Interest is building in the potential to issue asset-backed securities (ABS) collateralized by the receivables of solar energy companies. Solar ABS, along with real estate investment trusts (REIT) and master limited partnerships (MLP), are among the ideas emerging for expanding the capital available to renewable energy projects. The advantage of solar ABS over the solar REIT and MLP ideas is that solar securitizations could be issued now under existing tax law.
If current tax law permits solar securitizations, why haven’t we seen an issuance yet? In readily tradable ABS, high credit ratings function as a surrogate for investor due diligence. Rating agencies assume that identical customer contracts are the basis for receivables in each pool. Pools of U.S. solar customer receivables have not yet been rated, and securing an adequate rating will likely hinge on accumulating sufficient customer default data and standardizing the PPA and equipment leasing documentation signed by solar customers. One more wrinkle is that tax equity investors may not allow a securitization to be layered over their investment. But if ABS and tax equity can coexist on the same projects, securitizations could be an additional source of reasonably priced financing for the solar industry. If not, ABS could replace tax equity as the cheapest financing available after the 30 percent tax credit expires, although ABS would still be three to four times more expensive than the cash return earned by tax equity.
Could a securitization fit within the legal/tax structure of a tax equity financing?
In all three of the dominant tax equity investment structures — partnership flips, sale leasebacks and lease passthroughs — the project company that operates the projects and is the counterparty on agreements with customers could transfer customer receivables to an SPV ABS issuer in exchange for cash. In partnership flip and lease passthrough structures where the project company is a joint venture between developer and investor, additional tax complications would arise in trying to get the cash back up to developer without triggering gain and transferring customer receivables out of the project company without creating income allocable to investor.
Would tax equity require a higher yield on account of ABS?
Maybe. Once customer receivables are transferred out of the project company, payment obligations to tax equity investor could be supported only by the residual value of the projects, any guarantees provided by developer, and a cash reserve set aside within the project company. Both cash reserves and guarantees for the benefit of investor are problematic for tax reasons and the residual value of the equipment is not expected to be much more than 20 percent of initial value. Given those constraints tax equity is likely to seek a higher yield in cases where it is willing to invest in projects with securitized receivables. But since ABS would not cause additional liens to be placed on the hard assets of projects (with accompanying tax credit recapture risk), the bump in yield required may be less than in current leveraged tax equity transactions.
Assuming that ABS and tax equity can sit side by side on solar projects, what would the security look like?
In general, whether the payment terms of ABS closely match the payment terms on underlying receivables depends on the type of issuer used, whether the security is debt or equity and other variables. Because PPAs and equipment leases are not loans, payments on pools of solar receivables could not be organized according to payoff priority. For this reason one would expect solar ABS to be fairly plain vanilla compared with the exotic array of securities that can be backed by aspects of mortgages and other loans.
Solar ABS could be issued as either pass through certificates or pay through bonds. Holders of solar certificates would be treated for tax purposes as owning a share of the underlying customer receivables — i.e., as directly earning PPA and equipment leasing income. Certain institutional and non-U.S. investors may prefer solar ABS in the form of pay through bonds, which would be treated as debt producing interest rather than service fee or rental income. One risk of solar pay through bonds is that if the IRS ever treated solar equipment as real property solar ABS issuers in some cases could be hit with an additional corporate-style tax rate. The risk of the IRS treating solar equipment as real property has likely been overstated lately.
ABS can be issued from fixed or revolving pools, in a single or multiple classes, and with fixed or variable payments.
Fixed pools are used for long-duration receivables where the issuer does not reinvest payments into replacement assets. Given typical solar agreement length of 15-25 years, a fixed pool backing longer-term securities would work, although in April Moody’s suggested that solar ABS may need to be of shorter length than the underlying receivables or risk lower ratings. Where securities are issued in multiple classes it is usually in order to create securities with different rights to principal prepayments. For solar ABS a faster-pay class could be created that has priority over other classes with respect to customers’ prepayments (or defaulting customers’ termination payments), but because such a small percentage of solar customers prepay their agreements it’s not clear whether a meaningful quantity of fast-pay ABS could be issued by a single issuer.
Senior and subordinated classes could be issued with varying priorities to payments on all receivables in the pool, or different classes backed by different categories of receivables within the same pool could be issued. For example, a trust could issue a first class of securities backed by receivables of residential customers with FICO scores of over 760, and second and third classes with FICO scores of 720 and 680, respectively. Creating different classes of interests in the issuer based on differing payment priorities or quality of underlying receivables might accelerate the ratings process and large-market sales for the more senior classes of securities, leaving the subordinated classes to be placed with a smaller group of investors able to undertake due diligence.
What payments would be made on solar ABS?
Solar equipment leases with customers typically require the payment of a flat monthly fee. Solar PPAs may call for payment of a variable amount depending on generation. Both types of contracts can bear an annual escalator. In order to scale up solar ABS to a size that interests the public market, it may make sense to pool all variety of residential and commercial PPAs and leases, bearing both flat and variable payments, as backing for the securities. Assuming a large variable pool, solar ABS could be issued as variable rate pass through certificates or bonds. The variability of payments on the securities wouldn’t correspond to variations in interest rates or any other index so they wouldn’t function as a hedge against a fixed rate, although there may be potential to use solar ABS as a hedge against utility/natural gas prices or inflation.
What is the ideal solar asset-backed security?
In order to accommodate a range of potential investors and receivables types within the same pool and facilitate the highest possible credit rating, perhaps a variable-rate pay through bond issued in senior and subordinated classes, with a term of five or six years (maturing before the statistically average homeowner vacates his home in year seven).
With any luck, after two or three years of solar ABS banter, the time has come to declare securitizations inevitable for the U.S. solar industry. But important questions remain about whether and how securitization can work with tax equity in the era of a 30 percent ITC. It’s worth wrestling with these issues given the potential for decreasing the solar industry’s cost of capital and the retail costs of consumers.
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