Financing Strategies for Renewable Energy Projects Southwest Renewable Energy Conference 2010 Office: Cell: LinkedIn: Twitter: Geoff_Morgan Geoffrey R. Morgan Michael Best & Friedrich LLP 100 East Wisconsin Avenue Suite 3300 Milwaukee, WI michaelbest.com/grmorgan

2 Introduction Arranging finance for a renewable energy project is not a task to be underestimated by developers, especially those with no previous experience in raising finance or establishing successful power generation projects. It is important that developers bear in mind the following:

3 Introduction (cont’d)  Process of arranging financing is time consuming.  Technical, contractual and consent aspects of a project all affect the financing.  No template – problems will emerge that require determination and, often, ingenuity to overcome.

4 Introduction (cont’d)  Small projects (less than $30 million) may be difficult to attract the attention of lenders or investors. A developer may believe that the project will “sell itself” based on its own merits, but in reality the developer will have to adhere to the strict terms and conditions applied to project financing.  Identification and use of tax incentives has become critical.  Grants and loan guarantees helpful but difficult to procure. In summary, the technical difficulties of a project, which in themselves may appear daunting, are often exceeded by the complexities of raising the necessary finance.

5 Financing Alternatives  Most projects are highly capital-intensive and will require the developer to raise large amounts of finance well in advance of the start of operations.  Although every project is different, and a variety of means have been used to date, there are generally four possible routes for financing a project:

6 Financing Alternatives (cont’d) 1.Use of internal company or personal reserves, or obtaining funds from friends and business associates. Except for the smallest renewable energy projects, it is unlikely that sufficient personal reserves would be available to meet the total cost of the project. It may not be suitable to use company reserves and hence one of the alternative routes will need to be considered.

7 Financing Alternatives (cont’d) 2.Use of bank loans secured against other parts of the developer’s business or major assets (“on-balance sheet finance”) or personal guarantees often linked to property owned by the developer. 3.Co-development of the project with a financially strong joint-venture partner who is more readily able to raise the necessary finance. 4.Limited recourse project financing, whereby bank loans are secured largely against future cash flows rather than just physical assets, and involving a series of complex contractual arrangements.

8 Factors Which Affect the Financing Decision At an early stage in the project’s development, the developer and sponsors should therefore consider whether to finance a project on a limited recourse basis or on an on balance sheet basis by addressing the following questions:

9 Factors Which Affect the Financing Decision (cont’d)  Do the developers/sponsors have the financial wherewithal to provide the full financing requirement from within their own resources, and do they wish to use them for the project?  Is the magnitude of the potential financial obligations such that, if the project were a failure, there would be serious damage to the financial health of the developer?  Are there specific project risks with which the developer is not comfortable and desires to see laid off, i.e., technology risk in a structured manner to third parties?

10 Factors Which Affect the Financing Decision (cont’d)  Is the project in a non-core business segment for the developer, where the shareholders and financial markets would expect the company’s exposure to be limited?  Is the size of the financing requirement too small to attract the interest of project finance lenders, who are unlikely to consider a transaction where the debt component is less than about $ million, unless there are special factors which affect the bank’s decision such as loan guarantees  DOA  DOE  BIA

11 The Project Contracts  The commercial contracts form the basis of the security structure which creates the project cash flow and hence underpins a project financing. For renewable energy projects, the typical principal contracts are:  Power purchase agreement  Engineering, Procurement and Construction Agreement (may be separated into more than one agreement)  Fuel or waste supply contract (if required)  Operating Agreement  Shareholders (or joint-venture) agreement

12 Summary of Tax Incentives  Investment Tax Credit  Production Tax Credit  1603 Treasury Grant  Tax Credits vs Grant  Monetizing the ITC  Tax-Exempt Use Property Issues  New Markets Tax Credits

13 ITC  The investment tax credit (“ITC”) is a federal income tax credit equal to 30% of the tax basis of property which generates electricity from certain renewable sources. IRC §48.  No cap on amount of credit.  100% of the ITC is claimed in the tax year that the property is placed in service (i.e., when property is producing electricity).

14 ITC (cont’d)  2009 Stimulus bill deleted provision reducing the ITC by the amount of grants, tax-exempt bonds and subsidized energy financing.  Because the credit is calculated based on the tax basis of property, the credit would thus be reduced only by grants, etc. that are not taxable. See IRC §§118; 362(c).

