CONNECT WITH THE FOUNDATION Journal OF EQUIPMENT LEASE FINANCING Articles in the Journal of Equipment Lease Financing are intended to offer responsible, timely, in-depth analysis of market segments, finance sourcing, marketing and sales opportunities, liability management, tax laws regulatory issues, and current research in the field. Controversy is not shunned. If you have something important to say and would like to be published in the industry s most valuable educational journal, call 202.238.3400. VOLUME 31 NUMBER 2 SPRING 2013 USING LEASING TECHNIQUES TO FACILITATE DISTRIBUTED SOLAR PROJECTS By Ernest W. Chung Equipment leasing techniques have played a key role in driving the growth of solar photovoltaic installations in the United States. However, as key federal subsidies sunset or expire, continued innovation will be vital to expand the market s capacity to finance these projects. USING PREDICTIVE ANALYTICS TO IMPROVE DECISIONMAKING By Shawn D. Halladay Predictive analytics, a component of business intelligence, represents another step forward in equipment leasing and finance companies quest to exploit the increasingly large amounts of information available to them. EFFICIENCIES IN THE INDIRECT MARKET By Scott A. Wheeler In the wake of the 2008-2009 recession, larger intermediaries and their purchasing partners have had to re-establish themselves as viable participants in the indirect markets. As a new Foundation study shows, they must implement greater efficiencies at every level of the process, from marketing origination to final funding. The Equipment Leasing & Finance Foundation 1825 K Street NW Suite 900 Washington, DC 20006 202.238.3400 www.leasefoundation.org Copyright 2013 by the Equipment Leasing & Finance Foundation ISSN 0740-008X
Using Leasing Techniques to Facilitate Distributed Solar Projects By Ernest W. Chung Distributed generation, or the decentralized production of electricity primarily for onsite use, is increasingly being implemented as a cost-effective method of achieving energy efficiency and reliability goals. One form of distributed generation, on-site solar photovoltaic (PV) panel installations built on commercial and residential properties, has proliferated in recent years as a result of a combination of governmental subsidies, falling PV panel prices, and financial innovation. This article discusses the key role that leasing techniques have played in promoting the adoption of distributed solar PV projects. THE DISTRIBUTED SOLAR MARKET Solar PV installations in the United States increased by 76% in 2012, reaching 3,313 megawatts (MW) of installed capacity. 1 This frenzy of activity was particularly pronounced in the residential solar market, which saw over 83,000 new PV installations in 2012. Equipment leasing techniques have played a key role in driving this growth, as the overwhelming majority of these residential solar PV installations have been procured using third-party ownership models in the form of either leases or power purchase agreements (PPAs). Furthermore, sale and leaseback Equipment leasing techniques have played a key role in driving the growth of solar photovoltaic installations in the United States. However, as key federal subsidies sunset or expire, continued innovation will be vital to expand the market s capacity to finance these projects. transactions have enabled developers to monetize tax benefits that might otherwise have been unutilized, lowering the overall cost of financing acquisition of the system. However, as key federal subsidies such as the investment tax credit (ITC) and the Section 1603 cash grant program sunset or expire, 2 continued financial innovation will be needed to expand the market s capacity to finance these projects. AVOIDING UP-FRONT COSTS THROUGH SOLAR LEASES AND POWER PURCHASE AGREEMENTS Until recently, solar lease or PPA financing structures were rarely available for residential or small commercial-scale solar projects. 3 A residential or commercial user of electricity wishing to install solar PV generation had few options but to finance the purchase and installation of the PV system with its own resources or (assuming it had sufficient borrowing capacity) with bank debt borrowed on its own. In either situation, the user would face significant up-front capital costs, a potentially long payback period, and both construction and operational risk over the lifetime of the system. This combination of factors often would be sufficient to deter the user from purchasing a system.
