Client Alert: Inflation Reduction Act’s Renewable Energy Incentives to Embolden U.S. Energy Transition
Date: September 7, 2022
The Inflation Reduction Act (the “Act”), signed into law on August 16, 2022, creates new opportunities for the renewable energy industry and is a welcome change in an industry accustomed to uncertainty regarding its primary financial incentives. The Act’s provisions modified many of the clean energy credit and incentive provisions of last year’s Build Back Better Act. The Act earmarks $374 billion for decarbonization and modernization of U.S. manufacturing in the renewable energy sector (the “Renewable Sector”).
An important component of the Act is its underlying energy and trade policy initiative to transition the U.S. away from its dependence in this sector on equipment primarily manufactured and supplied from China. The Act’s tax credit incentives, wage and apprenticeship requirements, and domestic content requirements are anticipated to achieve this goal, while fomenting growth among Renewable Sector U.S.-parented companies (including manufacturing, production and engineering and design firms), as well as similar foreign-parented companies already in the U.S. market or looking to enter it from trading partner nations, like the U.K., Germany, Spain, South Korea, Sweden and others.
The Renewable Sector, particularly solar and wind projects, in the past relied on a Production Tax Credit (“PTC”) (Section 45 of the Internal Revenue Code) and an Investment Tax Credit (“ITC”) (Section 48 of the Internal Revenue Code) to attract investment and drive key project structures, including financial models, project deadlines, transactional documents and relationships among the parties, as well as to incentivize much needed development of renewable technologies, technical hiring and training in the sector.
The Act overhauls the ITC and PTC, thus stabilizing underlying financial incentives and expanding eligibility, while at the same time adding new qualifications and eligibility requirements. The economic impact on the Renewable Sector will take time to play out, though one thing is certain – the sector can expect a boom likely to last for several years. It is an exciting time for Renewable Sector developers, investors and professional advisors to adapt existing deal and project structures, and develop new ones, to maximize possible new financial incentives under a legislative paradigm intended to meaningfully impact the overall project finance and development roadmap of the energy transition.
The Act’s Extension and Expansion of Tax Credits
Perhaps the Act’s most significant impact to the Renewable Sector is financial stability. Over the last several years, the ITC was in a “step down” process where the value of the ITC dropped from thirty percent of qualifying renewable energy project costs in 2020 to ten percent of costs after 2023, for construction beginning before January 1, 2024, and placed in service before January 1, 2026. Now, certain renewable energy projects that begin construction prior to January 1, 2025, will be eligible for a thirty percent ITC, provided the projects meet certain eligibility criteria, and may qualify for additional ITC enhancements that could amount to up to a 50% ITC for projects located in brownfields or communities impacted by the green energy transition, i.e., communities associated with the fossil fuel industry. Renewable energy projects that begin construction on or after January 1, 2025, will be eligible for similar “technology neutral” ITC credits provided the projects result in zero greenhouse gas emissions.
This extension of the ITC and additional enhancements come with new eligibility requirements designed to raise wages, encourage apprenticeship and training within the Renewable Sector, and bolster U.S. based manufacturing in the sector. It’s important to note that the inclusion of the wage and apprenticeship requirements to compute credits is one of the most significant shifts in U.S. tax law under the Act.
Under the Act, the project owner must cause its contractors and sub-contractors to meet prevailing wage requirements to be established under forthcoming applicable Treasury Regulations and IRS guidance. This requirement will come into effect for any projects that begin construction sixty days after the regulations are published, the so-called “Beginning Construction Deadline.” The prevailing wage requirement will not apply to projects already under construction by the Beginning Construction Deadline.
In addition, the Act requires that a certain number of labor hours during construction, alteration or repair meet a required minimum percentage of apprenticeship hours, which starts at 10% for construction beginning before January 1, 2023, then is increased to 12.5% for construction beginning after December 31, 2022, and before January 1, 2024, and then is finally increased to 15% for construction beginning after December 31, 2023. Notably, the apprenticeship hours will apply to work performed after a project is placed in service, during the “Operations and Maintenance” phase of the project.
