As the impending “fiscal cliff” 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 1, 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 4 percent of GDP -- greater than the approximately 2 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 earning $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 percent, resulting in a total spending reduction of $279 million. As an example, if a developer had a 2-megawatt solar project that was expected to receive the 1603 cash grant at $3 per watt, the expected grant payment would go from $1.8 million to $1.66 million (a 7.6 percent reduction in the grant means that it would now be payable for 27.72 percent of the project cost). This ~$137,000 difference would decrease the project’s IRR from 10 percent to 9.4 percent. 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 the ITC would at least be considered for the chopping block. However, the current gridlock and timeline has limited Congress’ ability to examine all tax loopholes and deductions.
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 fifteen to twenty 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 was $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 approximately twenty tax equity investors active in renewable projects in 2007 according to US PREF, ten 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 the term "fiscal cliff,” the austerity cuts would likely take effect more gradually than one would 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 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.
Andrew Gilligan is an Associate on the SolMarket project finance team. Sol Systems is a solar finance firm addressing residential, commercial, and utility-scale projects.