With the advent of solar leases and solar power purchase agreements offered by solar PV developers such as SunRun, SunPower, and SolarCity, customers wishing to install small-scale solar PV systems for distributed generation had the possibility of acquiring solar energy generating systems at little to no up-front cost. Under a simple solar PV leasing structure, the provider of the system could, either through its own balance sheet or through banks or other sources arranged by it, finance the acquisition and installation of the PV system on the customer s rooftop, and recover the costs of constructing and financing the system through a fixed monthly lease payment (subject to escalation based on a pre-agreed formula) to be paid by the customer over a period of anywhere from 10 to 20 years. Under this simple lease structure, the customer would also assume the risk of system performance during the lease term (unless a separate operations and maintenance agreement with the provider gave the lessee some measure of third-party backup). USE OF SALE-LEASEBACKS TO MONETIZE TAX CREDITS Since neither the developer nor the customer is typically in a position to fully utilize the tax credits (ITC) or depreciation allowances generated by a solar PV project, those tax benefits may be stranded unless a third party capable of utilizing those subsidies can be brought into the transaction. To finance the acquisition and installation of the solar PV system, the solar developer may sell the project to an investor (the so-called tax equity investor), which, as owner of the equipment, would be entitled to use the tax credits and depreciation allowances attributable to the system. The tax equity investor (often a bank or other financial institution, but increasingly other types of companies as well), as owner, would be entitled to the tax credits and the right to depreciate the PV system, and would lease the PV system back to the developer. The developer would then transfer the right to use the system The relatively high borrowing costs of the solar PV developer could be replaced with the lower, subsidized borrowing cost of the tax equity investor through a sale-leaseback structure, thereby lowering the overall capital cost for the project. 2 to the customer by way of PPA or lease. In this manner, the relatively high borrowing costs of the solar PV developer could be replaced with the lower, subsidized borrowing cost of the tax equity investor through a saleleaseback structure, thereby lowering the overall capital cost for the project. 4 SOLAR LEASE VERSUS POWER PURCHASE AGREEMENT The PPA structure involves a slight variation on the solar lease structure. In the PPA structure, the customer would not pay a fixed monthly charge for the lease of the solar PV system. Rather, the customer agrees to purchase the energy output of the system for a price at a discount to the prevailing retail electricity prices (subject to escalation) for an agreed period (again, typically 10 to 20 years). In a PPA structure, the developer typically retains responsibility for operation and maintenance of the solar PV system. The choice between a solar lease and a PPA structure often depends on the regulatory environment in the state where the particular installation is to be located. For example, solar leases may be preferred in certain jurisdictions where a PPA could cause the seller to be subject to regulation as a public utility. On the other hand, PPAs might be preferred in those jurisdictions where the purchaser of the power may be entitled to benefit from net metering rules, which could entitle the purchaser to sell excess energy into the grid (in some jurisdictions, at the retail price). Both permutations of the third-party ownership structure (solar lease or PPA) enable users to acquire the systems with little to no up-front cost. These innovations are predicted to increase the size of the residential solar PV market from $1.3 billion in 2012 to $5.7 billion in 2016, 5 demonstrating the power of these techniques. OFF-BALANCE SHEET TREATMENT As an added benefit, particularly for the corporate customer, solar lease financing structures are typically constructed to enable the customer to treat the lease as
off-balance sheet. Under U.S. generally accepted accounting FACILITATING SECURITIZATION principles (GAAP), a lease contract meeting As indicated above, tax equity investors have been an certain criteria (principally that the term of the lease does important historical source of financing for distributed not exceed the estimated economic life of the leased asset, solar PV projects. However, federal tax incentives such 6 and that the lease does not contain an option to pur- as the ITC are scheduled to expire 8 and the prospects for chase the leased property at a discounted price) could be renewal are uncertain. Even if they are renewed, the capacity treated as an operating lease, and the long-term obligations of the tax equity market is likely to be insufficient of the lessee under the lease would not be required to finance the growing demand for PV. Accordingly, the to be reported as debt on the lessee s balance sheet. continued growth of the solar PV market will require the For certain customers, the ability development of alternative sources of to achieve operating lease treatment Solar leases and PPAs capital for financing. has been extremely attractive, as the The securitization of residential customer s long-term liabilities under generate steady payment and commercial solar PV leases may the lease would not be required to be offer one such alternative financing counted as debt for purposes of the streams and their source. The rapid growth of the solar customer s other debt financial covenants or credit ratings. While the avail- documentation is relatively pool of financial assets whose char- lease and PPA markets has yielded a able evidence is anecdotal, it is highly acteristics are generally well suited to likely that the ability of customers to standardized, allowing securitization. Solar leases and PPAs treat solar leases as off-balance sheet generate steady payment streams and them to be aggregated has also greatly facilitated the growth their documentation is relatively standardized, allowing them to be aggre- of this market. and analyzed as a pool However, under proposed changes gated and analyzed as a pool