The term “capital stack” refers to the layers of financing used by a developer or an investor to fund a project. Each layer has its own risk and return characteristics.

Tax equity can play a significant role in the capital stack of many projects because its presence can make the overall capital stack more efficient. Traditionally, the affordable housing and renewable energy sectors (wind and solar power) have made the most use of tax equity investors.

However, the Inflation Reduction Act (IRA) includes a wide array of additional tax incentives and benefits aimed at promoting overall decarbonization, and targets multiple other sectors and asset types to encourage investment in other types of renewable energy, energy efficiency, and other environmentally friendly technologies.

The asset types eligible to receive tax benefits under the IRA include:

• Broad renewable energy assets: solar, wind, hydroelectric, geothermal, and biomass
• Energy storage and grid modernization projects
• Building energy efficiency, electrification, and EV charging infrastructure projects
• Clean hydrogen and carbon capture utilization and storage
• Biofuels and renewable natural gas production
• Clean energy manufacturing and critical mineral supply chain investments
• Sustainable agriculture and forestry
• Emerging technologies (such as advanced nuclear and innovative technologies)

The IRA uses the tax code to drive climate-related investments by offering financial incentives — specifically, tax benefits. In order to maximize the financial efficiency and viability of qualified climate-related investments, it is crucial to understand how these financial incentives can play a role within your capital stack.

Introduction to the capital stack

A capital stack typically includes several types of financing mechanisms used to fund the project’s development and construction. These layers often include:

• Equity: Equity, the investment made by the project’s sponsors or developers, is generally classified into two categories. “Sweat equity” refers to the non-monetary investment contributed to a project – in the form of labor, skills, expertise, and time – that results in an ownership percentage of a project. “Cash equity” involves investing money directly into a project in exchange for an ownership stake. Equity investors are typically the last to be repaid and therefore bear the highest risk. However, they also stand to gain the most if the project is successful.
• Government contributions: Projects being developed under the IRA may be eligible for government assistance in the form of grants or “direct pay.” Direct pay allows tax-exempt entities to receive direct payments equivalent to tax credits from the federal government. Government contributions as a whole can be viewed as a form of equity in the capital stack because they do not have a mandatory repayment profile and are a direct substitute for cash equity.
• Debt: This includes bank loans and publicly issued bonds that must be repaid with interest. Debt holders have priority over equity holders in terms of repayment and security, making debt the least risky investment layer in the capital stack.
• Mezzanine financing: These instruments usually have both debt and equity characteristics and include convertible debt or preferred equity. Mezzanine financiers are repaid after senior debt holders but before equity holders.
• Tax equity: This unique form of equity investment is used primarily in sectors that benefit from specific tax incentives, such as tax credits and taxable losses. Tax equity investors can utilize these incentives to reduce their income tax owed to the federal government.

Role of tax equity

Tax equity investors typically provide project development capital (with a portion usually delayed to post-completion) in exchange for an investment return. This return is primarily derived from tax savings rather than operating cash flows from the project. The inclusion of capital from tax equity investors can be critical for the financial viability of projects that might otherwise struggle to secure sufficient funding. By establishing a capital stack that contains tax equity, project sponsors can spread operational and revenue risks among different types of investors.

By understanding and leveraging the available tax credits, project sponsors can attract investors who are primarily interested in tax-saving benefits and are able to use those financial benefits. Tax equity as part of the capital stack for a project can reduce the overall cost of capital for the project sponsor and make the project more financially viable.

The primary tax benefits that bring tax equity into the capital stack for decarbonization projects include Investment Tax Credits (ITC) and Production Tax Credits (PTC).

• Investment Tax Credits
  ITCs allow owners/investors to deduct a percentage of the investment capital cost required to construct an eligible project from their federal tax liability. For instance, standalone energy storage systems (e.g., battery storage systems) are eligible for an ITC through the IRA. These projects could qualify for up to a 50% ITC, meaning that 50% of the project’s capital cost can be used to reduce an investor’s overall tax liability on a dollar-for-dollar basis.
• Production Tax Credits
  PTCs provide a tax credit based on the amount of specific production by an eligible project. The PTC is typically generated over a defined period of time. For example, under the IRA, facilities that produce clean hydrogen using renewable energy or other low-carbon methods are eligible for the Clean Hydrogen Production Tax Credit. In addition to the cash flow generated by selling hydrogen, this provides a financial benefit in the form of a lower tax liability linked to the project’s operational performance.

Structuring tax equity investments into the capital stack

• Partnership flip
  One common structure for a tax equity investment is the “partnership flip.” In these structures, the tax equity investor and the project sponsor form a partnership that owns the project. Through the partnership agreement, the tax equity investor receives the majority of the tax-saving benefits and some portion of the project’s cash flows until a predefined “flip point” is reached. This flip point typically occurs when the tax benefits have been fully utilized or a specified return on the original tax equity investment is achieved. After the flip point, the majority of the project’s benefits are realized by the non-tax equity owner.
• Sale-leaseback
  In a sale-leaseback arrangement, the project sponsor sells the project to the tax equity investor and then leases it back. This allows the sponsor to continue operating the project while the tax equity investor benefits from both the tax credits and depreciation. Additionally, the lease payments also provide a return to the tax equity investor. The lessee (sponsor) will receive the cash flows derived from project operations, net of the lease payment.
• Inverted lease
  An inverted lease structure involves two parties, a lessor and lessee. A partnership that owns the tax credit property serves as the lessor, and a partnership that is majority-owned by the tax equity investor is the lessee. The lessee operates the project and pays rent to the lessor for its right to operate. Through its ownership of the lessee, the tax equity investor is allocated tax credits, cash flow, and possibly some tax losses.
• Transfers
  Transferable credits are a relatively new option as introduced by the IRA. The transfer proceeds are still elements of the capital stack, but have both advantages and disadvantages compared to the options above. Transfers provide greater flexibility in timing of monetization – the tax investor need not be a partner prior to placed in service – and they don’t require the negotiation of complex partnership agreements. However, the transfer proceeds are typically less than the amounts received from the other options, largely because the transferor is not monetizing any cash flow or depreciation.

Using tax benefits in your capital stack

The tax code allows for significant tax benefits that can attract tax equity investors and reduce the overall cost of capital. Tax equity is a crucial component of the capital stack for many decarbonization-linked projects because it promotes capital mobilization. By understanding the various structures and benefits of tax equity, project sponsors can enhance the financial viability of their projects, mitigate risks, and secure the necessary funding to bring their projects to fruition.

However, using the tax benefits introduced by the IRA to drive investments can add complexity and potential uncertainties related to policy and politics, which necessitates careful planning and consideration to maximize their effectiveness and protect the long-term success of the project.

The structuring of a capital stack to include tax equity investments can be complex, requiring careful legal and financial planning. Each project is unique, and the optimal structure depends on various factors, including the type of tax credits available, the financial profile of the investors, and the project’s cash flow projections.