Renewable Energy Roundtable Update in the Wake of COVID-19
The COVID-19 pandemic has resulted in widespread disruption of business and industry across California, including the state’s vibrant renewable energy and energy storage industry. Farella Braun + Martel attorneys are tracking developments and advising project developers, equipment suppliers, construction contractors and investors on COVID-19 day-to-day issues affecting the industry. Below we provide a roundtable update with Farella attorneys serving the industry to identify key developments affecting their sectors.
Consistent with the impact of COVID-19 on many other aspects of renewable energy development, financing transactions are continuing, albeit more slowly than before, with potentially higher costs of capital and more risk scrutiny. After a pause over the past few weeks while banks and other institutions evaluated and adjusted for the impacts of COVID-19 on their operations and portfolios, the majority of large banks remain quite active, although there is a greater focus on existing portfolios, and with respect to new transactions, on quality and existing relationships. Financing transactions that have already been structured and priced are for the most part moving forward, whereas others earlier in the process are more likely to be subject to repricing or restructuring. Also, smaller lenders are more likely to have hit the pause button on new financing transactions altogether.
The same can be said for M&A transactions in the renewable space. Those transactions already in contract or far along in the term sheet phase are more likely to move forward, again on a slower pace and with more scrutiny. Whereas transactions in an earlier stage, or those with unique risk characteristics, are less likely to survive. For example, we have seen transactions paused or fall apart where the developer was not an established player and was unable to timely secure its financing commitments necessary to execute on acquisitions. We have also seen transactions with tight execution or opportunity windows put at risk given the addition time needed to consummate transactions in today’s market. However, project acquisition and sale opportunities are continuing across the United States.
With respect to the residential solar market, given the inability to visit homes and work on installations, it is no surprise there have been significant layoffs, and the expectation is that these layoffs will continue to grow in the next few months. However, the benefits of residential solar still exist, particularly in states like California, where, prior to the COVID-19 pandemic, there was a tremendous uptick in demand for residential solar plus storage due to the power outages resulting from the wildfires. This demand may even increase as so many of us are working from home and seeing our electricity bills skyrocket due to increased usage, which usage will not likely return to prior levels, just as we will not all be going back to work in the same manner as we did pre-COVID-19. As a result, there is hope that the residential solar market will rebound quickly once the shelter orders begin to abate.
Lastly, with respect to potential future stimulus at the federal level, many believe a straight extension of the ITC would serve the markets best in providing much needed certainty. Others believe cash grants would provide the most help by putting capital to work in the near term. However, no one really knows what may come from Washington in terms of new stimulus legislation, particularly with respect to near term help for the renewable energy industry.
Impacts on the ITC and PTC
Tax incentives to develop renewable energy project have certain timing requirements—the project must “commence construction” before a certain date and must be “placed-in-service” within a certain time frame. COVID-19, however, has raised questions as to whether these requirements will be met by projects that are currently under development as the shelter-in-place orders, supply line disruptions, and other protective measures cause delays.
As way of background, both the production tax credit (PTC), which provides a tax credit of 1¢–2¢ per kilowatt-hour for the first 10 years of electricity generation for utility-scale wind, and the investment tax credit (ITC), which provides a credit equal to a percentage of investment costs at the start of the project, are being phased out. To qualify for 60% of the original amount of the wind PTC, construction must commence prior to January 1, 2021.
To qualify for the ITC, construction must commence and the project must be placed in service by the following dates:
Placed in Service
Solar ITC Percentage
1/1/2020 - 12/31/2020
1/1/2021 - 12/31/2021
On or After 1/1/2022
The IRS established two tests for determining that construction has commenced:
- the “Physical Work Test” that requires “physical work of a significant nature,” or
- the “Five Percent Safe Harbor Test” which requires “spending five percent or more of the total cost of the project in the year that construction begins.”
For projects that have yet to commence construction, COVID-19 may cause delay in the Physical Work Test as many shelter-in-place orders and other protective measures do not allow construction to be undertaken during this time. The assessment of whether construction can be undertaken in a specific jurisdiction is based on the local shelter-in-place order. As such, the Physical Work Test may not serve as the best method of commencing construction during this pandemic.
