With the recent successful completion of COP21, the Paris Global Climate Change Conference, resulting in a global climate accord, worldwide attention is now being focused on follow-through measures by the various countries of the world to achieve the ambitious carbon-reduction goals of the accord and to expand on these goals over the next five years. In addition to the governments of all of the major developed and emerging economies of the world that assembled in Paris, there is increasing buy-in by large corporations around the world to the notion of becoming a part of the solution rather than a contributor to climate change. Companies as diverse as Coca-Cola, Bank of America, Goldman Sachs, Citibank, Kellogg, DuPont, General Mills, HP, Total, Unilever, BP and Royal Dutch Shell not only attended the Paris conference but have pledged to be part of the solution to climate change. In addition to pledges of financial support from the developed nations to assist the developing countries in making the transition to a low-carbon economy, technological and financial innovation were highlighted in the accord as two of the keys for achieving the targeted carbon reductions.
Large financial institutions like Goldman Sachs and Citigroup are making major commitments to sustainability. Goldman Sachs recently announced that it was tripling the goal set in 2012 for clean-energy finance and investment arrangements, and that its new goal was US$150 billion of clean energy finance and investment arrangements by 2025. Kyung-Ah Park, the head of Goldman Sachs Environmental Markets, stated that “Environmental issues have become increasingly relevant to our clients and our investors, and have become core to our business.”
Citigroup, in a repor t entitled “Energy Darwinism II— Why a Low Carbon Future Doesn’t Have to Cost the Earth,” published in August of 2015, estimated that energy efficiency and renewable energy will require capital investment of US$13.5 trillion and US$8.8 trillion, respectively, over the next 20 years. (Standard & Poor’s has recently estimated that it will require US$13.5 trillion of capital investments by 2030 to achieve the international goal of avoiding a two degrees centigrade increase of average global temperatures.) The Citi repor t concluded that there are adequate capital reserves to fund these investments, but the missing link is lack of availability of investment vehicles of sufficient quality (i.e. investment grade).
Viewed in the context of this challenge, the acceleration of securitisation activity in the solar energy sector in the US can be seen as a concrete positive step toward creating investment grade vehicles to address climate change. Solar is, of course, only one of many mechanisms that must be deployed to meet the goals of COP21. To do so will require the creation of financial instruments covering all aspects of renewable energy, energy efficiency, natural resource allocation and preservation and carbon sequestration, to name a few. However, a closer look at some of the obstacles that have to be overcome in order for solar projects to gain access to the capital markets and some of the solutions used to overcome those obstacles provides a useful roadmap for the territory ahead.
One of the primary catalysts for the growth of the solar securitisation market in the US was the Solar Access to Public Capital (“SAPC”) working group organized in late 2012 by the National Renewable Energy Laboratory (“NREL”). Backed by a three-year funding facility from the US Department of Energy (“DOE”), NREL was instrumental in organising the solar, legal, banking, capital markets, engineering and other relevant stakeholder communities around the common purpose of identifying barriers to entry inhibiting solar projects from gaining access to the lower-cost financing of asset-backed securitisation. Some of the initial projects of SAPC included standardized solar leases and power purchase agreements, statements of best practices, and aggregation of data on the financial and technological performance of solar assets. The scarcity of data was a major impediment to obtaining investment grade ratings from the rating agencies, and Standard & Poor’s, which took the lead among the rating agencies in developing rating methodologies for solar assets in the US, proclaimed early in the process that because of the scarcity of data, the highest rating that could be assigned in the foreseeable future to solar securitisations was BBB+.
