| Using tax policy to promote green investment |
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| Tax policy could be critical to foster the investment needed to achieve Ireland’s climate change commitments and financial institutions could play a pivotal role in such investment, says Mike Hayes. |
Role of tax policy
The recent publication of the Stern Report has underlined the profound impact that fossil fuel emissions will have on society both in human and economic terms. Climate change is now very much an economic issue as much as an environmental one and the issue of carbon finance is clearly going to play a significant role in the success or failure of the Irish economy over the next number of years.
Under the Kyoto protocol, the EU agreed to achieve a significant reduction in total greenhouse gas emissions in the period 2008 – 2012. Ireland’s contribution to the EU commitment is to limit its greenhouse gas emissions to no more than 13% above 1990 levels. This clearly represents a very significant challenge for the Irish economy. Also, the Department of Communications, Marine and Natural Resources produced a Green Paper some months ago – Towards a Sustainable Energy Future for Ireland – which sets out a government objective of producing 15% of our total energy needs from renewable sources by 2010 with this increasing to 30% by 2020.
The extent of this commitment should not be underestimated. To achieve this, considerable investment in risk capital will need to be made from the private sector. We would estimate that the total investment (in present value terms) required to meet the Green Paper target will be in excess of €3 billion.
My view is that tax policy can be used in a much more meaningful way in helping to achieve our long term commitments to the development of renewable energy in this country and in this regard, financial institutions have a key role to play. It is useful to look at the role which tax policy has played in other jurisdictions in helping investment into renewable energy projects. An excellent example is the manner in which the US has used tax incentives to drive the growth in the wind power industry in recent years.
US experience
The specific incentive measures in the US, which were reintroduced in 2005 (and now look set to be extended into 2009 and beyond) consist of production tax credits (‘PTCs’) and accelerated depreciation deductions (‘MACRs’).
Where electricity is produced in an environmentally friendly manner such as with windpower, the producer is entitled to a PTC for the first ten years of operation (1.9c per kWh). The amount is adjusted annually using an inflation adjustment factor published by the IRS. The PTC is available for each taxable year for a 10 year period and begins on the date the project is placed in service.
MACRs are available to projects in respect of the capital expenditure incurred to construct a windfarm.
These tax benefits are of little use to windfarm developers who are incurring significant capital costs and are unlikely to pay any federal income tax for many years. What has revolutionised the wind industry in the US however is the fact that structures have been developed to monetise the PTC and the MACRs resulting in a very cheap and available form of equity finance and financial institutions have played a leading role in this area. The availability of this ‘tax equity’ also assists the developer in drawing down construction finance and senior debt facilities once the project has become operational.
The typical structure involves an equity investment by a financial investor into a partnership that owns the wind power project. The equity interest in the partnership can be structured so that the financial investor initially receives a large percentage of all cash distributions and tax benefits from the project including the PTC and MACRs. Once the financial investor has received the agreed upon after-tax return, the equity sharing ratios would typically flip so that the investor receives a smaller portion of cash distributions and tax benefits and the developer receives the larger portion. The key point is that much of the return required for the investor to meet its target IRR is delivered through the tax credits and from the availability of accelerated tax depreciation (both of which can be offset against the investor’s federal tax liability on other income) thereby reducing the investor’s exposure to the project.
Since these reliefs were reintroduced in their current form in 2005 in the US, there has been a significant upsurge in the number of windfarm developments in that country to such an extent that there has been a significant supply shortage of turbines as manufacturers did not anticipate the impact of the tax changes. For example, with no PTC in place for most of 2004, US wind development decreased dramatically to less than 400 MW. With the PTC reinstated, 2005 represented the best year ever for a US wind energy development with 2,431 MW of capacity installed with a further 2,454 MW installed in 2006.
Many of the leading US financial institutions have participated in these transactions which in substance amounts to a highly effective and cheap form of financing for both US and non-US windfarm developers who are constructing wind farm projects in the US. There are also similar reliefs in the US in the area of biofuels production (tax credits and excise reliefs).
The US is just one example of where tax reliefs have been used very effectively to promote Green Energy Investment. However, there are many other examples including Canada (specialised lease structures to pass the capital allowances benefits onto individual and corporate investors) and the Netherlands where a system of additional tax credits/accelerated depreciation is available to encourage financial institutions to invest in green projects.
Ireland - current position
At present, there is only a limited form of tax relief available to incentivise corporates to invest in renewable energy companies. This is a relief for equity investment (Section 486b) which can be written off for tax purposes against total income subject to various caps. Given that most Irish corporates would have an effective rate of 12.5% and as the benefit would have to be shared with the investee, this does not represent a significant incentive.
Also, the relief has been hampered by the fact that there are too many onerous conditions and the limits on the amount of relief which can be claimed are simply not appropriate in the context of the large capital costs which arise on renewable energy projects. For these reasons, the relief has only been used sparingly since its introduction with limited interest or involvement by financial institutions. It was hoped that the new BES relief would be more effective in terms of the amount of qualifying capital which a single project could raise.
What can be done?
In my view, if Ireland is to use tax policy to encourage risk capital to invest in renewable energy projects in an effective way, consideration will have to be given to the following:
(a) Introduction of some type of tax credit system along the lines of the US PTC model in such a way that the credit can be monetised. The advantage of having a credit system as opposed to an allowance system is that it removes entirely the impact of the low tax rate in Ireland. Instead, it should be a Euro for Euro relief against a corporate tax liability and therefore would act as a real incentive to some of the larger financial institutions who have a significant Irish tax liability and who wish to undertake ‘green’ investment.
(b) Amending the relief for equity investments by corporates (Section 486B) in order to significantly increase the amount of expenditure which can qualify for relief and again to replace the existing concept of an allowable deduction with a tax credit system.
(c) Removal of the leasing ring fence. This will enable financial institutions who lease wind farming assets to developers to offset the allowances against non leasing income thereby making such structures more efficient.
It is clear that the many interested parties in this process will be pushing strongly for legislative change in Finance Act 2008 and there would be an expectation of support from the EU for any such measures unlike many other tax incentives. However, no matter which changes might take place, it is crucial that the legislators remove any conditions prohibiting the use of a guaranteed return to the financial institutions who might participate in these arrangements.
As discussed above, in the US model, the financial institutions automatically exit from the PTC transactions once their target IRR has been achieved. This is a real commercial requirement in that wind farm developers do not want to pass too much upside to the financial institutions as they are simply providing a form of tax based debt funding. This is not a question of taking risk away from the financial investors as any investment in renewable energy company clearly involves considerable commercial risk whether or not there is a guaranteed return. Any tax investors in these projects would be subordinated to the senior and mezzanine debt providers who clearly believe that there is substantial risk attached to these projects.
Conclusion
To conclude, Ireland has set itself some very challenging targets for the next twelve years in order to reduce our dependence on fossil fuels. It is only by taking action now that we are going to have any realistic hope of achieving these targets and it is my view that tax policy is one (but clearly not the only) solution in helping to achieve this. |
Mike Hayes is a tax partner at KPMG.
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| Article appeared in the September 2007 issue.
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