Equipment leasing has been used for much of the last century by airlines, railroads, utilities, oil and gas developers and other industries as a way to finance expensive equipment. Indeed, equipment leases and similar instruments account for more than $600 billion of business each year. This number is remarkable as it constitutes more than half of the investments into all business and nonprofit goods and software in the United States each year.
It is not surprising that equipment financing has become common in the solar energy sector. Such financing systems make solar energy more accessible, allowing customers across a broader range of income levels to buy solar electricity without taking on the large upfront cost of purchasing the equipment.
Equipment Financing Structures and Domestic Energy Production
Equipment leases have been used broadly to finance domestic energy production. Industries such as housing, airline, oil and gas and a range of others have set up financing structures that have served as the precedent for modern equipment leases. At the same time, the government has recognized those structures and provided investment tax credits for a variety of assets in these industries dating as far back as the Kennedy administration.
Solar project owners are eligible for the Section 48 Investment Tax Credit (ITC), a 30 percent tax credit expanded under the Bush administration in the Energy Act of 2005 to encourage the domestic production of renewable energy. Solar developers rely on the precedents provided by the equipment leasing industry and decades of IRS guidance under the ITC to create financing structures in order to develop new solar service options for homeowners, businesses and nonprofit organizations. Because solar companies can’t always use all the tax benefits available, the solar developer will often seek out investors who can efficiently use the tax benefits to provide the financing at a lower cost than would be the case with direct borrowing. This tax-efficient means of financing means that more projects can be built at a lower cost to the host customers. This is no different than when an equipment rental company finances equipment for end customers through a lease.
Fair Market Value (FMV) and the Solar Industry
In the case of solar, the institutional investor (e.g., the bank, utility, etc.) can claim a tax credit for 30 percent of the purchase price it pays for the system. This is assumed to equal the fair market value of the system and in almost all cases is supported by an appraisal confirming the market value, or in the case of a lease pass-through, which is sometimes referred to as an inverted lease, the “fair market value” (FMV) of the system. But what does "fair market value" mean under the historic and accepted principles applied to leasing financing, as well as the investment tax credit?
Under both established practices, "fair market value" is generally defined as the price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts.
The concept of fair market value has been a source of confusion for many, including some who conflate FMV with the seller’s cost of materials and installation. The reality is that there have long been accepted appraisal methods for establishing the fair market value of an asset. Those methods are: (1) the income generated by the asset, (2) the prices at which similar assets are sold in the market and (3) the cost of developing or replacing the asset. These approaches have been in place for decades and are used across a broad range of equipment classes. Appraisers rely on accepted methodologies -- typically guided by Uniform Standards of Professional Appraisal Practice (USPAP) standards -- that are recognized by the courts and the IRS.
Some seem to believe that these methods should not be used in the renewable energy sector. It is difficult to follow the logic of those holding this belief. Indeed, it appears that the logic does not even address the appraisals or traditional methods, but instead starts with an assumption that in the renewable industry, FMVs are manufactured out of thin air to increase tax credit payments.
The reality is that in the solar industry, lease and power purchase agreement (PPA) financing follows the traditional valuation rules and is financed by large, well-established equity investors that have participated in these methods for decades themselves. The tax credits are based on the price an institutional investor pays for a solar asset, just as a cash buyer receives a tax credit based on the price he or she pays for a solar system, not limited to the seller’s cost of installation. Solar assets are valued very much the same way that any income-producing property is valued -- based on the income that the property will generate. To determine the appropriate purchase price for the asset, the institutional investor will primarily focus on the potential income (customer lease payments), or discounted cash flows that the system will generate over the term of the lease. As a more familiar basis for comparison, if an investor wants to purchase an apartment building to rent out the units, she won’t determine how much to pay for the building based on how much it costs to construct, but instead will base the value on the cash flow generated by renting the apartments. Solar investors do the same thing.
The solar industry is relatively young, and solar development costs can be particularly high due to a lack of financing contract standards, higher costs of capital, and other challenges typical in emerging industries. As a result, developers incur substantial costs to offer leased assets that are not incurred in cash sales. This is true whether the solar provider is integrated (with both developer and installer under one roof) or focuses solely on development. Many residential solar developers purchase leased solar systems from installers on behalf of customers and transfer them to institutional investors at the appraised fair market value of the system. Developers often employ hundreds of workers to handle financing development work.