of assets to U.S. GAAP lease accounting rules, 7 of assets rather than as rather than as individual transactions. the ability to treat solar leases as operating The customer base is rapidly becom- leases is likely to be eliminated, individual transactions. ing broad and diverse enough to afford with the result that (despite vocal opposition some of the credit benefits of diversilar from the leasing community) going forward, sofication. The developers of distributed solar PV that are lease payments will likely be required to be reported likely to sponsor such securitizations have established as liabilities on the lessee s financial statements. track records for project installation, operations, and Certain commentators have suggested that it may be maintenance and lease servicing. Finally, the technical possible for customers to preserve the off-balance sheet and reliability characteristics of the solar PV systems are treatment of their periodic payments by replacing solar thought to be well understood. leases with a PPA having certain characteristics (principally Major rating agencies have released detailed ratings that the contract specifies payment in terms of a guidelines for solar securitizations. 9 As of April 2013, a fixed price per unit of output). However, the final position residential solar PV lease-backed or PPA-backed securiti- cannot be predicted with certainty until the final zation has not yet come to market, but a wide variety of rules are issued later this year. In any case, these proposed industry participants have predicted that such transacfect changes appear to have already had a chilling eftions will come to market soon. 10 As of the time of this on the market for commercial-scale solar leases. writing, at least one bulge-bracket underwriter expects In contrast, the proposed rule changes have not, to to market a solar asset-backed security during mid-2013. date, appeared to have had much of an adverse effect on the residential solar lease market, perhaps reflecting that CONCLUSIONS the ability of customers to elect off-balance sheet treatment The market for solar PV projects has followed a rapid of lease liabilities may not be as important in the evolution from one-off transactions dependent on the residential or household context. availability of government subsidies to a mature indus- 3
try expected to be accessing the capital markets through securitization of pools of commoditized solar leases and PPAs. Leasing techniques have played a crucial role in this evolution through a number of different modalities. Solar leases have enabled the broad adoption of solar PV systems without the need for significant up-front investments by customers. Sales and leasebacks of equipment have enabled third-party financing of equipment while lowering the cost of capital by monetizing tax benefits that would otherwise have been stranded. Finally, the wide adoption of solar lease and PPA documentation has provided a relatively simple and commoditized contract structure that is well suited to facilitate securitization transactions. It is likely that these techniques have a wider application, and developers and users of other distributed energy projects, such as those using combined heat and power systems, would be well advised to consider them. 4. See, e.g., SolarCity Corp. registration statement on Form S- 1/A, filed with the U.S. Securities and Exchange Commission as of December 12, 2012, at p. 50, which contains a description of how these types of transactions frequently work. 5. Id., at p. 13. 6.The expected economic life of a solar PV facility is generally thought to range from 25 to 40 years. 7. See, Financial Accounting Standards Board (FASB), Proposed Accounting Standards Update (Revised): Leases (Topic 842), Exposure Draft, issued May 16, 2013. 8. See above, endnote 3. 9. See, e.g., ABS Commentary: Evaluating Risks in Solar Securitizations, Kroll Bond Ratings, October 17, 2012; Will Securitization Help Fuel the U.S. Solar Power Industry? Standard & Poor s Ratings Direct, January 23, 2012. 10. See, e.g., Securitization: Another Innovation in Solar Finance, by Herman K. Trabish, Greentech Media, March 20, 2013. Endnotes 1. U.S. Solar Market Insight Report, 2012 Year in Review, GTM Research and the Solar Energy Industries Association (SEIA), March 2013, p. 3. 2. Under the Section 1603 cash grant program (originally established under the American Recovery and Reinvestment Act of 2009), qualifying solar PV projects that began construction before January 1, 2012, filed a placeholder application prior to October 1, 2012, and are placed in service before January 1, 2017, would be eligible for a cash rebate from the U.S. Treasury of 30% of the eligible cost basis of the project (the so-called cash grant ). However, the Section 1603 cash grant program has expired with respect to solar PV projects and is not available for new solar PV projects. An investment tax credit of 30% of the eligible cost basis of a project remains available under Section 48 of the Internal Revenue Code for solar PV projects that are placed in service before January 1, 2017. 3. While there are no generally accepted definitions of residential or commercial-scale solar projects, the projects described in this article usually have a rated capacity of less than one megawatt (1MW) and may be contrasted with utility scale solar projects, which are grid-connected and involve facilities that generally exceed 1MW of rated capacity. Ernest W. Chung echung@blankrome.com Based in New York City, Ernest W. Chung is a partner in the law firm of Blank Rome. He concentrates his practice in the areas of project finance and development. In emerging markets transactions, he has represented clients in the former Soviet Union, Latin America, the Middle East, Africa, and Asia. Mr. Chung advises financial institutions, sponsors, governments, and multilateral institutions in the development and financing of natural resource, infrastructure, and energy projects, particularly in a cross-border context. With the International Bar Association, he is a member of the section on energy, environment, and natural resources as well as the section on infrastructure. Mr. Chung received his bachelor s degree, magna cum laude, from Harvard College, Cambridge, Massachusetts, in 1992, and his law degree from Harvard Law School in 1996. 4