1. TRENDS IN FINANCING AND INVESTMENT IN RENEWABLES James F. Duffy, Esquire Nixon Peabody LLP 100 Summer Street Boston, MA 02110-2131 (617) 345-1129 jduffy@nixonpeabody.com RENEWABLE ENERGY IN NEW ENGLAND Law Seminars International Boston, Massachusetts September 8-9, 2008

2. 2 PROJECT FINANCE This panel will focus on project finance, as opposed to company finance Both project finance and company finance are, as the seminar brochure suggests, “booming” but project finance for renewables is different than from other project finance, so it deserves special attention and special discussion

3. 3 PROJECT FINANCE Project finance for most renewable facilities is heavily tax driven The tax considerations are the primary drivers in financing these transactions Tax equity investors are a somewhat special type of investor, and their motivations and goals have to be understood

4. 4 TAX EQUITY INVESTORS Tax equity investors are generally (but not always) institutional investors -- banks, investment banking firms, insurance companies, and “companies that advertise on the Super Bowl” The investments addressed here are not traditional investments in companies or in projects, but investments in the tax attributes of renewable energy facilities

5. 5 INVESTOR MOTIVATIONS Tax equity investors in renewable energy are generally motivated by a combination of policy and economic reasons Investing tax equity in renewable energy is both “good” AND economically advantageous

6. 6 RENEWABLE ENERGY IS “GOOD” This is self-evident to some, including most or all of us here in this room, but increasingly corporate America is looking to be “green”, whether or not the corporation’s leaders believe in global warming Depending on the corporation’s situation and markets, the incentives can differ somewhat, but the policy motivations for tax equity investors generally have many common themes

7. 7 POLICY CONSIDERATIONS Green investments are viewed favorably by customers/suppliers/the public at large Green investments generate good press for companies beyond the investments themselves Government policies favor investments in renewable energy -- today this applies particularly to utility companies, but will spread (i.e., the recent federal real estate statute)

8. 8 POLICY CONSIDERATIONS Stockholders of public companies clamor for “green” Company leaders may be “true believers” in green OR in the nation’s need for energy independence Employees like to work for environmentally responsible companies Investments in green energy can be publicized to offset other not-so-green corporate activities

9. 9 ECONOMIC MOTIVATIONS Tax equity investors generally have an internal rate of return to achieve in making investments in renewable energy There are 3 components to this rate of return: – Tax Credits; – Losses to offset the investor’s income from other sources; and – Cash returns

10. 10 ENERGY TAX CREDITS There are two basic types of tax credits for renewable energy: Production Tax Credits (“PTCs”) for renewable electricity production, under Section 45 of the Internal Revenue Code Investment Energy Tax Credits (“ITCs”), under Section 48 of the Internal Revenue Code Each of the PTC and the ITC is a dollar-for-dollar reduction in Federal income tax liability

11. 11 PRODUCTION TAX CREDITS Available with respect to electricity produced from “qualified energy resources”: – Wind; – Closed-loop biomass; – Open-loop biomass; – Geothermal – Solar (but only if placed in service prior to 1/1/06); – Small irrigation power; – Municipal solid waste; and – Qualified hydropower production.

12. 12 PRODUCTION TAX CREDITS The Production Tax Credit is currently (for 2008) 2.1 cents per kilowatt hour of electricity produced by the taxpayer and sold to an unrelated person, for a 10- year period beginning on the date the facility was originally placed in service So, the amount of tax credits depends upon the amount of electricity generated

13. 13 PRODUCTION TAX CREDITS The 2.1 cents per kilowatt hour is reduced to by 50%, to 1.05 cents per kilowatt hour, for the following facilities: open-loop biomass, small irrigation power, landfill gas, trash combustion and qualified hydropower

14. 14 PRODUCTION TAX CREDITS The “Produced by the Taxpayer” requirement means that the owner of the energy facility receives the PTCs – subject to an exception for lessees of certain open- loop biomass facilities to receive the PTCs So, the PTCs are generally syndicated to a tax equity investor who becomes a partner or member of the entity owning the energy facility

15. 15 SYNDICATING THE PTCs You can’t just sell PTCs to a tax equity investor; you have to make the “purchaser” of the PTCs an owner of the wind project Most developers of renewable energy projects either: (i) do not anticipate having Federal income tax liability for the next 10 years such that they will be able to take advantage of the PTCs themselves, or (ii) need to monetize the PTCs up front in order to help pay for the costs of developing the project

