For the first 50 years following the passage of the Depression-era Public Utilities
Holding Company Act, governmental regulation of the electric utility industry
largely restricted investments in electric generating facilities to highly regulated
utilities.[1] But beginning with the enactment of the Public Utilities Regulatory
Policies Act of 1978 (PURPA), various measures designed to encourage investments
in electric energy generating facilities by non-utility investors have become
law.[2] Intended to bring an element of competition to the geographic monopolies
granted to utilities as part of the regulatory bargain, PURPA enabled non-utilities
to build, own and operate certain types of electric generating facilities (called
“qualifying facilities”) and sell the output of those facilities to investor-owned
utilities at a price (the “avoided cost”) designed to reflect the cost the utility
would have incurred had it built, owned and operated the resource itself. While
definitely a move in the direction of greater competition, the provisions of
PURPA that forced the incumbent utility to purchase the output of qualifying
facilities at the applicable avoided cost embodied a regulatory mandate that
cut against the competitive grain. Nevertheless, PURPA did provide significant
opportunities for non-utilities to participate in the generation side of the
electric industry.

The move to greater competition in the electric industry advanced further in
1992 with the enactment of Title VII of the Energy Policy Act of 1992, which
allowed non-utilities to gain the status of an exempt wholesale generator (EWG),
enabling them to sell electric at wholesale at marketbased prices – that is,
at price negotiated at arm’s length between the EWG and the purchaser. [3] (Sales
of electricity by an EWG are limited to wholesale transactions – that is, sales
where the purchaser will resell the output to third parties. Hence, an EWG can
sell to a utility that buys the power for the purpose of reselling it to the
utility’s retail customers. But an EWG cannot sell the power to an ultimate
end user such as a manufacturing plant.) To further facilitate the entry of
nonutilities in the electric generation business, the Federal Energy Regulatory
Commission subsequently adopted orders requiring regulated transmission providers
to allow third party generators access to the transmission system and to interconnect
their facilities to the transmission system under standardized agreements.[4] These actions, along with various initiatives by state public utility commissions
to increase competition in the industry, combined to make non-utility generators
important players in the quest to meet the nation’s demands for energy.

The Role of Renewable Technologies

While opening up the electric industry to competition was perhaps the prime
motivating factor behind these developments, in many respects they were also
motivated by, or were at least complementary to, efforts to reduce the nation’s
reliance on imported oil. A key focus in this regard has been the development
and implementation of alternate energy technologies such as wind, biomass, solar
and geothermal – renewable energy sources that are not dependent on petrochemicals
as the fuel to generate electricity in commercial quantities. The revamped regulatory
environment opened the door to developers of renewable energy facilities to
demonstrate and prove their technologies as viable elements of a diversified
electric generation system.

But even with the great strides that have been made in recent decades in improving
the efficiency, cost and reliability of renewable energy technologies, many
– such as wind and solar – still cannot compete effectively on a price basis
with fossil fuel technologies. While the gap is closing as oil prices rise,
a significant opportunity to diversify the generation base and gain hands-on
experience with the integration of commercial-size renewable energy facilities
into our electric supply system would have been lost in the absence of special
measures designed to overcome this economic barrier. The federal and state governments
have responded with a variety of such measures, ranging from renewable portfolio
standards to various federal and state subsidies such as grants and tax incentives.[5]

The most significant subsidy in the renewables area is the federal production
tax credit (PTC). By effective utilization of PTCs and other tax benefits (such
as depreciation), the price of energy produced by a qualifying renewable energy
facility can be brought down to a level where it is an economically competitive
alternative to fossil fuel generation.

Creation of Investment Opportunities

Commercial-size renewable energy facilities require significant capital investment
and generate correspondingly significant tax benefits such as depreciation and
PTCs. Some of the non-utility developers of renewable energy resources are entities
that have – or that are parts of larger consolidated groups that have – substantial
taxable income and can therefore efficiently utilize these tax benefits. However,
many renewables developers are economically smaller enterprises that lack the
taxable income to take full advantage of the associated tax benefits. And even
for some larger enterprises that might otherwise be in a position to effectively
utilize these tax benefits, their business strategies may involve the “monetization”
of those tax benefits by effectively transferring them to a third party in exchange
for an immediate cash return.

As a result, the entrance of non-utilities in the electric generation business
coupled with the tax benefits associated with renewable generation facilities
have created further opportunities for non-utilities who lack the development
and operation expertise to become significant investors in renewable generation
assets. Over the last few years, a growing number of investors (primarily financial
institutions) have turned their attention to renewable generation facilities
as an investment vehicle. This has been driven not only by growing maturity
of the renewables industry that has witnessed an increasing number of renewable
generation facilities being constructed each year, but also by other developments
such as decreasing returns on alternative investment vehicles. For example,
many of these financial institutions have long invested in low income housing
projects, transactions driven by the availability of the low income housing
tax credits.[6] But in recent years the returns on low income housing tax credit
investments have significantly decreased, making the returns available in the
renewable generation area that much more attractive. Furthermore, the structure
of PTC/tax benefit-motivated investments in the renewable area is the same in
many basic respects as the structure used in the low income housing transactions,
thus presenting these investors with a new application of a familiar investment
vehicle.