However, as significant as the scarcity of data was, the major presence of tax equity in the typical capital structure of solar projects loomed at least as large as another impediment to entering the capital markets. In both residential and commercial/industrial solar finance structures, tax equity usually occupies a significant portion of the capital stack, ranging from 40% to 50%. Tax equity is usually provided by large financial institutions or operating companies with sufficient tax exposure to utilize the investment tax credits in particular, as well as the depreciation and other tax benefits that, together with cash returns, comprise their overall yield. In order to realize the tax benefits from solar projects, tax equity investors must have either a real or deemed ownership interest in the assets generating the energy credit and other tax attributes. Tax equity usually acquires this in the form of participation in a partnership or limited liability company. Because the energy tax credit which tax equity receives upon the commissioning of the solar assets, which is equal to 30% of the tax basis in the assets, is subject to recapture in the event of a disposition of the assets over a five-year period, tax equity investors are resistant to subjecting those assets to the liens of indebtedness which could result in a foreclosure and therefore a deemed disposition for tax purposes. Moreover, tax equity often negotiates for protection against an Internal Revenue Service audit of the valuation used in computing the energy tax credit, by requiring the sponsor/developer of the solar project to indemnify the tax equity investor against a reduction of the credit resulting from a reduction in the value on which the credit was based. Finally, tax equity investors require certain control rights over major decisions of the entity owning the solar assets. These requirements, both separately and in the aggregate, run counter to the requirements of noteholders in an asset securitisation transaction.
These noteholders normally require that the assets securing their notes be encumbered by a first lien position in their favor, and that they be given rights to foreclose and sell the assets in the event of a default in the payment of their notes. Moreover, noteholders require control rights upon the occurrence of default events which give them the right, through the indenture trustee, to take various steps with respect to the collateral. Finally, noteholders in securitisation transactions are dependent upon cash flow generated from the assets being available to them to service their debt and to fill any reserve requirements under the indenture. Therefore, the existence of a potential indemnification liability on the part of the issuer of the notes creates a serious cloud over the viability of these cash flows. A further cloud is created by the fact that the tax equity investor normally is entitled to a priority claim on cash flows up to a level sufficient to give it a minimum cash return to supplement the tax benefits which it realizes on the investment. Although this priority cash return is small relative to the total cash flow in most transactions, it is a further encroachment on cash flow that otherwise would be available to the securitisation noteholders.
It was these headwinds – insufficiency of historical data and inconsistent requirements of tax equity – that prevented several companies with sufficient assets to support a securitisation transaction from issuing rated solar asset- backed securities, until SolarCity, the largest residential solar installer in the U.S., issued its first securitisation in November of 2013. However, this securitisation, like the two that followed in April and July of the following year also issued by SolarCity, sidestepped the tax equity problem by selecting solar assets that were not involved in tax equity structures.
During the same period of time, the SAPC working group undertook an additional project-the submission to the statistical ratings agencies of simulated rating requests based on hypothetical portfolios of solar assets that were based on actual portfolios with a distribution of pool characteristics that was representative of those present in solar portfolios of the leading solar developers which had shared their data on an anonymised basis with the SAPC working group. The legal structures presented in these mock rating submissions were developed by the legal team working on the mock rating project based on their best judgment of how a solar ABS transaction should be optimally structured, and these structures were presented in significant detail through definitive term sheets, transactional diagrams, and flow of funds charts. The central goal of the mock ratings project was to engage the ratings agencies, which were at various stages of developing solar ratings methodologies, in a productive dialogue that would provide a two-way information flow between the ratings community and the distributed solar industry and which would thereby accelerate the evolution of thinking on how solar ABS transactions should be structured to minimise risk, maximise ratings levels, minimise the cost of capital and at the same time maximise the advance rates achievable in rated solar ABS transactions.
Two different mock filings were developed – one for a hypothetical residential solar portfolio and one for a hypothetical commercial and industrial portfolio. The residential securitisation was envisaged as providing funds for the sponsor to buy out the tax equity investor after the 5-year recapture period, thus, as in the first three SolarCity securitisations referred to above, finessing the problem of detangling the Gordian knots that were impeding securitising from tax equity structures. However, the mock commercial securitisation was structured with the tax equity remaining in the structure and thus was forced to confront the friction points described previously.
