Sol Systems’ CEO, Yuri Horwitz, and Dan Yonkin, Director of Regulatory Affairs, were published in the October 2012 issue of the Novogradac Journal of Tax Credits. In the article, Solar Tax Credit Investing and the Challenge of SREC Markets, Horwitz and Yonkin analyze the risks to tax credit investors in the SREC market and provide solutions to mitigate these risks.

Solar Tax Credit Investing and the Challenge of SREC Markets

By Dan Yonkin and Yuri Horwitz, Sol Systems

The federal investment tax credit (ITC) for solar installations represents an important opportunity for tax credit investors. Of the four major tax credit markets, the $2.5 billion solar ITC market in 2011 ranked third in size among the low-income housing tax credit (LIHTC) market ($8 billion), the new markets tax credit

Sol Systems published an article in the October 2012 issue of the Novogradac Journal of Tax Credits that analyzes and provides solution to the risks faced by tax credit investors in the SREC market

(NMTC) market ($3.6 billion), and the historic tax credit (HTC) market ($800 million). The solar ITC market comprises 19 percent of the aggregate size of these markets. Its proportion will grow quickly as the industry itself continues to expand, and as investor yields continue to compress in LIHTC markets.

But while the market is expected to grow, challenges for solar ITC investors remain, such as those posed by a tax equity investment in Massachusetts solar projects that utilize solar renewable energy credits (SRECs), the fastest growing solar market in the United States.

Investing in Solar

Investing in Solar differs substantially from the real estate-driven LIHTC and HTC markets. For investors looking to make an ITC investment in solar projects, technical comfort with the asset class is paramount. The economic underpinnings of solar can be equally complex and investors often struggle with industry semantics, such as power purchase agreements (PPAs), feed-in tariffs (FITs), renewable portfolio standards (RPS), and of course, SRECs, (pronounced S-RECs). SRECs and SREC markets are one of the most important aspects of investing in solar transactions in the United States, however they are also a frustrating and difficult funding mechanism for investors to become comfortable with.

SRECs are tradable permits like carbon credits that represent the green attributes associated with each unit of energy (e.g., 1 megawatt-hour) from a solar project. SRECs are sold to energy suppliers and utilities, typically through intermediaries that must purchase them to meet certain state requirements for renewable energy sources. Failure to secure a sufficient number of SRECs results in a penalty, also known as a solar alternative compliance penalty. Each year, SREC requirements for these compliance buyers increase.

As noted, SREC revenue is one of the key drivers for solar projects. As example, a 1.25—MW system located in Massachusetts valued at $5 million would have generated more than $760,000 in SREC sales revenue in 2011. In this scenario, SREC revenue would be more than 500 percent of the electricity revenue.

Although SRECs are critical to the underlying economics of solar projects, investors in states like New Jersey, Pennsylvania, Massachusetts and others have to contend with significant SREC price volatility, incomplete and opaque SREC market data, a dearth of long-term SREC contracts andSREC regulatory risk—above and beyond the normal challenges of the solar asset class. Nowhere are these challenges more apparent right now than in Massachusetts, the country’s single fastest growing market for distributed solar energy development.

Mass. SRECs and Commercial Development

In the first eight months of 2012, total solar capacity installed in Massachusetts grew by 93 percent. When the year began, around 200,000 solar panels were producing electricity across the state. In the first two quarters of 2012, nearly another 185,000 new panels were placed in service. From a review of the interconnection queue for planned solar projects, it is clear the rate of growth in the state is still accelerating. The solar growth in Massachusetts is due to a lucrative SREC market. As mentioned in the example above, in Q4 2011 SRECs were trading in the state for five times the retail rates of electricity.

However, long-term contracts for the sale of Massachusetts SRECs are not available to owners of commercial and utility scale projects. The dearth of long-term SREC contracts, paired with reoccurring SREC revenue risk, has given pause to several tax equity investors looking to build a book of business in the state. The pause is justified, as the Massachusetts SREC market is the most complex in the nation. However, mechanisms to mitigate SREC revenue risk in Massachusetts do exist and are fundamental to the successful deployment of tax equity in commercial solar projects there.

SREC Contracts and Price Volatility

In Massachusetts, there is a dearth of long-term SREC sale contracts with financeable counterparties. Although utilities will occasionally purchase SRECs in one or two year strips, forward contracts of five to seven years are challenging to secure. This means that SREC contracts cannot easily support project-level non recourse debt. It also presents a significant challenge for tax equity investors looking to forecase a development’s economics to support an investment during the five-year recapture period for the ITC.

The inability to contract for the SREC revenue for a five-year period is the central challenge to tax credit investors working in Massachusetts, especially in light of a number of other state SREC markets where prices have collapsed in the last three years. The demand for SRECs is mandated by law and does not change without legislative or regulatory intervention. The supply of SRECs (i.e., growth in solar development) is not regulated. The result can be significant market volatility.