ITC vs. Section 1603 and the OIG Review
In 2009, Congress passed the American Recovery and Reinvestment Act, which included a mandate that the federal government provide certain payments to renewable energy developers. Congress was clear in its mandate, which is found in Section 1603 of the Act. The mandate was for the Treasury Department to make the payments by following the rules the IRS established for the ITC. The statute couldn't be clearer that Section 1603 payments were to "mimic" the rules and principles of the ITC. These are the same rules and principles that have been used in a variety of industries and a variety of leasing financing structures for decades.
Nonetheless, since the inception of the American Recovery and Reinvestment Act of 2009 section 1603 program, the U.S. Treasury Department has engaged in extensive discussions with the solar industry about FMV. Treasury's first "guidance" on the topic appeared in June 2011 in “Evaluating Cost Basis for Solar Photovoltaic Property."
It is difficult to understand why the administrators of the section 1603 Program believe the income approach to valuation is unreliable -- as the published guidance seems to indicate -- even though it is the preferred method of valuing income-producing property and has been used for other properties for decades. Treasury’s practice has resulted in setting the cost on which the grant is paid at an artificially low amount based upon the developer’s cost of installation, without properly taking into account the full range of costs incurred by the developer, and without regard to the property’s income-producing attributes. In short, the administrators of 1603 appear to be applying a different standard to the valuation of renewable projects than has been applied to fossil fuel development and other project types for the past 50 years. Treasury has never advanced a justification for the double standard or the rationale for ignoring the law’s clear mandate that 1603 ITC payments mimic traditional IRS rules.
Taxpayer Impact Myths
It is a common misconception that because leased solar systems receive higher upfront tax credits, such systems cost the federal taxpayer more than do direct cash sales. The reality is that solar lease payments are taxable as income, and the federal government recovers the cost of incentives paid for financed solar systems over time by collecting income taxes on the lease payments. A recent analysis by the U.S. Partnership for Renewable Energy Finance found that a leased residential solar system can provide a 10 percent nominal rate of return to the federal government on the initial tax credit paid over the expected life of a solar asset. Even when depreciation -- a tax incentive that is not exclusive to solar and applies to a wide range of assets -- is factored in, the higher incentives paid to owners of leased systems still deliver a better return on investment to the federal government than systems purchased for cash.
Expanding the Solar Demographic
One of equipment financing’s most significant contributions is that it makes solar power more accessible to customers who otherwise might not have considered it or been able to afford it. A June 2012 report from the California Public Utilities Commission noted that a significant increase in solar participation from customers in lower and medium income areas has coincided with a dramatic rise in third-party-owned systems. The report notes a 364 percent increase in applications since program inception from households in ZIP codes with median incomes of less than $50,000, and a 445 percent increase in applications from households in ZIP codes with median incomes between $50,000 and $75,000, and attributes this growth to “a sharp increase in third-party-owned systems, such as solar leases and power purchase agreements (PPAs), [which] allow households who cannot afford to own a PV system to go solar.” This democratization is critical to allowing solar to evolve beyond an early adopter phase and establish itself alongside coal, natural gas and nuclear power as a mainstream source of electricity.
Conclusion: The Race to Parity
Reasonable people can disagree about whether tax incentives are the best way to encourage the development of renewable energy, but there is no question that in the U.S., they are the most significant financial vehicles available to the industry to work toward parity with fossil-fueled sources. Energy has been subsidized in the U.S. for more than a century, with most of the incentives going to fossil fuel and nuclear development. Oil and gas companies even have access to special, tax-free investment structures called master limited partnerships that are currently off-limits to solar and other renewables. Many fossil fuel subsidies are so obscure and have existed for so long that they are invisible to most Americans. By contrast, solar incentives have been politicized to the extent that they have come under scrutiny from a wide range of sources, even though the tax rules that govern equipment financing have been in place for decades and should be the same for everyone. Despite the manufactured controversies surrounding them, these tax policies have created an opportunity for solar to achieve the scale necessary to reduce costs and lessen its dependence on incentives -- the identical role that the same policies played to encourage domestic oil and gas production in prior decades.
Equipment financing has brought billions of dollars in private investment to solar and has created tens of thousands of jobs. It has been an invaluable tool in the effort to grow solar adoption to a scale sufficient to compete with energy sources that have enjoyed more substantial government subsidies for longer periods of time. Absent dramatic, unforeseen changes in the way our country accounts for the costs of dirty power, solar financing will and must remain as an important bridge to a cleaner energy future.
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Jorge Medina is Senior Tax Counsel at SolarCity. Mr. Medina has spent much of the past decade as a tax attorney working on renewable energy and equipment leasing investment structures.
David Lowman is a Partner at Hunton & Williams LLP where he is chair of the firm's global renewable energy practice. Mr. Lowman has more than 25 years experience in advising on energy project finance.