Sol Systems Associate Andrew Gilligan was recently featured in Greentech Media for a piece he wrote on the fiscal cliff.
What Would the Fiscal Cliff Mean for the U.S. Solar Market?
As the impending “fiscal cliff” appears looms, government agencies and many industries are preparing for federal tax increases and spending cuts. Although the solar industry is not as directly vulnerable as some, it is still helpful and pertinent to understand what a post-fiscal cliff landscape might entail for the U.S. solar industry.
What is the Fiscal Cliff?
The term “fiscal cliff” was originally coined by Federal Reserve Chair, Ben Bernanke, and refers to the estimated $500 billion in tax increases and $200 billion in spending cuts that are scheduled to take effect on January 1st, 2013. Congressional decisions over the past few years, combined with the expiration of certain measures at the end of 2012, have created a need to reach a deal by the end of the calendar year. Without a deal, austerity measures could throw the U.S. back into a recession, as the Congressional Budget Office (CBO) estimates that tax increases and spending tax cuts would equal four percent of GDP — greater than the approximately two percent of the U.S. economy growth rate– thus creating a contraction in the economy.
Some of the most significant triggers of the fiscal cliff include the expiration of the Bush tax cuts and payroll tax holiday which would raise taxes significantly for many Americans (over $300 billion). The other major basis of the fiscal cliff is sequestration – spending cuts of around $110 billion in Medicare payments and discretionary spending – which would go into effect as mandated by the Budget Control Act of 2011, which was enacted during the debt ceiling debate. Neither Republicans nor Democrats want these austerity measures to go into effect, and many analysts are in agreement that failure to reach a deal could hurt the majority of Americans.
However, according to President Obama and House Speaker Boehner, the opposing leaders in this negotiation, little progress has been made in reaching a deal. The main sticking point has been taxes for those individuals making $250,000 or more annually. Democrats would like to increase this marginal tax rate (for those making more than $250,000) to Clinton-era levels of 39.6 percent, thus creating around $1 trillion of revenue. Republicans are opposed to any tax rate increases and want the Bush tax cuts to be extended for those making over $250,000. Republicans, meanwhile, have indicated they are open to raising revenue by eliminating deductions, but neither party appears any closer in finding compromise on tax revenue versus spending cuts, especially as it relates to increasing the marginal rate for wealthy individuals.
Assuming that no deal is reached, then the tax increases and spending cuts mentioned above would go into effect over the next two years, and the U.S. would be at risk of falling into a recession. The stock market would also likely react poorly, driving stock prices and company valuations downwards, potentially comparable to the response of global markets to the financial crisis experienced in 2008.
How would the fiscal cliff affect the solar industry?
One direct effect the fiscal cliff would have on the solar industry would be the reduction in the 1603 cash grant payable for qualified projects. The Sequestration Transparency Act of 2012 states that the 1603 cash grant would be reduced by 7.6%, resulting in a total spending reduction of $279 million. As an example, if a developer had a 2 MW solar project that was expected to receive the 1603 cash grant at $3/Watt, their expected grant payment would go from $1.8 million to $1.66 million (a 7.6% reduction in the grant means that it would now be payable for 27.72% of the project cost). This ~$137,000 difference would decrease the project’s IRR from 10% to 9.4%. In certain cases, this IRR reduction could be below the investor’s required return hurdle, thus jeopardizing the financing for the project, and the developer’s ability to complete the system.
However, the OBM’s report does not specify exactly how the grant will be reduced or if the application process will change at all. Moreover, there is no effective date provided in the sequestration. This environment causes uncertainty for investors closing deals and building “safe harbored” projects and may cause many investors to price in an extra margin for the increased risk.
Solar Investment Tax Credit (ITC)
On the bright side, the main federal incentive for solar, the Investment Tax Credit (ITC) will still be in effect through 2016 and should not be affected by the sequestration spending cuts. In fact, the lack of progress by Congress and the White House, in terms of larger tax reform, could actually be seen as a positive thing for the ITC. Congress has discussed targeting tax loopholes and government subsidies as a long-term strategy for reducing the federal deficit, and it is likely that ITC would at least be considered for the chopping block. However, the current gridlock and timeline has limited Congress’s ability to examine all tax loopholes and deductions.
How would the solar industry fare if the fiscal cliff caused another recession?
