45Q - The Drive to Qualify

The road to qualifying for the 45Q tax credit can be confusing, with strict limitations on project phases and what constitutes start of construction. But, navigated properly, the credit is a promising opportunity.
By Alex Tiller | December 22, 2020

Carbon capture and storage (CCS) presents a tremendous financial opportunity for many ethanol producers. Through CCS, producers can lower their carbon intensity (CI) score to increase profits through the California Low Carbon Fuel Standard market, with the potential for concurrent earnings from both 45Q tax credit transactions and sales in carbon credit markets. CCS also provides access to indirect economic benefits, namely the mitigation of enterprise risk from a future carbon tax and the improvement of commercial relationships with ESG sensitive lenders, investors and customers.

While the economic benefits of CCS can be numerous, producers will need to commit significant time and capital to pre-development. Proper due diligence is necessary to navigate the complexities of IRS Section 45Q tax credit rules. 45Q contains a litany of guidelines, timelines and limitations that require expertise and adherence to prevent inadvertent project disqualification.  

Among the intricacies of 45Q is the determination of what qualifies as the start of construction. Despite its apparent simplicity, the start of construction is a complex milestone that serves as the primary pacing item for all other pre-development activities. In addition to a start timeline, certain mandates must be met to consider construction officially started.

It’s also essential to understand that there are many other guidelines, both written and unwritten, drawn from previous tax credit programs and guidance. Tax credit program complexity can become a barrier to entry for inexperienced emitters. Retaining specialized legal counsel with experience in closing tax credit investment transactions, also known as tax equity investments, is an efficient way to obtain this support. Additionally, as 45Q guidance develops over the coming months, ethanol producers will be forced to make critical decisions and investments, or risk missing out altogether.  

Construction Clock
To qualify for the program, facility construction must begin by Dec. 31, 2023. Legislation proposed in December would extend the date for projects to begin construction to claim the 45Q tax credit for carbon dioxide sequestration by 10 years. It would also provide a direct pay elective for the full value of the tax credit.

With the current 2023 construction start date in mind, many steps need to fall into place before construction can begin.

Preliminary technical phase: The first phase includes, but is not limited to, acquiring internal funding and contracting with third-party providers, as well as conducting feasibility studies, geologic characterization, and FEED studies for geologic storage. In addition, plan on conducting FEED studies for carbon capture, securing land and subsurface rights with owners, initiating LCFS and carbon registry documentation, construction permitting, and U.S. EPA permitting.

Project finance: About $30 million to $50 million will need to be secured, and the lender will seek certainty that an experienced tax equity investor stands ready to monetize all the tax credits generated from the new facility. Since 45Q is a relatively new incentive, the tax equity investor market is still evolving and is relatively unknown, which makes the financial modeling required to make a go/no-go decision for a project even more difficult.

Once these phases have been completed, a project will need to meet strict start-of-construction criteria.

Qualifying for Construction Start
There are two ways to establish that a project has begun construction before Dec. 31, 2023. The first is by incurring at least 5% of the project’s total cost and making continuous efforts to advance toward completion of the project thereafter. It’s a seemingly straightforward approach to meeting the start of construction deadline, but it comes with important caveats:

• The total costs need to be calculated based on the project’s depreciable basis, including any tax credit structuring related basis step-up. Since there’s a chance the project cost overruns the budget, it is prudent to target about 7% as a rule of thumb.

• The payment approach is only available when using the cash method for accounting, as opposed to the commonly used accrual method.

• When purchasing components and equipment to meet the 5% threshold, delivery can be at the project site, the manufacturer’s factory or in transit, but steps should be taken to make it clear that the buyer has truly taken possession of the property.

• If the project developer cannot establish that the 5% test is met based on its own costs, the rules permit it to look through the contractor’s costs if there is a binding written contract in place.
Another way to mark the start of construction is by performing what the IRS calls “physical work of a significant nature.” This test focuses on the nature of the work performed as opposed to the cost or amount. It requires a continuous program of construction, but potentially leaves the door open for an unfavorable IRS judgment that construction was not truly underway, as “significant” is not clearly defined. Key points to consider include:

• A carbon dioxide emitter does not have to do the work itself if the work is performed under a binding written contract that is entered into before the work starts.

• If properly designed and implemented, project developers can take credit for the characterization work that is performed adjacent to construction.

• Physical work may not be deemed significant if it includes the manufacturing of components that are either in existing inventory or normally held in a vendor’s inventory.

• Consistent with previous renewable energy tax credit guidance, the IRS has indicated that certain preliminary activities do not count (such as exploration, research, etc.), even if their cost is properly included in the basis of the property.

Before beginning the construction process, it is crucial to consult with professional and legal resources to determine which strategy best suits the project.

Simplifying A Project
Determining whether a plant is a viable candidate for CCS through feasibility studies could cost millions. That alone could be a barrier to entry for many producers. One viable option is using third-party experts to conduct all the upfront assessments while minimizing cash and cost outlay at the same time.

Given recent economic setbacks from the COVID-19 pandemic and questions surrounding the future of ethanol production, creditworthiness for host emitters poses a challenge for project execution. Project lenders are going to need production covenants to mitigate the risk of project fallout. Considering the shutdown of some ethanol plants in 2019, additional expected shutdowns due to COVID-19, and projected declines in U.S. motor gasoline demand, the risk aversion of lenders could lead to many unbankable deals for host emitters.

Many ethanol producers don’t have the excess cash or team bandwidth for in-house development. The capital-intensive process further hinders the feasibility of undertaking a carbon capture project alone. Fortunately, there are well known commercial approaches to exploiting similar opportunities through third-party project development and finance teams.

For years, the oil and gas, solar and wind industries have partnered with project hosts. These partnerships have provided stakeholders with the technical and financial expertise needed to successfully stand-up new projects and manage the complexities of the finance and tax credit markets.

In these arrangements, a third-party project developer contracts with a project host for the right to develop a project at their facility in exchange for mutually beneficial financial terms. The project developer provides a dedicated team with a vested interest in the project’s success, allowing the project host to focus on their core business. Plants entering into CCS investments will likely be required to enter take-or-pay agreements with lenders, which can limit the ability of plants to react dynamically to market conditions. Through diversification of projects and substantial financial expertise, third-party developers can limit this risk for plants.

For large ethanol producers, it might still make sense to build in-house competencies in CCS development. For many others, entering into CCS projects alone will be difficult, considering the financial and technical complexities that coincide. Partnering with experts and sharing in the upside of generated benefits could be the best course of action.

CCS allows host emitters to monetize waste emissions while promoting the development of sustainable infrastructure. Lower CI scores, 45Q and additional state or local incentives create enormous market potential for emitters to profit from decarbonization. With proper execution, CCS provides a promising growth opportunity for emitters.

Author: Alex Tiller
President, Carbonvert Inc.
[email protected]