First Solar Takes a Shine to Yieldco
Last week Arizona-based First Solar (NASDAQ: FSLR) said it’s joining forces with California-based SunPower (NASDAQ: SPWR) to form a “yieldco” from assets contributed by both companies. First Solar is a provider of photovoltaic (PV) solar systems, while SunPower is a designer, manufacturer and provider of solar PV systems and components.
So what exactly is a yieldco? Yieldcos are investment vehicles spun off with income-generating assets to provide a predictable tax-deferred yield in exchange for cheap equity capital, similar to master limited partnerships (MLPs). MLPs pass profits directly to unitholders in the form of quarterly distributions, avoiding the double taxation of corporate income and dividends affecting traditional corporations and their shareholders. All things being equal, this sort of arrangement should deliver more money to unitholders.
MLP distributions also offer an important tax deferral benefit. Because of the depreciation allowance, much of a typical MLP’s distribution is considered a “return of capital” and thus not taxable when received (until the investor’s cost basis drops to zero).
Unlike MLPs, yieldcos are not automatically exempted from the corporate income tax. But the accelerated depreciation provisions of the tax code and other tax breaks offered to renewable power producers mean that they are able to report net losses for five years or more, while paying out positive cash flow to investors via dividends that will be classified as a return of capital.
Distributions from yieldcos are treated as dividends under US tax law to the extent they are paid out of current or accumulated earnings. If payouts exceed current and accumulated earnings, they’re treated as a return of capital for US federal income tax purposes, just as with an MLP. This reduces the adjusted tax basis of the shares, and any payouts in excess of the adjusted basis are taxed as a capital gain.
Internal Revenue Code Section 7704 states that at least 90 percent of an MLP’s income must come from qualified sources, such as natural resources or real estate. Section 613 of the tax code requires qualifying energy sources to be depletable resources or their derivatives such as crude oil, petroleum products, natural gas and coal. A proposal called The Master Limited Partnerships Parity Act (MLPPA) seeks to extend the MLP tax break to renewable energy producers, but it has faced opposition from Republicans who argue that this would layer additional tax breaks on top of the existing ones for renewable energy.
For example, renewable power producers are eligible for a Production Tax Credit (PTC), which is a tax credit paid for each kilowatt-hour (kWh) of renewable electricity produced. The PTC provides 2.3 cents per kilowatt-hour (¢/kWh) for wind, geothermal, and closed-loop biomass systems, and 1.1¢/kWh for other eligible technologies (typically through the first 10 years of operation). There is also a solar Investment Tax Credit (ITC), which is a 30 percent federal tax credit for solar systems on residential and commercial properties, in effect through the end of 2016.
Since Republicans are opposed to further tax breaks to renewable power producers because of the tax breaks already in place, and supporters (mostly Democrats, but some Republicans as well) don’t want to give up the existing tax credits in order for renewable energy projects to be afforded the MLP tax treatment, a stalemate has developed. Thus, the yieldco has emerged as an alternative for renewable energy assets that closely resembles the MLP.
There are half a dozen yieldcos operating in the U.S., with yields ranging from about 2% up to about 6%. I will delve into the specifics of these yieldcos in the next issue of The Energy Strategist, but Abengoa Yield (NASDAQ: ABY) is one example. ABY was formed by the Spanish power plant builder Abengoa (NASDAQ: ABGB) with initial assets of two concentrating solar power plants in the US, two smaller ones in Spain, and a handful of other assets (a mix of renewable and nonrenewable).
Abengoa Yield debuted in June to strong demand, and its share price rose 27.6% on the first trading day. But the bear market that hit energy stocks in the second half of the year also hurt demand for yieldcos, and at one point last fall ABY was down more than 30% from the IPO price. After a partial recovery since, the stock is still down over 11% from the IPO price — a bitter pill since it currently sports an annualized yield of only 3.2%.
The starting yields for most of the yieldcos thus far have been low, and therefore liable to lose much of their current appeal when interest rates meaningfully rise. There are also downside risks related to changes in public policy. The renewable energy tax credits have been allowed to expire several times, and there is always a chance that they won’t be reinstated. The next expiration date looms in 2016 for the PTC and ITC, and should these not be extended it would have a chilling effect on investor demand for renewable energy yieldcos.
Further, while energy MLPs have a full and indefinite shield against the corporate income tax, yieldcos can only shield income to the extent they can carry forward net operating losses, which will largely depend on their ability to keep growing so that new projects provide additional depreciation.
Many observers were surprised by the First Solar/SunPower announcement, not only because each had shown some reluctance to form a yieldco, but also because they decided to do it jointly. The attraction of a yieldco formed from these two companies is that both are relatively large (First Solar and SunPower have respective market caps of $6.1 billion and $4.4 billion), with strong balance sheets and lots of assets that could be dropped down into the joint venture.
For those wishing to invest in renewable energy, this is about as safe a venture as you could wish for, given the identified downside risks. The projects that will be contributed are likely to be eligible for the full tax credits, and will probably have long-term offtake agreements. Further, if costs for solar power continue to drop at the pace of the past decade, there may be upside even if the tax credits are allowed to permanently expire (which I don’t think is going to happen in any case).