Conservation Update: Financing Renewable Energy Projects on State and Local Government Property with Clean Renewable Energy Bonds
This article was featured in the May-June 2009 edition of the State Energy Program's bimonthly newsletter, Conservation Update.
by Claire Kreycik, Energy Analyst, National Renewable Energy Laboratory
When the City of Denver's water department, Denver Water, was evaluating options for financing the capital investment in two hydroelectric projects, it decided to investigate the use of a Clean Renewable Energy Bond (CREB). After applying and receiving an allocation, Denver Water issued two CREBs totaling $1.8 million, which were sold to Bank of America. The bond was structured such that Denver Water pays only a 0.75% interest rate over a 15-year term. CREBS, with their low-interest financing, may appeal to other state and local governments that want to implement their own renewable energy projects.
The process of applying for and issuing such bonds, however, requires a commitment of time and staff. Here we present a general overview; summaries of the process, tax credits, and potential challenges; and more about Denver Water's experience with CREBs.
The Internal Revenue Service (IRS) is accepting applications for new CREBs allocations until August 4, 2009.
CREBs are designed to be interest free; the federal government extends a tax credit to investors in lieu of interest payments from the issuer. In reality, local governments that use CREBs often must pay an interest coupon to investors or sell the bond at a discount to par, but this interest rate can be significantly lower than the interest paid on traditional tax-exempt municipal bonds.
The Energy Improvement and Extension Act of 2008 extended the CREB program and changed some program rules. The American Recovery and Reinvestment Act of 2009 expanded funding to $2.4 billion of new allocations. Of this amount, $800 million is available for state, local, and tribal governments; $800 million for public power providers; and $800 million for electric cooperatives (co-ops).
The Internal Revenue Service (IRS) is accepting applications for new CREBs allocations until August 4, 2009.
The CREB program was created under the Energy Tax Incentives Act of 2005, which added Section 54 to the Internal Revenue Code. $1.2 billion was distributed in the first two rounds. The table below shows the distribution of allocations by project type and issuer. In the first round, the IRS received 743 CREB applications totaling $2.1 billion in allocation requests. The size of allocations ranged from $23,000 to $3.2 million for government projects, and $120,000 to $31 million for co-op projects. In the second round, the IRS received 395 CREB applications totaling $898 million in allocation requests. Of the approved projects, government projects ranged in size from $15,000 to $2.95 million; and co-op projects ranged in size from $30,000 to $30 million.
The CREBs program has significant potential for financing public sector renewable energy projects. To be sure, some aspects can be challenging: there are tight deadlines for spending the proceeds and reimbursing projects costs. If more than one project is being developed, transaction costs could be an issue−unless the projects are bundled together and only one bond is issued. The key is to be proactive and meet all of the application and issuance requirements. In this way, CREBs can provide attractive, low-cost financing for deploying projects that will generate clean, reliable, and affordable energy to help our nation become more energy independent.
|Approved Projects||Round 1||Round 2||Total|
Process: Applying for and Issuing CREBs
How to Apply for an Allocation
The CREBs program is administered by the IRS. Each time that Congress funds the CREBs program, the IRS issues guidance and solicits applications from qualified entities with qualified projects. In April 2009, the IRS published a solicitation for applications for allocations of the new volume cap. The guidance document and application are available on the IRS Web site.
The guidance document and Section 54C(d)(6) specify that qualified issuers include: (1) public power providers; (2) cooperative electricity companies; (3) governmental bodies; (4) clean renewable energy bond lenders; or (5) not-for-profit electricity utilities that have received a loan or loan guarantee under the Rural Electrification Act.
Qualified projects can include the following technologies: wind, closed-loop biomass, open-loop biomass, geothermal, solar energy, small irrigation power, landfill gas, trash combustion, marine, and hydrokinetic.
The application must include: identification of a qualified owner and contact person, the project description for a qualified facility or facilities, the project location, a certification by an independent, licensed engineer, and the expected schedule of construction and completion of the project.
The applicant must describe prior CREBs allocations to the project or "related projects." Applicants may also apply for a CREB to expand capacity at an existing facility. However, projects that are "related" are ineligible. "Related projects" are those owned by the same entity (or related party), that are of the same type, located on the same site, and integrated, interconnected, or directly or indirectly dependent on each other.
The applicant must also obtain regulatory approvals; develop the financing plan, including the expected schedule for issuing and spending proceeds; and specify the dollar amount requested.