15 ITC (cont’d)  5 year graduated recapture period. IRC §50(a)(1). If the property ceases to be used to produce electricity within: The recapture percentage is: (i) One full year after placed in service: 100% (ii) Two full years after placed in service: 80% (iii) Three full years after placed in service: 60% (iv) Four full years after placed in service: 40% (v) Five full years after placed in service: 20%

16 ITC (cont’d)  Claiming the ITC results in a reduction in tax basis of renewable property equal to 50% of amount of grant (50% * 30%). IRC §50(c)(1) & (c)(3)(A).

17 PTC  The production tax credit (“PTC”) is a federal income tax credit of 2.1¢ (adjusted annually) per kilowatt hour of electricity produced over a 10 year period. IRC §45(a).  PTC requires electricity be produced by the taxpayer (i.e., no leasing). IRC §45(a)(2)(A).  PTC requires power to be sold to a third party. IRC §45(a)(2)(B).  Notice looks to the ultimate buyer of electricity to determine who is the third party (i.e., a customer of a public utility rather than the utility itself).  No such requirement for the ITC or the 1603 Grant, permitting net metering projects where the project owner uses the electricity.

18 PTC (cont’d)  Reduction of credit for grants, tax-exempt bonds, subsidized energy financing and any other credit allowable with respect to any property part of the project. IRC §45(b)(3).  Reduction is lesser of 50% or the ratio of the other financing to aggregate project costs.  Likely causes a reduction of the tax basis of the project when the PTC is coupled with new market tax credit financing, loan guarantees or other programs resulting in financing terms better than market rates. See IRS Form 6497.

Treasury Grant  Created under Section 1603 of the 2009 Stimulus Bill to be substantively similar to the ITC but paid as a grant.  Federal grant equal to 30% of the tax basis of property which generates electricity from certain renewable sources. ARRA §§1603(a) & (d).  No cap on amount of grant.  The grant can be claimed in lieu of either the ITC or the PTC. IRC §48(d)(1).

Treasury Grant (cont’d)  Not available for pass-through entities with a tax-exempt owner (including Indian tribal governments). IRC §54(j).  Generally tracks terms of the ITC.  5 year recapture. ARRA §1603(f); IRC §50(a)(1).  Causes reduction in tax basis of renewable property equal to 50% of amount of grant (50% * 30%). ARRA §1603(f); IRC §50(c)(1) & (c)(3)(A).

Treasury Grant (cont’d)  Not taxable to the project. ARRA §1603  Grant is paid within later of (a) 60 days of application or (b) the date the project is placed in service. ARRA §1603(c).  Application must be submitted by October 1, ARRA §1603(j).  Project must be placed in service by December 31, ARRA §1603(a)(2).

22 Monetizing the ITC Q: How can Project Developer monetize the ITC while ultimately owning the solar project? A: Partnership structure.

23 Monetizing the ITC (cont’d)  The project is owned by an entity taxed as a partnership (i.e., an LLC).  The LLC is initially owned by the developer.  A tax credit investor purchases an equity interest in the LLC from the developer. The developer retains a minority interest in the LLC.  LLC governing agreement provides 90%+ of tax items (including tax credits) which are allocated to the investor, with the remaining less than 10% interest allocated to the developer.

24 Monetizing the ITC (cont’d)  The developer holds an option to acquire the interest of the tax credit investor.  The option is exercisable after a period of time that is: 1.necessary for the developer to obtain a negotiated return on investment and 2.after any tax credit recapture period expires.  The option exercise price must be equal to the then-fair market value of the tax credit investor’s interest or else the IRS may recalculate the investor’s ownership percentage, jeopardizing the investor’s allocation of tax credits.

25 Tax-Exempt Use Property  Solar and wind equipment (i.e., electric generating equipment up to the transmission stage) generally is depreciated over a 5- year, double declining balance depreciation. IRC §168(e)(3)(B)(iv).  When property is “tax-exempt use property,” such property is required to be depreciated using the straight line method over a 40 year useful life. IRC §168(g)(2).

