From Knowledge@Wharton, March 11:
Tax equity investors in wind and solar projects can benefit at the expense of cash equity promoters, and this skews investment attractiveness, a new paper finds.
Tax credits are meant to spur investments by increasing returns for investors. But it turns out that with wind and solar energy plants, these credits can create distortions in their performance and value, according to a recent paper titled “Power Banks: Do Tax Equity Investors Add Value to Renewable Power Projects?” by finance professors Daniel Garrett at Wharton and Sophie Shive at the University of Notre Dame.
The authors studied the performance at 652 tax equity-financed wind and solar power plants in the U.S. from 2006 to 2024; essentially, they tracked electricity production scaled by total capacity, called the “capacity factor.” The wind plants in the study sample posted increases of between 6% and 9% in capacity utilization when financed by tax equity.
The study revealed that wind plants financed by tax equity investors increased capacity utilization because those investors brought sharper monitoring and contracting skills, and not because of reduced financial constraints or better project selection. With solar plants, production quantity is not a factor in determining tax equity returns.
Distortions Caused by Tax Equity
Tax equity structures are set up as special purpose vehicles (SPV), which bring together the project sponsor and a tax equity investor — usually a large bank — to extract the available tax credits. The bank’s role is also to ensure that the project is certified and that it operates the way Congress intended it to and that it wouldn’t be a fraudulent operation, Garrett said.
The study found outcomes that were markedly different from the original intent. “When you encourage these structures and bring in a tax equity investor, the tax equity investor will change the operations of the firm in a way that makes the equity claim of everyone else worth a little bit less through real operational changes,” Garrett said. “Tax equity investors care much less about the long-run equity value of the firm, because their claim to the firm is primarily on the short-run cash flows.”
“We find a real operational change in how these plants function with the presence of tax equity,” Garrett said. “The distortion from bringing in a tax equity investor is bigger than the price you pay them through a return. They invest 45% or 50% of the plant’s capital and get a 7% return on their capital until the end of their 10-year holding window in a wind plant.”....
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