Consider the challenge facing the manager of a large pension fund or the chief investment officer of a substantial university endowment or foundation. You are responsible for investing hundreds of millions, if not billions, of your fund, endowment, or foundation’s capital. You must invest a portion of the funds conservatively. This means low-risk investments that still must earn a positive return above inflation. The challenge is that for these types of low-risk investments, opportunities are limited. Individual investors face the same problem. Relatively secure investments with acceptable rates of returns are very limited. The current investment environment is certainly difficult.
As of April 2014, the benchmark US ten-year Treasury bond was yielding approximately 2.7 percent. Investment-grade domestic corporate bonds are yielding on average 3.1 percent. Taking on more risk than these standard low-risk investments such as US government and investment-grade corporate bonds does not result in substantially greater returns. The Financial Times reported, as of April 2014, according to Barclays’ indices, the average spreads on high-yield debt over Treasuries stood at 355 basis points. This is the lowest level since 2007, just before the Great Recession. Indeed, the quest for yield has become so great that in April 2014, the New York Times reported that the government of Greece, until recently considered a default risk, was able to sell about 3 billion euros in five-year bonds at a 4.75 percent yield. The offering attracted more than €20B in orders. The majority of the buyers were non-Greek pension and investment funds.
If the supply of low-risk investments with moderate returns is relatively small, the volume of capital chasing such investments is certainly not. According to a 2012 study by BNY Mellon, approximately $403 billion is under management by US endowments and $583 billion by US foundations. The Organization for Economic Cooperation and Development estimates that in its thirty-four member countries, as of 2012, private pension systems had accumulated a total of $32.1 trillion. All this capital must be invested somewhere.
It is no surprise that in the quest for low-risk yield both institutional and individual investors have turned to investments in energy assets, particularly midstream assets, such as interstate pipelines and transmission, along with conventional and renewable power generation. These investments, when they are backed by long-term offtake or power purchase agreements (PPA) with investment-grade counterparties, such as investor-owned utilities, municipally owned utilities or co-ops, or industrial hosts, are perceived as low risk and capable of providing highly predictable cash flows. Midstream and generation assets generally are large investments that enable investors to create scale. They also are favored by banks and lending institutions, enabling equity investors to take advantage of leverage to enhance returns. Institutional investors have been able to invest directly in these classes of assets or invest in them through managed funds, such as infrastructure funds that create a pool of investors that are able to invest large amounts of capital.
Institutional investors and pension funds are able to invest in infrastructure funds that focus on assets that provide long-term, low-risk, highly predictable returns. Some of these funds specialize in energy assets. Others include infrastructure such as roads, highways, ports, and water treatment plants, as part of their portfolio of assets.
Because investors’ alternatives for low-risk returns are limited and the supply of money seeking these investments is great, investors are willing to accept relatively modest yields. When investors accept lower returns for their investments, the cost of capital for project sponsors, developers, or sellers is reduced for certain classes of investment vehicles that may be used to invest in energy assets, generation assets, or portfolios of such assets. This article will review a number of investment vehicles that have been engineered, or adapted, to lower the cost of capital to an even greater extent and avail asset owners and developers of a wider group of investors who are “chasing yield.”
Master Limited Partnerships
One means of lowering the cost of capital is to avoid taxation at the corporate or entity level. If tax can be avoided at the entity level, more cash is available for distributions to the shareholders or limited partners and the cost of capital is lowered. The ability to avoid entity-level taxation is very significant and gives promoters a large competitive advantage as they seek to develop or acquire assets.
Generally C corporations, as well as publically held partnerships and limited liability companies, have a competitive disadvantage because they are subject to double taxation. The corporation’s profits are taxed at the corporate tax rate and the distributions to the shareholders are taxed at the shareholders’ tax rate. The following illustrates the problem: If a shareholder whose tax rate is 39.6 percent, the highest marginal rate for individuals, wants to earn a 4 percent after tax return on the asset held by a C corporation, the corporation must earn 11.04 percent. The 11.04 percent earnings of the asset will be taxed at the corporate rate of 40 percent, resulting in an after tax return of 6.62 percent. If that 6.62 percent return is distributed to the shareholder and the shareholder is taxed at 39.6 percent, the shareholder’s after tax return is approximately 4 percent. If taxation at the corporate level is eliminated, the asset only needs to earn 6.62 percent to give the shareholder 4 percent after tax return. If two bidders are competing for the same asset with one bidder not taxed at the entity level and the other is, the bidder who is not taxed at the entity level will be able to pay more for the asset than its competitor because it needs a lower return to give its shareholders or owners the same rate of return.