16. 16 SALE OF THE ENTIRE PROJECT One option is that at or just before the date when a wind project is placed in service, the developer will sell the entire wind project to a purchaser who will then own the project and receive the PTCs Under this scenario, the value of the PTCs is one component of the total purchase price paid for the project

17. 17 SALE OF THE ENTIRE PROJECT Also, under this structure, the original developer generally gives up control of the project Particularly in a community-oriented project, the original developer may not want to give up control of the project, as the original developer is generally a part of the local community

18. 18 BACK TO SYNDICATING THE PTCs Section 45(e)(3) of the Internal Revenue Code anticipates that the owner of a project may have more than one owner Section 45(e)(3) provides that if a project has more than one owner, the PTCs will generally be shared by the owners in proportion to their respective ownership interests in the “gross sales” from the facility

19. 19 SYNDICATING THE PTCs One way to structure a transaction so that there is more than one owner for tax purposes is to utilize, as the owner of the renewable energy project, a limited partnership or a limited liability company For tax purposes, a partnership (which includes a limited liability company) is not recognized as a tax- paying entity, so that the partners are treated as owners according to their allocable interests in the partnership

20. 20 SYNDICATING THE PTCs The original project developer can structure the legal owner of the project as a limited partnership or an LLC, and the tax equity investor who is interested in the PTCs can be a limited partner or member thereof and thus an owner of the project for tax purposes The owner can then allocate almost all (up to 99%) of the PTCs to the tax equity investor

21. 21 SYNDICATING THE PTCs The original developer can remain in control of the project by being the general partner of the partnership (or the managing member of an LLC) But, remember that the PTCs are shared between the owners in proportion to their shares of “gross sales” So, in my example the investor would generally have to receive a 99% interest in the gross sales of the project

22. 22 SYNDICATING THE PTCs However, the developer, as the general partner of the limited partnership, can receive a reasonable fee for managing the project The original developer could also receive a reasonable development fee for developing the project, and to the extent that there were insufficient sources of funds to pay that fee up front, some of it could be deferred and paid out of operating revenues

23. 23 SYNDICATING THE PTCs Debt on the project could be paid prior to reaching the 99-to-1 sharing ratio Where the developer has contributed capital to the limited partnership to fund the gap between the total development costs and the amount of the investor’s capital contribution, under Rev. Proc. 2007-65 (more on that later) the developer’s capital contribution can be returned as a priority cash flow item prior to the 99-to-1 sharing ratio

24. 24 SYNDICATING THE PTCs The developer could borrow outside the partnership to obtain this capital, possibly pledging its interest in the partnership as collateral The investor’s payments can be characterized entirely as capital contributions to the owner limited partnership or they can be characterized partially or entirely as a purchase price for the investor’s interest in the owner limited partnership

25. 25 99% Limited Partner (Investor)1% General Partner (Developer) Limited Partnership (Owner) Project

26. 26 SYNDICATING THE PTCs At some point after the end of the 10-year PTC period, there could be a ”flip” to give the general partner (the developer) a greater percentage interest (up to 95%) in the project’s cash flow (or gross sales) And at some point after the 10-year PTC period (or after the investor has achieved a targeted IRR yield), the general partner/developer could have an option to buy out the limited partner/investor’s interest at the fair market value of that interest (generally post-flip)

27. 27 SYNDICATING THE PTCs The tax equity investor’s payment can be made up- front, so that it can be used as owner’s equity in the development process, or (more likely) upon completion to pay off development period financing The investor could pay most (up to 80%) of its funds on a pay-in schedule of up to 10 years, as PTCs are delivered (a “pay-as-you-go” plan), but at least 75% of the investor’s reasonably expected investment must be fixed and determinable and not contingent

28. 28 SYNDICATING THE PTCs These are just general concepts. The terms of the syndication of the Production Tax Credits from each project will vary, based in part upon the economics of the particular transaction

29. 29 SYNDICATING THE PTCs Because of the sophisticated tax structuring involved, there will be not insignificant legal and accounting costs in each of these transactions, so it may not be as cost- efficient to syndicate the PTCs in this manner for smaller projects, unless (i) the investor is a community-oriented company willing to make a relatively small investment, (ii) a smaller project can be pooled with other similar projects to provide a larger investment to cover the transaction costs, or (iii) a smaller project can take advantage of favorable financing not generally available to larger projects

30. 30 AGGREGATING PROJECTS In the model shown on the chart on the following slide, each relatively small project can be structured based upon its own economics and can negotiate its own business deal with the investment fund

