ITC Tax Normalization Limits Solar Growth and Favors Fossil Fuels

SOURCE: | The following is a contributed article by Eric Blank, economist and co-founder of Community Energy, and D.R. Richardson, consultant and private equity expert.

Thanks to the solar Investment Tax Credit (ITC), a decade of explosive growth and a continuously descending cost curve, the cost of solar energy can now often out-compete the cost of operating and developing new fossil fuel power plants. And that’s before quantifying its role in meeting renewables targets, modernizing the grid, and reducing emissions — that’s based solely on economics.

Yet there’s something keeping utilities from investing in solar and missing from current discussions about extending the solar ITC. Solar could be the most profitable resource for utilities, if not for an obscure requirement associated with the ITC called “tax normalization.”

The requirement prevents for-profit utilities from maximizing the value of solar and encourages them to keep existing uneconomic coal plants open or build new natural gas because they are more profitable, despite being more expensive for consumers.

There’s an ongoing effort by some to remove tax normalization while extending the solar ITC as part of a next-round stimulus package. But the effort is met with pushback from a small handful of industry players who are attempting to keep for-profit utilities from directly owning solar assets.

Beyond that, there’s little engagement from the broader clean energy community on this issue. And that’s stunting the solar industry and encouraging uneconomic fossil generation.

Benefits of losing tax normalization requirements

Exempting the ITC from the tax normalization requirements would fundamentally align customer and shareholder interests and produce material economic benefits for utilities, customers and the environment. Here’s how:

For many years, unregulated energy companies, financial investors, and tax equity investors have partnered to efficiently finance and construct new solar facilities, leveraging the ITC and other depreciation benefits afforded by solar. Asset owners can utilize the full benefit of the solar ITC in the first year when the project is placed in service.

Regulated electric investor-owned utilities (IOU), however, are subject to tax normalization rules, which require the tax credits to be realized over the operating life of the solar assets (30+ years). This limits IOUs’ ability to efficiently monetize the ITC and depreciation benefits and increases costs to customers of utility-owned solar by as much as 20-30 percent, according to our financial models.

Given this cost differential, state regulators almost always favor third-party power purchase agreements (PPA) over utility-owned solar. While these projects tend to be cheaper for consumers, they don’t generate profits for the IOUs. This forces IOUs to choose between PPA-solar and non-solar resource investments, which cost more for customers, but can generate more profits for utility shareholders.

We modeled the choices for a typical utility running an aging coal plant in the Southwest Power Pool. Given that utility-owned solar, with tax normalization associated with the current solar ITC, is prohibitively expensive, the utility has three viable options: (1) keep running the existing coal plant, (2) replace the coal plant with a new combined cycle natural gas plant (CC) placed into rate base, or (3) replace the coal plant with a Solar PPA, firmed up by a new peaking resource.

As shown in Table 1 below, the best outcome for customers is to replace the existing coal plant with the Solar PPA + Peaker. This approach is about 20% cheaper on a levelized cost of energy (LCOE) basis. It is also materially less expensive than building a new natural gas plant. The Solar PPA + Peaker portfolio is the clear winner for customers.

When the economics of the same resource decision are analyzed from the perspective of utility shareholders, however, we found a different outcome.

Table 2 shows the financial impacts of the three options from utility shareholders’ point of view. We found that the CC — because of the heavy upfront capital investment that can be put in rate base — is the most profitable option. The coal plant, with its ongoing capital investment, is second.

The Solar PPA + Peaker option is the least profitable of the alternatives because the PPA is expensed — only the peaker is rate-based and earning a profit. Some utilities have found a path around the tax normalization requirements, with significant added risk and delay, but most have not.

With tax normalization, there’s a mismatch between what’s cheapest for ratepayers (Solar PPA + Peaker) versus what’s most profitable for utility shareholders (new natural gas plant).

Since the Solar PPA + Peaker option is least profitable, it’s clear why IOUs are slow to procure solar: Tax normalization restrictions on the ITC make solar less profitable than fossil fuels. Utility customers are the clear losers.

Table 3 shows what happens when we take tax normalization out of the equation. If utilities can rate-base solar assets with no tax normalization, returns to shareholders increase significantly, while costs to ratepayers stay low.

This makes the Solar + Peaker portfolio the most profitable path forward for utility shareholders and results in substantially lower costs to customers.

Ultimately, aligning utility and customer incentives will result in substantially more solar deployment. IOUs will have an economic incentive to accelerate coal plant retirements and replace fossil fuel generation with solar.

Without eliminating the tax normalization requirements, clean energy advocates can continue to engage in multi-year, state-by-state fights to push regulated monopoly utilities down paths that may not fundamentally be in their long-term profit interest.

Alternatively, the solar industry and the clean energy community can work with the electric utility industry to eliminate the tax normalization rules and make solar the most profitable investment for regulated utilities.

Eliminating tax normalization requirements for the solar ITC can unlock an enormous, utility-driven investment in solar, benefiting customers, shareholders, and the environment. For us, the choice is clear.

Eric Blank and D.R. Richardson

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