Equally important, these renewable energy investments do not just serve as
a vehicle for ensuring efficient use of the associated tax benefits. By monetizing
the PTCs and other tax benefits, investors and developers have been able to
significantly improve the economics of qualifying renewable power projects,
using a number of structuring alternatives to tailor the transaction to the
particular project and objectives of the participants.

The term “monetizing” is somewhat of a misnomer, since these transactions do
not involve “sales” of the PTCs and other tax benefits, as was done, for example,
with investment tax credits under the old safe harbor lease transactions in
the late 1980s. Rather, these transactions constitute real investments in wind
power projects by investors with sufficient income from other sources to fully
utilize the PTC and other potentially significant tax benefits generated by
those projects, with the potential of significantly higher returns. Choosing
the right structure will depend on the particular needs of the investor and
the developer, including the investor’s return requirements. With the right
structure, these transactions can have a tremendously positive impact on the
power market by matching investors that can use tax benefits with developers
looking for favorable financing alternatives.

The Production Tax Credit

The PTC is a nonrefundable credit against federal income tax liability that
is available for electricity produced at a facility owned by the taxpayer from
certain qualified renewable resources, including wind, biomass, solar and geothermal,
and sold to unrelated parties.[7] The amount of the PTC for 2005 is 1.9 cents
per kilowatt-hour ($19 per MWh) of electricity produced and sold during the
taxable year, an increase over the 1.8 cents per kilowatt-hour rate for 2004.[8] This amount is adjusted annually using an inflation adjustment factor published
by the Internal Revenue Service each spring.[9] The PTC amount is reduced by
a half for open-loop biomass, small irrigation power, municipal solid waste
and refined coal facilities.[10] For wind and solar projects, the PTC is available
for each taxable year in the 10-year period that begins on the date a project
is placed in service.[11] For other qualifying renewable energy projects such
as biomass and geothermal, this period is reduced to five years.[12] Because
the PTC is a relatively stable amount that is not directly affected by market
conditions or the financial performance of the project, it can help to ensure
a somewhat consistent return on investment regardless of the price of power,
project expenses or other variable factors.

To qualify for the PTC, a facility must be “placed in service” on or before
Dec. 31, 2005.[13] A facility generally is considered to be placed in service
for this purpose when it is “placed in a condition or state of readiness and
availability for a specifically assigned function.”[14] This is considered to
have occurred when each of the following requirements is satisfied: (i) the
necessary permits and licenses to operate the facility have been approved, (ii)
the critical tests for the various components of the project have been completed,
(iii) the project is placed in control of the operator by the contractor, (iv)
the project is synchronized into the grid for the purpose of generating electrical
energy for production of income, and (v) daily operation of the project has
begun.[15] In the case of a wind project, each wind turbine that can be operated
and metered separately is treated as a separate facility for purposes of these
rules.[16]

Monetization, Motivation and Structure

As noted, many developers do not have sufficient federal income tax liability
to fully utilize the PTC and other tax benefits generated by a renewable power
project. By bringing in an investor with sufficient federal income tax liability
from other sources to use those benefits, a developer can fund the project while
providing the realistic possibility of a high and relatively stable rate of
return on the investor’s equity investment. Because of the relative certainty
of the availability of PTCs, some equity investors are willing to provide certain
limited credit support for project debt financing, which may increase the leverage
available for a project (reducing the amount of equity needed to fund the project)
and improve the investor’s overall returns.

There are a variety of ways to structure an investment in a renewable power
project to take advantage of the PTC and other tax benefits. The specific structure
of an investment must be highly customized to meet the investor’s, developer’s
and project lender’s particular circumstances and requirements. To qualify for
the PTC, electricity generally must be produced at a facility that is “owned
by” the taxpayer seeking to claim the PTC.[17] This requirement has a significant
impact on how PTC “monetization” transactions may be structured. Whatever the
structure, the parties must be comfortable that the investor will be treated
as the “owner” of the facility (or the entity that owns the facility) for federal
income tax purposes.

One potentially useful structure involves an equity investment in a partnership
(or a limited liability company taxed as a partnership) that owns the renewable
power project (the “owner”). The basic project economics are premised on the
sale of the electricity generated by the project and any associated “green tags”
to utilities or other wholesale power marketers pursuant to one or more long-term
power purchase agreements, generating a relatively stable stream of revenues.
The equity interests in the owner can be structured so that the investor initially
receives a large percentage of all-cash distributions and tax benefits from
the project, including the PTC. Once the investor has received an agreed-upon
after-tax return or some other objective standard has been met, the sharing
ratios may flip so that the investor receives a smaller portion of cash distributions
and tax benefits and the developer receives a larger portion. The developer
also may retain an option to purchase the investor’s equity interest upon the
occurrence of an agreed-upon event. The alternatives available for structuring
the relationship between the investor and the developer are quite varied and
these transactions frequently are quite complex. Thus, these transactions require
careful structuring and drafting to meet each developer’s and investor’s unique
requirements.

