Jan Borchert, Current Hydro and Dana Hall, Esq.
Looking at the structure, economics and financing of the ownership model, the hydro-site owner can have one of two roles: either being the actual owner (Cash Financing, Debt or Loan Financing), or being a lessee (Lease to Own, Capital Lease, Operating Lease). In either way, the site owner will be sole customer of the on- site generated hydropower.
Cash Financing
With cash financing, the cost of construction, permitting and all other costs is entirely up-front, and the financing occurs on the owner’s balance sheet. The owner receives 100% of available incentives, including the possibility of a 30% tax credit (if the federal Production Tax Credits are extended by Congress for Hydropower).[1]
With cash financing there are no monthly payments and the energy output is essentially free (saving their usual monthly electric payments). The electricity generated is usable by the owner on-site (or metered to remote sites if remote net metering RNM is used). 100% of the value of the system is appreciated by the owner. The owner can also enjoy the benefits from a REC contract with NYSERDA, the value of which was $17.01/MWh for Tier 1 RECs in 2018.
The system maintenance and operation including compliance requirements related to environmental standards, dam safety, and other regulatory requirements can be contracted out to a service provider.
Debt or Loan Financing
With debt or loan financing, the owner is simply borrowing cash to pay the upfront costs of construction. You may write off interest payments on your taxes and use the depreciation benefits of the asset as a tax benefit. 100% of available incentives go to the owner (including any potential REC benefits) and you create the same savings as by cash financing.
The upfront payment is usually very low and monthly loan payments are determined at the time of the loan, typically with a fixed rate or escalator that ensures the lender their desired return. There may be the possibility of a balloon payment at the end of the loan term. The loan agreement may also provide the ability to pre-pay before the end of the term. 100% of the value appreciates to the system owner and the system maintenance, operation and regulatory management can be contracted out to a service provider.
Lease to Own
In a lease-to-own financing agreement the lessee will make little or no down payment towards the generation source, similar to a Power Purchase Agreement (PPA) structure. The lessee pays only a small portion of the system cost at the outset, and then makes fixed lease payments over time. The lessee does not actually own the system until the end of the lease term, when all the lease payments have been made and ownership transfers from lessor to lessee.
The two most common types of leases are the capital lease and the operating lease. These lease structures have different impacts on an organization’s accounting, according to generally accepted accounting principle (GAAP) rules.
Capital Lease
Capital leases keep the asset involved on the company’s balance sheet and eventually involve a transfer of ownership rights at the end of the lease term. Capital leases are counted as debt. They depreciate over time and incur interest expense. A capital lease involves one or more of the following characteristics:
- There is an ownership transfer to the lessee at the end of the lease.
- The lease contains a bargain purchase option.
- The lease life exceeds 75% of the economic life of the asset.
- The present value of the lease payments exceeds 90% of the fair market value of the asset.
GAAP rules require companies to treat leases as capital leases if they meet any of the above conditions. If none of these conditions are met, the lease must be classified as an operating lease.
Operating Lease
An operating lease is a contract that allows for the use of an asset but does not convey rights of ownership of the asset. Operating leases are similar to renting, where ownership does not transfer between the parties. An operating lease is a way to finance a microhydro project, where the leased project and associated liabilities of future rent payments are not included on the balance sheet of the lessee. The lease payments are treated as operating expenses and are expensed on the income statement, thereby impacting both the operating and net income of an organization.
With an operating lease, the lessee who wishes to consume the generation will pay an upfront payment to the microhydro developer as well as static monthly payments that were negotiated in the lease. The lessee can write off the entire lease payment on their taxes, but there is no depreciation available for an operating lease.
Incentives are typically exploited by the lessor, and not the site owner. There are usually pre-payment options and/or penalties in the lease as well. There may be a balloon payment. The lessee usually is not allowed to pre-pay the lease but will have an option to buy or return the system at the end of the lease term. The price of the final purchase is defined as “fair market value” according to IRS definitions. There is no capital appreciation available to the lessee until the system is purchased at the end of the lease. As with the cash and loan models, the lessee will typically contract out with a service provider for maintenance, operation costs and regulatory management, but often these costs are factored into the monthly lease amount. The RECs are usually owned by the lessor, and the site owner doesn’t have rights to the RECs until after the system is purchased at the end of the lease term.
Tax-Exempt Site Hosts
With rising electricity prices and increasing awareness about energy consumption and GHG impacts, tax exempt organizations, such as schools, churches, local governments, libraries, and more, are increasingly interested in green energy solutions. While, the financial stability and cost savings appeal to these groups, it is often the opportunity to be a good steward of the earth’s resources and to educate communities about clean energy that aligns with the mission of many tax-exempt organizations, solidifying their commitment to pursue renewable energy.
Tax-exempt site hosts have the option of using their balance sheet to finance the project, or if they are a municipality, they can issue low-cost tax-exempt municipal bonds. Another alternative is a tax-exempt lease, where the lease payments are exempt from tax.
Next Steps
Different tax implications, depreciation benefits and incentives that can be utilized should influence how a hydro-site owner chooses to finance their micro-hydropower system. The last aspects to discuss are the advantages and responsibilities of ownership.
Or download our full Microhydro Ownership Model report.
[1] A summary of the “Tax Extender and Disaster Relief Act of 2019” is available at: https://www.finance.senate.gov/imo/media/doc/Tax Extender and Disaster Relief Act of 2019 Summary.pdf
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[…] Our next post will focus on the economics and financial structures of the ownership model. We’re going to look into simple cash financing, debt or loan financing and different leasing structures. So follow the link to learn more about the ownership financials and economics. […]