds and oil prices return to the $90-$100 per barrel level, but the continued uncertainty about energy policy is seen as the most significant impediment to growth in the clean energy sector.
In June 2009, the U.S. House of Representatives passed the American Clean Energy and Security (ACES) Act (H.R. 2454).
In September 2010, the Renewable Electricity Promotion Act of 2010 (S.3813) was introduced in the Senate. These bills include provisions regarding conservation, cap and trade schemes, and national renewable or alternative portfolio standards. While neither bill has yet become law, they do send signals about the focal points of a national energy policy. And there’s already some federal money in the form of federal tax incentives that aim to stimulate the production of energy from renewable sources.
At the local level, 31 states plus the District of Columbia have renewable portfolio standards, but their goals vary widely from state to state. For example, California mandates 33% from renewable by 2030, Maine requires 40% by 2017, and Pennsylvania has set a modest goal of 8% by 2020. Some states have voluntary goals, and others have no standards regarding the use of renewables. States also often specify energy sources that qualify under local regulations and even in some cases stipulate that at least a certain portion of the renewable energy must be sourced in-state. There are many pieces to the energy policy puzzle at the state and federal level but overall these efforts fall far short of what other countries have done. Germany has built a solid industry in solar technologies, although the sun exposure in the sunniest places of Germany is similar to Seattle, WA, which has the lowest solar resources in the U.S. It is a belief that the most important factor that contributed to Germany’s solar industry growth is sustained and strategic public support through regulation and incentives.
In an environment marked by strategic, long-term public policies which create greater predictability, entrepreneurs will take the risk, make investments and create jobs. We see our clients and contacts taking measured risks to develop or improve materials, processes or services to create sustainable energy and business practices. Many of these investments are helped through the adoption of government credits or incentives.
MFA’s experienced personnel can help companies understand the maze of government credits and incentives.
Valuing and Leasing Solar Energy
Solar energy is rapidly becoming a viable alternative form of energy generation in the United States and around the world. It has moved from the probable to the mainstream, and all signs point to its continued growth. As indicated in the following table, the growth for 2011 is projected to be near double-digit in all areas except for Europe.
There are several reasons why there has been steady growth in solar energy. First, the mandate for renewable energy sources at the state and federal level, second the drop in price of the primary components (modules and inverters) in a solar collections system, and finally the recognition and understanding of solar energy by the leasing and financial community.
Previously, the financial community looked at solar energy as somewhat of a fad or an unrealistic investment. But gradually both the financial community and lease investors have begun to understand the reality and potential profitability of solar collection systems. Consideration of investment in the solar industry is difficult to ignore with the instability of the oil market from a price per barrel perspective and the cost of energy increasing at almost twice the rate of annual inflation, the need for alternative energy solutions has opened their eyes to the possibility of solar energy.
The two lease structures that are most commonly used to finance solar collection installations are the Sale-Leaseback Structure and the Inverted Lease Structure.
The Sale-Leaseback Structure
Under this structure, the system is sold by the Developer to the Investor and then leased back to the Developer, and the Developer delivers the power to the Off-taker via a Power Purchase Agreement (PPA). The Investor would be the owner, and would claim the tax depreciation and the Investment Tax Credit (ITC) Grant. In addition, the Developer would have a purchase option at the end of the lease term.
The advantages of a Sale-Leaseback Structure include:
- Common project finance structure
- Provides 100% financing for the system
- Transfers 100% of the tax benefits to the Investor
- Sale-Leaseback Structure can commence up to three months after the system has been placed into service
- ITC Grant based upon FMV rather than Developer’s cost
The disadvantages of a Sale-Leaseback Structure include:
- Generally not available for Production Tax Credit (PTC) because of ownership requirements
- Developer’s purchase option is more expensive
- Tax-exempt or government entities can’t be the Developer or Investor
- Lease must qualify as a true lease for U.S. federal tax purposes
The Inverted Lease Structure
Under this structure, the Developer leases the system to the Investor. The Off-taker receives the energy from the system via a PPA, and in turn pays the Investor for the energy produced. The Developer may operate the system on behalf of the Investor pursuant to an Operation & Maintenance (O&M) Agreement. The Developer (as owner) claims any tax depreciation, and can elect whether the Investor can claim the ITC Grant. The Investor (as lessee) claims any tax deductions for the lease payments. At the conclusion of the lease term, the system automatically reverts to the Developer.
