Docket No.: 10-07-017
Date: November 9, 2010
Witness: Keith Martin
ALJ: Jean Vieth
DIRECT TESTIMONY OF KEITH MARTIN ON BEHALF OF
NATURENER RIM ROCK WIND ENERGY, LLC CONCERNING
SAN DIEGO GAS & ELECTRIC COMPANY’S
APPLICATION TO AMEND RENEWABLE ENERGY POWER PURCHASE
AGREEMENT WITH NATURENER RIM ROCK WIND ENERGY, LLC AND FOR
AUTHORITY TO MAKE A TAX EQUITY INVESTMENT IN THE PROJECT
TABLE OF CONTENTS
I. INTRODUCTION .................................................................................................................. 1
II. THE GLOBAL FINANCIAL CRISIS AND ITS IMPACT ON THE
TAX EQUITY FINANCING MARKET FOR ENERGY
INFRASTRUCTURE PROJECTS ......................................................................................... 3
III. YIELDS REQUIRED BY TAX EQUITY INVESTORS ...................................................... 6
IV. BENEFITS TO RATEPAYERS OF UTILITY TAX EQUITY
1 I. INTRODUCTION
2 Q-1. Please state your name and business address.
3 A-1. Keith Martin
4 Chadbourne & Parke LLP
5 1200 New Hampshire Avenue, N.W.
6 Washington, D.C. 20036
7 Q-2. By whom are you currently employed and in what capacity?
8 A-2. I am a tax partner in the Washington D.C. office of law firm of Chadbourne & Parke. I
9 am co-head of the project finance group.
10 Q-3. Briefly describe your educational background and professional experience.
11 A-3. I graduated from Wesleyan University in 1974 and received my law degree from George
12 Washington University in 1977. I was awarded a master of science from the London School of
13 Economics in 1978. I served as a legislative assistant to Senator Henry M Jackson from 1974-
14 1977, and as counsel to Senator Daniel Patrick Moynihan from 1979-1982. I joined Chadbourne
15 in 1983 as a partner.
16 Q-4. What is the purpose of your testimony?
17 A-4. I will provide information regarding recent developments in and the current status of the
18 US tax equity markets, with particular focus on the cost and availability of tax equity financing
19 available to developers of wind energy projects.
20 Q-5. Describe your professional experience and expertise in the area of tax in the context
21 of energy projects.
22 A-5. I have worked 27 years as the principal tax lawyer in the project finance group at
23 Chadbourne. There are 83 lawyers working full time in the group. We have worked on projects
24 in more than 80 countries. Roughly 60% of the work of the group the last four years has been on
25 wind and other renewable energy projects. We see a large share of the market.
1 I advised 186 companies in the power industry last year. I also worked with the tax
2 committees in Congress and the US Treasury Department on design and implementation of the
3 Treasury cash grant program for renewable energy projects that was in the economic stimulus
4 bill enacted in February 2009.
5 I have written more than 130 articles and book chapters on tax issues affecting the
6 independent power industry. I gave 61 speeches last year at industry conferences, including a
7 presentation on the economics of the wind industry at the Global Windpower convention and
8 chaired the annual finance forum of the American Wind Energy Association in New York. The
9 2010 Chambers USA directory, which does year-round interviewing of corporate law
10 departments and peers, says "[Keith Martin] is regarded by many commentators as the best tax
11 equity projects lawyer in the USA." I have spoken on tax issues every year since 1989 at the
12 annual meeting of the Independent Energy Producers Association in California.
13 From 1989 to 1992, I represented a group of large independent power companies in a
14 proceeding before the CPUC to address when "qualifying facilities" should be required to "gross
15 up" payments they make to California utilities to reimburse the utilities for the cost to
16 interconnect their facilities to the utility grid. I had represented the independent power industry
17 on addressing the same issues at the federal level with the US Treasury in 1987 and 1988.
18 Q-6. What is your experience or source of information regarding recent developments
19 and the current status developments in the tax equity markets?
20 A-6. Chadbourne has been engaged as counsel in some capacity in a majority of the tax equity
21 transactions in the US wind market during the last four years, including in 17 of the 18 such
22 transactions in the market in 2007, and six of the seven such transactions that closed in 2009
23 involving Treasury cash grants under section 1603 of the economic stimulus bill.
1 We have probably seen a majority of the wind tax equity transactions this year, but it is
2 impossible to tell until a final count of the transactions is taken at year end. I moderate panel
3 discussions from time to time among the principal tax equity investors. A transcript of one such
4 panel discussion at the wind finance summit in February this year in San Diego can be found in
5 the April Project Finance NewsWire on the Chadbourne website.
