infrastructure project equity financing

Running Head: Infrastructure Project Equity Financing

Presidio Graduate SchoolPresidio Graduate School

Capital Markets SUS6175_S12_SP11Capital Markets SUS6175_S12_SP11

May 12May 12 , 2011, 2011

Infrastructure Project Equity Financing

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Table of Contents

1. Executive Summary ................................................................................................................. 3

2. History .................................................................................................................................... 3 2.1 Challenges around raising funding/bond issues ........................................................................................................ 5

3. Capital Markets and Sustainability .......................................................................................... 5

4. Analysis ................................................................................................................................... 7 4.1 Alternatives: ............................................................................................................................................................................... 7 4.1.1 REIT ............................................................................................................................................................................................. 7 4.1.2 S-Corp and C-Corp................................................................................................................................................................. 9 4.1.3 Master Limited Partnership (MLP) ............................................................................................................................... 9

4.2 Comparison of Corporate Structures............................................................................................................................... 9

5. Recommendation .................................................................................................................. 11 5.1 Assessment of MLPs and S & C corporations .............................................................................................................11 5.2 Next Generation REITs Show Great Promise .............................................................................................................12 5.3 IRS recognition & Congressional Approval of Next Generation REITs ...........................................................12 5.4 Next Steps for Local Governments..................................................................................................................................13

6. References ............................................................................................................................ 14


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1. Executive Summary The demand for and cost of electricity is growing and is expected to do so for the foreseeable future. There is general interest in building renewable energy infrastructure projects to help meet that demand. Climate Action Projects depend on increased use of renewable energy to lower environmental impact and also include provisions for infrastructure to support electric vehicles. Municipalities are experiencing severe financial hardship and in many cases, are overwhelmed by debt while under pressure to execute their climate action goals. These fiscal challenges are preventing municipalities from using new bond issuances to financing infrastructure projects. An alternative method to support the development of new infrastructure projects is proposed and relies on public private partnerships financed with equity rather than debt. Such alternatives can allow projects to move forward in the current economic situation. Several recommendations are offered; the most preferred involving an adaptation of the existing Real Estate Investment Trust (REIT) vehicle to allow it to better meet renewable energy infrastructure project requirements. Other options, which do not require such adaptation, are recommended as alternatives.

2. History Traditionally, funding for municipal infrastructure projects has been raised through municipal bonds, also called “munis.” These bonds are divided into two primary categories, general obligation bonds which are repaid out of the municipality’s budget and revenue bonds, which are repaid based on revenues earned by the infrastructure project, such as bridge tolls and fees for use of mass transit. Muni bonds have historically been attractive due to perceived low risk coupled with tax benefits that exempt their interest payments from federal taxes. Recently, there has been a reversal in the popularity of munis with many cities defaulting on repayment as they file for bankruptcy. As a consequence of the increasing perceived risk, muni bond debt has become expensive for a city to repay. Currently, a 10-year muni bond from a AA rated municipality would pay interest of up to 5.64%. In contrast, a similarly rated corporate bond would pay just 4.9%, but would not offer the same tax incentives, thus resulting in an even lower effective rate of return. A few currently trading muni bonds have yields as high as 8%. Investors have flocked to safer investments such as U.S. Treasury Bonds and Bank CDs even though their


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returns are lower with ten-year treasuries yielding just 3.46% and two-year notes yielding a fraction of one percent. Launching infrastructure projects has become increasingly challenging as state funding has declined and basic infrastructure, such as roads, have remained under funded causing infrastructure to crumble and decay. San Francisco, for example, is estimated to have a backlog of $440 million dollars of street maintenance projects alone. Similar problems exist throughout California and across the United States. As these problems persist, others brew in the background. Demand for electricity is growing (see Figure 1) and that growth is expected to continue for the foreseeable future. At the same time, the cost of purchasing energy is increasing (see Figure 2). Climate action plans have begun to put pressure on cleaning up the generation of energy. Municipalities don’t have the luxury of putting these projects on hold until existing infrastructure projects are addressed. Power Purchase Agreements can be part of the solution. These projects can produce immediate returns by guaranteeing a price for energy that is lower than the municipality currently pays (see Figure 3). The benefit will increase over time as the cost of energy rises. Additional revenue opportunities exist for projects that include electric vehicle charging infrastructure, which can charge a premium rate for convenient access to charging, while still saving consumers compared to the price of fossil fuels. This however, doesn’t address the problem of how to raise needed monies.