31. 31 Project D Project C Project A 99% Limited Partner(s) (Investor(s)) 1% General Partner (Syndicator) 99% Limited Partner(s) (Investment Fund) 1% General Partner B (Developer) 1% General Partner C (Developer) 1% General Partner D (Developer) Limited Partnership A (Owner) Limited Partnership B (Owner) Limited Partnership C (Owner) Limited Partnership D (Owner) Project B 1% General Partner A (Developer)

32. 32 AGGREGATING PROJECTS With aggregation, the investor benefits from diversification of sponsor and energy regime, and perhaps off-taker, compared to an investment in one large project To keep down transaction costs, the same base documentation can be used as the starting point for each project

33. 33 AGGREGATING PROJECTS Facilitating these structures is an area where the states and public advocacy groups could be very helpful States and institutional non-profits have done this in the housing tax credit area to facilitate the syndication of those tax credits

34. 34 PTC POINTERS The PTC is reduced by up to 50% to the extent that project costs are funded by (i) federal, state or local government grants for use in connection with the project, (ii) the proceeds of state or local tax-exempt obligations, (iii) subsidized energy financing provided directly or indirectly by federal, state or local programs or (iv) other credits allowable with respect to any property which is part of the project

35. 35 PTC POINTERS For the first 4 years of the 10-year PTC tax credit period, PTCs can be applied to reduce the investor’s Alternative Minimum Tax The amount of the PTC, currently 2.1 cents per kilowatt hour of electricity generated, is re-calculated by the IRS for each year of the PTC period of a facility (it was 1.9 cents per kilowatt hour for 2006 and 2.0 cents per kilowatt hour for 2007)

36. 36 PTC POINTERS PTCs are received by the taxpayer as they are earned, so there is no recapture risk to a tax equity investor if the investor sells its PTC investment during the 10-year PTC period (this is an advantage over many other tax credits where there is a tax credit recapture risk if the investment is disposed of during the tax credit period)

37. 37 REVENUE PROCEDURE 2007-65 Revenue Procedure 2007-65 (effective November 5, 2007) gives guidance in structuring wind energy transactions (although it is also taken into consideration in PTC transactions which do not involve wind projects) This is a “safe harbor”, but be very wary of not following it

38. 38 REVENUE PROCEDURE 2007-65 In order to comply with Rev. Proc. 2007-65, the developer must have a minimum 1% interest in each item of partnership income, gain, loss, deduction, and credit throughout the term of the partnership Also, an tax equity investor’s interest cannot “flip” down to less than 5% of its initial interest

39. 39 REVENUE PROCEDURE 2007-65 Under Rev. Proc. 2007-65, there are no calls (developer’s rights to buy out the tax equity investor’s interest) in the first 5 years, and no puts (tax equity investor’s rights to require the developer to buy out the tax equity investor’s interest) at all Any calls must be for not less than the fair market value of the interest involved

40. 40 REVENUE PROCEDURE 2007-65 In order to comply with the Rev. Proc., as of the later of the project’s placed in service date or the investor admission date, the investor must have at least 20% of its total anticipated capital invested in the partnership Also, at least 75% of the investor’s capital must be not subject to adjusters

41. 41 INVESTMENT TAX CREDITS ITCs are available, generally, for energy property using solar energy to generate electricity, to heat or cool (or provide hot water for use in) a structure, or to provide solar process heat (except for swimming pools), or to produce, distribute or use solar energy to illuminate using fiber-optic distributed sunlight, or qualified fuel cell property, or qualified microturbine property So this is a generally described as a solar energy tax credit -- Photovoltaic “PV” and Concentrated Solar Power (“CSP”), but also includes fuel cells

42. 42 INVESTMENT TAX CREDITS As an investment tax credit, the credit is based on the cost of the facility, not on how much electricity is produced There is no requirement that electricity be sold, just that the facility generate electricity, heating, cooling or lighting

43. 43 INVESTMENT TAX CREDITS The credit is generally 30% of the cost of the “facility” (which does not include ancillary aspects like transmission lines and substations) The credit is claimed in the year the facility is placed in service in daily operation (although in certain circumstances it could be claimed based on “progress expenditures” over more than one year) Recapture possible for 5 years (credit vests 20% per year)

44. 44 INVESTMENT TAX CREDITS ITCs are generally claimed by the owner of the solar facility, so the tax equity investor generally becomes a part owner of the facility and the ITCs are syndicated in a manner similar to the syndication of PTCs Unlike the situation with wind and most PTCs, a lease can be used so that the tenant claims the ITCs

