With the cost of solar equipment falling, its economics are fast approaching a tipping point where it will reach parity with conventional grid supply. But developers are still dependent on a raft of federal tax incentives, which govern both the pace of solar development and the industry's choice of financing structures.

Solar financing in the US is dependent on investment tax credits (ITC), which are set to expire at the end of this year, if not renewed by Congress. The credit currently applies to 30% of a project's costs and market participants still expect a multi-year extension. Without the extension the ITC would not go away, but its coverage would drop to 10%, reducing the benefit to tax-driven investors.

Several developers consider the extension a foregone conclusion. But according to Edwin Moses, the founder of Clean Energy Development & Finance, they should not hold their breath. "My opinion is Congress will still miss the extension in 2008, despite the heightened awareness of energy issues, but the risk of not extending retroactively in 2009 is very small," he notes. Whether they are right to be anticipating this is not nearly as important, however, as what their fallback financing plans are.

Maria Klutey, senior vice-president in the renewables group at GE Energy Financial Services, says whatever happens, developers will go on using the same structures they have before because they will still have some tax benefit available to them. "Because we've been in an ITC world, the structures that have made sense for the last two years will prevail. The incremental 10% is still critical." The extension would merely bring larger deals using the models that are already available, she adds, referencing partnership structures, leases and sale-leasebacks.

Large-scale utility projects best fit a partnership or leveraged lease structure, says Mark Zanoli, managing director and head of clean technology at JPMorgan Chase. But he says most developers prefer the latter because they require far less equity given the technology risk involved. "With leasing, you can add debt on the back end and there is tax equity – it's very similar to a sale-leaseback." The partnership model mainly works for an owner/operator that plans to flip the project to an investor downstream, he says.

Size matters

There have been a very small number of project financings in the US for utility-scale solar. The first project to be financed since the SEGS projects were constructed in the Mojave Desert, California – 16 years ago – was Acciona's 64MW Nevada Solar One complex near Boulder City, Nevada. Both facilities use solar thermal technology, using mirrors to capture sunlight that heats a liquid into vapour to drive a turbine.

Susan Nickey, CFO at Acciona Energy North America, says the Nevada project lent itself to a leveraged lease structure because that was the most efficient way to optimize the 30% tax credit at the same time as leveraging the cash flows with third-party debt. An owner trust, held by JPMorgan (50%), Northern Trust's NorLease (25%) and Wells Fargo (25%) bought the project for $271 million and leased it back to the project company. It was the first large US solar project to use non-recourse financing, since previous projects were either equity financed or used corporate debt.

Nevada Solar One could have supported a partnership flip structure, more commonly used in wind, but tax accounting considerations made this more complicated explained Nickey. "With the 30% ITC, it let us allocate the different streams of benefits from the project in the most efficient way for us. And our tax credit investors in the project liked the accounting treatment from a leveraged lease." The partnership structure is harder to apply debt to because of the way the leasing streams of payment work, says Zanoli, adding, "Under the leasing structure, you have streams of payment you can collateralise."

Banks' appetite, on the other hand, will depend on the technology used and its operating history, says Matthew Ptak, vice-president of structured finance for the Americas at BayernLB, noting, "People are looking for proven technology." But the legal costs for banks' due diligence do not decrease in proportion to project size on small projects, which discourages some developers from seeking debt financing, explains Dan Svejnar, assistant vice-president in structured finance at HSH Nordbank. "In order to justify adding debt, the deal needs to be very large – on the order of $100-150 million, or more than 30MW. When you start involving debt, the tax equity issues get complicated with respect to inter-creditor issues." Both HSH and Bayern were part of the syndicate that bought into the 18-year, $133 million senior loan and $7 million letter of credit funding Nevada Solar One, sold down by lead arrangers Banco Santander, BBVA and La Caixa.

Financing structures will not distinguish much between solar photovoltaic projects (PV) and solar thermal, says Svejnar, because the tax code does not distinguish between them. PV can be constructed much faster because its equipment comes as panels that are easier to install, which has led to more activity in that area than on the thermal side. But portfolio financing could be used to finance a collection of smaller, 1MW PV units – an option several commercial sponsors have been looking at. "For commercial-scale rooftop projects, if there's enough of a portfolio you can get some scale there and do a financing," says Ptak. Single investor leases – where there is no debt – have also been discussed for PV, says Nickey, because the transactions are that much more manageable.