A master limited partnership (MLP) is a publicly traded tax pass-through entity, meaning that the MLP itself does not pay federal income tax at the corporate level. Normally, publically traded entities, including partnerships, are treated as corporations for federal income tax purposes and are subject to double taxation. A certain class of publically owned partnerships is exempt from entity level taxation if it meets certain criteria. Ninety percent of its income must be “qualifying income,” which is income from “exploration, development, mining or production, processing, refining transportation . . . of any mineral or natural resource” as well as income from real estate. This tax pass-through feature allows an MLP-enhanced cash flow, and MLPs are all about cash. A key feature of the MLP, and a reason it is attractive to investors, is its stable and predictable cash flows.
A MLP’s stable cash flow is a product of the requirement to distribute all of its available cash to its unitholders. This requirement is found in the MLP’s partnership agreement. The general partner retains significant discretion on precisely how much “available cash” to distribute. Such “available cash” is typically all cash on hand in a quarter, minus reserves established by the general partner for operation of business, cash needed to comply with debt covenants, reserves to ensure distributions for any of the next four quarters, and working capital borrowings after the end of the quarter.
While the MLP’s partnership agreement requires this distribution, the market itself incentivizes significant distributions as well. Because MLPs are traded based on a multiple of cash flow, the investor community is seeking strong assurance that it will receive cash distributions, which therefore increase the market valuation of the MLP. Internal mechanisms exist to support cash distribution. Essentially, the sponsor’s units are subordinated to those of the public common units, meaning the public unitholders get their cash before the sponsor gets its distribution.
Certain tax rules make for a limiting feature for the investment base in an MLP. Income from MLP investments is considered unrelated business taxable income for a tax-exempt investor, such as a pension fund, and it must pay income tax on its share of the MLP’s income. In addition, mutual funds are limited by tax rules that permit the fund to own less than 10 percent of any one MLP, and no more than 25 percent of the value of the mutual fund’s total assets can be invested in an MLP. Foreign investors are also discouraged by the US tax code from investing in MLPs, further limiting the investor pool.
MLPs most commonly are found in the energy industry, and many MLPs own energy assets. This is because in order to qualify for the MLPs tax pass-through status, 90 percent or more of the MLP’s revenue must be “qualifying income,” generated from the “exploration, development, mining or production, processing, refining, or transportation . . . of any mineral or natural resource,” including coal, lignite, oil, natural gas, and natural gas liquids, and certain passive income, such as interest, dividends, and real property rental income. In 1988, Congress clarified that certain inexhaustible resources such as water and air are excluded from the definition. This means that renewables such as solar and wind power do not constitute a natural resource and cannot receive the same favorable MLP tax treatment carved out for fossil fuels.
The MLP structure was not always reserved solely for energy-related business. From the time of the first MLP IPO in 1981 until 1987, there were many IPOs for companies with no connection to the energy industry. The Boston Celtics raised nearly $50 million with an MLP IPO following the Larry Bird-led NBA championship of 1986. In 1987, Congress passed legislation to severely restrict the use of MLPs. Congress did expressly carve out much of the energy industry from the legislation, however, allowing energy-related businesses to maintain the tax flow-through status.
As the search for stable yield continues, there has been a recent push to remove the limitations Congress placed on the MLP market by allowing renewable energy assets to be added to the mix. Renewable energy projects with signed PPAs could deliver a healthy rate of return for investors, while also offering stable returns for the length of the PPA (typically twenty years). In an attempt to provide renewable energy projects access to capital at a lower cost and make them more attractive to private investment, Senators Chris Coons (D-DE) and Jerry Moran (R-KS), introduced the MLP Parity Act to the Senate in 2012 (S. 3275). The bill was reintroduced in 2013 as S. 795. Senator Coons’ white paper on the MLP Parity Act (the Act) notes that the Act would expand the definition of qualified sources to include clean energy resources and infrastructure projects. Included are those energy technologies listed in Section 45 and 48 of the tax code, such as wind, closed and open loop biomass, geothermal, solar, municipal solid waste, hydropower, fuel cells, and combined heat and power. The proposed legislation also allows cellulosic, ethanol, biodiesel, and algae-based fuels to qualify, along with energy-efficient buildings, electric storage, carbon capture and storage, renewable chemicals, and waste-heat-to-power technologies.