These prevailing wage requirements affect a project’s eligibility for certain ITC “adders” created by the Act. Projects may be eligible for a ten percent ITC adder if the project is located in qualifying energy communities and a further ten percent adder if the materials used to construct the project qualify as “domestic content” (or a made in the U.S.A. requirement intended to curtail offshoring) (i.e., generally and subject to certain production cost limitations, the taxpayer must certify that any steel, iron or manufactured product which is a component of the project was produced in the United States, except metallurgical processes involving refinement of steel additives (upon completion of a project or construction)). Finally, there is an additional ITC adder of 10% for projects under 5 MW (AC) located in qualifying low-income communities beginning in 2023. These adders are worth just two percent if the prevailing wage and apprenticeship requirements are not met.
In addition to the ITC, the Act extends the PTC for wind and solar projects for those projects that are placed in service after December 31, 2021, and begin construction before January 1, 2025. The value of PTC is 0.3 cents/kWh as a base rate and 1.5 cents/kWh if the project meets prevailing wage and apprenticeship requirements. This is expected to have significant impact on renewable project finance structures as solar projects were ineligible for the PTC prior to the Act’s passage. It’s expected that many solar project developers will opt for the PTC over the ITC, because it may yield a higher return, depending on project variables, and it avoids the risk of IRS-recapture associated with the ITC. However, it is expected that there will be a period of adjustment in the solar tax equity market as developers and investors evaluate new pricing and deal structures.
Other notable provisions of the Act include the creation of the following:
- New ITCs for energy storage, biogas property, microgrid controllers, dynamic glass, linear generator assemblies and certain qualified interconnection property; and
- New PTCs for solar, zero emission nuclear and clean hydrogen.
Broad Eligibility, Credit Transferability, and Other Tax-Centric Points
Prior to the Act, a person or entity could claim the ITC or PTC only if it was a taxpaying eligible entity—the credits were not refundable. Under the Act, if an eligible entity makes a direct pay election, it will receive a direct payment in lieu of any applicable credit—i.e., the credit is made refundable. As with other provisions in the Act, there are certain qualifications and eligibility requirements to be addressed on a project-by-project basis.
Another innovation under the Act is that it creates a secondary market for tax credits. The Act does so by allowing most taxpayers to transfer all or a portion of their ITC or PTC (as well as a number of other credits) to an unrelated taxpayer, the proceeds from which are excluded from the transferor’s gross income for tax-years beginning after 2022. Taxpayers must make the transfer election no later than the tax return due date for the year of the transfer and the election is irrevocable. The buyer cannot re-transfer the credit to another taxpayer. The credit transfer option is new in the Act and the Renewable Sector has little if any prior experience in modeling and structuring these transactions, allocating risk or factoring insurance and credit support products that purchasers may desire. It is expected that new deal structures will emerge over the next several months as project owners look to realize the benefit of this option.
Lastly, the Act:
- Extends the carryback period for excess applicable ITCs and PTCs from 1-year to 3-years and the carryforward from 20 to 22 years for tax years beginning after 2022; and
- Applies a 15% corporate alternative minimum tax (“AMT”) for tax years beginning after 2022, while permitting taxpayers to offset their AMT liability with certain credits (subject to certain limitations).
Final Observations
In short, the new financial incentives under the Act make renewable energy projects more attractive but have strict rules and requirements. From 10,000 feet, the Act’s innovation lies in its utilization of more carrots than sticks to drive its underlying energy and trade policy in the Renewable Sector. The months to come will certainly prove interesting with the U.S. Treasury and IRS issuing volumes of guidance and regulations under the Act.
The information contained here is not intended to provide legal advice or opinion and should not be acted upon without consulting an attorney. Counsel should not be selected based on advertising materials, and we recommend that you conduct further investigation when seeking legal representation.