IRS guidance "big win" for carbon capture tax equity

After two years of waiting, tax equity investors finally have much-needed guidance from the Internal Revenue Service (IRS) on the framework for investments in carbon capture and storage projects.

With a few more clarifications, the nascent sector could be inundated with capital, say market observers.

"Now when investors and sponsors call me up, at least I have a framework I can work within," says David Burton, a tax partner at Norton Rose Fulbright in New York. "It may not be as accommodating of a framework as people were hoping, but it’s still a big win."

The guidance, in the form of Revenue Procedure 2020-12 and Notice 2020-12, recommends a structure for potential investments, outlines safe-harboring terms, and defines "start of construction," among other things.

The documents build on the FUTURE (Furthering carbon capture, Utilization, Technology, Underground storage, and Reduced Emissions) Act of 2018, which lifted restrictions on carbon capture tax credits under Section 45Q of the tax code.

Some of the biggest wins include a recommendation that the tax credit investments be structured in the form of a partnership flip − similarly to wind project financings based on the production tax credit (PTC) − and the approval of a six-year safe harbor period, two years more than the equivalent period for wind and solar projects.

Section 45Q allows investors to claim a tax credit for the capture of "qualified carbon oxide" from industrial facilities − including qualified power plants − that are built by 1 January 2024. The credit can be claimed for 12 years from the date the carbon sequestration equipment is placed in service, and ranges from $10 to $50 per metric ton, depending on what is done with the captured carbon dioxide and the date when operations begin.

Flipping great

The wind-style partnership flip recommended by the IRS is in line with expectations, since the wind PTC and the carbon capture tax credits are both production-driven.

"It's very similar to the wind safe harbor and addresses several critical open items from the tax equity wish list, so to speak," says Shariff Barakat, a partner at Nixon Peabody in Washington, DC.

Under the new rules for carbon capture, tax equity investors can fund up to half of their investment on a 'pay as you go' basis, as opposed to just a quarter for wind projects. This allows investors to adjust subsequent investments depending on project performance, i.e., how much carbon is captured.

The guidance also "blesses" certain types of puts, providing for investors to sell their partnership interests back to the developer at fair market value.

This provides leeway for investors to exit a deal, which could be helpful for those with non-tax legal constraints on the holding period of an investment, says Barakat.

Banks, for instance, are typically unwilling to hold tax equity investments for more than 10 years because of the impact on capital charges.

However, the guidance is unlikely to satisfy everyone.

Some market participants were pushing for simpler, non-partnership structures, such as the contractual transfer of the credit from the owner of the equipment to the entity that sequesters the carbon dioxide.

"I think the carbon capture industry is pleased to have guidance and a path to follow forward, but the revenue procedure is somewhat more conservative than what people were hoping for," says Burton.

Some questions, meanwhile, remain unresolved, such as whether qualifying partnerships can be supported solely by tax credits and without any cash revenues from activities such as enhanced oil recovery.

“While this has not been explicitly blessed and will likely require additional tax guidance for the tax equity community to get comfortable, the presence of guidance for allocating the credits in projects without revenue is a promising step in the right direction," says Barakat.

Beautiful clean coal

The guidelines provide for a six-year continuity safe harbor period for carbon capture projects, two years longer than the period granted to wind and solar, which means that qualifying projects have six years from their start of construction date to become operational.

Some market participants attribute the extra two years to President Donald Trump's support for fossil fuels, especially coal.

"Since the Trump administration, there's been a new process where this guidance has to go through the Office of Management and Budget," says an observer. "The current acting director of the Office of Management and Budget is Mick Mulvaney, who is also the president's chief of staff. Obviously the president is a big supporter of the fossil fuel industry and wants to do what he can to encourage it.”

The definition of "start of construction" for carbon capture projects is broadly in line with the definition for wind and solar projects. The developer must either incur 5% of the project's costs or undertake "significant physical work" by the end of 2023.

"That seems pretty generous to me and pretty feasible," says Burton. "I think things will start moving rather quickly."

"There had been some hope that the threshold would be lowered below 5% given the sheer size of some of the 45Q projects being developed," adds Barakat. "I expect developers of these larger projects to push hard to rely on physical work-based grandfathering strategies."

First movers

The first set of investments is expected to come to fruition this year, now that there is clearer guidance. Owners of ethanol plants in the Midwest are likely to be the first movers, since the plants are already built and located near carbon capture pipelines or favorable geological formations. Oil and gas companies are also likely to move quickly. The shale plays in North Dakota and Texas are among the prime locations.

Major financial and non-financial institutions − rumored to include Wells Fargo, JP Morgan and Berkshire Hathaway − have already been sussing out potential investments, though the carbon capture tax credit’s similarity to the PTC for renewables makes it unlikely to appeal to investors that favor the investment tax credit, such as US Bank, which said last year (2019) that it was not considering this area.

In any case, investors are expected to hold back until further guidance is issued on the thorny subject of recapture, including what can trigger it and what exceptions there may be, for instance in cases of force majeure.

Once this is resolved, insurance companies are likely to quickly develop policies that protect against the risk of recapture.

"It took two years for the IRS to cut and paste the rules in the first round of guidance, so it is difficult to say how long will it take to do something wholly new like this type of recapture," says Burton.

However, the White House will probably want to settle the matter before the end of Trump's first term as president, the attorney notes, in case he does not win reelection.

(A version of this story first appeared on Power, Finance & Risk)