The renewable energy industry is quick to point out, however, that it does not like the idea of trading the MLP qualification for allowing tax credits, such as the PTC and ITC to expire. The American Council on Renewable Energy (ACORE) and other industry groups sent a letter to Congress noting that
Supplementing the existing federal investment tax credit (ITC) and production tax credit (PTC) with MLPs could work for renewable energy and other clean energy technologies as it has for oil and gas. The ITC and PTC have been foundational to spurring private sector investment, creating jobs, and driving down costs significantly, to the point where some renewable technologies are approaching cost competitiveness.
Additionally, the American Wind Energy Association stated that it
. . . supports the MLP Parity Act to allow everyday Americans to invest in renewable energy, as they are able to do with other energy sources. Extending the PTC is the industry’s top priority; given its effectiveness in driving renewable energy development in the U.S., MLPs can complement the PTC.
With the PTC having expired at the end of 2013 and the ITC set to expire at the end of 2016, the industry may not get its wish that the Act serve as a supplement to tax credits instead of an alternative.
Real Estate Investment Trusts
Another investment vehicle that has the potential to reduce the cost of capital for some energy investments is the real estate investment trust (REIT). REITs have been available for real estate investment since the 1960s but are now being used for investment in some renewable energy projects. Like MLPs, REITs provide a lower cost of capital by avoiding or minimizing entity-level taxation. If the REIT meets the requirements of the Internal Revenue Code (IRC), it may deduct the distributions to its owners from its taxable income. Thus, if the REIT distributes 100 percent of its income to its owners, it effectively eliminates tax at the entity level. In order to qualify the REIT must meet several tests under sections 856 and 857 of the IRC. It must (1) primarily own real estate assets, cash, cash equivalents or US government securities; (2) derive the majority of its income from passive sources such as rent and interest; (3) be broadly owned; (4) distribute at least 90 percent of its income to its equity owners; and (5) elect to be treated as a REIT.
The challenging issue facing developers or owners of renewable assets who wish to create a REIT is whether they can meet the first two tests: does the entity primarily own real estate assets and derive the majority of its income from passive sources, such as rents, interest, dividends, and gains from sales. Section 856(c)(5)(B) of the IRC defines real estate assets as real property, including real property and interests in mortgages on real property. The IRC does not contain a definition of real property, but Internal Revenue Service (IRS) regulations defines it as land and improvements on the land, such as building and other permanent structures. Under the IRC regulations, however, equipment or machinery used to operate a business on the land is not considered a real estate asset.
Whether renewable assets qualify as real estate assets under section 856 is difficult to answer absent specific facts. The IRS has issued a number of private letter rulings regarding different classes of assets, which suggest that certain classes of renewables, such as rooftop solar and inside-the-fence combined heat and power systems could be considered real estate assets.
In May 2014, President Obama issued an executive order that the IRS will publish new regulations clarifying that certain solar assets may be eligible for REIT treatment. The proposed IRS rule seeks to clarify exactly what solar assets are considered “real property.” Under the proposed rule, if an asset has an active function, such as the generation, manufacture, or creation of a product, then the asset is not considered “real property” unless it has a “utility-like function” such as electricity, heating, and cooling for an “inherently permanent structure” of which it is a constituent part.
The proposed rule clarifies that certain intangible assets can meet the definition of “real property” and generate qualifying REIT income. These intangible assets must derive their value from and be inseparable from a REIT’s real property, and any income generated from the intangible assets is linked to consideration for the use or occupancy of the space. Importantly, the IRS notes in the proposed rule that this expanded definition of “real property” is only meant to apply to sections 856–859, and should not impact the preferred broad definition of personal property, which is crucial to asset depreciation permitted under the investment tax credit.