Figure 1 - U.S. Total Electricity Consumption

Figure 3 –Cost Benefit of Using a Solar Power Purchase Agreement

Figure 2 - PG&E Average Commercial Rate


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2.1 Challenges around raising funding/bond issues Federal stimulus money is being used to meet immediate needs such as filling potholes and helping to rebuild crumbling infrastructure. Cities are mired in debt. Oakland, CA for example, a city that struggles with one of the highest crime rates in the U.S., laid-off police officers last year to balance its budget. This year it has threatened to lay off over 500 teachers. Raising funds for renewable energy or electric vehicle projects would normally be completed through revenue bonds, which, due to current fiscal challenges, are not an option. (Personal Communication, Garrett Fitzgerald, Sustainability Director, City of Oakland). While interest rates remain low, banks are hesitant to lend, especially to municipalities with downgraded credit ratings. The state and federal government continue to struggle with their own budget challenges and are in no position to assist. Municipalities need an alternative means to raise needed funds, preferably without creating new debt.

3. Capital Markets and Sustainability In capital markets today, investors can choose from a number of different vehicles (e.g. mortgage backed securities, bonds) that offer a steady stream of payments over a fixed period of time. However, investors who want to invest directly in public sector infrastructure development have a limited number of options. They could purchase shares of the companies involved with implementing and/or managing of such a project. This investment, though, would be indirect: any potential appreciation in share price would be subject to market sentiment and conditions as much as the overall profitability of the company (let alone the project itself). Alternatively, investors could purchase general obligation or revenue bonds, assuming they were issues specifically for the project. In the case of revenue bonds, the investor would be entitled to a portion of the revenue stream generated by the project. In general, this option is best suited to secure investors in infrastructure projects, however bond issuances are still not easily approved given current economic and budgetary conditions. That being said, infrastructure installations that promise to generate profits (and eventually returns for its investors) would likely generate interest amongst individuals looking to share in those returns. Given the general need for liquidity, and the varying investment horizons of the market, investors would require both: a convenient method of buying in (e.g. shares) and a market that would allow trading of shares (or equivalent investment vehicle). Project sponsors could accomplish the first objective by creating a legally compliant business entity (e.g. REIT or C-Corp) that was funded, at


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least in part with equity shares. Equity ownership structure would make it easier for investors to compare the opportunity to other currently traded alternatives. Project sponsors would also need to ensure that individuals could freely buy and sell these shares, ideally in a public marketplace. If the shares could be listed on an existing exchange (see Figure 4), it would significantly increase the visibility of the shares and likelihood of finding interested individuals. Being exchange-listed would help assure interested parties that shares would be subject to the same oversight and legal enforcement (e.g. SEC regulations) as are their existing investments. Listing shares on a publicly traded exchange would provide access to the largest pool of potential investment dollars.

This approach to funding could be used to spur the development of any revenue generating infrastructure project. It could be used to further the development of the United States’ renewable energy infrastructure. However, as discussed earlier, most infrastructure development efforts are subject to municipal or state budgetary constraints. Alternative means of funding projects could therefore break the logjam amidst cost cutting efforts by legislators. Additionally, twenty-nine states have already set renewable electricity standards (RES) that require a minimum percentage of electric utilities’ generated energy to come from renewable sources within the next 10-20 years (Slabaugh, 2011). In order for the public and private sectors to meet these numbers, they will need to fund both large and small initiatives. Funding big projects will likely require outside help, e.g.