The Five Percent Safe Harbor Test may be a viable option to commence construction. Construction will be considered as having begun once the developer “pays or incurs” five percent or more of the total cost of the energy property that is integral to the project. For purposes of the Five Percent Safe Harbor Test, whether the taxpayer is an accrual method or cash method taxpayer will determine if such costs are paid or incurred. For cash method taxpayers, the Five Percent Safe Harbor Test is satisfied when payment is made. Accrual method taxpayers will satisfy the Five Percent Safe Harbor Test when the expense accrues for tax purposes—all the events have occurred that establish (1) the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) that economic performance has occurred with respect to the liability (i.e., economic performance occurs when the taxpayer receives services or property or uses property another party provided). As such, economic performance would occur, and the five percent safe harbor would be deemed met, when the property is delivered.
One developer-friendly exception to the economic performance requirement is the so-called “3½-Month Rule”, which allows a developer to treat services or property as being provided (i.e., as economic performance) when the developer makes the payment, if the taxpayer can reasonably expect the person to provide the services or property within 3½ months after the date of payment. This exception may be relied upon at the end of 2020 to ensure that the project commences construction in 2020, and this exception may also have been relied upon in 2019. Developers who relied on this exception to meet the commence construction cut off for 2019 may not have yet received such inventory and equipment due to the disruption to supply chains caused by COVID-19. It would be reasonable to argue that the emergence of COVID-19 and the global disruption it caused is a force majeure event that could not have been reasonably expected and, therefore, developers would be deemed to meet the deadline. However, developers should review supply contracts to determine who bears the risk related to a delayed delivery.
Under either the Physical Work Test or the Five Percent Safe Harbor Test, the developer of the project will need to show continuous progress on the project after construction has commenced. This can be achieved in two ways: (1) the project is completed within four years, or (2) under the Physical Work Test, construction was continuous, or under the Five Percent Safe Harbor Test, efforts were continuous. IRS Notices provide some reprieve with respect to the continuous progress, which allows for some disruptions; however, it is unclear to what extent such leeway will be allowed.
As you can see, COVID-19 and the related protective measures may cause many issues with respect to qualifying for the maximum tax incentives. Industry groups have begun to advocate for an extension of the ITC and PTC and the placed-in-service deadlines and an option for a direct cash payment in lieu of the ITC or PTC.
Power Purchase Agreements and Construction Implications for On-Going Projects
Project developers with existing power purchase agreements (PPAs) whose projects are currently in construction (or have not yet started construction), and whose construction schedules have been impacted or may be impacted by the COVID-19 pandemic and/or the related governmental responses to same (e.g. business shutdowns, stay at home orders, travel restrictions and the like), are currently assessing their power purchase agreements to determine how a pandemic is addressed in their PPAs. In particular, a review of the PPA’s force majeure and/or change in law provisions and their related remedies will be critical.
In addition to undertaking a review of their PPAs on their own merits with regard to available schedule relief, project developers must also undertake a comparison of their particular PPA’s treatment of COVID-19 under its force majeure and/or change in law provisions with the parallel provisions in their EPC contracts (and equipment supply contracts in connection with owner-supplied equipment, if any) to ensure that any schedule relief that may be available to their EPC contractor or third party equipment supplier “flows through” under their PPA in a manner that provides similar schedule relief.
As all of the contracting parties involved in renewable project development and construction are still relatively early in the process of ascertaining the full impact of COVID-19, to the extent any notices of force majeure and/or change in law have been issued by EPC contractors with project currently under construction or to be constructed (or equipment suppliers providing equipment for such projects), we have seen preliminary “placeholder” notices to project owners of the COVID-19 pandemic as an event that may entitle the EPC contractor or equipment supplier to schedule relief, in order to preserve later and more specific claims to relief once the full impact of the pandemic can be more specifically determined. These notices are typically intended as a reservation of rights under the applicable contract and as a safeguard against project owner objections that notices of force majeure and/or change in law were not made in a timely manner.
