In the public market, ESG investing is affecting capital. The largest fund managers have dedicated ESG funds and analysts, and they are making allocation decisions based on ESG scores and the principles of public companies. Now, the amount of ESG assets under management in the US has climbed 42%.
Asset allocation in the debt and equity markets has climbed, and investment-grade companies are doing most of the green issues. By the midpoint of 2020, capital flows had accelerated, along with valuations, amid a very active M&A market. This surge began before the broader market started pricing in the change of administrations at the federal level, and then it became supercharged. Right now, valuation premiums are highest in the EV segment.
In this environment, tax equity has become an important way to bring in capital to construct a project from an entity that wants to put its tax capacity to efficient use — an arrangement that has existed for decades in real estate but has since evolved into the renewables space. In other words, the companies that have the skill set to build and operate such a project, such as a solar developer, can’t necessarily use the tax benefits to the same extent as, say, a bank or larger corporation with a tax liability. Tax equity involves structuring partnerships and leases to effectively transfer partial ownership that’s generating favorable tax attributes to another entity that can use them, for a raise that might be 40% of the typical project cost in a solar deal, for example. The typical structure is one that persists as long as the tax attributes do — maybe six or seven years for a solar project, driven by the five-year investment tax credit recapture period. In wind, with a 10-year window, such deals are perhaps 11 to 12 years. Note that, as refundable tax credits potentially change, the tax equity market should evolve as well.
Players should take a thoughtful approach, particularly if they are newer entrants and don’t fully understand the risk profile. “A leading practice is to take a step back and ask: Which part of the market should I play in? Do I need a partner? Do I need tax equity?” said Stephanie Chesnick, Strategy and Transactions Principal with Ernst & Young LLP. “Take the time to model out the economics. When you’re investing capital in an area where you haven’t in the past, modeling it out can be more challenging. Do this before you have an investment opportunity in front of you — you need to be ready to move.”