In New Jersey, for example, SRECs in September 2011 were trading for $635. As of Aug. 30, 2012 they are trading for $90. This sharp dip in pricing is primarily driven by a significant oversupply of solar being built in the state (essentially too much of a good thing) compared to the mandated SREC supply. As forward SREC prices began to dip in 2011, investors should have slowed their development of solar projects. Because of a lack of transparency in the SREC market, a rush to secure the Section 1603 grant and unrealistic policy expectations, they did not. The result was an SREC price collapse, as illustrated in the spot market pricing chart below.

Massachusetts is undergoing a similar growth phase that mimics trends observed in all other markets that witnessed a crash in pricing. The risk to a tax credit investor by a collapse in SREC prices is that the project sponsor will not generate sufficient cash flows to meet their debt service payments to third-party debt providers, or the preferred returns and exit payments to investors.

Solving the Mass. SREC Dilemma

Solving for SREC revenue risk in Massachusetts is possible, but not simple. The Massachusetts SREC market is unique. Fundamental to mitigating revenue risk in Massachusetts is to understand the premises of the market, and to create sufficient capital reserves to prepare for cash flow disruptions.

The Massachusetts RPS provides a framework for the SREC program. A section of the law stipulates that the qualifying agency in Massachusetts, the Department of Energy and Resources (DOER), can approve only 400 MW of solar projects to produce SRECs in the state during the length of the program. Four hundred MWs is also the maximum compliance objective to be met over time, and estimates on when this target will be reached range from 18 to 36 months. Unlike New Jersey and all other states, the Massachusetts SREC market is structured to prevent a long-term oversupply of SRECs. Put simply, the state wants 400 MW of solar, the first 400 MW to be installed can play in the SREC market, and others cannot. This market cap is coupled with a clearinghouse mechanism that utilizes an auction to help set an SREC price floor in the market so prices don’t collapse. In the event the market experiences oversupply in one year, the DOER uses the clearinghouse mechanism to incentivize regulated electricity suppliers and utilities to purchase SRECs at a price floor of $285. This clearinghouse is commonly referred to as a soft floor in the market.

The wrinkle in the marketplace is that SREC demand, regulated through an annual compliance obligation, is slow to respond to growth in the market.

The compliance obligation refers to the number of SRECs required in aggregate in a given year by all of the compliance entities in the state. In 2011, the state required 65 MW of solar to meet the compliance obligation, while in 2012 it is 68 MW. The obligation for 2013 is 113 MW.

The market is designed to automatically price stabilize with time, and to react to an oversupplied market by increasing demand when supply increases. The closer the market is to oversupply, or the more oversupplied the market is, in 2011 and 2012, the larger the requirement in 2013 and beyond.

The flip side to these calculations is that because DOER uses two years of market data to calculate the compliance obligation, they cannot respond quickly to dramatic increases in SREC supply, as is the case today. As of Aug. 10, 2012, the state already has 98 MW of operational solar, 20 MW more capacity needed in all of 2012 to meet the SREC compliance requirements.

The delay in increasing future compliance obligations combined with the rapid growth in solar energy development indicates an oversupply of Massachusetts SRECs in late 2012 and 2013, with possibilities for oversupply into 2014 and 2015 as well.

Managing Cash Flow Disruptions

A disruption in cash flow may negatively impact an investor’s preferred returns and exit payment. Assuming a $10 million tax credit investment into a 6-MW project utilizing an inverted lease structure, with a 2 percent preferred return and 5 percent exit payment; the project must generate $200,000 in annual cash, and also transfer $500,000 to the tax equity investor upon exit. If the project also has debt, the inability to clear SRECs at sufficient prices may constrict the overall debt coverage ratio and cash returns, putting both the preferred return and cash investor exit payment at risk.

Assuming the majority, if not all, of the electricity revenue is immediately eaten up through debt service payments and debt service reserves, the revenue from SREC sales is going to be the lion’s share of a tax investor’s preferred returns and exit payments.

The obvious solution to this dilemma is to contract to sell a project’s SRECs for a five-year period with a financeable counterparty, such as an energy supplier or utility. However, as noted, the problem is the forward market with creditable counterparties in Massachusetts is severely limited, and for all practical purposes does not exist. As an alternative, we would recommend the following.

Capital Reserves

The next solution is to create a project-level capital reserve to cover cash flow. Determining the value of the capital reserve requires a modeling effort and a firm set of informed assumptions on the future of the Massachusetts SREC market.

Given our own experience in the SREC market and our study of the Massachusetts SREC market and clearinghouse mechanism, we would recommend the following. Three years is a good rule of thumb in which a project company may have to withhold selling their SRECs until the market conditions stabilize at or near the price of $285 per SREC. To remain solvent through those three years, the project company should contract for a one- to two-year SREC contract initially (these are available in the market). The revenue from the SREC sales here should be held in reserve, and may be called upon to meet investor annual payments.

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.

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