As you've seen, tax equity can improve in its breadth and reach.
A system called "direct pay" promises to remove some inefficiency from the process.
We wrap up our series with a primer on how direct pay happens and why players consider it vital.
As momentum built for the Build Back Better (BBB) Act in 2021, the clean energy industry seemed poised for a potentially major shift in financing. The bill included a provision which would change the current clean energy tax credits payments to a “direct pay” system. Though the future of the Build Back Better Act is highly uncertain, there is an increasing industry awareness of gaps in the current tax credit incentive system and the ways it does not provide equitable benefits for everyone. Moreover, because the vast majority of taxable income on clean energy projects is at the federal level and state tax credits are proportionally minuscule, there is little opportunity for states and localities to push for alternatives to the system. The shift to direct pay is the only widely affirmed alternative to the status quo.
Through a direct pay system, tax credits which currently move through complex transactions to be claimed by outside investors would instead apply directly to the developer’s tax return. As a reminder, current tax law only delivers credits to entities with enough taxable income to owe a meaningful amount to the IRS. In a direct pay system, any company or individual that files taxes may claim the credit in the following tax season, so a tax credit would arrive in the next tax season.
But as with any policy, some caveats come attached. Under the Build Back Better Act, direct pay would also place provisions on the amount of U.S. manufactured content, as well as union jobs employed for the project.
Would direct pay replace the current system?
Under a direct pay system, the time until an entity receives tax credits would be delayed as credits are returned at the time of the next tax return. Therefore, traditional tax equity investments would still offer benefits as they’re applicable for immediate investment. In addition to claiming tax credits under the current model, tax depreciation from capital-intensive projects, such as solar, also make financial sense for a tax equity investor.
Due to traditional tax equity’s efficient returns, we expect most large-scale projects will still include tax equity investments. Traditional investments may also continue through the desire to bypass domestic manufactured content and labor requirements.
Though large-scale project financing might continue with the status quo, the benefit of direct pay opens the door for homeowners without sufficient tax liability. This could include low-income households or retirees looking to put solar on their rooftops. In addition, smaller project developers, who historically have lacked access to relationships with large banks for tax equity financing, may gain wider access to these tax credits for community solar or commercial and industrial projects.
How might direct pay impact the expansion of new low-carbon technologies?
As we mentioned in Article 3, some technologies have been unable to take advantage of tax credits despite their availability, such as (carbon capture). For these projects, most tax equity investors might still be unwilling to take on technology risk. With the introduction of a direct pay system, project developers may be able to skip the arduous task of searching for a tax equity investor and take advantage of tax credits directly. The Build Back Better Act would also expand tax credits to other clean energy technologies, such as transmission assets, electric vehicle charging, direct air capture, battery storage, and green hydrogen, in addition to additional tax credits for renewable energy in low-income communities.
So what’s the future of tax equity? While it still remains uncertain, there is a high likelihood that traditional tax equity will continue for some time, even if direct pay is enacted and with it, a larger possibility of financing for community and C&I projects, as well as greater financing potential for new technologies, such as carbon capture, that we will need for our net-zero future.