The American Recovery and Reinvestment Act of 2009 (ARRA) included several provisions intended to stimulate the development of wind power projects. In particular, ARRA not only extended the deadline for production tax credit (PTC) eligibility, but also granted developers the ability to choose between the $US 21 per MWh (2008 inflation adjusted value) PTC and the 30% investment tax credit (ITC). The economic decision-making process for selecting a tax credit can be complex since the value of the PTC is driven by production while the value of the ITC depends on the installed cost.
In this article, we aim to build on a recent National Renewable Energy Laboratory (NREL) analysis by extending its results to determine the percentage of future projects that are likely to select one tax credit over the other. In order to make this determination, we first answer two questions: (i) how do tax credit preferences vary by region, and (ii) in which regions are wind projects likely to be installed?
Based on our analysis, approximately 70% of the wind installations projected to occur through 2012 should favor the existing PTC rather than the newly-available ITC. However, we recognize that “should” need not imply “will.” In a financially constrained environment, the ITC – particularly in cash-grant form – may be the only feasible alternative to developers even if it results in “money left on the table.” In the event that external factors force the suboptimal selection of tax credits, we estimate that the wind industry would be forfeiting as much as US $2 billion in potential value by 2012.
Historically, the construction of wind power projects has been highly correlated with the availability of the PTC. Installations surged in the years following a PTC extension; conversely, when the PTC was allowed to expire (temporarily) in 2000, 2002, and 2004, wind installations dropped.
In 2008, the PTC was again set to expire at year’s end. As a result, developers exhibited caution as they awaited legislative action on an extension. In October 2008, the PTCs were extended by an additional year via the Emergency Economic Stabilization Act of 2008 (EESA). At that time, however, it was primarily the macroeconomic forces of the credit crunch that were driving market conditions.
Renewable energy projects in general – and wind projects in particular – were affected by both their demand for capital and their need for investors with an appetite for tax credits. Because of the financial crisis, many of these institutions no longer had sufficient taxable income to make full use of the offsets. The wind industry suffered, as few entities possessed both the capital necessary to invest in a renewable project, and the tax posture required to exploit the tax advantages of such projects.
ARRA contained certain provisions that sought to remove these barriers. First, ARRA extended the PTC through 2012, which is three years beyond the extension provided by EESA. In addition, ARRA gave wind projects the opportunity to elect to take the ITC in lieu of the PTC. The ITC is equal to 30% of a project’s qualifying costs. Previously the ITC vested linearly over a five-year period. However, ARRA also permitted qualifying projects to select a one-time cash grant in lieu of the original five-year schedule. The significance of this provision is that the benefits of the ITC can be recognized immediately, and therefore a developer does not necessarily require a partner with a tax appetite to realize the full value of the project.
The Big Question: ITC or PTC?
The question facing developers now becomes: which tax credit maximizes investor returns? The value of the ITC is heavily dependent on a project’s construction cost. The value of the PTC, however, is driven by a project’s energy production and the discount rate used to calculate the present value of future tax credits.
In seeking to answer this question, NREL constructed tables that identify the type of tax credit that offers the highest value for a project with a particular capacity factor and installed cost. NREL’s tables not only identify the optimal tax credit, but also quantify the value foregone by a project in the event that a project is forced by financing or operational constraints to select the suboptimal tax credit.
We can provide additional insight, however, by combining NREL’s results with data on historical cost and production. Since cost and production tend to be functions of location, historical data can be used to ascertain tax credit preference by region.
Our analysis indicates that on average only the Northeastern and Mid-Atlantic regions prefer the ITC to the PTC; the remaining regions favor the PTC. The tax credit preference of a region can then be combined with regional capacity addition projections to determine the tax credit profile of the country as a whole. Despite the preference of the Northeastern and Mid-Atlantic states for the ITC, the remaining states – representing fully 70% of project installations by megawatt – are expected to continue to employ the PTC.
