Once a niche investment approach thought to come at the expense of returns, environmental, social, and governance (ESG) investing—or strategies that align with a company’s ESG values—has grown into a $30 trillion market as of 2019, according to a McKinsey & Co. report.
Issues like energy consumption, greenhouse gas emissions, climate change, resource scarcity, health and safety, diversity and inclusion, and effective board oversight are all having a greater effect on the financial performance of companies and investors have taken notice. The 2019 Global Impact Investing Network (GIIN) Annual Impact Investor Survey results show the increasing scale and maturity of the impact investing industry. This most recent report includes responses from 266 leading impact investing organizations worldwide that manage $239 billion of the more than $502 billion U.S. market.
One major underutilized strategy that could enable companies to significantly boost their ESG performance and mitigate ESG related risks is tax credit investments. By repurposing and redirecting a company’s estimated tax payments into qualified tax advantaged investments, companies can achieve triple bottom line results and fulfill their ESG commitments.
TAX CREDITS EXPLAINED
A tax credit is a type of government sponsored tax incentive that can reduce a company’s tax liability dollar-for-dollar. The federal government uses tax credits to incentivize corporate taxpayers to invest in certain types of projects that produce economic, environmental, or social benefits. For these projects, the tax credit is an important source of capital, but many project developers do not have enough taxable income to take advantage of the tax credits themselves. In such cases, the developer may monetize the tax credit by attracting a “tax equity” investor, usually a corporate tax paying investor partner.
Tax equity is a term that is used to describe a passive equity ownership interest in a qualified project, where an investor receives a return, based not only on cash flow from the project, but also on tax benefits. In such a transaction, a partnership is typically formed among the parties to facilitate the investment and the allocation of tax credits, deductions, and distributions. The specifics of each partnership vary by project, tax credit type, and transaction structure.
In practice, a tax equity investment uses the same dollars that are earmarked to satisfy a company’s tax liability. The funds are repurposed and then invested into qualified projects that generate tax credits, such as a solar farm or an affordable housing project. The tax benefits generated from the project flow back to the investor, eliminating a corresponding amount of tax liability. Typically, the investor also receives a cash return generated through earnings from the project.
Corporate and institutional investors inject well over $25 billion per year into the allocated tax credit market. While the amount is significant, it also suggests there are billions of dollars of tax capacity available that could be deployed for ESG impact in addition to financial performance.
Tax credit investments are really about taking responsibility and being intentional with your tax dollars. Instead of wiring estimated tax payments into the general fund, corporate taxpayers can direct their dollars to worthy projects that match their sustainability goals.
THE BENEFITS OF TAX CREDITS
Federal and state governments offer tax credits to promote public private partnerships, incentivizing investment capital to flow to domestic programs that benefit society, the nation, and communities, such as:
- Building affordable housing for our nation’s ever-increasing population in need of affordability (Low Income Housing Tax Credit Program (LIHTC) under tax code Section 42);
- Preserving America’s historical buildings and repurposing those facilities to the benefit of communities (Historic Rehabilitation Tax Credit Program (HTC) under Section 47);
- Building sustainable energy infrastructure through solar and wind projects (Renewable Electricity Production Tax Credit Program (PTC) and the Investment Tax Credit Program (ITC) under Section 45); and
- Carbon sequestration activities that reduce greenhouse gas emissions from U.S. industries (See PTC Tax Credit program under Section 45Q).
A common thread connecting federal, state, and local tax credit programs is the positive intent and long-term environmental and social impacts on society as a whole. Tax credits are a sustainable source of financing for addressing market failures, such as the lack of affordable housing in low-income communities.
INCENTIVES—NOT TAX AVOIDANCE
Tax equity investments are not tax loopholes or tax avoidance. Rather, when a business chooses to make a tax equity investment, they are simply repurposing their estimated tax payments to invest in qualified projects that also meet their ESG goals. In place of taxes paid to the Treasury department, the investor is able to put their money to work even more efficiently and effectively to benefit underserved communities and the environment. The outcome appears as a reduced effective tax rate on financial reports, but, in either case, real money goes out the door. Instead of paying taxes to the federal government, the investor shows good corporate citizenship by taking the time and effort to underwrite the opportunity, and then deliver meaningful capital to high impact projects on the federal government’s behalf. The taxpayer effectively invests their tax payments in socially responsible projects, and can earn a cash return on that investment while generating ESG benefits.
ESG INVESTING EXPLAINED
ESG investing is the integration of environmental, social, and governance factors into the investment process. Using ESG criteria, corporate investors and fund sponsors are able to select companies and projects with suitable attributes that align with the investor’s voluntary ESG commitments.
