October 2, 2023

By Thomas Dee, CFA, head of Financial Services, and Eric Scheriff, head of Global Energy

The US bank regulators’ recent “Basel III endgame” proposal has drawn rebuke from nearly every corner of the financial services sector – a natural response to a package that would raise capital requirements for the most complex US banks by almost 20 percent. Receiving less attention, though, is the impact the proposed rule would have on the tax equity market – a vital financing source for clean energy projects, especially after the passage of the Inflation Reduction Act (IRA). 

Receiving less attention…is the impact the proposed rule would have on the tax equity market – a vital financing source for clean energy projects.

First, some background on the tax equity market. Tax equity partnerships have traditionally been a cornerstone of clean energy project finance, especially for solar and wind projects, since tax credits could not be bought and sold outright. Instead, a counterparty such as a bank with a predictable tax liability would provide equity for a project in exchange for being able to use a project’s clean energy tax credits. In 2022, the Inflation Reduction Act extended key clean energy tax credits and created new ones, increasing the opportunity for tax equity partnerships, particularly by extending the existing renewable investment tax credit (ITC) and production tax credit (PTC) at full value until 2025, then instituting a tech-neutral ITC and PTC from 2025-2031. The credit would then phase down starting in 2032. The IRA also increased the potential value of credits through adders for domestic content, siting in an energy community, or low-income community benefits. The IRA makes 11 of the clean energy tax credits transferable, opening up a potential alternative that may result in a wider variety of counterparties and a simpler transfer process.

Capital requirements for US banks are set by the three prudential regulators: the Federal Reserve (Fed), Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC). On July 27^th, the regulators jointly proposed a 1,087-page rule implementing the so-called “Basel III endgame” in the United States, a similar package to what was agreed to internationally in 2017. The rule would apply to all banks with at least $100 billion in assets; for these firms, the proposal would tighten capital requirements both relative to the status quo and relative to the international accord.

Under current capital rules, tax equity investments receive a 100% risk weighting if a bank’s total equity investments are less than 10% of capital. The proposed rule would increase the risk-weighting for equity investments, including tax equity, to 400%.  For the roughly three dozen banks covered by the rule, the proposal would quadruple the risk-weighted assets (RWA) banks must allocate toward tax equity investments. Banks and clean energy companies have argued that the rules would make projects uneconomical – and the proposal is already taking its toll on new commitments.

In a recent letter, the American Council on Renewable Energy (ACORE), an industry group, cautioned that if the rule is finalized, “annual tax equity investments in the clean energy sector could shrink by 80-90%.”  Already, some banks have reportedly paused new investment.  Amidst the uncertainty, we have received many questions on this provision from our client base.

It’s hard to question the damaging impact the proposal would have on tax equity investments if adopted – and, for that matter, the negative impact the proposal will almost certainly have in the near term. But we believe there are reasons to be more optimistic in the long term.

It’s hard to question the damaging impact the proposal would have on tax equity investments if adopted…But we believe there are reasons to be more optimistic in the long term.

First, the proposal is just that: a proposed rule with a lengthy process ahead. The comment period closes on November 30^th. Regulators have guided toward finalization in mid-2024, with the new risk-weightings becoming binding starting in mid-2025. We expect many changes to the final rule relative to the proposal, which is typical for federal rulemaking.

Second, we expect the clean energy industry to pour advocacy efforts behind influencing the final rule. The energy transition is arguably the Biden Administration’s top priority, and tax incentives are the primary policy tool to incent the energy transition.  We expect industry to focus its advocacy efforts not just on the bank regulators (which in this context should be mainly focused on the actual credit risk posed by clean energy investments) but also on the White House. We would not be surprised to learn that the National Economic Council (NEC) is lobbying the bank regulators on the clean energy industry’s behalf (fortuitously, NEC is directed by former Fed governor Lael Brainard).

“Fixes” could include restoring the 10% threshold test or, alternatively, subjecting tax equity to the same treatment as the Low-Income Housing Tax Credit (LIHTC). Under the proposal, LIHTC investments would remain subject to a 100% risk weight.

Third, the entire Basel package faces a less-than-certain future.  Banks are typically ill-advised to sue their primary regulator. However, this proposal may shift that paradigm. The banking industry has asked the regulators to withdraw the proposal, citing a lack of analytical rigor and analysis behind the proposals. In our view, the industry is likely preparing for a legal challenge when the rules are finalized.

The tax equity market is just one of many that would be challenged under the proposal.  The proposal would also discourage banks from making low-down-payment mortgage loans, discourage commercial loans to companies without publicly traded securities, and broadly pressure fee-based businesses within banks. In these markets, in tax equity, and elsewhere – we see challenging months ahead, as banks digest the capital impact of the proposal, and hope that the proposed changes don’t stick.

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