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A Transition to a Securitized Market: Can Credit Enhancements Leverage Solar Investment?

How does the solar industry transition from the current project-based financing structure to one where more capital is available at faster speed and lower cost? That was the question discussed by various industry stakeholders in a recent meeting of the Solar Access to Public Capital (SAPC) working group convened by NREL.

The answer the industry seeks might lie in public capital vehicles, such as asset-backed securities, master limited partnerships, and other mechanisms designed to pool projects and allow investment via a liquid, tradable product.  These vehicles could increase the availability of capital because they represent a simpler and lower-cost mechanism for investors, such as pension and insurance funds, to commit capital to solar projects.

Important to this conversation is the fact that the investment tax credit (ITC), currently at 30 percent, reverts to 10 percent in 2017. According to Albert Luu, Structured Finance Vice President for SolarCity and a SAPC participant, the ITC along with accelerated depreciation are too large to leave off the table to make a project cost-effective. These tax benefits can account for roughly half of the capital stack of a given project in the current tax environment. Under the current ITC structure, future solar development will likely continue to need tax equity — a form of capital that often constrains industry growth — to monetize these benefits.  This can complicate the opportunity for accessing public capital.

But someone from the group raised a question: What if the ITC were restructured as a credit enhancement to support securitization or other public capital vehicle adoption? If so, the argument went, industry reliance on tax equity could decline. Tax equity wouldn't likely disappear, as accelerated depreciation benefits are still a relevant part of the deal, but at a reduced level would be easier to incorporate into a financial structure that includes securitized debt or equity.  Also, the supply of tax equity in the market could be spread over more projects.  And finally, a credit enhancement support mechanism would better align with securitization and other public capital vehicles.

Credit enhancements represent a variety of investment support structures generally designed to leverage market investment. In the case of solar, credit enhancements can be sourced from various entities, including the public sector (federal, state, or municipal government entities), developers or project originators that participate in the pool, the non-profit sector, or some combination of these stakeholders.

These facilities could be designed in numerous ways based on the risk acceptance of the parties, regulatory constraints, or other contextual factors that might be relevant. General forms of credit enhancement include:

  • "First loss" reserve.  An insurance product offered by the credit enhancement party to a pool of projects; it is the first source of capital to take a loss (i.e., last to be paid).
  • Co-investment with private equity.  The credit enhancement party invests in renewable projects alongside private investments, taking an equal risk to other equity investments (but not necessarily an equal return expectation).
  • Mezzanine investment. The credit enhancement party invests in renewable energy projects.  They are paid back before equity investors but after lenders (see Figure 1 a general comparison of these three structures).

These strategies can greatly reduce the risk perception among investors, reduce yield requirements, and provide valuable experience to nascent securitization transactions.

Figure 1. Credit enhancement structures

Entities providing the credit enhancement could establish ground rules for participation in the pool, such as adoption of standardized contracts and installation of best practices.  In effect, the credit enhancements could represent a valuable incentive by which to organize the industry and thus improve the opportunity for the success of solar securities.  By doing so, the working group members argued, credit enhancement would likely only be needed during an initial transition period toward industry maturation.

Importantly, credit enhancements can be a low-risk strategy because renewable energy generation projects are backed by long-term contracts. That's an important distinction as we've learned from the DOE loan guarantee program—electric generation projects and manufacturing facilities carry very different risk profiles.  In addition to long-term contracts, generation projects often carry performance guarantees from the developer, equipment manufacturer, and/or construction entity, all of which could protect a credit enhancement from actually being drawn down in a period of stress. If projects perform and customers pay as projected, the entity providing the credit enhancement would earn a small return.  In contrast, public investment through the ITC provides an indirect return only, for example through higher payroll taxes or taxes on developer and component manufacturer profits. Credit enhancements could provide both a direct and indirect return.

On the downside, it's not clear at this juncture how large the credit enhancement needs to be to make a solar securitization broadly attractive to the investment community, or alternatively, what improvement in required yield can be expected from different credit enhancement investments. From the various experts I talked to, the answers to these questions are simply — to be determined.

This article was originally published on NREL Renewable Energy Finance and was republished with permission.

Lead image: Solar panels via Shutterstock

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