ITC Step Down: Understanding Solar Federal Tax Credits
The Federal Investment Tax Credit for solar energy is one of the most important federal policy initiatives to support the growth of renewable energy in the US. The ITC currently allows you to deduct 30% of the cost of installing a solar energy system, which has commenced construction through 2019. The ITC then steps down to 26 percent in 2020 and 22 percent in 2021. As we enter the period of the ITC step down, it is important for corporate buyers of renewable energy to understand how this reduction could affect clean energy prices in the future.
How Does the Solar Federal Investment Tax Credit Work?
The original solar investment tax credit (ITC) was established in 2005 as part of the Energy Policy Act and is based on the amount of investment in solar property. Both the residential and commercial ITC are equal to 30 percent of the basis that is invested in an eligible property. Since 2005, the solar investment tax credit has been extended several times, most recently in late 2015 — leaving us with the policy in its current form. The 2015 extension included an ITC step down schedule that reduces the tax credit amount for commercial installations between now and 2022. After the step down from 30 percent to 22 percent in 2021, the residential credit will drop to zero, while the commercial and utility credit will drop to a permanent 10 percent.
For corporate renewable energy buyers, the decrease in federal investment tax credits from 2019 to 2022 could result in increased solar PPA/ VPPA rates.
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The ITC Phase Out & Safe Harbor Guidance
With the impending step down of the solar investment tax credit, there remains one area of uncertainty — when a project begins to be eligible for the credit. The IRS issued a guidance statement, Notice 2018-59, which provides two methods a taxpayer may use to establish that construction of a qualified solar facility has begun; for the purposes of claiming the solar investment tax credit (ITC).
Those two methods are:
- The Physical Work Test, or
- The Five Percent Safe Harbor Test
The Physical Work Test
Under the physical work test stipulation, a project can satisfy the begin construction requirement if “physical work of a significant nature” has been initiated. Activities like acquiring permits and funding do not count as “physical work”.
The Five Percent Safe Harbor Test
Projects can also satisfy the begin construction requirements by paying or incurring 5% or more of the total cost of the project. This is often the more flexible and reliable method to “begin construction”.
Both tests require continuous progress towards completion.
As utility-scale solar developers look to secure the full 30% ITC for their projects, we expect to see many procure equipment early, such as solar modules, to meet the 5% threshold. This will put a strain on the supply of modules in the short term and may lead to a rise in solar module prices over the next couple of years. This is just another reason for corporates to get moving on a solar PPA and take advantage of today’s low prices.
What Happens After the ITC Step Down?
According to projection data released in 2015 by the George Washington University Solar Institute, if the 30% solar investment tax credit had not been extended, residential solar installations could have plunged 94% in 2017, and utility-scale projects could have declined 100% — with neither recovering anywhere close to today’s levels. Bloomberg New Energy Finance also predicted solar installations would drop by another two-thirds in 2017, which the Solar Energy Industries Association estimated would have cost America over 100,000 jobs. These predictions were used to help successfully lobby for the ITC’s multi-year extension and phase-out.
The 2015 extension and ITC step down seems to have prevented dramatic decreases in residential and utility-scale solar development. However, we won’t begin to see the phase out’s impact until 2020. In the short term, we expect the overall steady decrease in corporate PPA rates to flatten out, or even increase in some markets, due to pressure on solar panel prices. Even with upward pressure on prices due to the ITC step down, there are factors that could mitigate this. The following market conditions will continue to influence the amount of solar that gets deployed over the next several years, and the value proposition to corporate buyers in particular.
Solar Market Drivers:
- Declining costs of solar equipment
- Demand for residential, commercial and utility-scale solar projects
- Rise of retail electricity rates
- Increase in natural gas prices — a key variable in wholesale electricity prices
- Rise in coal-fired electricity
Additionally, the ITC phase out may actually lead to greater competition among tax equity providers as it expands access to the market for investors with sufficient tax liability to absorb the lower tax credit. Solar developers could eventually take traditional tax equity investors out of the capital stack altogether in the future. Solar energy’s low risk and steady returns are attracting new investors whose profit expectations are much lower than current tax-equity investors.
The ITC phase out may also lead to reduced financing costs, as the need for separate tax equity investments for financing solar projects requires complex deal structures and due diligence.
The cost of solar power purchase agreements (PPAs) could increase as the investment tax credit steps down over the next five years. Corporate buyers have an opportunity to take advantage of today’s low prices by executing PPA’s before the tax credit reductions take effect. If you are in the market for purchasing renewables or have sustainability commitments that could be accomplished via renewable energy purchase, it makes good financial sense to prioritize it now, with a little bit of urgency.