Godofredo A. Vásquez/AP Photo
Wind turbines operate in Livermore, California, August 10, 2022.
On Wednesday, the Treasury Department released proposed guidance on direct pay, a new cash payment system to incentivize local governments, churches, public power utilities, nonprofits, and other tax-exempt entities to build renewable energy.
The details of this new tool, which was created in last year’s Inflation Reduction Act, will determine whether public entities make use of infrastructure subsidies that have long been reserved for the private sector.
During the New Deal, rural electric cooperatives, schools, and other public entities were major beneficiaries of federal grants for electrification. But since the 1980s, Congress has moved away from direct investment in energy and other forms of development, relying increasingly on the federal tax code, in a shift that has concealed the role of the state in economic planning.
“Direct pay turns that on its head,” according to Mike Konczal, an economist at the Roosevelt Institute who supports direct pay. He wrote on Twitter that the policy makes tax credits into “a kind of grant for the public sector.” Since most of the IRA’s support for clean energy is funneled through tax credits, the provision gives entities that don’t pay income taxes a cash payout for upgrading facilities or producing lower-carbon energy.
Notably, the Treasury said that it will make subdivisions of government eligible for direct pay. These include a constellation of “agencies and instrumentalities” such as state and city green banks, economic development corporations, water districts, school districts (and the school bus fleets they own), as well as subdivisions of tribal governments, such as utilities and housing authorities. The Treasury appealed to simplicity, arguing that discriminating between different qualifying ownership structures would be a bureaucratic mess.
Now, some progressives are asking the Treasury to go further.
FIRST, SOME HISTORY: The Clean Energy for America Act, the bill authored by Sen. Ron Wyden (D-OR) that became the basis for the IRA, started off with direct pay across the board. But Sen. Joe Manchin (D-WV) opposed direct pay for the private sector, and insisted on limiting companies’ ability to claim direct pay to advanced manufacturing, carbon capture, and clean hydrogen credits.
In response, legislators came up with “transferability,” allowing businesses to sell their tax credits to others, who can then claim the credits on their tax bill. This scheme is already a feature of existing tax credits for solar and wind production, though it is a clunky market with high transaction costs.
Transferability helps small businesses whose qualifying green activities outstrip their tax bill. For example, a small solar developer might build a project that qualifies for $3 million of tax credits, but it might only owe $1 million in taxes. To avoid losing the other $2 million, it can sell the tax credits to any business with a big tax bill—typically a large institutional bank like J.P. Morgan—that can subsequently claim the tax cut on its filing.
“The two are meant to be exactly symmetric. Either you’re eligible for direct pay, or you’re eligible to transfer your credit to a third-party buyer,” explained Jeff Gordon, a researcher at Yale Law School who was a tax fellow with Democratic staff on the House Ways and Means Committee during the Inflation Reduction Act negotiations.
But they aren’t quite symmetric. Nonprofits eligible for direct pay are sent a check for 100 percent of the credits they’ve logged. By contrast, the private solar developer must find a tax equity investor, like J.P. Morgan, which will not pay for that tax credit at face value. Currently, tax equity investors are receiving the credits for around 85 cents on the dollar, according to a report by Credit Suisse.
Tax equity investing has attracted a handful of insurance companies and banks. Since 2015, according to the report, just three banks accounted for more than half of U.S. wind and solar capacity growth financed through tax equity. But the IRA massively scaled up the market for clean-energy tax credits, attracting more players.
THE CENTER FOR PUBLIC ENTERPRISE, a group that advocates for the public sector, sees an opening in the new two-track system of direct pay and transferability. Executive Director Paul Williams argues that green banks, a growing form of public finance that received its own cash infusion in the IRA, should be able to buy private companies’ tax credits and claim direct-pay reimbursements.
“The federal government is losing 15 cents of every dollar it invests that go through the tax credit equity markets,” Williams told the Prospect. “If Treasury allows green banks to purchase the credits like it allows traditional banks to, it can start to close that gap.”
Williams’s team is now trying to persuade the Treasury that this idea, called “chaining,” is possible within the parameters of the IRA. It hinges on how the agency chooses to interpret a narrow distinction in the law.