45. 45 TAX-EXEMPT OWNERSHIP CONSIDERATIONS One complication for installations on property owned by governmental or tax-exempt entities is the existence of the so-called “tax-exempt use” rules Essentially, the tax credits are not available to the extent that the energy property is used by a tax- exempt entity (such as a government or a non-profit school, hospital, etc.) So, the government or other tax-exempt entity cannot own, or to protect 100% of the tax credits, have an ownership interest in, the energy facility

46. 46 TAX-EXEMPT OWNERSHIP CONSIDERATIONS The tax-exempt entity can purchase the electricity from the owner of the energy facility So, at least for the duration of the tax credits, the tax- exempt entity cannot be an owner of the facility And the transaction cannot be structured so that the tax-exempt entity would be considered an equity owner from the beginning (for example, no right to buy the facility for $1 down the road)

47. 47 DEPRECIATION DEDUCTIONS Facilities are generally depreciated over 5 years (5- year MACRS), so losses accumulate quickly For facilities placed in service in 2008, under the economic stimulus act, 50% of the facility can be depreciated in 2008

48. 48 CASH FLOW Project Cash Flow generally comes from two sources: Payments for electricity, generally through a power purchase agreement or by merchant sales Monetization of renewable energy certificates (RECs) In some states there are also state incentives or grants which subsidize construction or operations

49. 49 CASH FLOW The cash returns to a tax equity investor can vary greatly, as some properties produce significant cash flow while others do not The tax equity investor generally only wants to remain in the transaction for the duration of the tax benefits, 10 years for PTCs and 5 years for ITCs After the tax benefit period, it is generally intended that the tax equity investor exit the transaction

50. 50 CASH FLOW One common exit strategy is for the tax equity investor’s interest to flip down from 99% during the tax benefit period to, 5-10% after it has received aggregate benefits (tax credits, depreciation losses and cash flow) equal to the investor’s negotiated internal rate of return hurdle The project developer can often then have a call to buy out the tax equity investor’s remaining 5-10% interest at its then fair market value, generating additional cash on exit for the tax equity investor

51. 51 RETURN TO TAX EQUITY INVESTOR The return to the tax equity investor is a combination of the PTCs or ITCs, the depreciation losses, and the cash flow As a result the financial models for the facility are closely scrutinized for each transaction The equity contributed by the tax equity investor constitutes a significant portion of the facility’s funding sources

52. 52 EXTENSIONS OF THE PTC AND THE ITC Under current law, a facility must be placed in service and be in daily operation prior to January 1, 2009 or PTCs go away and ITCs reduced from 30% to 10% – Credit extension legislation is under consideration now in the Congress – Many financings will close in 2008, but developments scheduled for 2009 are being delayed due to uncertainties as to the status of the tax credits in 2009

53. 53 NEW MARKETS TAX CREDITS One federal incentive which can be used by renewable energy projects located in certain census tracts is New Market Tax Credits New Market Tax Credits are designed to promote investment in communities in need of economic revitalization

54. 54 NEW MARKETS TAX CREDITS New Markets investors receive a federal income tax credit (39% over 7 years) for making qualified equity investments in designated Community Development Entities (CDEs) The CDEs could then invest in or lend to renewable energy projects The net result of utilizing New Markets Tax Credits is often a lower interest rate on project debt and a partial forgiveness of the debt after the 7-year New Markets period

55. 55 NEW MARKETS TAX CREDITS New Market Tax Credits are somewhat complicated, but taking advantage of them can help fund project costs Large scale renewable energy projects generally do not utilize New Markets Tax Credits because New Markets Tax Credits do not generally work well with larger projects due to the size of the typical award of New Markets Tax Credits

56. 56 CREBs In certain situations, an alternative to PTCs or ITCs can be Clean Renewable Energy Bonds (“CREBs”) CREBs come under Section 54 of the Internal Revenue Code, which was added in 2005 CREBs were designed to provide an incentive for governmental bodies (including Indian tribes) and cooperative electric companies to produce renewable energy

57. 57 CREBs CREBs are “tax credit bonds” The borrower gets a 0% loan, as the Federal Government pays interest on the bonds in the form of a tax credit to the bond holder

58. 58 CREBs A total of $1.2 billion of CREBs was authorized to be allocated in 2 rounds, in 2006 and 2007 (See IRS Notice 2007-26) These CREBs have now been allocated and, under current law, all of these CREBs must be issued by December 31, 2008

59. 59 CREBs CREBs were allocated to qualifying and approved applicants beginning with the project with the smallest dollar amount of volume cap requested and then the next-smallest dollar volume cap, until the volume cap was exhausted (after allowing for minimums to be allocated to munis and coops) An extension of, with modifications to, the CREBs program is now before the Congress and is expected to be enacted later this year or early next year