“The easiest way to deal with tax equity is to start with portfolios that don’t have tax equity.” — Benjamin Cohen, CEO, T-REX

The U.S. solar industry was built on tax credits. At the federal level, the Investment Tax Credit (ITC) allows both residential and commercial developers to offset 30% of their cost. Various states also offer credits.

Since it was introduced in 2006, the ITC has helped boost annual installations of photovoltaic systems — panels and related components — from 104.7 megawatts of direct current to 6,201 (MWdc) in 2014. That’s approaching enough energy to power a million average American homes.

Developers typically do not have the tax liability to use these credits for themselves, so they bring in “tax equity” investors to capitalize their projects in exchange for use of the credit. 

The ITC is being phased out, which is one of the reasons that there is so much interest in securitization as an alternative source of financing. In two years, by 2017, the credit is set to decline to 10% for commercial and third party installers, and zero for residential developers.

While growth in the industry isn’t expected to tank as a result, it will probably sold down.

In the meantime, any securitization of solar assets has to avoid jeopardizing this tax break for existing investors. Many of the features of the legal structure required to execute a securitization could expose tax-equity investors to a potential “recapture” of their unvested credits.

There are a few financial structures used to monetize federal tax credits. The arrangement most promising for effectively dealing with the recapture issue in a securitization is known as the “inverted lease.”

While SolarCity, the largest residential developer, used another method in its first two securitizations, for its most recent deal it bundled only assets that entered inverted-lease arrangements. And as of press time peer Sunrun had just launched a solar-backed deal that, apart from being the first from an issuer other than SolarCity, is also backed only with assets that are linked to inverted-lease arrangements.

SolarCity’s deal was mostly residential, and Sunrun’s is entirely residential.

There have been no pure commercial solar securitizations in the U.S. to date. Solar finance boutique T-REX is working on two deals backed by commercial solar assets; the first one, for $75 million, could be come in the third quarter; the second one, for $150 million, has a scheduled launch in the fourth quarter, according to Benjamin Cohen, the firm’s chief executive.

None of these assets have tax equity investors.

“The easiest way to deal with tax equity is to start with portfolios that don’t have tax equity,” said Cohen, who is aggregating assets without tax equity investors attached. “Not every deal has tax equity and part of that is because from 2009 to 2011, the U.S. Treasury’s 1603 payment allowed for a simple cash grant from Treasury in lieu of a tax credit.”

To be sure, there are other impediments to securitizing solar assets, such as the lack of standardization of contracts, which is a function of the predominance of small-to-medium-sized owners; the difficulty warehousing assets while they are accumulated; and the fact that the long terms of contracts put them at greater risk of being renegotiated if the retail price falls.

This is true of residential assets, which are typically financed by a loan or lease from the developer to the homeowner; as well as commercial assets, which can range from small establishments — say, a laundromat — that can obtain financing similar to that of a homeowner, to larger establishments — a facility powering a Walmart, for instance — that often sign power purchase agreements (PPAs).

At the utility scale, projects producing from several-to-several-hundred megawatts and providing electricity to large clients, such as cities, under PPAs, can often find financing outside the securitization market. Numerous developers have formed “yield cos,” publicly traded companies with assets that produce cash flows chiefly through long-term contracts, which in the case of solar means PPAs.

“On the utility scale projects with a publicly rated off-taker, there’s a fairly robust market right now of bank lenders and other financing providers, so the need for securitization on the utility scale PPA side isn’t as great because there’s competing, low-cost funding sources,” said Scott Zajac, CEO of Rockwood Asset Management, which invests in the solar space.

Doc Diversity

A lack of standardization in documentation and processes is a major hurdle to bundling a number of smaller developers into a single securitization — the natural course of action in order to build enough scale to interest investors.

“Ancillary fees of getting a structure — legal, accounting, placement, structuring — all are larger than what people have wanted to pay to get a bond in the market done,” said an investor in environmental assets. “The reason why fees are so high is there hasn’t been a lot of standardization.”