If the U.S. fell into another major recession with higher unemployment, increases in taxes, and a reduction in consumer spending, it’s safe to assume that the industry would see fewer customers purchasing residential and small commercial solar energy systems. However, with the growing popularity of third party financing for residential and commercial systems, a reduction in purchased systems may turn out to have a negligible effect on the overall industry. Much more important is the effect that the fiscal cliff could have on the tax equity market…
The Tax Equity Market in a post-Fiscal Cliff World
Prior to 2008, the tax equity market for solar and wind projects in the U.S. was fairly robust, although still very specialized, with 15-20 potential investors comprised primarily of financial institutions and insurance companies. With the 2008 recession, the number of tax equity investors greatly contracted. In order to support the economy and encourage investment, the federal government elected to provide a “grant in-lieu-of tax credit” which is also known as the Section 1603 cash grant. This grant, which stemmed from the American Recovery and Reinvestment Act of 2009 (ARRA), became a lifeline for the solar industry as the tax equity market dried up following the 2008 financial crisis. Although new players are entering the market now, tax equity has still not returned to pre-financial crisis supply.
If the fiscal cliff is not avoided, it is possible that financial markets would react similarly to 2008, leading the U.S. economy into recession. If the U.S. also defaults in February or March 2013, when the current debt ceiling is likely be reached, some analysts believe there could be a financial crisis of even greater scale than 2008. However, assuming that worst case scenario does not happen, and we are only dealing with the austerity measures caused by the fiscal cliff, then it is still likely the solar industry would experience a contraction in the tax equity market.
According to the U.S. Partnership for Renewable Energy Finance (US PREF), there were $6.1 billion of tax equity supplied to wind and solar projects in the U.S. in 2007. That number decreased 44 percent to $3.4 billion in 2008, the year before the grant was implemented. If a comparable decrease in tax appetite occurred between 2012 and 2013, it would substantially slow the growth of the solar industry.
Sol Systems estimates that there will be approximately $3.8 billion of tax equity investment necessary in 2013, and $4.67 billion necessary in 2014 to keep pace with the expected growth of the solar industry. According to US PREF, the current 2012 tax equity appetite, for both wind and solar together, is estimated at approximately $3.6 billion (on an optimistic basis) implying that solar projects are already facing a shortage of tax equity in the market and that this shortage will continue in 2013.
If the $3.6 billion of tax equity available in 2012 decreased as much as it did in 2008, it would imply that only $2 billion of tax equity would be available for both solar and wind in 2013; thus creating a significant shortage in the market, and an environment where developers with good, bankable projects (at least by today’s criteria) would not be able to find requisite financing.
Fortunately, there is reason to believe the tax equity market would not contract as much in 2013 as it did in 2008. Of the ~20 tax equity investors active in renewable projects in 2007 according to US PREF, 10 of them dropped out of the market in 2008 due to insufficient taxable income or bankruptcy. In 2008, these bankruptcies and losses were largely due to too much leverage in the financial system and risky bets on the housing industry by both banks and insurance companies. Therefore, the worst hit companies in the 2008 financial crisis, players like Lehman Brothers and AIG, were also the same specialized investors who were previously active in the renewable energy tax equity market. If there is a fiscal cliff induced recession in 2013, the companies at greatest risk would likely be defense-related companies, not the financial institutions that tend to invest in solar.
Furthermore, despite the imagery invoked by a fiscal “cliff,” the austerity cuts would likely take effect more gradually than would one believe. Therefore, current tax equity providers and new players would not see such a swift and unexpected drop in expected taxable income, as in 2008. The more pertinent question will be if tax equity investors are still able to generate sufficient taxable income during a recession in 2013 to support planned tax equity solar investments.
Unfortunately for the solar industry, obtaining tax equity will continue to be the one of the main limiting nutrients for development in the U.S. over the next several years, with or without a fiscal cliff driven recession.
In the end, no one knows what will happen if a deal is not reached in Washington, but it can be said that fiscal uncertainty is a hindrance, not a help, to the solar industry. A higher degree of certainty would allow tax equity investors, and their clients, to make business investments that generate taxable income, which could be used to invest in solar projects for the ITC and depreciation benefits. Given this perspective, the industry should oppose the idea of letting Congress “kick the can” and push the fiscal cliff off until a distant future date. Instead, the industry needs some type of long-term deficit resolution plan to allow tax equity investors to have the confidence in their future income and encourage active players to remain in the market.
About Sol Systems
Sol Systems is a solar finance firm and a leader in financial innovation in the renewable energy industry. Since its inception in 2008, Sol Systems has partnered with 350 solar installers and developers to bring over 3,000 solar projects from conception to completion by offering innovative financing solutions for residential, commercial, and utility-scale projects.
Sol Systems’ financing programs catalyze investments for a broad set of solar projects by simplifying their origination, diligence, and financing processes. Developers seeking financing for solar projects can access over $2.5 billion in capital through the Sol Systems investor network.
In addition to providing financing, Sol Systems also offers project due diligence, deal structuring, and asset management services – all designed to reduce overhead and transaction costs and quicken project development timelines.
For more information, please visit www.solsystemscompany.com.