Tax equity investments are an underutilized strategy for boosting ESG performance and reducing ESG risk exposure. Transactions that pair the tax credits generated by a qualifying investment with the financing associated with that investment, enables corporate investors to put their capital to work in funds, organizations, companies, or projects that generate a positive, measurable, social, or environmental impact, alongside a financial return.
In August 2019, the Business Roundtable, a group representing the nation’s 192 most powerful chief executives of the largest companies issued a statement on the purpose of corporations. While the American corporate community has long held that companies must maximize profits for shareholders as a top priority, detractors have contended that this practice creates increased inequity. The new approach delineates the belief that the needs of shareholders should be balanced with the needs of stakeholders, including customers, employees, supply chains, and local communities. Investors like BlackRock have added increasing credibility to incorporating ESG factors into the investment process. In his 2020 annual letter to CEO’s and the broader market, BlackRock’s CEO Larry Fink vowed to place sustainability at the core of its asset management fiduciary duty to investors, and pushed corporations to do the same or to be judged accordingly.
THE BENEFITS OF ESG INVESTING
ESG issues have become financially material over time. As social and environmental factors become more tangible, a strong ESG proposition can safeguard a company’s long-term success. According to global consulting firm McKinsey & Company, a strong ESG proposition creates company value in five essential ways:
1. Top-line growth—achieve higher valuations than competitors with lower social capital;
2. Cost reductions—help combat rising operating costs;
3. Reduced regulatory and legal interventions—achieve greater strategic freedom, easing regulatory pressure;
4. Employee productivity uplift—help companies enhance employee motivation and increase productivity; and
5. Investment & asset optimization—enhance returns by allocating capital to more sustainable opportunities.
The largest asset managers in the world, including BlackRock, JP Morgan, Vanguard Group, and Goldman Sachs, have all announced a variety of initiatives to place sustainability at the center of their investment strategy for their institutional and retail investors. In the absence of strong ESG practices and voluntary disclosures, investors will increasingly conclude companies are not adequately managing risk and invest elsewhere.
TAX CREDIT & ESG INVESTING OPTIONS
The inherently subjective nature can make ESG factors hard to quantify. There are several main reporting frameworks, including but not limited to the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), CDP (formerly the Carbon Disclosure Project), and the Task Force on Climate-related Financial Disclosures (TCFD) that aim to guide companies on how to measure, assess, and report on their ESG initiatives, risks, and opportunities. An acceptable degree of standardization around transparency, governance, and environmental impact is essential for providing investors a framework with which to evaluate investments. In turn, as gathering and processing data becomes even easier and cheaper, investments in areas like renewable energy and sustainable development will increase.
Environmental—Accelerating Clean Energy and Decarbonization
The Solar Investment Tax Credit (ITC), Section 48, is one of the most important federal policy mechanisms to support the growth of solar energy in the U.S. Since the ITC was enacted in 2006, the U.S. solar industry has grown exponentially, creating hundreds of thousands of jobs and investing billions of dollars in the U.S. economy in the process.
The ITC is currently a 26% federal tax credit on the upfront cost of a solar system. The tax credit is a dollar-for-dollar reduction in the federal income taxes that a company would otherwise pay the federal government. The ITC is earned at the placed in-service date of the project and is a one-year credit. The credit is available to all federal taxpayers, regardless of industry. The ITC allows a taxpayer to control the utilization of their tax dollars, directing them to worthy projects that benefit their communities or align with their corporate social responsibility goals and commitments.
Benefits of clean energy tax credit investing include:
- Creating economic development investment and jobs in manufacturing, installation, and operations;
- Improving public health by reduced air and water pollution;
- Enhancing electricity reliability and resilience; and
- Improving energy security.
Carbon Capture and Sequestration
Section 45Q provides a tax credit on a per-ton basis for CO2 that is captured and permanently sequestered. In February 2018, the Bipartisan Budget Act (Pub. L. No. 115-123.) included a new expanded Section 45Q to include enhanced Production Tax Credits (PTC) for companies that capture and sequester carbon dioxide. Now, technology that can capture CO2 emissions and is necessary for slowing global warming is economically and financially viable for investors. Enhancements to the new Section 45Q tax credit is intended to spur the deployment of and unlock investment in clean energy in the U.S.
Carbon sequestration is considered to be essential to global efforts to reduce CO2 emissions and is beneficial to U.S. domestic energy security. Captured CO2 can be used to produce more energy through enhanced oil recovery, resulting in low carbon fossil fuels that will bridge the gap through the ongoing energy transition.
Benefits of Carbon Sequestration tax credit investing include:
- Preventing atmospheric carbon dioxide release;
- Reducing the conventional energy sector’s environmental impact; and
- Providing additionality by increasing investment in carbon capture which lowers costs, attracts more investors and development, and eventually turns back the clock on previous CO2 emissions.