6 II. THE GLOBAL FINANCIAL CRISIS AND ITS IMPACT ON THE TAX EQUITY
7 FINANCING MARKET FOR ENERGY INFRASTRUCTURE PROJECTS
8 Q-7. Please explain why tax equity financing structures are used to finance renewable
9 energy projects.
10 A-7. The federal government pays between 56¢ and 65¢ per dollar of capital cost of the typical
11 wind farm in the United States through tax subsidies. The subsidy is in two forms. There is a
12 tax credit worth at least 30¢ per dollar of capital cost and depreciation worth roughly 26¢ per
13 dollar in projects on which Treasury cash grants or investment credits are claimed and a little
14 more on projects with production tax credits.
15 Almost no US wind developers are in a position to take advantage of the tax subsidies
16 directly. They lack the tax base to do so. Therefore, many developers essentially barter the
17 subsidies in complicated tax equity transactions with banks, investment banks and insurance
18 companies for cash to build their projects. Before the global financial crisis, these entities
19 usually had tax positions that would let them make full use of the tax benefits on renewable
20 energy projects.
21 Q-8. Please describe the effect of the global financial crisis on the financial institutions
22 that historically participated in the tax equity market.
23 A-8. The cost of capital available from tax equity investors to wind developers has increased
24 since the economy began to unravel in the fall 2008. There were 18 active tax equity investors in
25 2007. The market for tax equity investments started to collapse in September 2008 when
1 Lehman Brothers filed for bankruptcy. New tax equity commitments in the wind sector ground
2 to a halt by the end of that year.
3 Q-9. Why has the tax equity financing market remained under stress in the aftermath of
4 the global financial crisis?
5 A-9. The recession substantially decreased corporate profits. Lower profits and corporate
6 losses cut into the ability of the market to absorb tax subsidies. Some companies that might have
7 provided tax equity financing in the past moved to hoard cash. A number of tax equity investors
8 disappeared altogether from the market. Examples are Lehman, Fortis, AIG and Wachovia.
9 Morgan Stanley dropped out of the market in 2009 because of loss of tax base. GE Energy
10 Financial Services dropped out for a time and has since been in and out and back in. Citibank
11 remained in the market despite large reported losses, but may be pricing deals on the assumption
12 that it will turn profitable enough to use tax subsidies in two to three years rather than being able
13 to use them immediately.
14 Q-10. Explain the measures the federal government initiated early in 2009 to revive
15 investments in renewable energy projects.
16 A-10. In early 2009, the incoming Obama administration was concerned that new development
17 of renewable energy would slow due to lack of the availability financing. It persuaded Congress
18 in the economic stimulus bill in February 2009 to implement two initiatives to jump start
19 financing for renewable energy projects. First, the stimulus bill authorized the US Department of
20 Energy to guarantee loans to renewable energy projects. The loan guarantee program has been a
21 disappointment. Only four guarantees have been written to date and another 16 commitments
22 have been given against more than 400 applications. A major frustration is the amount of time it
23 is taking from the point a commitment is given to close on the guarantee.
1 Second, the bill directed the Treasury Department to pay owners of new renewable
2 energy projects 30% of the project cost in cash within 60 days after the projects are completed.
3 Developers must agree to forgo the tax credit part of the subsidy in exchange for the cash grants.
4 The idea was to have the Treasury act as a tax equity investor of last resort since the traditional
5 tax equity investors were not actively investing. The cash grants are only available for projects
6 that are completed in 2009 or 2010 or that start construction in 2009 or 2010 and are completed
7 by 2012 in the case of wind farms.
8 Q-11. Did the Obama cash grant program succeed in reviving tax equity investing?
9 A-11. That was not its goal. The goal was to serve as a bridge until the market could revive.
10 The idea was to convert the tax credit part of the subsidy into cash during a period when
11 developers were expected to have trouble raising tax equity because of a weak market. The only
12 tax equity transactions that closed during the first half of 2009 were legacy transactions to which
13 tax equity had committed before the market collapsed. New transactions remained on hold,
14 awaiting guidance from the US Treasury about how the cash grant program would work. That
15 guidance was issued in July 2009. Seven deals were done in the last half of 2009 involving
16 projects on which Treasury cash grants were paid.
17 Q-12. Describe the status of the tax equity market in 2010 and, in particular, whether
18 traditional tax equity investors are making commitments to provide the tax equity
19 financing necessary to support the construction of wind energy projects.
20 A-12. There are 16 active tax equity investors in 2010, however, three or four of those have
21 been more focused on the distributed solar market. As a result of the cash grant program the
22 market has largely recovered in terms of deal volume, but tax equity financing remains more
23 expensive than it was in 2007 when yields bottomed out at 5.8%. A developer planning to claim
24 production tax credits can expect to pay roughly 395 basis points more for tax equity than in
1 2007. That translates into a yield on projects considered least risky by the market of 9.75%.