The advantages of the Inverted Lease Structure include:
- Popularity and understanding of lease structures
- Developer retains the residual interest
- Easy exit for the Investor
- Developer may capture some upside during lease term under an O&M Agreement
- ITC Grant based upon FMV of the system rather than the Developer’s cost
- Achieves separation of ITC Grant and depreciation
The disadvantages of the Inverted Lease Structure include:
- Generally not available for PTC because of ownership requirements
- Investor recognizes income equal to 50% of ITC Grant over initial five years of lease term
- Tax-exempt or government entities can’t be Developer or Investor
- Lease must qualify for credit pass-through election
- Lease must qualify as a true lease for U.S. federal tax purposes
Cleantech Companies Continue to Draw Investor Interest; Albeit at a Measured Rate
Some pundits have predicted a significant decline in cleantech investments and returns. Some cite the decline in venture investment. Indeed, Kleiner Perkins announced in 2010 that it is looking to scale back its investment in cleantech. According to Dow Jones VentureSource, VC investment in Q4 2010 reached $979 million with 72 financing rounds, down 14% in terms of capital invested in Q4 2009. Globally, cleantech venture investment was approximately $5.8 billion in 2010, generally flat with 2009 and well below the 2008 investment level of approximately $8.5 billion. The cleantech industry carries significant risks in the areas of technology, market and funding; those risks have caused the VC community to pull back on early stage investing. CBInsights notes in a recent report that “investors favored Series C and later stages in Q4 2010.”
We think that cleantech has hit a more mature investment climate. According to a survey by law firm Norton Rose, over 75% of private equity investors surveyed expect expansion stage capital or later to be the key focus for investment with 26% stating that they will focus on established technologies. The underlying demand drivers of cleantech remain resource scarcity and the drive for greater efficiencies, the desire for energy independence, and concern over climate change. There is still capital going into cleantech, as the California Public Employees Retirement System recently announced plans to invest over $500 million in cleantech initiatives. General Electric is stepping up cleantech investment, including over $200 million in investments in the form of competition. President Obama in his recent State of the Union address stated his goal of doubling the country’s use of clean energy over the next 25 years. Government grants and investments continue to be a driver in the market.
It Is Not Just The U.S.
The European Commission said recently that investment in renewable energy in the EU needs to double to reach its goal of 20% of the EU’s energy from renewable sources by 2020. This is supported by certain organizations. According to Aspire Clean Tech Communications, the European Photovoltaic Industry Association published a bullish report on solar recently, projecting that global investments in solar photovoltaic technology could double from €35-40 billion today to over €70 billion in 2015, adding that estimated investments in the European Union alone would rise from today’s €25-30 billion to over €35 billion in 2015.
Of course, China is a major cleantech investment success story. In the solar sector alone in 2010, credit facilities provided to Chinese companies by Chinese banks came in at an eye popping $34 billion. According to Mercom Capital, large-scale project funding came in at $4.1 billion in 2010, while debt and other funding types logged in $36 billion, of which $34 billion was in the form of credit facilities provided by Chinese government banks to Chinese companies.
Mercom Capital further noted that solar, smart grid and wind projects made up the vast majority of M&A activity in 2010. Solar M&A transactions in 2010 totaled $2 billion in 44 deals. Solar project M&A activity amounted to another $450 million in 18 deals out of which only four were disclosed. Included among the top 2010 solar M&A transactions were the acquisition of Etimex Solar by Solutia for $326 million; Recurrent Energy by Sharp Corp. for $305 million; NextLight Renewable Power by First Solar for $285 million; and SunRay by SunPower for $277 million.
M&A activity in the smart grid sector in 2010 included 40 noted transactions. Only four were disclosed for a total of $1.3 billion, of which $1 billion was the acquisition of Ventyx by ABB.
M&A transactions in the wind sector came to $1.3 billion in 23 deals, with the $860 million acquisition of John Deere Renewables by Exelon making up the bulk of it.
Cleantech will continue to attract significant investment in 2011. According to the Norton Rose survey, nearly 40% of investors selected the impetus of political and regulatory support as the most important driver supporting long-term growth in the cleantech investment sector. Needless to say, there is still strong government interest in the sector. According to the Department of Energy (DOE), $2.5 billion was spent in the fourth quarter of 2010 compared to $3.04 billion in the third quarter. The DOE has spent a total of $10.39 billion to date out of the $32 billion funding commitments from the Recovery Act.
While political and regulatory support helps drive capital expansion, with the continued awakening of the consumer to the need for a more sustainable environment, MFA expects to see continued expansion and investment in the cleantech sector.