PV, meet PF

Julie Blunden, vice-president of public policy at equipment supplier, builder and developer SunPower, says large-scale PV has not yet seen the light of day in the US because the costs of the silicon for the cells has been too high. That is beginning to change, however, as is evidenced by Pacific Gas and Electric's recently unveiled plan for two plants that would double the country's grid connected PV capacity by 2013. The first would be developed by OptiSolar at 550MW and the second with SunPower at 250MW, the latter also featuring so-called single axis tracking, orientating solar panels to the sun as it moves across the sky. "PV didn't have the scale to deliver hundreds of megawatts per year until now," says Blunden. "We will be the first to market. Our production volume for solar cells in 2007 was 100MW, whereas in 2010 we are guiding Wall Street that we will be at 650MW. There's a fundamentally different scale of delivery now."

SunPower will go out to traditional project finance banks that have shown an interest in doing utility-scale financing, adds Blunden, but will also use an equity partner, just as its subsidiary PowerLight did with its previous PV project – a 15MW unit on Nellis Air Force Base near Las Vegas. Players that have worked with SunPower in the past include MMA Renewable Ventures, which did the Nellis deal, Deutsche Structured Finance, AIG Financial Products and Morgan Stanley.

But with the credit crunch roiling financial institutions, many tax equity investors are shying away from the market or in some cases dropping out altogether. AIG, Lehman Brothers and CIT Group have been active in the space, but may not be going forward. Fortunately, one large constituency that has been left out but may be able to fill the void is the utility. Utilities have been unable to use the ITCs under the current tax regime, but new legislation has been drafted that may reverse that restriction and level the playing field.

Elizabeth Paul, a project manager at Portland General Electric, says if those limitations are removed, "You will definitely see [financing] structures [for utilities] change... We wouldn't need to bring in an institutional partner – we'd just worry about selling on the credits," she says, noting there is a strong market for so-called business energy tax credits. So far PGE has closed on one solar project: a 104 W unit for the Oregon Department of Transportation. "ODT offered us access to a right of way on the intersection of two highways," says Paul. "For the first five years, until the flip, it'll be metered and after that the power goes straight to our company."

Its investor was Firstar Development, part of US Bancorp, with which is working on a planned 3.5MW follow-up project for an unnamed host. The deals were brokered by United Fund Advisors and used a utility flip model. Solar developers will need to balance the benefits of bringing in deep-pocketed utility partners with the fact that these utilities have less need of the developers' services.

Lessons learned

Flip structures have been widely used in wind, and a lot of the lessons from wind project financing could easily be applied to the solar market, according to Jim Brown, vice-president of project finance at First Solar, and a former project finance banker at HSBC.

In both a strategic and institutional investor flip structure, the investor is allocated cashflows and tax credits upfront for a majority equity commitment, before ownership and revenues flip back in favour of the developer after a pre-defined threshold is reached. These work best for sponsors that want to grow by funding future projects with revenues from their first unit, or companies that plan to go public and need to demonstrate contracted revenue streams.

Another structure, one less common, is the pay-as-you-go structure, which sees the developer commit half the upfront cost, with the investor paying annual instalments for a set amount of tax credits.

Wind's production tax credits are earned through producing and selling output from wind farms, whereas in solar they are provided for simply investing in the technology. But the three key building blocks are the same: tax equity from either a strategic or institutional player, commercial bank debt and sponsor equity. "There are similarities because the elements of the capital structure are likely to be the same, but the ITC is not structured like the PTC used in wind. Also solar is much more costly than wind, unless it's offshore," says Emeka Ngwube, a director at Credit Suisse.

Since solar only works on a subsidised basis and if the ITC is not renewed, there will be a sharp drop-off in new solar installations. "I wouldn't say lenders are lining up because sponsors aren't exactly lining up. You're seeing sponsors putting stuff on hold," says Ptak. A short-term extension of some kind would provide a leg-up for developers to get to the next level, and go it alone from there. "There is an expectation that you are bridging a gap, not providing unending support," explains Klutey. "Over time the expectation is solar costs will continue to come down. You saw the same effect in the semi-conductor world. At some point, solar becomes self-financing without incentives."