Helpfully, the IRS provides hypothetical examples of solar assets that would or would not qualify as real property for REIT purposes. Although the analysis is fact-dependent, utility-scale solar likely will not qualify as real property for REIT purposes, while distributed generation likely may qualify. The first example describes merchant generation. Here, the REIT owns solar assets, which include land, PV modules, ground mounts, and an exit wire to the grid. The REIT enters a long-term triple net lease with a tenant for the site and assets, and the electricity is sold to third parties off-site. The IRS concluded that this does not meet the REIT definition of real property because (1) the PV modules are easily removable, (2) the assets produce electricity for sale to third parties, and (3) the income generated by the PV modules does not represent consideration for the use or occupancy of the real property. This means that most utility-scale solar projects with long-term PPAs will not qualify as REITs.
The second example describes distributed generation. The REIT owns both an office building and a PV site adjacent to the property. The REIT leases the building and energy site to a tenant and the energy site powers the office building, with excess power sold back to the utility. Here, the IRS says the PV modules serve a “utility-like” function, directly delivering power to the office building. The power is not generated for sale to third parties. The income generated from the PV modules is deemed consideration for use or occupancy of space in the office building. The building and solar assets can be treated as real property for REIT purposes. The IRS also noted that an office building with solar shingles that serves the power needs of the building (even if some power is occasionally sold back to the utility) would qualify as real property for REIT purposes.
The IRS has addressed a very limited set of projects—where the rooftop solar installation is owned by the REIT-building owner. This very narrow approach is clearly not what energy project developers were seeking and will probably do little to promote the use of REITs for renewable development.
Yieldcos: The New Kid on the Block
Yieldcos are created to give investors an opportunity to buy shares of a company that has as its asset base operating contracted assets, which have been contributed by the sponsor after they have gone into operation. The investor avoids development risks and obtains a regular dividend, and hopefully a better yield than it can obtain in the bond market or from treasuries. Yieldcos are among the more interesting products that have enabled developers and owners to attract low-cost capital. Sponsors, moreover, have used the yieldco structure to create essentially a “synthetic” MLP, that is to say it is engineered to mimic the principal characteristic of MLPs but have an asset base consisting of renewable and conventional power generation assets, whose income is not eligible for MLP treatment.
These yieldcos create MLP-like tax treatment by combining tax-favored investments such as renewables (wind and solar) with nontax-favored assets such as conventional generation units. Some yieldcos have exclusively tax-favored renewables. The tax benefits generated by the renewable assets are sufficiently large to shield all the earnings of the yieldco from corporate level taxation. The yieldco effectively eliminates the double taxation problem.
NRG Yield, Inc. (NRG Yield) is an example of successfully structured yieldco that had its initial public offering (IPO) in July 2013. According to NRG Yield’s 10-K (February 26, 2013), NRG Yield held assets amounting to 1,447 megawatts (MW) of net capacity. Of these assets, 910 MW of net capacity is conventional generation, 303 MW is utility-scale solar, 10 MW is distributed solar generation, 101 MW is wind generation, and the remainder is thermal infrastructure assets. All the assets are under long-term contracts with investment-grade counterparties having a weighted average Moody’s rating of A3. There is an opportunity for dividend growth because of NRG Yield’s relationship with NRG Energy, Inc., which will be able to “drop” new assets into NRG Yield that meet NRG Yield’s investment criteria as they are acquired and developed. Because of the renewables in the portfolio, in the words of NRG Yield’s Fourth Quarter 2013 Results Presentation (February 28, 2014), “NRG Yield does not expect to pay significant federal income taxes for approximately 10 years.” Thus, NRG Yield has engineered a synthetic MLP, providing investors with steady, contracted yield from strong, creditworthy counterparties and essentially avoiding federal taxes at the corporate level.
Yieldcos also have key advantages over certain other classes of similar vehicles such as REITs and MLPs. First, the category of assets that the yieldco can own is not limited as is the case of MLPs and REITs. Absent a change in law, MLPs cannot own generation assets. As discussed above, there is still an evolving definition as to what types of energy assets REITs can own and what structures must be put in place to permit inclusion of the assets into the REIT. Yieldcos do not have these limitations. A yieldco can have a diverse portfolio of assets, giving it better business development opportunities and allowing it to diversify among generation types (wind, solar, gas, coal, nuclear) and markets. Additionally, it can appeal to a larger segment of investors. The tax rules for REITs and MLPs make them less attractive for investment by nontaxpaying entities, such as pension funds, foundations and endowments, mutual funds, and non-US taxpayers. Yieldcos as taxpaying, publically traded corporations do not have this handicap. This enables the yieldco to expand its potential sources of capital to a much larger and deeper investment base.
