With strong growth and increasing state and federal incentives, the solar energy industry presents a unique market opportunity for lenders willing and able to maneuver through the regulatory and other hurdles facing the industry. This article will examine the industry’s growth and offer tips for lenders seeking to participate in this active market.

The Growth of the U.S. Solar Energy Market

Favorable federal policies, declining costs and increasing demand for clean energy in both the public and private sectors have resulted in significant growth over the last decade. This growth has continued despite myriad difficulties stemming from the COVID-19 pandemic, such as supply chain issues and labor shortages.

According to the Solar Energies Industry Association, over the last 10 years, the solar energy industry has seen annual growth at a rate of 33%. As a result, more than 140 gigawatts of solar capacity are currently installed throughout the United States,¹ over 255,000 workers were employed in the solar industry as of 2021,² and the value of the U.S. solar market reached $35 billion in 2022.³ It is this unparalleled growth that presents a unique value proposition for lenders.

The Inflation Reduction Act Has Driven More Growth and Laid the Groundwork for Further Increases

The Inflation Reduction Act (IRA),⁴ which was signed into law by President Biden on Aug. 16, 2022, implemented numerous policy changes that have already had a significant impact on the commercial solar market and should play a pivotal role in driving the industry forward for the next few years.

Prior to the IRA, the primary federal tax incentives for solar projects were the Production Tax Credit, the Investment Tax Credit and accelerated depreciation deductions.⁵ The Inflation Reduction Act increased or extended those existing tax credits and also added several new tax credits (energy community, domestic content, and LMI credit).⁶ Many states also provide additional tax incentives. In California, Net Energy Metering (NEM),⁷ and property tax and sales tax exemptions,⁸ provide additional benefits which accelerate the benefits to be captured from qualifying projects. Colorado’s various tax credits, property tax exemptions and rebates for certain solar projects also support increased returns.⁹

The impact of the IRA is clear. Expected solar deployment has increased by over 40% compared to pre-IRA projections, even with persisting supply chain issues in the near term.¹⁰

At the same time, solar adoption by the largest U.S. companies has also rapidly increased, with more than half of all solar capacity installed with commercial and corporate off-takers having been installed since 2020.¹¹ 77% of such new installation capacity since 2020 was in large off-site systems used to power these companies’ operations.¹²

Lenders looking to take advantage of the substantial opportunities in the commercial solar space should be familiar with the complexities of solar project financing.

On top of the dramatic growth to date, the solar energy industry has an untapped capacity for continued and even increased growth. Even with the progress to date, solar still only accounted for roughly 2.8% of U.S. energy generation in 2021, with that number rising to 3.4% in 2022, according to the U.S. Energy Information Agency.¹³

Additionally, based on their current energy expenditures, approximately 70% of commercial buildings in the U.S. could benefit financially from investing in solar systems, but only about 3.5% of commercial buildings in the U.S. had solar as of 2020.¹⁴

Solar financing deals are a mix of potential real estate, personal property, equipment leasing, energy and regulatory issues, so lenders should seek counsel with a team that has expertise in all of these areas.

The Role of Tax Equity Structures

Lenders should first understand how solar projects are structured and the role that tax equity investors play. As a result of federal and state tax incentives, there can be significant value in solar projects for sponsors, but in order to ensure profitability, deals have to be structured in a manner that maximizes this value, which often includes the involvement of a tax equity investor as a key source of funding.¹⁵

The main tax incentives for solar projects are the availability of tax credits. However, tax credits can only be used to offset against profits, and sponsors generally do not generate enough profit to take advantage of these credits.

For this reason, sponsors often turn to tax equity investors. Tax equity investors are typically institutional investors who invest in solar projects in order to take advantage of the tax benefits¹⁶ and do generate sufficient profits to take advantage of the credits. The three primary tax equity structures are sale-leasebacks, partnership flips and inverted leases. There are many variations of these structures, but lenders should understand the key features of the typical structures.¹⁷

In a sale-leaseback, the project company, which is typically a special purpose entity owned by the sponsor, develops and constructs a project and then sells the project to a special purpose entity owned by a tax equity investor. The investor then leases the project back to the project company, and the project company uses the sale proceeds to repay project debt and make lease payments. This structure allows the tax equity investor, as the owner of the project, to claim the Investment Tax Credit and depreciation deductions.¹⁸

In a partnership flip, the project company is owned by a holding company, the membership interests of which are owned by the sponsor and the tax equity investor. The holding company is treated as a partnership for federal income tax purposes, while the project company is treated as a disregarded entity. Thus, the holding company and project company are treated as a single partnership, and as the owner of the project, the partnership is entitled to claim the Investment Tax Credit and the depreciation deductions. The tax credit and deductions, in turn, pass through to the sponsor and the investor, as the partners in the partnership, since the partnership is a flow-through entity.¹⁹

In an inverted lease, an LLC owned by the sponsor develops and constructs the project and then leases it to an LLC that is owned by the tax equity investor. Since both LLCs are treated as disregarded entities for federal income tax purposes, the sponsor is considered the lessor and the investor is considered the lessee. The sponsor makes a pass-through election to allow the investor to claim the Investment Tax Credit, but the sponsor claims the depreciation deductions since there is no similar election for depreciation.²⁰