Congress wrote that under both direct pay and transferability, the tax credit must be “determined with respect to” the eligible entity (that is, the one owning or doing the green activity). Under transferability, the law creates a special category of “transferee taxpayer.”
In Treasury’s proposed rule, the agency says it will not permit chaining because of a requirement that the entity claiming a direct-pay reimbursement “owns the underlying eligible credit property or … otherwise conducts the activities giving rise to the underlying eligible credit.”
In other words, if a public-sector entity claims a tax credit, it must do or own the green activity at stake. By contrast, a private-sector firm can sell off its activity into the tax equity market, where another private buyer inherits the firm’s tax position.
It is a fascinating philosophical distinction—doing a project versus paying for it to be done—and one that might dissolve on closer scrutiny. When a bank like J.P. Morgan buys tax credits on the tax equity market, it appears to be taking an equity position in that project; it is responsible for it happening. Transferred credits are still subject to due diligence. If a solar project fails to perform, the IRS could claw back its tax credits from the bank. That would seem to give the bank a stake in the activity.
Williams said that Treasury should make it possible for a private company generating tax credits through its activities to sell those credits to a government entity or green bank that has no operating or financial stake in the venture—just as it could sell the credits to any other private bank or business.
“There are so many wide, varying partnership structures you can have in any of these kinds of projects. Creating a structure where green banks can buy the tax credits and become a partner on the project, in order to be eligible according to that rule, is not hard. Treasury could make the argument if they wanted to,” he said.
Gordon, the tax researcher, said the idea surprised him.
“The core issue motivating my interest in direct pay has been, how do we empower local government entities to own and operate as much clean-energy infrastructure as possible? So, once we’re talking about entities not involved in owning and operating their own energy infrastructure, it feels like we’re solving a somewhat different problem,” he said.
But Gordon is not opposed to it, he added. “Insofar as we want to put [green banks] on an equal playing field with the for-profit banks,” he said, “it’s a good thing.”
What would green banks stand to gain? Just like a private bank, they would pocket a share of the tax credit—maybe a little less than 15 cents on the dollar, as more entrants drive down profits on the trade. But unlike private banks, which could spend the profits on whatever they please, public green banks would plow the profits directly back into green investment.
Whether or not green banks are allowed to participate, new rules should make it easier for ordinary businesses to become tax equity financing partners, rather than just big banks and insurers.
Ironically, the more businesses become tax equity financing partners and drive down the current 15 percent transaction costs, the less incentive there will be to participate. So under the terms of the work-around, the small solar developer or other credit earner can never be reimbursed the full value of the tax credits they “earned,” or the market would be destroyed.
ALSO AT STAKE AS TREASURY spells out rules for direct pay are the parameters around public-private partnerships.
Many private and nonprofit or government entities may want to team up in joint-venture agreements, and Treasury is laying out how they can partner to build or install green infrastructure—and how they divvy up the benefits.
Partners in typical corporate partnerships have immense flexibility. They can usually agree to share the income and costs of the arrangement however they like. “That would be a risk for Treasury,” Gordon says, since “government and for-profit firms could write their contract to say either the for-profit firm gets a larger share of the tax credit, or the government does. And maybe they would pick the government to claim more of the tax credit, because it can claim direct pay.” There could be other, unforeseen risks, too.
Instead, Treasury has laid out rules where public and private partners’ income stake is proportional to their ownership of the assets of the partnership. “Basically, it requires you to be a very simple kind of LLC,” Gordon said.
The next two months of public comments on the Treasury guidance will see more wrangling over the terms of ownership of green assets.
“We know from experience and looking at deals that a building owner derives more benefit from solar or geothermal or any of these energy upgrades if they own the assets themselves,” said Joe Morris, a clean-energy financing expert with community group Metro IAF. “But because of the lack of financing, and other factors like risk, this industry has grown up that creates third-party ownership.”
The debates illustrate the complexity of turning tax breaks into incentives to build—the complexity that direct pay was meant to circumvent in the first place.