How the IRS Allocates Funds
After receiving the applications, the IRS allocates the funds to qualified applicants. For government bodies and electric co-ops, allocations are awarded to projects in order of the size of the qualified request from smallest to largest, until the amount of volume cap set aside for that category of qualified owners (currently $800 million) has been exhausted or until all applications have been granted. The methodology is different for public power providers (i.e., municipal utilities), who often submit applications for larger projects. The IRS allocates the funds on a pro-rata basis; each qualifying project will receive a fraction of the $800 million volume cap that is proportional to the total amount of money requested for all qualifying projects by public power providers.
How to Issue a CREB
It is recommended that the issuer consult with a tax lawyer before issuing the bond.
To issue a bond, a government agency must find a private investor to take on the tax credit and right to the principal. Given recent tax credit rates and the 70% credit reduction, anecdotally, it is estimated that high quality issuers will have to make annual supplemental interest payments in the range of 1% to 3%, depending on the structure of the transaction.
Investors may prefer that the issuer structure the CREB as a voter-approved general obligation bond. If this is not possible, the investor may require that the issuer create a debt reserve fund (sinking fund), into which the issuer makes scheduled payments for the purpose of principal repayment. This reserve fund is exempt from arbitrage rules, and its yield limitation is published monthly on the TreasuryDirect® Web site.
Alternatively, in certain cases, CREBs have been structured as secured-lease transactions, where the actual renewable energy system is treated as collateral.
Once applicants receive their allocation, they have three years to issue the bond. Proceeds can be used to reimburse prior expenditures on the qualified project, as long as the original expenditure was made no more than 18 months prior to receiving the allocation.
Timing of issuance can impact the amount of supplemental interest required and the permitted bond length. At higher tax credit rates, investors require less supplemental interest. Furthermore, bond length is derived from applicable federal rates (AFR), which are published monthly by the Federal Reserve.
The maximum term of a CREB is set by the U.S. Secretary of the Treasury and is based on a quantitative estimate of the present value of half the bond. The discount rate is equal to 110% of the long-term adjusted applicable federal rates, compounded semiannually, for the month in which the bond is sold. First, it is assumed that half of the face amount of the bond is the balance in year one. Then, the 110% discount rate is applied to determine the present value of the loan during each six-month period thereafter. Once the discounted amount of the loan balance reaches the face value of the bond, the total years of the term of the CREBs can be determined. For example, the long-term adjusted AFR fell from 4.56% in April to 4.53% in May 2009, resulting in an increase in the maturity limit from 14 to 15 years for bonds issued in May.
Spending Proceeds and Repaying the Debt
All of available project proceeds (APP) must be used on qualified expenditures within three years of the date of issuance. Available project proceeds are considered the bond proceeds and any investment earnings on these bond proceeds, less issuance costs. Issuance costs and an initial debt service reserve fund (which may be required by investors) are considered nonqualified costs, but can be financed by the issuer as long as they do not exceed 2% of the sales proceeds.
At issuance, the issuer must be able to reasonably expect to spend 10% of the APP within 6 months, and 100% of the APP by the third anniversary of issuance. The three-year expenditure period is considered a hard deadline, but the statute does have a relief valve, permitting the borrower to apply to the IRS for an extension of the expenditure period. Any amount left unspent at the end of three years must be used to redeem an equal amount of the outstanding CREB.
Available project proceeds invested during the three-year expenditure period are exempt from arbitrage restrictions. In previous rounds of CREBs, if money was invested during this period, the project developer had to pay to the IRS earnings in excess of the cost of borrowing. For new CREBs, investment returns on money placed in a construction fund to be used over the three-year construction period may be retained. Additionally, if a reserve fund is created, it must not earn more than what is needed to repay the debt. The "permitted sinking fund yield" is limited by the IRS; rates can be found on the TreasuryDirect® Web site.
CREBs are structured with a "bullet maturity," meaning the issuer can repay the debt at the end of the bond term, which is currently on the order of 14 to 15 years. These maturities are shorter than terms of typical tax-exempt municipal bonds, which are often structured as 20- or 30-year level debts.
Tax Credit Rates and Implications for CREB Issuers
|Date||Tax Credit Rate||"New" CREBs (70%)||Maturity|
The IRS Code requires that the Treasury Department set tax credit rates such that the issuer need not discount the bond nor pay additional interest payments. However, this has not been the case historically, nor is it estimated that it will be possible under the new CREBs program.
For the new round of CREBs, the tax credit rate is determined by the Treasury Department daily, based on its estimate of the yields on outstanding bonds with investment grade ratings between A and BBB for bonds of a similar maturity. However, it should be noted that the Energy Improvement and Extension Act of 2008 has reduced the annual tax credit rate allowed to 70% of the rate determined by the IRS. The following table shows recent rates published by the Treasury, with and without the 70% credit reduction.
