As a Partner in one of the few private equity groups dedicated to investing in the renewable energy sector, I have been asked by many, including a few members of Congress, to share my thoughts on the simplest way in which federal tax policy can be changed to more effectively accelerate the development and construction of renewable electric generating capacity in United States. The following is my attempt to address these requests and to share my thoughts and market insight with the broader public.Current Situation Under the newly signed Working Families Tax Relief Act of 2004 and the American Jobs Creation Act of 2004, Section 45 tax credits have been extended for wind and introduced for other forms of renewable power generation – including biomass, geothermal, and solar – for plants brought into service through the end of 2005. It is generally accepted, though far from certain, that continued political support for the expansion of renewable forms of energy will lead to an extension and possibly an increase of federal tax support – probably through lengthening the qualification period of the Section 45 credit through 2008 or beyond. So far, so good. The problem is – aside from Wind power which has evolved to become dependent on Section 45 – the 45 credit, in its current form, is extremely ineffective at stimulating the growth of the kind of renewable generating capacity that can supplant conventional plants. In order to grow effectively and replace (not just offset) fossil fuel generation the power industry needs a great deal more baseload renewable generation which Wind is conspicuously incapable of supplying. To be certain of a more balanced energy future and to avoid potential grid management issues, we should probably be adding at least one MW of dispatchable renewable generation for each MW of Wind. How Section 45 Is Supposed to Work Section 45 tax credits grant the owner of an operating plant an amount of credit – typically quoted as $0.018 per kWh generated – that can be directly deducted from the total amount of federal tax payable. The credit should act as an incentive, helping to defray the higher capital cost usually associated with renewable generation and allowing the power produced to be sold at a price at or near a price competitive with conventional sources of electricity. The provisions of the credit require that the entity claiming the credit (1) owns the facility, (2) faces on-going operating risk, and (3) generates sufficient taxable income to use the credits generated. The Section 45 credit is ideal in theory for a large utility with consistent taxable income and a high degree of comfort with the operational risks associated with power generation. Unfortunately, many utilities are burdened with losses from previous forays into merchant generation and international expansion, do not have tax credit appetite and in any event and for a variety of reasons are not the primary developers of new renewable generation. Increasingly, renewable power developers are individuals, small to medium sized companies and private equity investors (who often use private capital from trusts and pension funds). Generally speaking, these groups have little or no tax capacity to utilize the 45 credit. As a result, many otherwise viable projects go un-built because developers cannot use the 45 credits associated with projects. There are ways to structure project ownership to allow for third parties with tax capacity to participate and monetize the value of the credits for other owners. Without getting into the details, however, it is important to note there is no liquid market for these types of structures. In addition, transaction costs are relatively high, causing many smaller transactions to be uneconomic. Further, the potential investor pool for Section 45 credits remains small because of the stop-start nature of federal authorization of the credit (i.e., it is hard for the few willing investors to allocate capital to the market or invest the time to understand operating risks when the credit is authorized on a year-to-year basis). For sponsors of projects smaller than 30 MW (70MW for wind) the cost of the structure can be prohibitive and often there are no available buyers. Outside of wind, the vast majority of planned renewable capacity is for projects smaller than 30MW. For these size projects, the most Developers can expect is 80% of the value of the credits and a large invoice for transaction costs, creating a structural disadvantage versus traditional power generators. Suggested Legislative Changes To make federal tax policy more effective at spurring the development of and investment in new renewable generating capacity, it is crucial the support is channeled more directly to those small and medium sized entities taking development risk. This means Section 45 credits must become either tradable, refundable, or both. Tradable – Once earned, the credit can be sold or transferred to a party with sufficient tax capacity to utilize it. In form it could look and trade like emissions credits. Structured in this way, a very liquid market could quickly grow assuring developers, investors and project owners of a reliable and market based source of cash flow. A central issue with tradable credits, however, is the general antipathy displayed by Congress for this form of subsidy. There is a certain amount of administrative infrastructure that would be required to establish the validity of a credit, record its transfer, and make certain that it was claimed only once. On the other hand, comparable systems are already in place in States where Renewable Portfolio Standards have created tradable Renewable Energy Certificates. Refundable — In theory this means that once earned the credit may be used by the owner(s) to (1) offset their federal tax liability or (2) if greater than their liability or if they have no liability the balance of the credit can be paid to the owners as a tax refund. In form this might look a little like the Earned Income Credit we all wonder about when we file our individual tax returns and in practice it would put developers, investors and project owners directly in control of the credit value stream, provide greater incentive and certainty in regard to the economic outcome of project development, and reduce or eliminate most of the transaction inefficiencies inherent in the existing Section 45 structure. When the people who do such things begin to score these suggested changes to Section 45 they should find, unsurprisingly, that they cost a great deal more than the current provisions. Concerned citizens and deficit hawks (myself included) should recall, however, that any increase in cost is directly correlated to the success of the policy – an increase in clean, renewable energy generated (which, it should be noted, is the whole point of this section of the tax code). We should all also recall the increasing importance of renewable sources of energy to economic and national security. Several billion dollars spent on renewable energy will do more in this regard than a similar sum spent on a new weapon system. If, in an effort at compromise however, the revised code were to treat refunded credits as taxable income in the year received or apply a lower value to credits refunded or traded – say 85% of the value of a tax credit used in the normal way – it would still have a significant positive impact on new renewable energy capacity while ameliorating the cost impact. It would be wrong if these proposed changes to Section 45 became a victim of their potential success at increasing the production of renewable energy. About the author… Thomas King, is a partner with the US Renewables Group. Mr. King has provided strategic and financial advice and execution on multi-billion dollar structured, project, cross-border and acquisition financings to clients in the Power, Utility, Environmental and Energy Sectors for over 15 years. Prior to joining US Renewables Group, Mr. King ran CrossRiver Capital, an advisory group serving the power & energy sectors and related industries. Through May of 2003, Mr. King was Head of Energy and Utilities within the Capital Markets Group of Dresdner Kleinwort Wasserstein in New York where he and his team provided capital markets, structured finance and financial advisory solutions to clients in the North American Power and Energy Sector.