The viability of the yieldco model is dependent on the availability of tax benefits to shield the yieldco’s corporate income. This should not be a problem in the short term, but it may be a challenge in the long term. The PTC for wind has not been reauthorized, so unless a project was “commenced” by year-end 2013, it is not eligible for the PTC. The 30 percent ITC for solar will expire at the end of 2016 and then revert to 10 percent. Given the rush to start construction of wind projects by year-end 2013 and ongoing solar development, there should be plenty of inventory for tax-favored investment opportunities for the immediate future. If Congress, however, does not reauthorize and extend the PTC to cover wind projects that commenced construction after 2013 or the 30 percent ITC for solar after 2016, long-term growth of yieldcos, which combine tax-favored renewables with conventional generation, may be adversely affected.
Impact and Risks of Low-Cost Capital
The availability of inexpensive capital has impacted the energy industry in a number of ways. Developers of conventional and renewable generation projects have been able to raise capital at a lower cost. Many developers are not the most economically efficient long-term owners of the projects they develop. Developers who have developed projects with a goal of selling or monetizing the projects once they are ready to commence construction or operation are able to obtain favorable valuations because their buyers are willing and able to accept lower returns.
Long-term owners of assets who have access to lower-costing capital are able to offer investors steady and relatively safe income streams. An indicator of how successful such an offering can be is the reception to NRG Yield. The NRG Yield initial public offering was 10 times oversubscribed and raised $430.7 million. Initially offered in late July 2013 at $22.00 per share and a 5.5 percent yield, as of April 2014 NRG Yield was trading at $42.57 per share with an approximately 3 percent yield. The trend continues. On May 20, 2014, NextEra Energy, one of the largest US developer and operator of renewable generation assets, filed an S1 for NextEra Energy Partners, LP, a yieldco that is organized like a MLP (but is still a federal income tax payer). The initial portfolio will include nearly 1 gigawatt of contracted wind and solar projects in the United States and Canada.
Utilities and their ratepayers and other purchasers of power also may benefit from the lower cost of capital and the willingness of investors to accept low returns for cash flows that are perceived as low risk. Utilities that are purchasing power are able to require generation asset owners to accept lower PPA pricing as asset owners compete for the long-term contracts that underwrite their investment vehicles.
There are risks that should be considered. Generation assets have inherent commercial, operational, and regulatory risks. Competition from new, more efficient assets can make existing assets uncompetitive. Forced outages when equipment breaks down can reduce cash flows and result in lower than expected returns. Changes in environmental regulations and policies could impact the cost structure of many generation assets. Does the market adequately assess and price the operational and regulatory risks? Arguably not. When investors are willing to accept lower returns on their investments, it leaves very little “margin for error” if things go contrary to expectations in the future.
It should be asked whether investors are adequately compensated for these risks. This is an open question. One clear lesson from the banking crisis of 2008 and the Great Recession is that some very smart people and the markets generally can underestimate risk. The risk of the subprime housing market was not adequately understood nor priced by the market. Are the risks of “fully contracted” assets adequately understood and priced now? It remains to be seen how much value of conventional generation assets could be destroyed by future developments such as a national policy that puts a high cost on carbon. How much value is being put on assumptions regarding the recontracting of the assets after their current PPAs expire? It is possible that imbedded in the valuations of these “contracted” assets is a lot of merchant exposure once the contract period ends. Could game-changing advances in technology, advances in energy efficiency, or large-scale adoption of distributed generation invalidate current assumptions regarding the long-term value of the assets?
Even with these risks taken into account, there is no reason to believe that the current environment that has created the opportunity to access low-cost capital will change soon. It does not appear that the era of low interest rates and yields will end very soon. The US economy and Europe still have high levels of unemployment and their economies are growing, if at all, at very slow rates. China and other developing economies, such as Russia, India, and Brazil, appear to be slowing, as well. Inflation looks to be in check. For the foreseeable future, energy project owners and developers should be able to access low-cost capital to support investment in energy assets. Creative companies, bankers, and lawyers have developed new or repurposed, well-established investment vehicles such as yieldcos, REITs, and MLPs to enable individual investors who are “chasing yield” to invest in energy projects that were until recently the exclusive territory of funds and strategics. They have made another source of lower-cost capital from investors who are “chasing yield” to the energy industry.