26 Tax-Exempt Use Property (cont’d)  All or a portion of property owned by a partnership with a tax- exempt partner may be tax-exempt use property. IRC §168(h)(6)(A).  If allocations to the tax-exempt partner are “qualified allocations,” then property owned by the partnership will not be tax-exempt use property. IRC §168(h)(6)(A)(ii).

27 Tax-Exempt Use Property (cont’d)  “Qualified allocations” are allocations that both: 1.Are consistent with the tax-exempt partner being allocated the same (i.e., identical %) distributive share of each tax item and such share remains the same throughout the life of the partnership, and 2.Have “substantial economic effect” IRC §168(h)(6)(B); Treas. Reg. §1.168(j)-1T (Q&A 22).  Partnerships with (i) tax-exempt partners and (ii) a “flip” structure have tax-exempt use property because of the varying ownership % of the tax-exempt partner.

28 New Markets Tax Credits A.Credits are allocated by the Community Development Financial Institutions Fund (“CDFI”), an arm of the US Treasury Department. B.The credits are allocated to Community Development Entities (“CDEs”). C.The CDEs don’t use the credits – rather the CDE will monetize the credits by selling equity of the CDE (or a pass-through CDE subsidiary) to a tax credit investor. D.The CDE is required to invest the investor’s proceeds to an active business located in a low-income community (referred to as a “qualified active low income community business” or “QALICB”).

29 New Markets Tax Credits (cont’d) D.The investment in the QALICB must take the form of debt or equity and is referred to as a “qualified low-income community investment” or “QLICI.” E.The credits are claimed by the investor in the CDE over a 7 year period. F.The tax credit thus allows lenders to reduce the interest rate on the funds below market, and under certain structures forgo repayment of a portion of the principal.

30 New Markets Tax Credits (cont’d) G.The program requires the investment in the QALICB remain outstanding over the 7 year period.  Failure to do so results in a recapture of the credit.  This means that the funds may neither be amortized nor prepaid (i.e., no return of capital).  Interest on the funds (i.e., a return on capital) is OK.  The financing is often interest-only with a fixed interest rate with a balloon principal payment in year-7.

31 New Markets Tax Credits - Direct Investment Model CDE tax credit investor $10M equity investment (a) $3,900,000 new market tax credits plus (b) debt service QALICB $10M loan (QLICI)

32 New Markets Tax Credits - Direct Investment Model (cont’d)  Benefit to QALICB is reduced interest rate on QLICI loans.  The principal amount of a loan or equity investment typically expected to be repaid at the end of the investment term.  Often used for smaller projects.

33 New Markets Tax Credits – Leveraged Loan Model CDE tax credit investor $2,730,000 equity investment (i.e., $10M * 39% * 70%) (assumes investor pays 70¢ per credit) (a) $3,900,000 new market tax credits plus (b) interest payments on “B” Note QALICB $10M equity investment Investment LLC Bank (“leveraged lender”) $7,270,000 loan (at market rate terms) (“Leveraged Loan”) 100% Loan 2: “A” Note $7,270,000 at market interest rate Loan 1: “B” Note $2,730,000 at discounted interest rate

34  The “A” note (at market interest rates) is typically paid off or refinanced at the end of year 7.  The “B” note (at below market interest rates) is forgiven through a put (at a de minimis price) and a call (at a market price) in year 7.  Leveraged loan structure allows tax-credit equity component to be “written off” after 7 years.  Tradeoff is that the “A” note bears interest at market rates.  The interest on the “A” note can be reduced through applicable loan guarantees. New Markets Tax Credits – Leveraged Loan Model (cont’d)

35  The leveraged loan model enables the leveraged loan to be taken into account in calculating the new market tax credits available to the tax credit investor.  This structure was sanctioned by the IRS in Revenue Ruling  The leveraged lender may not have a direct security interest in the QALICB assets.  The “security” for the leveraged lender is indirect (i.e., the CDE loans to the QALICB can be secured by QALICB assets).  The leveraged lender can not be an equity owner of the QALICB.  Revenue Ruling expanded this structure to permit the leveraged loan to be either recourse or nonrecourse. New Markets Tax Credits – Leveraged Loan Model (cont’d)

36 Questions ? Geoffrey R. Morgan Michael Best & Friedrich LLP Office: Cell: LinkedIn: Twitter: Geoff_Morgan michaelbest.com/grmorgan