This inconsistency ranges from leasing, loan and PPA contracts to operation and maintenance agreements for the panels. The independent engineer [IE] reports — crucial to the due diligence in rating a deal — can be all over the map. “If you have 20 different IE reports from 20 different firms on 20 different projects and those reports are not comparable in their methodology — that makes the rating agencies’ jobs harder,” said Ronald Borod, senior counsel at DLA Piper.

There is an effort spearheaded by the Solar Access to Public Capital (SAPC) to standardize lease documents and PPAs by providing a few templates — residential lease and PPA, and commercial lease and PPA. Grouping over 200 organizations in the fields of solar deployment, finance, counsel and analysis, SAPC operates as a working group under the National Renewable Energy Laboratory (NREL) of the government’s Department of Energy.

SAPC also released last April best practices for O&M agreements.

But the take-up by developers hasn’t spread particularly far, as SAPC reported last May that about seven were using the standard contracts.

This has not mattered so far because the only deals marketed to date, bundle assets from one developer, either SolarCity or Sunrun. So rating analysts and investors need to understand how a single developer originates and manages its assets. In a multi-seller deal — required for most of the market since smaller developers lack critical mass — they need to get a handle on the processes of a number of developers.

On this front, the commercial sector faces more challenges than the residential one. “You have a pretty well developed ratings-criteria platform from the mortgage securitization and consumer credit world that can be translated to the residential PPA-ITC product market, metrics like credit scores, and zip codes that investors can look at and model,” said Zajac. “A lot of the tools and rating criteria that are out there that can be applied and adapted” to residential solar securitizations.

The commercial world is more challenging, as the counterparties that aren’t rated may not have easily accessible metrics available to asset their creditworthiness.

The first deal that T Rex is working on would be all commercial collateral, such as panels on an office building, while the second would also include “small utility” assets, each with a capacity of no more than 6 megawatts.
The bulk of flows would come from PPAs, but a smaller portion is related to SRECs [solar renewable credits]. An SREC is created when solar electricity is generated in states with a renewable portfolio standard (RPS), which requires electric suppliers to buy a share of their power from solar generators. SRECs are stripped out from the electricity itself and can be sold to suppliers that need to meet their requirement. Not only do prices of SRECS fluctuate as they would in any market, they can also differ markedly between states.

Commercial assets were also part of SolarCity’s deal, although they accounted for a small share of the collateral, 14%, in the issuer’s last deal in July 2014, down from 29% in the first transaction in November 2013.

Need for Warehousing Facilities to Aggregate Assets

Standardization will no doubt make warehousing these assets easier for eventual securitization, a necessary step to create the size of issuance that will open the door to more institutional investor interest, particularly from those segments, such as insurance companies, that prefer long-term paper.
“The need for a warehouse facility is critical to aggregate multiple small to mid-size commercial solar developers and create a single issuance out of it,” said T-REX’s Cohen.

Aggregation may be coming from buy-side entities as well with a lot more of them trying to directly access assets.

“A significant amount of securitization growth may come from the investor side acting as issuer, somewhat similar to what you see in marketplace lending right now – with investors aggregating assets and then securitizing,” said Manish Kapoor, managing principal of West Wheelock Capital. “These aren’t traditional asset managers but some of the specialty funds out there. However some traditional asset managers are looking at this as a way to offer diversification and a different risk profile to their end investors.”

Kapoor added that banks have warehouse lines with the larger developers but these originators are not the ones that would necessarily need to be in multi-seller deals down the road.

Borod said there is reportedly more than one asset management firm aggregating solar assets from various sellers in the residential or commercial sector and when they have enough critical mass, they will securitize.

Risk that Contracts Will Be Renegotiated

Another major challenge for solar securitization is the long terms of the contracts — typically 20 years — which, for some investors, raises the specter of certain risks.