Figure 4 – Listing Shares of an Equity Financed Project on Major Exchange


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the Energy Department’s $3.7B in loan guarantees (Hull, 2011) made in April of this year for solar thermal projects in CA. Smaller initiatives, though, could be made possible with budget negotiations & appropriations or even more creative funding approaches. Using an equity model could also help promote local ownership & involvement within the community. At face value, the idea of infrastructure that generates renewable energy for the community while turning a profit for its investors would seem like an easy sell. The local government could benefit even more by positioning the project as an opportunity for citizens to invest in the community’s long term well being. Assuming regulations and/or incentives were utilized to encourage residential ownership, more people could be directly connected with the global sustainability efforts underway.

4. Analysis

4.1 Alternatives: Efforts have been made to develop alternative solutions to raising capital for infrastructure projects. We researched a number of different solutions including Real Estate Investment Trusts (REITs), S-Corporations and traditional corporations (C-Corps), as well as Master Limited Partnerships (MLPS). Each of these offer interesting advantages along with their own challenges. All but the C-Corp are good contenders for the initial formation of an entity and are discussed in more detail below:

4.1.1 REIT A number of these alternatives have revolved around modifications to an existing investment vehicle: the Real Estate Investment Trust. REITs were created to allow individual investors the ability to invest in real estate. They generally trade as publically as stocks and thus have greater liquidity then direct real estate investments. REIT’s are a type of corporation and have many of the benefits of a C-Corp, without the burden of double taxation. REITs can also be held in retirement accounts that offer tax deferral. REITs must conform to a number of guidelines: ● 90% of taxable income needs to be distributed to the shareholders ● No more than 50% of the shares can be held by five or fewer individuals during the last half

of each taxable year (5/50 rule) ● Excise taxes are levied on annual profits that are not distributed


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● Cash can be invested in government securities or other REITs, or can invest in property Renewable energy infrastructure projects have a difficult time conforming to all of these stipulations, yet the REIT is attractive due to significant tax and liquidity advantages. The IRS has recently extended REITs to allow for investment in gas and electric distribution systems (Deloitte 2010), taking it closer to being a fit for renewable energy infrastructure projects. Additionally, several efforts to offer alternatives types of REITS are underway. These alternatives include the S-REIT and the Infrastructure REIT.

4.1.1.1 S-‐REIT (Solar REIT) Joshua Sturtevant of the George Washington University Solar Institute has proposed an amendment to current tax codes to treat revenue generated by power purchase agreements as rent. Such an amendment would allow the benefit of REITs to be extended to solar power generation projects and would offer a number of benefits including: increased liquidity, increased opportunity for participation by individual investors, and the avoidance of the double taxation inherent with C-Corps.

4.1.1.2 Infrastructure REIT The Infrastructure REIT is an alternative that has been proposed by several backers including Deloitte. Under this proposal, REIT benefits would be extended to public private partnerships (P3s) by counting all revenues as qualifying income, regardless of whether the revenue is generated by real estate. It may be possible to use a REIT in its current form, but doing so will pose significant challenges. Failing to succeed in approval for any of the aforementioned alternatives with leave a number of other less ideal alternatives, including S-Corps and possibly MLPs.


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4.1.2 S-‐Corp and C-‐Corp

S-Corporations are treated similarly to partnerships and like REITS, avoid the cost of double taxation. The S-Corp could be offered through a Direct Public Offering (DPO) on a limited scale, but in order for a true public offering to occur, it would first need to be converted to a C-Corporation.

C-Corporations are traditional corporations. They have the advantage of being able to offer stock on a scale limited only by the corporation itself. They have the undesirable characteristic of double-taxation, causing the corporation to be taxed and the owners to be taxed as well.

