The Section 1603 Cash Grants in Lieu of Tax Credits program (the “1603 Program” or “Program”), enacted as part of the American Reinvestment and Recovery Act of 2009, was designed to reduce the need for an investor with taxable income to utilize credits by providing cash grants for the development of renewable energy projects. The goal was to accelerate capital investment in, and construction of, clean energy projects despite the impact on renewable energy investors caused by the economic downturn. The 1603 Program has been, by most measures, a success with cash grants reportedly valued at $6.4 billion in connection with 7,180 projects supporting the installation of more than $21 billion in renewable energy facilities since the program was launched.

Despite its apparent success, the 1603 Program appears to have run its course and is set to expire on December 31, 2011. The successful year end-push by the renewable industries to extend the program at the end of 2010 was a key win for the industry, but there is effectively no hope for a similar extension this year, with the program’s fate almost certainly sealed by the sharp focus on spending cuts that has evolved under this Congress. The end of the 1603 Program will mark an important shift in the landscape for financing renewable energy development. This loss of the grant program will be an insurmountable challenge for some, and enormous opportunity for others – planning and positioning over the remainder of the year will be critical for future success in the renewable power industry.

The Last Push to Qualify

The 1603 Program provides owners or lessees with an opportunity to apply for and receive cash grants for renewable energy projects that are originally placed into service prior to December 31, 2011, or alternatively, placed into service after December 31, 2011, if construction on the project commences prior to December 31, 2011. In order to meet the commencement of construction requirement for a project not ready to be placed in service this year, developers may have to accelerate the timing of activities within their development plans and manage their contractual relationships with a careful eye towards meeting the requirements for starting construction as defined under the 1603 Program and supporting guidance.

The commencement of construction is defined as when physical work of a significant nature begins. Both on- and off-site work may be taken into account for the purposes of demonstrating that physical work of a significant nature on a project has commenced. Moreover, applicants can use any of the following three ways to satisfy the construction commencement requirement: 1) self construction; 2) construction by contract; and 3) the 5% safe harbor.

The self construction standard is a relatively easy test to understand – even though identifying which specific construction activities are considered adequate in meeting the significant nature standard leaves some room for interpretation. The requirements for qualifying under both the construction under contract standard and the 5% safe harbor standard are, however, less clear, and there are a number of strategies that companies can use to successfully meet these standards to support the qualification of a project.

Construction by contract begins when physical work of a significant nature begins under a binding contract, and this can include parts that are manufactured, constructed, or produced on behalf of the applicant under contract. A contract is binding under the 1603 Program if it is enforceable under state law against the applicant, and does not limit contractual damages to a specified amount of less than 5% of the total contract price. For example, contracts that provide a full refund of the purchase price of equipment or materials for the project in lieu of allowable damages would not be considered binding in the context of a 1603 Program application. Given these requirements, structuring the underlying contract and clearly associating work under the contract with a specific project must be done carefully. A nuanced approach can provide opportunities to better position a project for qualification, while enhancing risk management and cash flow.

The safe harbor provisions allow an applicant to treat physical work of a significant nature as beginning when the applicant incurs or pays more than 5% of the total cost of the project prior to December 31, 2011. Again, careful planning is key to meeting the safe harbor requirements, including an understanding of what is actually required for a cost to be paid or incurred in this context. Many developers are structuring contracts with vendors and service providers in an effort to meet the 5% incurred requirement of the safe harbor. Again, carefully planned (e.g., safely exceeding the 5% test for possible project costs rather than merely hitting exactly 5% of projected costs) and nuanced approach may better manage risk and cash flow while ensuring the project will qualify for a grant prior.

Companies should carefully review their project development plans, as well as relative position to the marketplace, in order to qualify for cash grants under the 1603 Program prior to the December 31, 2011, deadline. A well capitalized developer with a solid pipeline of projects may be more aggressive in its approach than a developer trying to manage a single large project. Additionally, there are many other rules that an applicant must address in preparation for submitting an application under the 1603 Program, and a detailed understanding of all program rules is necessary. Coordinating the operation of the grant program, how the program integrates with broader financing strategies, contracting terms and construction management is critical for successfully navigating the best course through the expiration of the 1603 Program.

The Return of Tax Equity

As projects are identified that will not qualify for the 1603 Program, many developers will be forced to return to the tax equity market.

Future projects will once again require taxable income to realize the value of the federal incentives for renewable power. For many projects, this will require tax equity participation in project finance. Early positioning for 2012 projects that do not qualify for 1603 grants will be important. The tax equity market continues to improve from the extreme contraction during the financial crisis, however, the market next year will be a difficult one for developers.

Despite new interest and new participation, the pool of tax equity investors remains limited. This limitation will likely be stretched by demands from a number of projects that fail to meet the construction start test for the grants—especially if the Treasury and the Department of Energy review teams take an aggressive position on qualification for 2011 activities. These projects will generally still be tax credit eligible, but developers may be willing (or forced) to take on tax equity participation at substantial premiums to cover the gap left by failing to obtain the grant proceeds, draining available tax equity from the broader marketplace.

For some developers and vendors with strong balance sheets and taxable income, this may provide a competitive advantage in this altered market, for others it will be a very real disadvantage.