January 7, 2016
By Fred Greguras
The omnibus spending legislation (Consolidated Appropriations Act of 2016) enacted on December 18, 2015 includes a five year extension of the investment tax credit (“ITC”) for solar and an extension for the production tax credit for wind power generation. This action provides hope that someone in Congress, perhaps a climate change advocate who understands the importance for the environment as well as the economy, will be inspired to champion the same type of incentives for water projects. Improving water quality, mitigating scarcity and increasing supply in the U.S. are equally as important as reducing the demand for natural resources in energy generation. The effects of global warming may increase the water scarcity problem in California and elsewhere. Private sector financing can be a simpler, faster and a more viable alternative in many cases if such incentives are implemented, particularly for smaller projects.
The ITC for solar provides a 30% tax credit for certain equipment and other personal property purchased and used in solar projects. Under the December, 2015 extension, the 30% tax credit will continue through 2019 and then decline gradually to 10% in 2022. Currently, equipment and other personal property used for water desalination, remediation, reclamation, storage or other water projects are not eligible property under the IRC § 48(a) (3)(A) categories or any other IRC § 46 investment credit category.
The 30% ITC and five year accelerated depreciation (“AD”) (rather than 25 year depreciation) have stimulated private sector financing of solar projects and are needed to attract private investment to water projects. Solar installations have grown in the U.S. at a compound annual rate of 76% since the ITC was implemented in 2006, according to the Solar Energies Industry Association. The availability of the ITC and AD for water projects could be monetized for financings with tax equity investors which has been an important source of funding for the renewable energy sector.
The Public-Private Solution
Public water facilities have historically been funded by public financings such as bond issues rather than by private financings. Necessity may drive the authorization of private financing techniques for public facilities since general obligation (“GO”) or revenue bond issues to finance new or upgraded water facilities may simply not be feasible.
The passage by California voters of Proposition 1 in November, 2014 illustrates the difficulty of public funding of water facilities and why incentives are needed for private sector financing of water projects. It was the first state water bill approved by voters in almost 10 years.
Both the state and local governments may issue GO bonds under the California Constitution. However, state level bonds need to be approved only by a majority of voters in an election while local GO bonds must be approved by 2/3 of the voters and are rare. Local governments usually need to increase property taxes to repay the GO bonds to the extent permitted under Proposition 13, the 1978 proposition that limited property tax increases. California voters are unlikely to change the Constitution to make it easier to be taxed at the local level.
The 2/3rds voter approval requirement has made it very difficult for local governmental agencies to raise money for water projects using GO bonds and has caused a greater reliance on state level bonds. Spending under Proposition 1, however, requires matching funds from non-state sources in many cases which will continue to put pressure on local funding.
While Proposition 1 authorized $7.12B in GO bonds, it is not enough to solve the California water financing problem. A March, 2014 report, Paying for Water in California, prepared by the Public Policy Institute of California indicates that such funding will, best case, cover half of the total spending gap.
The concern over the water shortage in California has become so great that the state is supporting innovative long-term solutions such as the Carlsbad, California Desalination Project (“Carlsbad Project”) which began operations in December, 2015. The billion dollar project was built by a private company, Poseidon Water, and financed with over $700M in tax-exempt bonds with the rest of the financing by a private equity investor. The tax-exempt bonds were issued by the California Pollution Control Financing Authority on behalf of the project developer and the San Diego County Water Authority (“Water Authority”). The revenue stream for repayment to investors is a 30 year water purchase agreement with the Water Authority (“WPA”) similar to a power purchase agreement in the solar and wind energy sectors. The WPA provides a predictable source of revenue to make the numbers work for investors and provides the Water Authority with long term certainty for water costs and supply.
Financing Smaller Water Projects
Incentives at the national level such as a 30% ITC and five year AD are needed to attract private investment to smaller water facilities at the local level. An August, 2015 Congressional Research Services report (“CRS Report”) states that the majority of water infrastructure needs in the U.S. are for smaller projects in terms of the amount of the financing. As indicated, currently, equipment and other personal property used for water desalination, remediation, reclamation, storage or other water facilities are not eligible property for the ITC.
A water project must have a meaningful revenue stream (WPA, lease payments, water fees, etc.) and demonstrate creditworthiness in order to be viable to investors. Successful project finance depends on making the return on investment (“ROI”) numbers work for developers and investors with a high degree of predictability. The numbers must work when matching revenue streams against startup and recurring costs. The greater the ratio of equity to debt, the more likely a financing is feasible and the better the debt financing terms that are likely to be available.
