Financing Investment in Carbon Storage Projects

Martin T. BooherJohn R. LehrerChristopher J. CarolanJessica M. LenardL. Poe Leggette

September 30, 2021

Section 45Q – Overview

• Original Law– Originally enacted on October 3, 2008 as part of the

Energy Improvement and Extension Act of 2008 (P.L. 110-343)

– Amended on February 17, 2009 as part of the American Recovery and Reinvestment Tax Act of 2009 (P.L. 111-5)

– Amended on December 19, 2014 as part of the Tax Increase Prevention Act of 2014 (P.L. 113-295)

• Current Law– Amended on February 9, 2018 as part of the Bipartisan

Budget Act of 2018 (P.L. 115-123) for tax years beginning after December 31, 2017

– Amended on December 27, 2020 as part of the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (P.L. 116-260)

– Final Treasury Regulations issued January 6, 2021 (TD 9944)

– IRS Revenue Ruling 2021-13 issued July 1, 2021

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Section 45Q – Overview (cont.)

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Equipment Placed in Service Date Before February 9, 2018 On/After February 9, 2018

Credit Amount (per metric ton CO2)

- Geologically Sequestered CO2 $23.82 in 2020 (inflation adjusted) $31.77 in 2020, $34.81 in 2021 (increasing to $50 by 2026, then inflation adjusted)

- Geologically Sequestered CO2 with Enhanced Oil Recovery (EOR)

$11.91 in 2020 (inflation adjusted) $20.22 in 2020, $22.68 in 2021 (increasing to $35 by 2026, then inflation adjusted)

- Other Qualified Use of CO2 None $20.22 in 2020, $22.68 in 2021 (increasing to $35 by 2026, then inflation adjusted)

Claim Period Available until 75M tons of CO2 have been captured and sequestered

12-year period once qualifying facility is placed in service

Qualifying Facilities Capture carbon after October 3, 2008 Begin construction before January 1, 2026

Annual Capture Requirements Capture at least 500K metric tons • Power Plants – Capture at least 500K metric tons

• Facilities that emit no more than 500K metric tons per year – Capture at least 25K metric tons

• DAC and other capture facilities –Capture at least 100K metric tons

Eligibility to Claim Credit Person who captures and physically or contractually ensures the disposal, utilization, or use as a tertiary injectant of the CO2

• Person who owns the capture equipment and physically or contractually ensures the disposal, utilization, or use as a tertiary injectant of the CO2

Section 45Q – Overview (cont.)

• Qualified Carbon Oxide (Section 45Q(c))– Any CO2 which:

1. Is captured from an industrial source by carbon capture equipment originally placed in service before February 9, 2018;

2. Would otherwise be released into atmosphere as industrial emission of greenhouse gas or lead to such release; and

3. Is measured at the source of capture and verified at the point of disposal, injection or utilization.

– Any CO2 or other carbon oxide which: 1. Is captured from an industrial source by carbon capture equipment originally placed in service

on/after February 9, 2018;2. Would otherwise be released into atmosphere as industrial emission of greenhouse gas or lead

to such release; and3. Is measured at the source of capture and verified at the point of disposal, injection or utilization.

– In the case of a direct air capture facility (DAC), any CO2 which1. Is captured from ambient air; and2. Is measured at the source of capture and verified at the point of disposal, injection or utilization.

• Includes the initial deposit of captured carbon oxide used as a tertiary injectant, but does not include carbon oxide that is recaptured, recycled, and re-injected as part of the enhanced oil recovery (EOR) and natural gas recovery process.

– “Tertiary Injectant” (defined in Section 193(b)(1)) – Any method described in subparagraphs (1) through (9) of Section 212.78(c) of the “June 1979

energy regulations”; and Any other method to provide tertiary enhanced recovery approved by the Secretary of the

Treasury

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Section 45Q – Tax Reporting• IRS Form 8933• Note form instructions updated on January

28, 2021

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Section 45Q – Final Regulations

• History– March 9, 2020

Rev. Proc. 2020-12 (safe harbor for partnerships for allocating Section 45Q credit in accordance with Section 704(b))

Notice 2020-12 (guidance on determination of when construction has begun on qualified facility or carbon capture equipment)

– June 12, 2020 NOPR published containing proposed regulations under

Section 45Q– August 26, 2020

Public hearing on proposed regulations– January 6, 2021

Release of final regulations under Section 45Q

• Section 45Q(h)

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Section 45Q – Final Regulations (cont.)

• What do they do?1. Define “Carbon Capture Equipment”2. Add Aggregation Rule3. Reduce Recapture Period4. Clarify Eligibility by Contract5. Measurement Clarifications6. Miscellaneous Items

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Revenue Ruling 2021-13

• Released on July 1, 2021• Key components

– Provided example of functionality-based definition of CCE

– Investor must own at least one component of CCE

– Clarified placed in service date considerations for single process train

– Different place-in-service date for tax depreciation and Section 45Q purposes

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Monetization – Why?