2 That would be the yield for purposes of pricing (or establishing the amount of money the tax
3 equity investor is prepared to invest). The yield used to determine when the investor has
4 basically been repaid its investment plus a return, after which the project economics shift back
5 largely in favor of the developer, could be 50 basis points less.
6 Q-13. Does the volume of tax equity investment dollars in 2010 suggest that the private tax
7 equity market has been restored as a viable financing option for developers of wind
9 A-13. Tax equity is available for many of those who want it, but it is more expensive. The
10 higher the cost of capital, the more expensive a project and the more a developer will have to
11 charge for electricity to make the project economic. In 2009, just 40% of the external capital
12 raised for wind projects came from the tax equity market; the rest was debt. This reliance on
13 debt financing to supplement tax equity financing is in contrast to past years when most wind
14 projects were financed solely with tax equity. For example, of the 18 tax equity transactions in
15 the wind market in 2007, only two had project-level debt.
16 The Treasury cash grants are helping to keep the tax equity market afloat. Three to five
17 tax equity investors have said they will drop out of the market if the cash grant program is not
19 III. YIELDS REQUIRED BY TAX EQUITY INVESTORS
20 Q-14. How have the disruptions and changes in the tax equity markets affected the yields
21 required by tax equity investors?
22 A-14. Yields required by tax equity investors bottomed out at 5.8% in August 2007. In 2010,
23 tax equity yields are roughly 270 basis points above where they were in 2007 for projects that
24 claim Treasury cash grants and are unleveraged (i.e., the project is financed entirely with tax
1 equity and not also with permanent debt at the project level). They are 125 basis points higher for
2 unleveraged projects that use production tax credits, which, as I explained earlier, translates into
3 a yield for purposes of pricing of at least 9.75%. Investors charge more if there is also debt at
4 the project company level. The highest yield we have seen paid for wind tax equity this year was
5 close to 14% in a deal with project-level debt.
6 Q-15. Why would a project elect to take advantage of production tax credits rather than a
7 Treasury cash grant?
8 A-15. The reason a project might claim production tax credits rather than a Treasury cash grant
9 is that production tax credits can lead to a greater subsidy. Production tax credits are a function
10 of electricity output. They are 2.2¢ per kilowatt hour of electricity generated and sold during the
11 first 10 years after the project goes into service. Treasury cash grants are a function of project
12 cost. Thus, a higher-than-average capacity factor tends to push a project in the direction of
13 production tax credits rather than a cash grant. The developer must weigh that against the
14 challenges of raising tax equity in the current market.
15 Q-16. You have discussed the increasing requirements and costs that tax equity investors
16 are imposing on developers of wind energy projects. Can you also report on the
17 corresponding issue of the status of the demand by wind project sponsors to obtain tax
18 equity financing?
19 A-16. Demand among project developers for tax equity remains strong. Yields are ultimately a
20 function of demand and supply. The fact that yields are significantly higher in 2010 than before
21 the economy collapsed is a sign that there is greater demand today in relation to supply than in
23 The supply of capital in the tax equity market is expected to tighten somewhat in 2011.
24 New capacity additions in the wind market are down 50% this year compared to 2009, but there
1 is a rush to start construction of new projects, as the year draws to a close, that will be built in
2 2011 and 2012 in order to qualify for Treasury cash grants. In addition, a number of $1+ billion
3 solar thermal projects are expected to seek tax equity financing in the next two years. The tax
4 equity market for wind and solar was $5.4 billion in 2007. It is expected to reach roughly the
5 same level this year before the additional demands of the large solar projects are placed on the
6 market. Tax equity investors have been warning since last year about the difficulty the market
7 will have finding enough tax capacity to handle the solar bulge as well as the other demands
8 from wind, geothermal and biomass projects.
9 Circumstances in the low-income housing market may also reduce funds available for tax
10 equity investments in renewable energy projects. Tax equity yields in the low-income housing
11 market, which competes for tax equity funds with renewable energy, were above the yields in the
12 renewable energy sector early in the year, even though low-income housing projects are viewed
13 as less risky for investors. Inverted yields like this have the potential to draw some tax equity
14 away from renewable energy.
15 IV. BENEFITS TO RATEPAYERS OF UTILITY TAX EQUITY FINANCING
16 Q-17. In his testimony at page 1, SDG&E witness Michael Niggli states that “this is the
17 first instance of a regulated investor owned utility (‘IOU’) participating in a project
18 development through a tax equity investment….” Is that your experience?