In addition to accelerating the learning curve for both the solar installer and the rating constituencies and the resulting development of ratings methodologies and transaction structures that are defining the solar ABS market, the SAPC mock ratings project produced a recommended structure for combining tax equity with securitisation, called the “Tandem Tax Equity/Securitisation” structure. Under this structure, the inver ted lease format, which is used by some (but not all) tax equity investors currently in the market, has been tweaked to isolate tax equity in the lessee entity and the developer-issuer in the lessor entity, and thereby remove some of the friction currently present in the par tnership flip structure where the tax equity and the developer are required to co-exist in the same par tnership or limited liability company.
More or less concurrently with the mock ratings process, work was progressing on two new solar securitisations one sponsored by Sunrun Inc., another large solar developer in the U.S., and the other sponsored by SolarCity. These two transactions hit the market at approximately the same time and were closed in the summer of 2015. Both transactions, like the three SolarCity securitisations which preceded them as well as the two SAPC-sponsored mock ratings discussed, involved collateral in the form of solar photovoltaic equipment installed on primarily residential rooftops, with the sponsors retaining title to the solar systems and either leasing them to the homeowners under fixed rate leases with periodic adjustments and power production guarantees or entering into power purchase agreements with the homeowners.
Thus, the cash flows to service the securitisation debt were derived from lease revenues or PPA off-taker payments. However, what was different about these two transactions from the three that preceded them was that both involved solar assets that were financed in part by tax equity. The SolarCity transaction was layered on top of partnership flip structures and the Sunrun transaction involved solar assets that were subject to an inverted lease structure.
The SolarCity transaction addressed the conflicting lien issue discussed previously by pledging only the sponsor’s interest in the managing member of each LLC that owned the actual solar assets and thus only the cash flow that was distributable to the sponsor was assigned in a bankruptcy “true sale” to the issuer of the securitisation notes and pledged under the indenture to the note holders (this is known as a “back- leverage” structure). The same transaction addressed the tax indemnity issue by having SolarCity, agree to guarantee the indemnity obligation of the issuer. By providing insurance policies from rated issuers insuring up to 35% of any tax indemnity liability resulting from an IRS audit, this would provide added protection in the event that SolarCity failed to cover the indemnity obligation. The Sunrun transaction addressed the competing lien issue by having the issuer pledge its interest in the lessor entity to secure the notes and the tax indemnity issue by having the tax equity investor agree to look only to the sponsor – Sunrun – for any tax indemnity payment.
With the recent extension of the energy credit by the U.S. Congress for another five years beyond the end of 2016, tax equity will remain a significant component of the capital structure of solar assets for the foreseeable future, and thus additional solutions will have to be developed through the cooperative relationship between the tax equity provider community and the solar developer community.
The Solar Energy Finance Association, which has been formed to carry on the mission of SAPC on increasing the distributed generation solar industry’s access to the capital markets and identifying and ameliorating the friction points inhibiting the growth of the solar industry in the U.S., has announced its intention to act as convener of the tax equity and developer constituencies to come up with actionable and practical solutions to these friction points. To date, over US$660 million of solar ABS transactions have been issued and more are in the works as of this writing. Each of these transactions was rated investment grade by either S&P or Kroll, and the two 2015 issuances received an A rating from Kroll. However, in the context of total annual ABS issuance, this is not a large number. And solar energy as a percentage of total installed energy capacity in the U.S. remains under 10% despite the fact that solar installations are growing at a rate of over 24% year-to-year and solar installation costs per- KWh continue to decline.
For solar power to achieve the scale necessary to meet its potential for addressing the U.S.’s Climate Change goals, other headwinds must be overcome. These include: (i) elimination of the regulatory uncertainty surrounding efforts by the utility industry to cause state utility regulatory bodies to reduce the price at which excess power generated by solar facilities can be sold back to the grid (so-called “net metering”); (ii) development of the capacity to store unused solar energy to eliminate the need for a net metering regime and to create more reliability of solar power for users which require uninterrupted power flow; and (iii) creation of products or policies which eliminate or mitigate the risk that the price of energy from the grid will fluctuate to a level below the price of solar energy, thereby putting into jeopardy the long-term value proposition on which the growth of distributed solar is based.