4.1.3 Master Limited Partnership (MLP) Master Limited Partnerships (MLPs) offer the tax benefits of a limited partnership along with the ability to trade on a public exchange. MLPs are generally limited to very specific businesses, such as those related to oil, natural gas, or coal. There are also MLPs for the finance sector, other natural resources and real estate. There are groups that are advocating for IRS changes that would allow MLPs to be used for renewable energy (Zweibel, 2010). It does not seem like it would be a big step to add that allowance. MLPs have some key differences from REITs, even though their benefits are quite similar at a first glance. REITs are better understood by investors as they have been available for a greater period of time. Taxable obligations are reported on a 1099 form, something most investors are already familiar with. They offer the advantage of passing through earnings and losses, a significant benefit in periods where there are losses, for example, in the early years of a newly launched business. Tax-wise, the IRS treats dividends from an MLP more favorably as they reduce the cost basis of investment. Taxes on dividends are not paid until the holding is sold. Another difference is that an MLP is not a corporation and thus is not a separate legal entity as is a REIT. Partners who own the MLP are personally liable and could be called on to repay any capital they receive. Likewise, partners are personally liable for any loans received by the partnership.

4.2 Comparison of Corporate Structures MLP REIT S-Corp C-Corp Corporate Structure A Master Limited

Partnership is a partnership that is able to trade assets, similar to stocks, on stock exchanges

May be structured as a c-corporation, trust, or association

Treated as partnerships for tax purposes while having some of the advantages of a C-Corp in terms

Exist as an entity separate from their owners and pay taxes as such an entity. Managed by majority owner.


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of liability. Managed by majority owner.

Ability to trade stock MLPs are able to trade “units” which perform similarly to stock

Trade on exchanges in a manner equivalent to stocks

May have only one class of stock, May not have more than 100 shareholders. Shareholders must be U.S. Citizens, or entities

May have multiple classes of stock, no limit in the number of stockholders, shareholders may be U.S. or foreign citizens

Ownership Owners are partners in the firm

Must be jointly owned by 100 or more individuals

May not have more than 100 shareholders.

Owned by shareholders, with largest powers of ownership going to the majority owner. There is no maximum number of owners.

Liability Partners are personally liable to creditors. This liability can extend to shareholders

Shareholders do not have personal liability

Offers Limited Liability Protection from creditors

Shareholders do not have personal liability

Taxation Treated as partnership

Treated as partnership

Treated as partnership

Double taxation: Net income is taxed at the corporate level before it’s distributed to shareholders, who must also pay tax on income.

Dividends Payouts are called distributions rather than dividends and they reduce the equity owned causing a tax advantage.

Pay dividends of at least 90% of the REIT's taxable income Not taxed at the preferred 15% but instead are taxed at 35%

S corporation is not eligible for a dividends received deduction.

Dividends are taxed at the preferential 15% rate. Is eligible for a dividends received deduction.

Losses Passed through to shareholders

Not passed through to shareholders

Passed through to shareholders

Not passed through to shareholders

Income Limitations N/A Must earn 75% of more of its gross income from rents or mortgage interest

Unlike a C corporation, an S corporation is not subject to the 10 percent of taxable income limitation applicable to

Subject to the 10 percent of taxable income limitation applicable to charitable contribution deductions.


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charitable contribution deductions.

Other Disadvantages No more than 20% of its assets may consist of stocks in taxable REIT subsidiaries. At most 50% of the shares can be held by five or less individuals during the last half of each taxable year (5/50 rule)