Debt Financing, Credit Support and Project Financing

Renewable electricity projects often are partly financed with project debt,
which can increase the returns offered to an investor. As discussed above, because
of the availability of the PTCs combined with an investor’s desire to increase
the return on investment, an investor may be willing to provide credit support
to cover certain circumstances that may occur, such as lack of wind in a wind
power project, that could prevent a project from generating sufficient revenue
to cover debt service. This credit support may take a variety of forms, such
as an agreement by the investor to make additional capital contributions in
the event of a cash shortfall, to be made up in later years from distributions
when project production is at or above anticipated levels. In addition, products
such as insurance and liquidity facilities may be available from third-party
financial institutions to cover some of these risks. If the investor is willing
to provide credit support, or if insurance or liquidity support is available
at a favorable price, the amount of debt may be increased or the overall cost
of debt financing may be significantly reduced, or some combination of the two,
which may improve the investor’s overall return.

The developer typically manages the wind power project and is responsible for
operation and maintenance, subject to customary rights of the investor to remove
the developer from management and operation functions due to nonperformance.

Conclusion

Private investments in renewable projects should be carefully structured to
enable the investor to take full advantage of the PTC and other tax benefits
available. Because of the complexity in this area, structuring a private investment
in a renewable energy project should involve careful analysis and planning.

Endnotes

1. 15 U.S.C.A 79a et seq.
2. Public Law 95-617 (92 Stat. 3117); portions were codified at 16 U.S.C.A.
   2601 et seq.; various provisions appear elsewhere in the U.S. Code.
3. This Act effected various amendments to the Public Utilities Holding Company
   Act of 1935, supra, PURPA, supra, and the Federal Power Act, 16 U.S.C.A 791a
   et seq.
4. See FERC Order No. 888, Promoting Wholesale Competition Through Open Access
   Non-Discriminatory Transmission Services by Public Utilities, 61 Fed. Reg.
   21,540 (May 10, 1996), FERC Stats & Regs. ¶ 31,036 (1996), order on reh’g,
   Order No. 888-A, 62 Fed. Reg. 12,274 (March 14, 1997), FERC Stats & Regs.
   ¶ 31, 048 (1997); order on reh’g, Order No. 888-B, 81 FERC ¶ 61,248 (1997),
   order on reh’g, Order No. 888-C, 82 FERC ¶ 61,046 (1998), aff’d in relevant
   part sub nom. Transmission Access Policy Study Group v. FERC, 225 F.3d 667
   (D.C. Cir. 2000), aff’d sub nom. New York v. FERC, 535 U.S. 1 (2002); and
   FERC Order No. 2003, Standardization of Generator Interconnection Agreements
   and Procedures, 68 Fed. Reg. 49,845 (August 19, 2003), FERC Stats & Regs.
   ¶ 31,146 (2003), order on reh’g, Order 2003-A, 69 Fed. Reg. 15932 (March 26,
   2004), FERC Stats & Regs ¶ 31,160 (2004).
5. Programs implemented by some states requiring regulated utilities in those
   states to have a certain percentage of their loads met by renewable energy
   sources.
6. Available for qualifying low income housing projects under IRC § 42.
7. See IRC § 45(a), (c)(1)(A). The PTC is allowed as part of the general business
   credit pursuant to IRC § 38. Although the PTC is not refundable, any unused
   credit for a particular tax year can be carried back one year and forward
   20 years. See IRC § 39. The PTC generally does not apply to electricity sold
   to a utility pursuant to an avoided cost contract entered into before January
   1, 1987. See IRC § 45(e)(7).
8. The PTC is 1.5 cents per kWh, adjusted for inflation. See IRC § 45(a)(1).
9. See Notice 2005-___, 70 Fed. Reg 18071-01 (Apr. 8, 2005) (announcing that
   the inflation adjustment factor for 2005 is 1.2528).
10. See IRC § 45(b)(4)(A).
11. See IRC § 45(a)(2)(A)(ii).
12. See IRC § 45(b)(4)(B).
13. See IRC § 45(d)(1). This sunset date has been extended a number of times
    over the years and has been extended each time it expired.
14. See Treas Reg § 1.46-3(d)(1)(ii) (applying a similar standard for purposes
    of the investment tax credit); see also Rev Rul 76-256, 1976-2 CB 46; Oglethorpe
    Power Corp. v. Commissioner, TC Memo 1990-505.
15. See generally Rev Rul 76-256, supra.
16. See Rev Rul 94-31, 1994-1 CB 16.
17. See IRC § 45(d)(1). An exception is made for open-loop biomass facilities.
    Under this exception, if the owner of a facility is not the producer of the
    electricity, the lessee or operator of the facility who actually produces
    the electricity can claim the PTC. See IRC § 45(d)(3)(B).