19 A-17. Yes.
20 Q-18. Has it previously been possible for a regulated investor-owned utility to take
21 advantage of tax equity investments? Have any changes occurred in the tax code recently
22 that now make it possible?
23 A-18. An investment tax credit could not be claimed on renewable energy projects that are
24 considered public utility property before mid-February 2008. Without this change, no Treasury
1 cash grants would have been paid on such projects either. A project is considered "public utility
2 property" if the rates at which the electricity from the project is sold are set on a rate-of-return
3 basis. Regulated utilities also faced a practical hurdle to claiming production tax credits for wind
4 projects through a tax equity structure prior to 2008 because Internal Revenue Code Section 45
5 states that production tax credits are not available where the offtake is sold to a “related person.”
6 However, in Notice 2008-60, the IRS clarified that the offtake will not be considered to be sold
7 to a related person if the electricity is ultimately resold to an ultimate purchaser who is not a
8 related person. This was an important clarification by the IRS which opened the door to utility
9 investment in wind energy projects as tax equity partners.
10 Q-19. Does the potential for tax equity investment by regulated utilities create a new
11 avenue for the financing of renewable generation?
12 A-19. It does.
13 Q-20. Will SDG&E’s tax equity investment in the NaturEner Rim Rock project enable
14 ratepayers to purchase its green attributes at a lower cost than if NaturEner obtained tax
15 equity financing from one of the traditional non-utility participants in the tax equity
17 A-20. Yes. My understanding is that SDG&E is essentially lending both its ability to borrow at
18 a lower cost of capital and its tax base to enable the project to be financed with lower-cost money
19 than would otherwise be available to NaturEner from the traditional tax equity market players. I
20 also understand that NaturEner has agreed to reflect this lower cost of capital in the price at
21 which it will be selling power to SDG&E.
22 Q-21. Is the method of ratepayer repayment of the SDG&E investment reasonably
23 assured due to the monetization of tax benefits?
24 A-21. A tax equity investor's return comes substantially from tax benefits, partly from cash and
1 partly from its residual interest in the project (i.e., its remaining ownership interest after any flip
2 down in sharing percentages after it reaches its target return). The amount of MACRS
3 depreciation is largely fixed at the start, even though the deductions are taken over time. The
4 production tax credits that can be claimed are a function of the electricity generated and sold
5 during the first 10 years after the project is placed in service.
6 Q-22. Several parties have questioned whether ratepayers should be at “risk” for a
7 utility’s tax equity investment. Can you explain the risks of a tax equity investor?
8 A-22. In the typical partnership flip deal involving production tax credits, the parties share risks
9 as follows. Risks about which the developer has greater insight are borne by the developer.
10 Thus, for example, the developer takes the risk that the project was placed in service when the
11 parties assume that the production tax credits will start to run. It takes the part of the operating
12 risk that it can control as the contract operator of the project.
13 Risks over which the parties have equal insight are borne by the tax equity investor. An
14 example is that the deal is properly structured to make the tax equity investor a part owner of the
15 project for tax purposes. The IRS issued guidelines in 2007 for partnership flip transactions on
16 wind farms claiming production tax credits. My understanding is that the SDG&E/NaturEner
17 transaction has been structured to stay within these guidelines.
18 Other risks over which neither party has any control are borne largely by the developer in
19 the sense that the tax equity investor continues to receive 99% of the economic benefits from the
20 project until it reaches its target yield. Examples of the risks born by the developer are the wind
21 is not as strong as expected or there is a change in law affecting the project economics.
22 Projects are riskiest during the development phase. The tax equity investor does not
23 invest in a production tax credit transaction until after the project is in commercial operation.
1 The project developer and anyone who financed the development and construction work
2 assumed the complete risk for the development and construction of the project.
3 Q-23. You have suggested that the “market rate” for tax equity financing for a relatively
4 low risk renewable energy project would be approximately 9.75%. Is it your opinion that
5 if NaturEner’s only tax equity financing alternative available was the traditional private
6 tax equity market, its financing costs would be in that range?
7 A-23. That is my conclusion based on overall conditions in the market and on the proposal
8 letters we have been seeing lately from tax equity investors to other developers.
9 Q-24. Is your assessment of the cost of tax equity financing that NaturEner would incur
10 from the traditional tax equity market consistent with the perspective of other
12 A-24. I can’t speak for other professionals. However, Lee Rigney, a veteran tax equity
13 arranger, sent the attached letter about the results of contacts made to tax equity providers. He
14 believes NaturEner could raise tax equity for its project at a yield of between 8.5% and 10%.
15 That is within the range of what our experience in the current market suggests. Lee is an
16 experienced participant in the tax equity market.
17 Q-25. Does this conclude your testimony?
18 A-25. Yes.