Management Partners Board of Directors

Partners Board of Directors

5. Recommendation

5.1 Assessment of MLPs and S & C corporations C and S corporations are well defined and understood company structures that can be used for equity financed infrastructure initiatives. Whereas S-Corps receive more favorable tax treatment than C type entities, their capped number of total shareholders and additional liability exposure limit the scope of projects that they can be used for. S corporations would be best utilized for small, local initiatives with relatively low risk of default and a small number of potential investors. C corporations, on the other hand, do address the two limitations of S type entities described above. However, they are subject to a 39% national corporate tax rate (Hodge, 2008) and double taxation rules that significantly impact the returns to investors. C corporations are therefore not ideal for such projects unless they expect to grow significantly over time (justifying the associated overhead) and offer robust returns to compensate for tax expenses. MLPs are liquid and receive favorable tax treatment and pass through abilities; attributes which make them attractive for infrastructure project sponsors to consider. However, the risk exposed to partners may limit investor participation. A means to reduce risk and relaxation of rules by IRS to allow their use in renewable energy infrastructure projects would both be needed to make them a viable option.


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5.2 Next Generation REITs Show Great Promise Project sponsors utilizing a REIT structure would reap benefits similar to those offered by MLPs and S-Corps. Given a REIT’s composition and revenue distribution requirements, though, the majority of renewable energy infrastructure projects do not fit within current guidelines. Disparate efforts have been proposed to redefine REITs to make them more suitable for such projects. Sponsors would be best served by the creation of a next generation REIT designed specifically for this purpose: a Renewable Energy Infrastructure Trust (hereafter called REIT-2G). Fundamentally, a REIT-2G would differ from a traditional REIT with respect to the source of income requirements. The REIT-2G model would require a project to certify that the overwhelming majority (if not all) of the energy they generate comes from renewable sources. (This would essentially be a further extension of the IRS’ decision to allow gas and electric distribution projects to qualify for REIT status.) Similar to the modifications proposed with S-REITs and Infrastructure REITs, the definition of approved income sources should be broadened to encompass the different types of projects being considered today. If a project were able to meet these qualifications, it would then enjoy the tax and liability benefits of a traditional REIT. Making the REIT-2G a reality can only occur if either (a) the current interpretation of REIT tax code was broadened via an IRS private letter ruling or (b) changes were made to the U.S. tax code to allow for a new such entity. Given the information and feedback collected thus far, a private letter ruling seems unlikely. As such, this initiative would need to be sponsored by individuals who have the authority to change the tax code – the United States Congress.

5.3 IRS recognition & Congressional Approval of Next Generation REITs Getting the REIT-2G added to the federal tax code would require lobbying Congress with several groups of interested parties. Ideally, representatives from PPA organizations (e.g. Tioga Energy, Solar City) should be brought in to testify how much more successful their renewable energy infrastructure ventures would be (or could have been) with the proposed legislation changes. In addition, key NGOs with financial resources and lobbying power (e.g. EDF, NRDC, Sierra Club) should be brought on board ask key sponsors of the initiative. Their support (and that of the groups’ members) could go a long way in lending legitimacy to the effort. Lastly, city and state legislators should collaborate to inform their federal counterparts about the benefits that the tax code changes would bring to the state. Within Congress itself, REIT-2G should be ideally championed by legislators either pushing for renewable energy infrastructure projects and/or changes to the tax code that promote job growth and


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energy independence. Getting their buy-in and commitment would require a fair amount of effort on the part of the aforementioned groups, but ultimately would offer the best chance for success.

5.4 Next Steps for Local Governments While awaiting legislative changes to occur the federal level, municipalities can (and should) explore alternative project funding approaches. (For example, the city of Berkeley, CA could lease roof space on buildings to a company for the purpose of operating and maintaining a renewable energy installation.) For such initiatives, the city would be best served by collaborating with private sector technology/business partner(s) to conduct a feasibility and impact assessment of the proposed project. These joint discussions should drive the completion of a joint RFP which included preferences for equity based ownership structures. The city could then, through an RFP process, green light the project once a profitable business model and technology partner were identified. Assuming the newly formed entity chose to issue equity shares of the project (perhaps through a Direct Public Offering), the city could work with them to promote the initiative within the region/state and beyond.


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infrastructure project equity financing

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