Social—Providing Substantial Benefits to Underserved Communities
The U.S. has a severe affordable housing shortage. Housing insecurity undermines employment, health, education, and sustainable and stable living. The consequence of the affordability gap is costly for individuals, families, communities, and the economy. According to a 2019 study by the National Low Income Housing Coalition, “in no state can a person working full-time at the federal minimum wage afford a two-bedroom apartment at the Fair Market Rent.”
The LIHTC is the federal government’s main program for encouraging investment in the development of affordable rental housing for low-income families. The LIHTC program was established as part of the Tax Reform Act of 1986 (Pub. L. No. 99-514) and provides tax incentives to encourage corporate investors to invest in the development, acquisition, and rehabilitation of affordable rental housing. The tax credit is calculated as a percentage of costs incurred in developing the affordable housing property and is claimed annually over a 10-year period.
Benefits of LIHTC investing include:
- Providing lowest default rate of all real-estate asset classes;
- Providing the most predictable 10-15 year benefit stream;
- Offering dollar-for-dollar tax liability offset;
- Creating high impact investments; and
- Credit Community Reinvestment Act (CRA) compliance (for bank investors).
The HTC encourages private sector investment in the rehabilitation and re-use of historic buildings. The HTC creates jobs and is one of the nation’s most successful and cost-effective community revitalization programs and has leveraged more than $102 billion in private investment in efforts to preserve 45,383 historic properties since 1976. A HTC project takes qualified buildings and converts them into residential, retail, office, cultural, community, and educational centers, increasing property values on surrounding parcels, and encouraging continued redevelopment. These properties can also be used for affordable housing. HTC projects have revitalized distressed areas by creating jobs and bringing renewed commerce to the historic cores of cities and towns.
The HTC tax credit equals 20% of the qualifying expense spent rehabilitating historic buildings. The tax credit is amortized over a five-year period after the property reaches its certificate of occupancy. Past-periods data shows historic credits are one of the safest real estate-related asset classes.
In addition to the federal HTC program, many states have historic building preservation tax credit programs that mirror the federal program and can be used in conjunction with the federal credit.
Benefits of HTC investing include:
- Revitalizing communities by reusing historic structures to the benefit of the community;
- Providing the most predictable five-year benefit stream;
- Offering dollar-for-dollar tax liability offsets; and
- Creating local jobs and capacity for community investment.
Governance—Thinking about Governance and the Stakeholders
While governance issues, such as business ethics, are less quantifiable, it is not necessarily any more difficult to integrate governance factors into qualitative due diligence of a project or development company. When selecting and directing capital into environmental and social impact tax equity investments, investors can apply a governance filter to their investment thesis, underwriting and diligence process, and formal ongoing reporting framework. For example, solar project development companies seeking tax equity investments can be interviewed about their board diversity, executive pay, ownership and control, accounting, anti-competitive practices, and contribution to financial system instability. This governance information can be considered in the context of ESG investing and used to screen potential investments.
Engagement and active ownership can positively influence a company to achieve targeted ESG objectives along with financial returns. In addition, continuous monitoring over the project’s life cycle aids strategy and materiality reporting. Enhancing investors’ ESG understanding and giving investors a broad set of standardized ESG data and metrics is integral to the dialogue around increasing ESG transparency and voluntary disclosure.
Benefits of good corporate governance include:
- Encouraging positive behavior,
- Reducing the cost of capital,
- Improving top-level decision-making,
- Assuring internal controls, and
- Enabling better strategic planning.
Gradually shifting weather patterns, rising sea levels, and more extreme weather events disproportionately affect people living at the base of the economic pyramid and perpetuate inequity as an effect of climate change. Climate risk is business risk, and major investors will increasingly scrutinize the ESG goals and performance of companies they invest in. Now, more than ever, tax credit investments can be used as a tool to combat the negative effects of climate change and expand economic opportunity for underserved people and communities. By incorporating climate-positive and social-impact into a company’s investment and underwriting policy framework, an organization can spur investments in initiatives that align with their mission and values.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
About the Author
Bryen Alperin is the Director of Foss Renewable Energy Partners, LLC, a leading renewable energy and sustainable technologies tax equity investment platform. Prior to Foss, Alperin led debt underwriting for an impact-focused bank. In this role, he specialized in a broad range of sectors including clean energy development, affordable housing, social justice nonprofits, women- and minority-owned small businesses, and sustainable food production. Alperin has dedicated much of his professional life to “changing the financial system for good,” and is a regular writer, speaker, and conference panelist on the topics of thematic investing and risk management, renewable energy project finance, and tax equity markets. Alperin earned his BA magna cum laude from the University of California, Davis.