Given the current rates, issuers will need to pay some supplemental interest. The table below presents a matrix comparing 14-year "new" CREBs with average tax-exempt bonds (TEB) issued the week of April 14, 2009. Though the tax credit rate is posted at 7.89%, the 70% credit reduction makes the effective rate 5.52%. At a corporate tax rate of 35%, an investor might require supplemental interest from the issuer of at least 2%, depending on the issuer's credit rating. If the municipality is single A, an investor might require as much as 3.5% supplemental interest.
|Year 1||"New" CREB||"New" CREB||"New" CREB||TEB (AAA)||TEB (AA)||TEB (A)|
|Tax Credit Rate (70%)||5.52%||5.52%||5.52%||0.00%||0.00%||0.00%|
|Tax on Credit||$1,933||$1,933||$1,933|
|Tax on Interest||$700||$1,050||$1,225|
Experience with CREBs
Potential challenges for state and local governments
With the new program rules, the deadline for spending CREB proceeds is tight at three years. Additionally, the window for reimbursement of project costs is only 18 months. Project developers must pay close attention to this deadline. Seeking time extensions is possible, but not necessarily straightforward or easy.
The most significant challenge with the CREBs program for state and local governments is that the high cost and complexity of issuing a CREB can drive up overall financing costs for a project. CREBs require considerable upfront leg work to apply for an allocation and to issue a bond. In previous rounds, some state and local governments have cited high transaction costs as a barrier to issuing CREBs. These costs are relatively independent of project size, and include the labor required to submit an application and issue the bond, legal fees, costs associated with voter approval (if pursuing a general obligation bond), and printing costs. In fact, a project revenue team estimated that the cost of issuing a CREB is roughly equivalent to issuing a revenue bond as much as five times its size.
One creative solution to reduce transaction costs was used by the Commonwealth of Massachusetts. The State's bonding agency, MassDevelopment, bundled 12 projects totaling 1 MW together and issued one bond. This approach reduced the cost of issuance significantly and helped attract investor interest, due to the larger bond size. See the NREL technical report, Solar Photovoltaic Financing: Deployment on Public Property by State and Local Governments, written by K. Cory, J. Coughlin, and C. Coggeshall and published in May 2008.
Case Study: Denver Water
Denver Water issued two CREBs in June 2008 for a total of $1.8 million. The bonds ($900,000 each) funded construction and improvements on two hydroelectric projects: the Gross Hydroelectric Project, a 7.6-megawatt (MW) facility, and expansion of the Williams Fork Small Hydroelectric Project from 3.15 MW to 3.65 MW.
With the aid of a bond counsel and financial advisor, Denver Water sold the CREBs to Bank of America with a 0.75% supplemental interest coupon over the 15-year term of the bond. It must be noted that these bonds were issued under the old CREBs rules, which were different with respect to tax credit rate, principal repayment, and use of proceeds.
The CREB covered all final-stage construction costs for the Gross Hydroelectric project, which was less than 10% of the total project cost. The CREB also covered about 70% of the cost of modifying and expanding the Williams Fork small hydroelectric plant. The remaining expenditures of each project were covered by revenue bonds issued in 2007.
Per the bond resolution, the investor required a reserve fund of approximately $130,000 for each CREB, which could not be funded by the CREB proceeds. This fund was a line item of the larger Water Works Fund.
The process of issuing debt for these projects took longer than if traditional municipal bonds had been issued due to the timeline of applying, receiving the allocation, looking for investors, and then preparing all the usual documents. Otherwise, Denver Water found the process of issuing CREBs straightforward.
This article is based on a brief that will be published by DOE's National Renewable Energy Laboratory titled Financing Public Sector Projects with Clean Renewable Energy Bonds. For background information, read an article published in the May–June 2008 edition of Conservation Update titled States Explore Financing Options for Solar Photovoltaics, which in turn, was based on an NREL technical report written by K. Cory, J. Coughlin, and C. Coggeshall and titled "Solar Photovoltaic Financing: Deployment on Public Property by State and Local Governments" and published in May 2008.
About the Author
Claire Kreycik, Energy Analyst, National Renewable Energy Laboratory
Claire Kreycik is an Energy Analyst at the National Renewable Energy Laboratory. Her primary areas of research are state and local renewable energy policy, electricity markets, and renewable fuels. She holds a B.S. in biology from Georgetown University and was a 2007 Research Fellow at the National Human Genome Research Institute.