Project Permitting and Environmental Review Implications
Despite the impact of COVID-19 on public agency and consultant support staffing, project permit applications, environmental reviews and entitlement processes are continuing to move forward, albeit at a slowed pace due to statewide and local work-from-home orders. The slowdown and related extension of certain deadlines, including agency hearing dates and statutes of limitations, however, are affecting project approvals and the certainty of those approvals at a critical time in light of federal tax credit, regulatory procurement and off-taker contract deadlines.
Reports from key counties in the Central Valley and Mojave Desert, as well as the Bureau of Land Management’s district and field offices, find agency staff continuing work to process permits and environmental review processes despite limited in-office staffing and remote work arrangements. The resulting effects on agency staff, compounded by similar impacts on supporting environmental and technical consultants, is invariably slowing permitting and entitlement timelines to process National Environmental Policy Act (NEPA) and California Environmental Quality Act (CEQA) documents and related individual permits and approvals. We are encouraged to see federal, state and local agencies moving forward in issuing documents for public review and comment and with guidance at both the federal and state levels (such as California Executive Order N-29-20 waiving certain provisions of the Brown Act) authorizing agencies to convene public meetings and hearings through telephone conference and to make public meetings accessible telephonically or electronically.
While projects are moving forward with permit and environmental review, the most profound impact on project development is the delay in obtaining final project approvals and the certainty of those approvals at a critical juncture in meeting upcoming federal tax credit, regulatory and contractual deadlines.
In the case of project approvals, we are seeing some council and board hearings suspended and observing delays in both discretionary and ministerial permit issuance, where even a relatively minor delay can have a significant impact on meeting construction and operations deadlines. Related hurdles have also arisen in connection with required third-party consultation processes including those with Native American tribes pursuant to AB52 and Section 106 of the National Historic Preservation Act due to tribal office closures.
Further complicating approval delays are extensions in critical statutes of limitations and federal and state court scheduling orders which directly affect the certainty of key project approvals. For example, on April 6, 2020, the California Judicial Council adopted an emergency rule tolling the statute of limitations for civil lawsuits, including CEQA causes of action from April 6, 2020 until 90 days after the Governor declares the end to the state of emergency. This lack of certainty and resolution of pending court challenges will cause a ripple effect on project construction and financing in the absence of further relief of critical tax, regulatory and contract deadlines.
We continue to closely monitor these considerations at the federal, state and local levels, and to assist our clients to advance renewable energy and storage project permits and entitlements as essential businesses and/or critical infrastructure under applicable COVID-19-related orders.
A Look to the Future
These are extremely unique and trying times. With the constant bombardment of bad news related to COVID-19, and the general uncertainty regarding the domestic and global economies, it is easy to take a negative view of the future. However, there are a number of reasons to be hopeful about the future of the renewable energy industry. Over the past few weeks, there has been a concerted focus on rebuilding the economy sustainably, through initiatives like the “Green Stimulus” that was proposed by a plethora of climate and social policy experts. Additionally, a recent national survey conducted by Data for Progress indicates that 74% of likely voters support public investment in renewable energy. There seems to be a growing consensus that devoting resources to renewable energy projects is essential for a healthy rebuild of the country.
Although the actions of Congress can be difficult to predict, there is optimism that our government will comply with expert and public opinion in this case. In the aftermath of our nation’s last economic recession, Congress passed the American Recovery and Reinvestment Act (ARRA) of 2009, which focused on jumpstarting the economy through investment in infrastructure, energy, education and tax cuts. In particular, the ARRA created incentives designed to promote clean energy and renewable energy, which played a major role in strengthening the economy as a whole. On a global scale, the International Renewable Energy Agency recently released a report arguing that accelerating investment in renewable energy could power an economic recovery from COVID-19 by causing global GDP gains of approximately $100 trillion between now and 2050. There is optimism that investments in the renewable energy industry will continue, and even grow, in the wake of COVID-19.
Throughout the coming weeks and months, we will continue monitoring the effects of the COVID-19 pandemic on the renewable energy industry and providing you regular updates. Thank you for your support – we look forward to navigating through these difficult times together.