Dealing With the Recapture Risk of Lender Financing

Since lender underwriting is more concerned with a project’s overall creditworthiness than with specific tax structuring matters, tax equity structures and lender financing are typically compatible from a lender’s perspective.²¹ However, from a tax equity investor’s perspective, lender financing raises what is known as “recapture risk.” Recapture risk refers to the possibility of the IRS claiming that a transaction’s structure is invalid or even an abuse of the tax code, resulting in the IRS recapturing Investment Tax Credits and depreciation deductions, and thus taking away a tax equity investor’s main sources of return on their investment in the project.²² This is particularly significant in lender financing transactions because a key cause of a recapture event is when a party with an interest in the project (such as a secured lender) sells or disposes of its interest in the property (such as in a foreclosure scenario) during the five-year period after the project is placed in service, referred to as the “recapture period.”²³

Thus, tax equity investors will generally oppose a lien in favor of a lender during the recapture period,²⁴ and lenders should familiarize themselves with the workaround options:

• One option is for the lender to limit its loan to a construction loan and release its lien upon completion of construction before the tax equity investor enters the project.
• Alternatively, if a project requires both debt financing and tax equity investment, a lender may still have options such as executing a forbearance agreement agreeing to forbear from foreclosing on the project assets during the recapture period or providing back-leverage debt (a loan made to the sponsor which it uses to fund its capital contribution in the project company) at the sponsor-level instead of at the project-level.²⁵

For these reasons, lenders must carefully consider the way their security interests are granted in solar projects having both tax equity investors and lender financing²⁶ and should understand their options to work around the potential issues.

Other Issues for Lenders

Other than tax equity concerns, there can also be issues related to a lender’s access to the project site, solar easements, interconnection and net metering, federal and state regulations, and various other legal and business considerations involved with structuring a solar financing transaction.

For example, in a transaction where the project company installs and operates a solar facility on the roof of a commercial building, the company will likely need to (i) obtain a site lease or easement in order to access the rooftop, and (ii) enter into an interconnection agreement with the local utility to sell energy to the grid, which may be in the form of a direct sale to the utility or a net metering arrangement which provides the building owner with credits to offset its electricity bills. Depending on the structure, companies could have to obtain authorization from the Federal Energy Regulatory Commission to engage in wholesale sales of power in interstate commerce or from state public utility commissions for retail and other sales of electricity.²⁷ A lender will need to determine how these issues will impact the structure and underwriting of the financing transaction.

Lenders looking to position themselves as reliable sources of financing should ensure that their personnel, and consultants and counsel they work with, are knowledgeable and up to date on the various legal, tax and business issues involved with solar financing transactions, including the various options and structures that can be utilized to address such issues. This knowledge is key to ensuring that both the underwriting and legal processes run smoothly.

Buchalter is a full-service business law firm that has been teaming with clients for nine decades, providing legal counsel at all stages of their growth and evolution, and helping them meet the many legal challenges and decisions they face. Visit www.buchalter.com to learn more.

1. https://www.seia.org/solar-industry-research-data
2. https://irecusa.org/programs/solar-jobs-census/
3. https://www.seia.org/research-resources/solar-data-cheat-sheet
4. https://www.whitehouse.gov/briefing-room/legislation/2022/08/16/bill-signed-h-r-5376/
5. Sources of Available Project Financing: Tax Equity, Practical Law Article 3-601-6606
6. https://www.projectfinance.law/publications/2022/october/bonus-tax-credits-and-the-inflation-reduction-act/#:~:text=LMI%20Credit&text=It%20is%2020%25%20for%20such,the%20area%20median%20gross%20income
7. https://www.cpuc.ca.gov/industries-and-topics/electrical-energy/demand-side-management/net-energy-metering
8. https://programs.dsireusa.org/system/program/ca
9. https://programs.dsireusa.org/system/program/co
10. https://www.seia.org/solar-industry-research-data
11. https://www.solarmeansbusiness.com/
12. https://www.seia.org/solar-industry-research-data
13. https://www.eia.gov/tools/faqs/faq.php?id=427&t=3
14. https://www.forbes.com/sites/woodmackenzie/2020/08/04/us-commercial-solar-presents-massive-opportunity/?sh=78ec822235d8
15. Sources of Available Project Financing: Tax Equity, Practical Law Article 3-601-6606
16. https://advance.lexis.com/api/permalink/9ee8f64c-6e0a-47e8-a157-86f853d8a814/?context=1000522
17. Sources of Available Project Financing: Tax Equity, Practical Law Article 3-601-6606
18. Sources of Available Project Financing: Tax Equity, Practical Law Article 3-601-6606
19. Sources of Available Project Financing: Tax Equity, Practical Law Article 3-601-6606
20. Sources of Available Project Financing: Tax Equity, Practical Law Article 3-601-6606
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22. https://advance.lexis.com/api/permalink/388d6423-c013-41cb-b26c-dd4115bbd206/?context=1000522
23. https://advance.lexis.com/api/permalink/744db967-b416-4f6b-8321-9dbd294c295f/?context=1000522
24. https://advance.lexis.com/api/permalink/23511aaa-4f06-4968-a431-702344e99d6a/?context=1000522
25. https://advance.lexis.com/api/permalink/b89fbb4a-918d-4990-80e2-0ba06574d6f3/?context=1000522
26. https://advance.lexis.com/api/permalink/23511aaa-4f06-4968-a431-702344e99d6a/?context=1000522
27. Solar Energy Project Development Issues: Preliminary Considerations, Practical Law Practice Note 7-522-8476