Round about the time I got out of college, I (like seemingly everyone else) got a Leatherman — the Swiss Army knife cum pliers cum screwdriver that fit in your pocket. Since I was finally out of the dormitories and in my own apartment, it was handy to have a tool to assemble the odd futon, replace a busted light fixture, and take care of other odd jobs.
The great thing about the Leatherman was that it was easy to use, portable, and great for my single-guy mojo ("wait, I can fix that, I happen to have a multi-tool in my pocket"). The downside? When all’s said and done, it’s not that great a tool. My fingers always got pinched in the pliers, the screwdriver didn’t have enough leverage, and the knife always seemed rusty and dull.
Tax credits are the Leatherman of US energy policy. They’ve got massive sex appeal, and they’re relatively easy to pass compared to other fiscal measures. But when all is said and done, they’re a lousy tool.
Easy to pass
If the government passes a bill that gives a $100 million grant to the solar industry, the total cost to the federal treasury is $100 million. If, on the other hand, it passes a bill that provides a $100 million tax credit to the solar industry, the total cost to the federal treasury is … also $100 million. But the tax bill is far easier to get through, for reasons that have to do with the nuances of fiscal policy.
For reasons I do not claim to understand, a tax bill requires only one vote (Okay, three, to pass both houses of Congress and get the President’s approval, but it’s basically one process). But a grant requires two votes, first to authorize the payments and then to appropriate the money.
In theory, when Congress authorizes money, the appropriation ought to be a formality. In practice, the time between authorization and appropriation can stretch into years, with the latter decision made in a totally different fiscal environment than the former. (More cynically, one might argue that the act of authorization gives political gain to the authorizing party without any fiscal consequence, so we are prone to authorize more than we appropriate.)
The net result is that if it’s all the same to Congress anyway, it would seem that the most politically efficient thing to do is just to pass it as a tax bill, so those funds can immediately go to work, right?
Who gets paid
Not really. If a company is building big capital projects that require lots of money to construct and are eligible for tax credits, the one thing you can be virtually certain of is that the company won’t have to pay any taxes, regardless of the size of the tax credit. For those with an accounting background, you can ignore the explanation, but for those who don’t, here goes:
When you build a capital project, you are not allowed to declare all that cost as an expense. Instead, you have to spread the expense over several years. Accountants call this depreciation. In the meantime, if you borrow money to build the project, the interest payments you make on that loan also count as an expense. And for tax purposes, you only pay tax on your income, which is your total revenues minus your total expenses. So in the early years of a project, when you are still getting big credits for depreciation and paying down a lot of interest each period, you don’t have any taxable income. (This is exactly analogous to a home mortgage, which decreases your tax more in the first year than the 20th year.)
A simple example may illustrate. Suppose you’re building a million dollar capital project that has 10-year straightline depreciation (e.g., $100,000 per year). Suppose further that you borrow $400,000 of the total capital cost, which you pay off over 7 years at 8% interest. That will add another $32,000 of interest in the first year of operation. Now let’s suppose that this investment generates $120,000 of net cash to you each year. In year 1 you have a $120,000 revenue, but a $132,000 expense and therefore a $12,000 net loss. The good news is that you don’t pay any tax. The bad news is that to the extent that you also have tax credits available, you can’t use them. (The government doesn’t give money back to people who lose money, for rather obvious reasons.)
In other words, that $100 million that seemed so easy to pass is essentially useless. It’s a pile of Leathermans (Leathermen?) doled out to help people build suspension bridges. Right idea, wrong tool.
Tax equity to the rescue
Enter tax equity. You have tax losses you can’t use. Other people (most often banks) have taxable income they would prefer not to pay taxes on. Thus, we have developed a framework wherein the bank agrees to pay you some money in exchange for your tax losses. You get more cash for your project, and they get to save money on their tax bill. Everyone wins, right?
For the most part, yes. Lots of renewable projects (not to mention other tax-credit-generating projects, like low-income housing) have been built with exactly this model, using tax equity to lower the total money needed from other sources to build the project. But here’s the rub: banks don’t do this unless they can make money at it. That doesn’t make them bad, of course, but it does mean that for every $1 of tax equity, less than $1 is actually going to the company building those solar panels.
Let’s go back to our solar example. Still $1 million to build, 10 year depreciation, etc. But let’s also assume that the tax credit is providing $10,000/year to the project of tax credit. Tax equity deals are really complicated, but in that scenario, over 10 years, this project would generate something in the neighborhood of $1.2 million of total tax offsets (from credits, depreciation, and interest). Give those to a tax equity partner and they’ll pay you something like $600,000 up front for the savings. That’s nothing to sneeze at on a $1 million deal. But look at what’s happening from a policy perspective: something like 50% of the tax benefit goes to the company building the solar panel and 50% goes to the bank.
Put this more generally: the feds pass a $100 million tax credit bill, which pays $50 million to various green businesses and $50 million to banks.
I am in no way suggesting this is cause for some rabble rousing, damn-those-greedy-wall-streeters diatribe. The point here is much more substantive: we’re not getting much bang for our energy policy buck.
In today’s market it is even worse, as lots of those banks that used to be providing tax equity are now in a situation where they are losing money hand over fist and have no use for tax credits either. The immediate result is that about 50% of the tax equity market no longer exists, and those that remain in are finding it possible to charge a higher price for their services. Again, that’s nothing to get riled up about — supply and demand, after all. The problem isn’t the bank. It’s the tool.
Better ways
As reported by Greenwire this week ($ub req’d), the renewable energy community is rather concerned of late about the dry up in tax equity markets. This is galvanizing an effort to try to amend the recently-extended tax credits so that green companies can use the credits themselves. Elsewhere, there have been some rumors about a partial repeal of the 1982 Tax Equity and Fiscal Responsibility Act (TEFRA), to allow individuals to invest in these tax credits (in other words, give Main St. access to tax offsets currently available only to Wall St.). Both arguments have their merits.
Personally — and perhaps naively — though, it seems to me that it would be vastly simpler to find some vehicle other than the tax code in which to drive energy policy. As noted above, direct payments from the federal government have the same fiscal cost as tax credits, but can be much more precisely targeted. But for the authorization/appropriation challenge, it seems like a vastly better idea. Federal actions to create (or unencumber) markets so that others can make direct payments (a la an RPS or a cap & trade) would have similar benefits and advantages over tax credits.
None of these are perfect, any more than there is one single tool that is perfect for all home projects. But at least from my vantage point, using tax policy to shape energy policy is about the least economically and societally efficient of the bunch.