California and other states can help solve the financing problem by authorizing the ITC and AD at the state level as well. States can also help make private financing more feasible by excluding property taxes on a water facility when owned privately. Eliminating sales and use taxes on purchases of equipment and other personal property used in the facility would also help make a financing more feasible since it would reduce the amount needed to be financed. There are other ways to reduce project costs such as for equipment, construction, operation and maintenance (“O&M”), taxes and financing costs like interest payments. For example, using “bankable” equipment reduces the cost of O&M; using an engineering and procurement contractor with a strong track record reduces construction costs and using the same financing team for multiple projects reduces transaction costs.
Consider the impact of the proposed federal incentives on the financing of a $40M water reclamation facility. The project entity monetises the ITC and AD with a tax equity investor. The tax equity investment would be about 40% of the $40M or $16M. Assume the private sponsor/developer makes an equity investment of 20% or $8M in order to satisfy investors requirements to have skin in the game. The beauty of a tax equity investment is that an investor only receives tax benefits and not a repayment stream. The remaining amount, $16M, would be debt financing. The amount of the debt financing becomes smaller because of the equity investments with a resulting smaller amount of debt service that is more likely to be covered by project revenue streams. In contrast, a public revenue bond financing would likely have to be for the full $40M and would be difficult to have a tax equity component because of the forbearance requirements of the tax equity investor and the constraints of the public financing process.
If a solar property is foreclosed on by the lender, the IRS will “recapture” the remaining tax credits that have not yet vested over the five-year period (20% of the total tax benefit per year). The AD deduction for the tax equity investor will cease upon a foreclosure. A tax equity investor does not want to lose any portion of the tax benefits because of the adverse impact on the projected ROI that was the basis of its investment. As a result, a tax equity investor wants the project lender to forbear exercising its foreclosure rights against the borrower during that period to avoid recapture. On the other hand, the lender wants the right to exercise its remedies in the event of a default by the borrower which creates a conflict between the interests of the project investors. This conflict is resolved by a forbearance agreement. Tax equity investors and lenders have developed a number of alternatives to absolute forbearance in renewable energy financings that mitigate the risks to both investors which can also be used in water project financings.
Financing Large Water Projects: WIFIA Program
The federal Water Infrastructure Finance and Innovation Act (“WIFIA”) financing program was enacted in June, 2014 for large water infrastructure projects throughout the U.S. The purpose of WIFIA is to provide credit assistance to such facilities that otherwise have difficulty in obtaining financing. Projects must be a minimum of $20M in cost to be eligible for credit assistance under WIFIA, except for a lower threshold for projects in rural areas. According to the CRS Report, WIFIA can be an important financing tool for large and costly projects but the majority of water infrastructure needs are for smaller projects. No projects have been financed under WIFIA since Congress has only provided start-up funding for the program but none for loans.
WIFIA will provide low-cost loans from the U.S. Treasury for up to 49% of a project’s cost. WIFIA loans are intended to be combined with other financing alternatives to enable public-private partnerships for financing water infrastructure. Projects must have a revenue stream and demonstrate creditworthiness to be eligible. This requirement should reduce the federal government’s risk and also encourage private investment. In December, 2015 WIFIA was amended to permit loans to be used in projects which are financed in part by tax exempt bonds. Previously, large projects using such financing such as the Carlsbad Project were not eligible for WIFIA loans. The amendment should make such loans more feasible since the interest cost is lower for tax exempt bonds and a private investor is likely to want to spread the financing risk of the cost of such a large project.
Tax equity investors are less likely to be interested in projects with extremely large costs involving public financing because they want to spread the investment risk across a portfolio of projects rather than one large project and the difficulty of negotiating acceptable forbearance provisions with public entities for the five year period of the ITC and AD.
Now is the time to become more innovative and promote and enable more private sector investment in public water projects by providing financing incentives instead of continuing to propose more income and property taxes and fees for public funding of water projects. Bond issues to finance water projects are increasingly difficult to get approved. Congress needs to enact the same ITC and AD for water projects as for solar projects to enable financings throughout the U.S. Additionally, California and other states can help make financings more feasible by enacting a state level ITC and AD and also by excluding privately owned water facilities from property tax and the equipment and other personal property used in such facilities from sales and use tax.
January 7, 2016
 Innovative water related technologies are likely to be implemented sooner in privately financed projects. For example, see http://rroyselaw.com/water-and-the-internet-of-things-2016/