Small solar projects are not known to yield high returns. With a capacity of only a couple megawatts at best, the economic viability of such a project can be considered unfeasible. Therefore, incentives from the government and utilities aiming to meet their mandated renewables targets are particularly important.

Solar projects in the US are entitled to tax credits from the federal government and certain direct and indirect benefits from some state governments.

What emerges is a complicated web of incentives that must be navigated in order to determine the profitability of a solar development. Different methods of taking advantage of the benefits on offer have surfaced involving developers, investment funds, bankers and lawyers.

Last year saw intense activity from funds attracting investment for the development of portfolios of small solar projects that reap the benefits of the US system.

This year - 2008 - is set to continue the trend at a heightened level. However, as legislation for incentives are scheduled to sunset within a year, pushing projects that depend so heavily on government assistance carries significant risk.

Understanding the system

At the national level, Federal Solar Tax Credits have operated for two years in their current state following the signing of the Energy Policy Act in 2005.

The legislation established a 30 per cent tax credit up to US$2,000 for the purchase and installation of solar electric and solar water heating property for residential users.

Initially, these credits were scheduled to expire at the end of 2007 when created by the Act but the deadline was extended to the end of 2008 by Section 206 of the Tax Relief and Health Care Act of 2006.

Businesses gained from the 2005 legislation as the existing 10 per cent tax credit was extended to 30 per cent with no cap. However, this credit is currently slated to revert to 10 per cent on 1 January 2009.

At the state level, benefits take the form of direct incentives and tax credits - the provision of which differs widely across states.

Differences across states

Renewable Portfolio Standards (RPS) operate in 25 states and to a lesser extent in four states which have non-mandated renewable portfolio goals.

Each state has its own incentive system for solar projects. Programmes operated by utilities work in a similar manner.

State programmes may take the form of a direct incentive or a tax credit.

Tax credits are an indirect way of promoting the development of new small solar projects. In general, a tax deduction is less desirable than a tax credit.

The following map shows the tax credits available in each state for residential and commercial PV installations:

Within direct incentives there are straight rebate programmes which are calculated on the basis of the capacity of the system (usually in watts, or W), and production incentives which are based on the amount of electricity a system generates (in kilowatt-hours, or kWh).

Production incentives are increasingly viewed as superior to straight rebates, especially in states where the solar incentive system has truly taken hold, for instance in California and New Jersey.

The following map shows the direct incentives available for PV installations in each state.

As a result of these differences, several states have emerged as solar development hotspots. These include California, New Jersey, Maryland, Connecticut and Oregon.

California in particular stands out as a state committed to solar through the California Solar Initiative which began as a sizeable upfront grant and now takes the form of a production-based incentive (kWh).

The new system is considered more desirable than the old although it passes the implicit risk onto the investor. As a result, many are turning to project developers to guarantee the success of the systems thus passing the risk on to the developers.

Other states have been involved in significant solar development as a result of their access to abundant feedstock. The commitment demonstrated by Florida's government is thought to be the primary reason for the proliferation of solar project developments, in addition to the high utility costs that make solar appear economically feasible rather than the solar incentive programmes on offer.

Incentives in action

SunEdison financed its US$95 million SunE Solar Fund III with HSH Nordbank as sole MLA and Wells Fargo as a participant. The fund was appropriated to 48 projects creating a total capacity of 14.1MW.

HSH Nordbank put US$50 million forward while Wells Fargo stumped up US$41 million when it joined through buying 14 projects from the MLA.

The fund already has US$98.7 million committed by financials for 2008 which HSH Nordbank expects to extend to US$500 million for the whole year.

HSH Nordbank has been involved in other funds including those for Nautilus Energy and MP2 Capital, both of which closed last year, and Tioga Energy's fund which is expected to close in the very near future.

Morgan Stanley uses a similar technique called an equity flip structure to accomplish the same objectives. The bank worked with SunPower in achieving funds for small solar projects that can take advantage of federal and state incentives.

California-based Solar Integrated uses a similar tax equity flip system to meet its fund targets. Of its 31 total PPA agreements, the first 25 were arranged by GE Energy Financial Services and the most recent through an unidentified financial institution.

Bank of America's leasing department is similarly active. Its participation can take the form of:

• a solar PPA structure in which the bank owns the project and can monetize the incentives
• debt financing for the federal government
• commercial and tax-exempt debt facilities
• straight tax leasing where the bank owns all of the project and leases the equipment to the user. At the end of the lease the lessee can buy or reject the equipment.

San José Unified School District last year decided to engage the services of Bank of America and Chevron in a three-party agreement to establish a 5MW solar power facility. Under the agreement, Bank of America agreed to own the equipment and sell the power back to the district at favourable rates under a service contract.

The future for small solar financing

As the sun sets on the existing federal investment tax incentives for residential applications on 31 December 2008, and the federal business energy tax credit for solar reverts from 30 per cent to 10 per cent on 1 January 2009, all eyes are on the expected new programme.

While it will almost certainly be renewed, the question of how much will be on offer remains. Industry specialists seem to be pointing to a renewal of the same level or an increase of benefits for a multi-year period.

North Carolina Solar Center's Rusty Haynes thinks this is justified: 'The solar industry assumes that the US federal government will extend and increase incentives for solar-energy systems. This is a fair assumption, in my opinion.'

However, what is less certain is the timing of the renewal. Will there be a lag between programmes similar to that felt by wind power? This delay led to the suspension of some projects and a temporary cutting-back of investment.

Herein lies the source of the risk. As Bank of America's Senior Vice President Jim Thoma points out: 'projects really do fall apart without the incentives.'

Funds devoted to small solar projects that rely on tax incentives and grants are rising. SunSolar's SunE Solar Fund III is a good case in point. The stakes were raised considerably by the decision to pursue five times more financing resulting in five times more capacity in 2008 on the proceeding year.

Such dependence on the government relies on the continued will of politicians to promote solar and the ability to do so at the same level. It is not the will but the resources which is the threat to New Jersey's future small solar projects as a result of the system's popularity.

Further complication lies in the sheer number of developments included. The solar projects in question are typically small yet still require an individual engineering report and appraisal for each project.

Added to this is the importance of framing the contracts so that they are clearly PPAs rather than concealed sales. The implications of failing to do so has lead to the collapse of many projects.

Finally, should there be a time lag with the implementation of the next federal solar project, some plans may be held back as a result. Small set-backs, it would seem, can potentially become large losses for all involved.

The European model of feed-in tariffs whereby utilities are required by law to take - and pay premiums for - power produced through renewable processes is looking increasingly attractive for its simplicity and long-term guarantees (20 years guaranteed offtake). Indeed, Hawaii and Michigan have proposed a similar tariff to replace their existing systems but have not been adopted.

In sum, while the US system remains as it is, taking advantage of incentives for small solar developments is not for the faint-hearted in terms of appetite for risk and ability to navigate the systems in place. Having the nerve and the patience, however, appears to pay off.