Two such concerns are that a homeowner moves and the new one does not want the keep the solar system or that the prevailing utility rate falls below that of the contract, providing an incentive for the customer to renegotiate.

“We do think that renegotiations are one of the most significant risks that investors would be exposed to,” said Andrew Giudici, managing director at Kroll Bond Rating. “It’s unlikely this would happen but it depends on the underlying contract.” He added that if a consumer enters into a contract for solar energy that’s initially 15% below current retail rates but includes an escalator that exceeds the increase in the retail rates, then they could eventually converge or, in an improbable worst case scenario, the contract could become more expensive.

T-REX’s Cohen dismisses this concern. “Realistically there’s been negligible incidence of renegotiation,” he said. Citing SolarCity as an example, Cohen said a developer that prices its leases at roughly 80% of the [retail] price would only face renegotiation risk if the retail price falls below that 80% level. Rhetorically, Cohen asks. “Does anyone have an example where this has happened over the last 30-40 years?”

He added that usage could potentially drop, but the nominal price-per-kilowatt hour has risen over the last 40 years. Even as the price of natural gas — a major input of electric production — has fallen, the price of power has gone up, Cohen said. “This shows that utility prices are not merely a function of market forces as PUC [Public Utility Code] regulation plays a role as well.”

Inverted Leases Easiest to Securitize

While a headache for doing securitization, the ITC has also played a role in mainstreaming the adoption of solar energy. A sharp drop in PV systems has also spurred demand.

Cohen, for one, isn’t lamenting the reduction of the credit in the commercial sector, because he says it will force the industry to adopt market-driven economics. But others in the industry, even those that acknowledge the difficulties it has posed for securitization, are concerned about the impact of phasing out on solar demand. Still, while growth in installations is expected to slow, projections by research firm GTM research and trade group Solar Energies Industries Association show that the total capacity should still keep rising by a substantial amount [see table on first page].

For the 10% tax benefit that will remain for commercial and third-party developers, and for pre-2017 projects that will have the full tax credit, SAPC will keep promoting the use of one the inverted lease between solar developers and tax equity investors. And it seems to be working, since SolarCity’s last transaction, SolarCity LMC Series 2014-2, and Sunrun’s upcoming deal, Sunrun Callisto 2015-1, are backed only by assets that were included in inverted lease arrangements.

Borod said these arrangements “are more amenable to securitization since they pose no recapture risk to tax equity investors and avoid the control issues that usually are present in partnership flips,” another approach that was used for assets backing SolarCity’s first two deals.

In an inverted lease, also known as a pass-through lease, the sponsor invests in a lessor entity, which owns the assets and enters into a lease agreement with the tax equity investor as lessee.

As Borod explains, under the IRS code, the lessor can elect to pass the tax credit through to the lessee, even though the lessor is the only owner of the assets. “This causes less friction with recapture or reduction in the tax basis, as the tax equity investor received credit on the basis of the pass-through election and not because it owns the asset,” he added. “It can continue to receive the benefits of the tax credit even if the ownership of the assets change during the five-year period, provided any subsequent owner of the assets is required to honor the rights of the lessee under the lease.”

With the reduced ITC “the problem will still be there but it will be a smaller part of the capital structure,” said Borod.

Borod thinks players will cope with ITC phase out — other incentives at the state level that may still be in place, and, of course, prices for PV systems keep falling. Also, securitizations may increase in leverage as the risks of the industry are better understood. “Right now the maximum leverage for a triple B plus rating is around 60%,” he said. “The last SolarCity deal went up to 70% but that was by issuing a tranche that was below investment grade.”

While balancing the concerns about the long-term nature of the contracts and the risks they entail, Kapoor sees a significant amount of promise in the securitization of the asset class: “When you look at situations where people’s finances are shaky, in terms of the order, they’ll stop paying their credit card bills, mortgage, car lease, and one of the last things they stop paying is the electricity bill.”

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