– Tax credits and other tax benefits can be very valuable

– But:• Developers often don’t have “tax capacity” to

efficiently use the tax credits and other tax benefits, and

• Developers often need cash to repay construction financing and/or fund construction of the next project

– Federal tax credits (such as Section 45Q credits) cannot be sold

– A “tax equity” market has developed

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Monetization – What is Tax Equity?

– An investor invests in a Section 45Q credit-eligible project

– The investor receives some portion of the operating revenue and tax benefits (including Section 45Q credits)

– The developer may utilize the investor’s upfront investment to repay construction financing and/or fund construction of the next project

– The investor may seek to exit when it receives a certain after-tax return on its investment• The investor’s return generally is calculated

based on cash in, cash out, tax benefits received and tax liabilities paid

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Monetization – Partnership StructureThe IRS has provided a safe harbor for a partnership structure (Revenue Procedure 2020-12)

Developer Investor

Project Company

• Developer develops carbon capture projects

• Developer organizes Project Company to own and operate one or more carbon capture projects developed by Developer

• Investor acquires an ownership interest in Project Company for cash

• Project Company:• has rights to capture carbon

oxide from one or more emitters; and

• sells the carbon oxides to one or more offtaker(s)

Carbon Capture

Equipment

Emitter(s) Offtaker(s)

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Pre: 99%Post: 5%

Pre: 1%Post: 95%

Monetization – Partnership Structure (cont’d)Sample Transaction

Developer Investor

Project Company

Carbon Capture

Equipment

Emitter(s) Offtaker(s)

• Pre-Flip Period:• Developer receives 1% of tax

items (Section 45Q credits, tax deductions, taxable income), and a negotiated percentage of cash distributions

• Investor receives 99% of tax items (Section 45Q credits, tax deductions, taxable income), and a negotiated percentage of cash distributions

• Flip occurs when Investor achieves an agreed after-tax internal rate of return

• Post-Flip Period:• Developer receives 95% of tax

items and cash distributions• Investor receives 5% of tax

items and cash distributions

• Investor has an option to sell its interest to Developer post-flip at fair market value

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Monetization – Partnership Structure (cont’d)IRS safe harbor requirements include:

Developer’s minimum interest: at least a 1% interest in tax items (including Section 45Q credits)

Investor’s interest:o Interest in tax items (including Section 45Q credits) equal to at

least 5% of Investor’s largest interest in tax itemso Bona fide, commensurate investment, with value contingent

on Project Company’s results (which are not substantially fixed)

o Minimum unconditional investment in the Project Company of at least 20% of the fixed and reasonably-anticipated contingent investments to be made by Investor

o More than 50% of Investor’s fixed and reasonably-anticipated contingent investments must be fixed and determinable

o No call options; Investor may have a put option at no more than fair market value

No person in the transaction may guarantee Investor’s ability to claim Section 45Q credits

Allocations of tax items (including Section 45Q credits) must satisfy the tax regulatory requirements

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Monetization – Other Possibilities?

– Leasing structures– Election to allow 45Q credits to other

taxpayers– Refundable credit– Others?

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State Incentives

– In addition to Section 45Q credits, state-level incentives may be available

– Examples: Credits Income tax deductions Property or sales tax reductions or exemptions Grants or loans

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Tax Credit Insurance

– Consider purchase of tax credit insurance in connection with project development

– Marsh and other carriers are offering insurance

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Monetizing Section 45Q Credits

• Assume a Qualified, Compliant Sequestration Project– The IRS has disallowed more than half the tax

credits claimed as of earlier this year. Failure to comply with EPA requirements for monitoring,

reporting and verification of the carbon emissions captured

• Tax Equity Structures

– The new guidance confirmed availability of tax equity structures

– Familiar: Structures used regularly to finance wind and solar projects

– Most common: the "flip partnership."

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What is a Flip Partnership • A legal entity set up as partnership for tax purposes to own the carbon

capture equipment

• Parties: the developer and the tax equity investor(s)

• Developer: – in early stages of development, like cannot avail of the tax credits fully. It may

have little to no taxable income.– Owner of an industrial facility that generates carbon, and transfers ownership of

the carbon capture equipment to the Partnership

• Tax equity investors: high taxable income; can benefit from tax credits– financial institutions– strategic investors– other companies with significant taxable income

• Investor must – make a minimum unconditional investment equal to at least 20 percent of the

sum of the fixed capital investment plus any reasonably anticipated contingent investment required to be made by the Investor under the partnership agreement.

– Share in losses– No guarantees from any other Person of any return on Investment or return of

capital

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Tax Equity Tolerance for Risk

• Tax Equity Investors are generally not accepting:

– Carbon capture at facilities with large carbon footprint may not be economic even with the tax credit.

– New technology risk – investors shy away from untried technology

– Avoid construction risk

– Environmental risk from disposal obligations –may limit the market of investors (leakage of stored carbon)

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Assets of the Flip Partnership

• May own the Project outright– Ownership of the carbon capture

equipment

• An Assignee of the 45Q credit– Must have a contractual obligation to

dispose of or utilize the carbon

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Waterfall as between Partners

• Proceeds that are distributable to the Partners– Net of debt service and repayment, expenses, reserves,

etc.

