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Solar Project Financing Structure Comparison for Tax Equity Investors

Solar Project Financing Structure Comparison for Tax Equity Investors

By far the most common financing structure we see for solar tax equity is the power purchase agreement (PPA). That appears to be changing, however, as solar leases become more common. Though there is ample information available to solar customers about how various financing options compare, solar tax equity investors should also take time to understand the various forms of financing.

Customer’s Viewpoint

Generally speaking, there are three ways for a customer to purchase solar electricity: purchase, PPA and lease. In the case of a purchase, the customer owns the system and receives any tax credits and depreciation. The customer also pays for all maintenance and repairs. The biggest drawback to a purchase, of course, is the high upfront investment, which can be mitigated somewhat with a loan. A loan reduces the upfront out-of-pocket cost, but some electricity cost savings are lost to interest expense.

A solar PPA allows the customer to avoid upfront costs and instead purchase solar electricity on a per kWh basis at a contracted price. Operating and maintenance is the responsibility of the system owner, who also receives the tax benefits. The per kWh price is typically subject to fixed escalations and therefore increases over time.

A solar lease shares many characteristics of a PPA. A lease allows the customer to avoid upfront costs and outsource the burdens of maintenance and repairs. Unlike a solar PPA, lease payments aren’t based on the amount of electricity produced. In addition, lease payments tend to be fixed over time rather than escalate.

A recent wrinkle in the lease structure for customers who have capital available to purchase the system, but who can’t utilize the ITC is the prepaid lease. With a prepaid lease, the customer pays the present value of lease payments up front, but ownership of the project (including tax credits and depreciation deductions, as well as maintenance and repairs responsibility) remains with the owner.

A comparison chart of the three financing structures is shown below:

Customer benefitOwn systemNo cash outlay, low monthly paymentsNo cash outlay, low monthly payments
Monthly paymentNone, unless financed with a loanYes, with annual escalationsYes, fixed over time
Maintenance and repairsCustomerInvestorInvestor
Tax creditsCustomerInvestorInvestor
Finance / Investor Considerations

When we look at the various financing structures from an investor perspective, a couple important distinctions become clear. First, in the case of a purchase, the customer is the owner and there’s no role for outside financing unless the customer uses a loan. Customer solar project purchase financing is readily available from several sources and relatively easy to obtain and inexpensive if the customer has good credit.

When considering a PPA compared to a lease, the most important distinction is that with a PPA, the production risk remains with the owner whereas with a lease the production risk is assumed by the customer. This risk transfer, however, is not free: PPA structures typically have annual per kWh rate escalations while leases do not escalate.

Tax Equity Considerations

This production risk distinction between a PPA and a lease is most relevant to the long term owner, rather than to the tax equity investor. Most tax equity investments share in operating cash flow only to the extent of a preferred return, and are thus insulated from production risk of a PPA. In addition, the ownership term at five to six years is too short to truly benefit from compounding of the escalations.

A prepaid lease, on the other hand, is quite different for the tax equity investor. Recall that in a prepaid lease the customer pays the owner the present value of future lease payments up front. This prepayment is considered income for Federal tax purposes and is offset by depreciation deductions. There is no additional cash flow to the owner from the customer, so there’s no preferred returns to the tax equity investor. Similarly, there’s no payment from the sponsor to the tax equity investor to redeem the tax equity interest. The tax equity investor in a prepaid lease makes all of its return from the ITC, which is taken in the first year. Thus, tax equity for a prepaid lease is sold at a discount to the amount of the ITC rather than at a premium as for PPAs and leases.

The table below compares the tax equity investment for a PPA or a lease to a prepaid lease:

PPA / LeasePrepaid Lease
Tax CreditsInvestorInvestor
DepreciationAllowable to the extent of basisOffset by prepaid lease income
Preferred cash flowYesNo
Redemption paymentYesNo
Price115% to 125% of tax credit75% to 85% of tax credit
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