Riding the tailwinds of constituent demand for the rapid decarbonisation of the US power grid, Congress passed the Inflation Reduction Act (IRA) on 16 August 2022. The IRA expanded the US federal tax credits that are available under section 48 of the Internal Revenue Code to, among other things, promote the development of clean energy, including the deployment of battery storage systems.
Prior to the enactment of the IRA, section 48 of the Code provided an investment tax credit (ITC) for certain types of commercial energy projects, including solar energy facilities; and a battery storage system generally could only qualify for the ITC if was considered part of a solar energy facility that itself qualified for the ITC and which provided charging energy to the battery. The IRA has eliminated this limitation, enabling standalone battery storage systems to qualify for the ITC regardless of the source of charging energy.
Observers will note that the domestic power market has been undergoing significant structural change over the better part of the past two decades, with renewable and other low-carbon power sources comprising a vast majority of the nation's mix of newly deployed energy sources. With the recent passage of the IRA, it comes as no surprise that battery storage systems are expected to play a key role in the nation's ongoing efforts to decarbonise the power grid.
Such systems help alleviate the ‘intermittency' issue posed by renewable energy sources such as wind and solar, whose power production is dependent on meteorological conditions and solar irradiance. Batteries enable power grids to function with more flexibility and resilience, helping to smooth out the generation curve by ensuring that generation can be stored and discharged at times when demand outpaces generation.
The value of the ITC for a battery storage system is calculated as a percentage of the eligible cost of the energy storage equipment, and this percentage can vary depending on whether certain factors are satisfied. The base value of the ITC is 6 percent. This rate increases to 30 percent if the asset was under construction before 29 January 2023, or if certain prevailing wage and apprenticeship requirements are satisfied.
In addition to the foregoing, energy storage technologies are also eligible for up to two additional 10 percent adders (for a total ITC percentage of 50 percent) if either: (i) the asset is placed in service in an ‘energy community', or (ii) certain ‘domestic content' requirements are satisfied. The taxpayer claiming the ITC enjoys a dollar-for-dollar reduction of its tax liability.
The ITC is taken in the year that the storage project is placed in service for federal income tax purposes but remains subject to ‘recapture' if the eligible property is disposed of or otherwise ceases to be investment credit property with respect to the taxpayer during the five-year period after the battery storage system is placed in service.
The recapture amount is reduced 20 percent for each full year that elapses after the storage property is placed in service. As a result, the recapture amount is 100 percent if the property is disposed of or ceases to be investment credit property less than one year after the property is first placed in service. There is 80 percent recapture after one year, 60 percent after two years, 40 percent after three years, 20 percent after four years and no recapture after five years.
In order for a battery storage system to be eligible for the ITC, the system must be at least 5 kWh in size and construction must commence by the end of calendar year 2024. Moreover, the ITC can only be claimed on eligible energy storage technologies. “Energy storage technology” is defined in the Code as: (i) any property (other than property primarily used in the transportation of goods or individuals and not for the production of electricity) that receives, stores and delivers energy for conversion to electricity (or in the case of hydrogen, which stores energy) and has a nameplate capacity of not less than 5 kWh; and (ii) thermal energy storage property, which is property that connects to a heating, ventilation or air conditioning system, removes or adds heat to a storage medium and is used to heat or cool a building.
While the Code's definition of energy storage technology encompasses various storage technologies, such as pumped hydro storage and compressed air energy storage, the prevailing technology for new energy storage developments is chemical battery storage and, more specifically, lithium-ion batteries. Lithium-ion technology currently boasts one of the highest energy densities (kWh/kg) when compared to other storage technologies, and such technology has benefitted from significant cost reductions given the emergence and development of portable electronics and, more recently, electric vehicles.
Moreover, the IRA also includes incentives that are intended to foster the development and deployment of electric vehicles, which is only expected to further expand the development of lithium-ion technology.
Notwithstanding the strides that lithium-ion has made from a technological and cost perspective, utility-scale battery energy storage nevertheless remains a capital-intensive technology. Because of this, developers have expressed significant interest in the IRA as it has made a new source of capital available to finance standalone battery energy storage projects – the tax equity investor.
Tax equity investors are typically large financial institutions that have substantial tax obligations (i.e., an appetite for tax credits that reduce their tax liabilities on a dollar-for-dollar basis). Although there are various structures that tax equity investors utilise in order to monetise tax credits such as the ITC, the prevailing structure in the tax equity market is the ‘partnership-flip'. Under this structure, the tax equity investor invests capital into a special purpose vehicle that is set up by the developer and which is treated as a partnership for federal income tax purposes whose primary purpose is to develop, own and operate one or more energy storage assets.
In return for its investment, the tax equity investor is issued a class of shares in the partnership which entitles it to virtually all of the partnership's tax items and an agreed portion of its cash distributions. At a certain point when the tax equity investor has received sufficient tax items and cash to reach a negotiated internal rate of return on its investment – this is commonly referred to as the ‘flip date' – the percentage allocations of tax items and cash flow ‘flips' such that most company tax items and cash flows are allocated and distributed to the developer instead of the investor.
The partnership-flip structure is expected to continue to be employed by the majority of tax equity investors for standalone battery storage projects, given that investors in the tax equity space have years of experience underwriting tax credit transactions utilising the ‘partnership-flip'.
As is the case with other tax equity investments of this type, investors will expend significant resources underwriting a battery storage system. Aside from the typical diligence that is performed by investors, there are some unique challenges facing investors and developers in this space. Namely, the fact remains that the utility-scale deployment of battery energy systems is a relatively novel concept when compared to the deployment of traditional and renewable power generation sources.
There are fewer equipment and battery manufacturers with significant, meaningful experience in the project development and finance space, and as such, it can be difficult and costly for developers to procure some protections that investors might otherwise expect to receive in other tax equity transactions, such as property insurance.
Furthermore, from a safety perspective, utility-scale battery storage systems simply do not have as long a track record as other technologies. Chemical batteries can pose the risk of ‘thermal runaway', which occurs when a battery cell is unable to dissipate the heat generated as the cell produces electricity, which can impact other cells that are located in close proximity, starting a chain reaction and potentially resulting in gas ejection, extremely high cabinet temperature and pressure, and fire. Safety experts are actively enhancing safety protocols and best practices for the deployment and operation of utility-scale battery storage systems. In an effort to mitigate exposure to reputational risk, tax equity investors will take care to verify that the battery storage system is being deployed in a safe manner.
Finally, one of the appeals of battery storage systems is the fact that they can fulfil various use cases and provide multiple revenue streams. For example, a battery can be used as a generation project (a source), an energy load (a sink) or an ancillary service, and it can have varying revenue arrangements such as a virtual or physical power purchase agreement, a resource-adequacy or capacity-type arrangement or an ancillary services agreement. This feature of battery storage systems can also pose a challenge from a financing perspective as investors will need to pay close attention to the battery storage system's revenue arrangements to ensure that they align with the battery's intended use case.
As the battery storage industry strives to replicate the advances in technology and cost savings that solar and wind have achieved over the past two decades, the ITC is expected to serve as a highly effective policy tool that helps developers bring capital-intensive storage projects to completion by unlocking a new avenue through which they can raise capital in the marketplace. Tax equity investors – fuelled by their own corporate social responsibility initiatives and growing stakeholder demands to decarbonise their own businesses – are expected to continue investing in clean power technologies for years to come.
Originally Published by Financier Worldwide Magazine
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