• Initial waterfall:– tax equity investors have 99 percent of all partnership

taxable items, including tax credits and losses, along with a lower percentage of cash distributions

– Developer/other partners share the remaining 1 percent

• Waterfall “flips” after Tax Equity receives a pre-determined fixed rate of return– The developer receives 95 percent of the partnership

taxable items and is entitled to distributions of an equal amount of cash, while the remaining 5 percent is allocated or distributed to investors.

• Tax credits shared by partners in the same ratio they share in income or loss

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Other Possible Tax Equity Structures• Sale/Leaseback: tax investor acquires the equipment

and leases it back to the developer. – Lessee must be obliged to capture and dispose the

carbon– Fluctuating rent may be a challenge– Fixed percentage of gross sales revenue as rent

(shopping centers)– Ensure tax benefit remains with the tax equity

investor/lessor

• Sale to Tax Equity Investor: – outright sale of equipment– Investor accepts disposal obligations; may subcontract

• Disposal Contract– Investor responsible for disposal; may subcontract

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Debt Finance to Carbon Capture Facilities• Equipment and project development generally are

highly levered, and depend on loans, bonds and other credit support.

• Carbon Capture Facilities are many types– Ethanol plants, gas plants, hydrogen plants, biomass– Different lenders and debt structures will be attracted to

different projects,– Scale, size, capital cost, construction vs operating,

economics will all impact

• Availability, willingness to lend and terms of credit may be enhanced by tax equity investors. Lenders look for substantial equity investment in projects. To extent 45Q successfully attracts additional equity investment, it should encourage more lenders, and more competition among lenders

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Lenders: Different Risk Appetite

• Will fund understood risk that comports with their investment strategy (i.e., project finance lenders, cash flow lenders, equipment lenders)

• May shy away from novel or untested facilities or legal structures until a track record is established

• Environmental and reputation risk from potential carbon leakage and other environmental impacts to be considered

• Not unique to carbon sequestration facilities or 45Q

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Leverage: Use of Proceeds

• Construction Loans– intent to use tax equity proceeds to partially retire the debt

• Bridge Loans– Tax equity bridge loan – tranche of debt to

carry the project from construction to tax equity closing

• “Take-out” Permanent Financing– Longer term financing post-construction to

cover operations and maintenance

• Generally, secured by all assets of the project, including assignment of contracts, receivables, liens on equipment, bank accounts

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Lender vs Tax Equity Investor

• Lender may lend at the project level or the mezz level• Backleverage:

– Tax equity prefers investing in a vehicle that is not a borrower– Projects that have longer term debt (either term-out of construction

debt or take out loans repaying construction debt) often do so by placing the longer term debt at an entity above the tax equity partnership

• In addition to a security package, lenders will negotiate to have a priority interest on the cashflows distributed to the sponsor to ensure repayment.

• Lenders will also review the tax equity partnership agreement – Limits on distributions until debt is repaid– Won’t allow excess cash to flow out of the partnership if it would

jeopardize the lender’s repayment prospects.

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Availability of Loans?

• Lenders will look to a stable value of collateral and cash-flows when underwriting a loan.

• In contrast to wind and solar tax equity deals, cash flow may be limited and unstable

• Cash flow may depend in large part on the type of facility being financed

• The ERTC can account for a significant portion of the return profile.

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White House and Congressional ProposalsBiden Proposal

• Extend credit to January 1, 2031• Credit increases to $85 per metric ton; “hard-to-abate” industrial sectors• Direct air capture projects – eligible for an extra $70 per metric ton credit• Direct pay option – option for direct payment in lieu of the credit with no “haircut”• Labor Requirements

Congressional Budget Reconciliation & Infrastructure Debate

Senate Finance Committee Bill• Direct Pay• Extends incentives for smaller projects• Repeals EOR 45Q credit (2026) requires permanent sequester/utilization• Eliminates Begin of Construction Date/Establishes sunset date• Increased Credit Amount for Direct Air Capture Facilities

U.S. House Ways and Means Committee• Extends commence construction window – 2031• Direct Pay – option at the full value of 45Q for project beginning construction

2032

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The Imperative of Carbon Removal

• Why today?

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The COVID Consumption Cliff

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China and Critical Minerals

• 2018: China produced more than 75% of world’s cobalt chemicals

• 90% of all rare earth magnets are manufactured in China

• 2019: seven of the world’s ten largest solar panel manufacturers were Chinese, making 84% of capacity in solar panels

• 2019: China controlled 73% of lithium cell manufacturing capacity; the U.S. 12%

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“Artisanal Mining” = Child Labor?

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A child breaks rocks extracted from a cobalt mining at a copper mine quarry and cobalt pit in Lubumbashi on May 23, 2016. The price of copper has fallen heavily, directly impacting workers in the town. JUNIOR KANNAH / AFP

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Thank you for attending!

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John R. Lehrer202.861.1620jlehrer@bakerlaw.com

Christopher J. Carolan212.589.4658ccarolan@bakerlaw.com

Jessica M. Lenard202.861.1584jlenard@bakerlaw.com

Martin T. Booher216.861.7141mbooher@bakerlaw.com

L. Poe Leggette713.276.1647pleggette@bakerlaw.com

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