These results, however, are predicated on the assumption that the sole objective in selecting a tax credit is the unconstrained maximization of a project’s value. Undoubtedly, other factors will influence a developer’s decision. For example, the continued absence of investors with a tax appetite could prompt some projects to select the ITC cash grant option regardless of whether it maximizes the project’s return or not.
In addition, the NREL report identified other factors that may constrain a developer’s profit-maximizing incentive choice, including concern over performance risk, project salability, subsidized energy financing, power sale requirements and owner/operator requirements.
While the details of these factors are beyond the scope of this article, we note that only the issue of project salability favors the PTC. Imposition of the remaining constraints favors selection of the ITC. For example, receipt of the PTC requires meeting the electricity production forecasts projected at the project’s financing. Concern over the ability of project to meet such forecasts creates a risk not present under selection of the ITC.
Therefore, if the difference in value between selection of the ITC and PTC is modest for a particular project, the addition of constraints could motivate the project to select the ITC even though it may diminish its return (or, one might say, the project was seeking to maximize its return subject to constraints).
Will the Wind Industry Leave Cash on the Table?
The U.S. Department of Energy’s Energy Information Administration (EIA) used this line of reasoning in their post-ARRA revision of the Annual Energy Outlook. In performing its analysis, the EIA assumed that the aforementioned constraints would compel companies to select the ITC grant option over the PTC regardless of any resulting diminution of value. If the EIA’s logic holds and all installations through 2012 select the ITC rather than the PTC, it would result in the wind industry essentially leaving nearly $2 billion “on the table” due to these constraints.
It is unlikely that developers would allow this to happen. As a result of the superior returns available from selection of the PTC in most regions, we would expect to see efforts made to find ways to “share the wealth” among potential investors so that all stakeholders end up better off.
If, however, tax equity financing continues to face constraints, an unintended consequence of the ARRA could be a shift in the geographic location of wind installations from the wind resource rich Midwest to the high-energy price Northeast. The Northeast’s high installation costs would no longer be detrimental to the development of projects since they would essentially result in larger tax credits.
The remaining tradeoff between the two regions is the higher energy prices of the Northeast versus the higher capacity factors of the Midwest. While the Midwest offers a significant advantage in electricity production, its advantage may be curtailed by the fact that a project in the Northeast will receive an average of 68% more for the power it produces.
Therefore, in the short term while various constraints remain in place, yet RPS goals remain in effect, it is conceivable that developers will focus their energies on projects in the Northeast, as those projects may receive the greatest incremental incentives under ARRA. Given the challenging market conditions prevailing today, developers may temporarily refrain from projects in the Midwest until the market recovers in such a way that those projects are able to realize their inherent full potential.
Note: Additional analysis on tax credits for wind developers is offered in the print version of this article, which will be available in the Nov/Dec issue of Renewable Energy World North America magazine.
Budd M. Shaffer, P.E., (pictured at the top of this page) is a senior financial analyst at DAI Management Consultants Inc. DAI is a full-service valuation and risk management consulting firm specializing in the power and energy infrastructure sectors. DAI provides appraisals and power market studies for a diverse ensemble of clients including banks, institutional investors, utilities, law firms, and government agencies. Budd is a licensed professional engineer in Pennsylvania, and holds a B.S. degree in mechanical engineering from Virginia Tech and an MBA from Carnegie Mellon. He can be reached at email@example.com.
David C. Rode is managing director of DAI Management Consultants, Inc. David has a B.S. degree in economics from the Wharton School of the University of Pennsylvania, an M.S. degree in behavioral decision making and economics from Carnegie Mellon University, and is currently completing his PhD in decision sciences also at Carnegie Mellon. David’s principal research interests are in valuation of power generation assets, risk management, and simulation methods. He can be reached at firstname.lastname@example.org.
Steve R. Dean, ASA, P.E. is managing principal of DAI Management Consultants, Inc. A graduate of the U.S. Naval Academy, Steve has an MBA from the University of Pittsburgh and is an accredited senior appraiser of the American Society of Appraisers in the specialties of public utilities and machinery and equipment. In addition, he is a licensed professional engineer in Pennsylvania, Michigan, and Hawaii. He can be reached at email@example.com.