Tax credits are meant to spur investments by increasing returns for investors. But it turns out that with wind and solar energy plants, these credits can create distortions in their performance and value, according to a recent paper titled “Power Banks: Do Tax Equity Investors Add Value to Renewable Power Projects?” by finance professors Daniel Garrett at Wharton and Sophie Shive at the University of Notre Dame.

The authors studied the performance at 652 tax equity-financed wind and solar power plants in the U.S. from 2006 to 2024; essentially, they tracked electricity production scaled by total capacity, called the “capacity factor.” The wind plants in the study sample posted increases of between 6% and 9% in capacity utilization when financed by tax equity.

The study revealed that wind plants financed by tax equity investors increased capacity utilization because those investors brought sharper monitoring and contracting skills, and not because of reduced financial constraints or better project selection. With solar plants, production quantity is not a factor in determining tax equity returns.

Distortions Caused by Tax Equity

Tax equity structures are set up as special purpose vehicles (SPV), which bring together the project sponsor and a tax equity investor — usually a large bank — to extract the available tax credits. The bank’s role is also to ensure that the project is certified and that it operates the way Congress intended it to and that it wouldn’t be a fraudulent operation, Garrett said.

The study found outcomes that were markedly different from the original intent. “When you encourage these structures and bring in a tax equity investor, the tax equity investor will change the operations of the firm in a way that makes the equity claim of everyone else worth a little bit less through real operational changes,” Garrett said. “Tax equity investors care much less about the long-run equity value of the firm, because their claim to the firm is primarily on the short-run cash flows.”

“We find a real operational change in how these plants function with the presence of tax equity,” Garrett said. “The distortion from bringing in a tax equity investor is bigger than the price you pay them through a return. They invest 45% or 50% of the plant’s capital and get a 7% return on their capital until the end of their 10-year holding window in a wind plant.”

“We find a real operational change in how these plants function with the presence of tax equity.”— Daniel Garrett

“We show that the 7% return they get does not fully capture the distortion they’re putting on the value of the equity share for the other owners; they also are changing the way the plant operates,” Garrett continued. “We find an extra distortion with the presence of the tax equity investor.” That might end up making the plant more expensive than it otherwise would be, he added.

Agency Conflict

Instead of playing a certification role, banks as tax equity investors are changing the operations in a way that is potentially destructive to the equity value of the manager, Garrett said. “Essentially, they’re taking a little extra value from the manager than just the tax credits by saying, ‘Hey, we want you to also operate the firm in a way that increases our value of the project and doesn’t necessarily maximize your own value.’”

Garrett described that as “a classic agency conflict,” where there are two agents who have some ownership claim over the company, and the equity shareholder is not able to maximize their own value because of the presence of this other source of capital (the tax equity investor).

That effect of an agency conflict is concentrated in wind plants where the tax equity investor prefers more production over profitability, the paper stated.

Promoters or sponsors of tax equity-funded projects often use their cash equity holding to raise debt (called back-levered debt). This creates another conflict between tax equity investors and cash equity investors. The back-leverage is specifically a claim on the underlying cash equity position instead of debt directly secured by the assets of the project.

Garrett explained how that conflict of interest plays out. The tax equity investor wants to max the production tax credits, which comes from maximizing production. The provider of back-leverage wants to max the remaining equity value after 10 years to increase their likelihood of complete repayment. Each of these agents will use their role in up-front contracting and monitoring to protect their own interests. “Since these interests are at odds, we expect the presence of back-leverage to attenuate the ability of the tax equity investor to restrict operational decisions in their favor,” he said.

How Renewable Energy Project Finance Works

Incentives in the U.S. to attract private investment are chiefly two types of tax credits totaling 30-50% of a plant’s construction cost. One is the Investment Tax Credit, which is used primarily by solar plants. The other incentive is the Production Tax Credit, which is used mostly by wind plants. Project sponsors who do not have enough taxable income to use these credits can turn to “tax equity” investors with high taxable income, typically large banks. In 2024, the U.S. attracted tax equity investments of up to $23 billion.

Tax equity structures require financial sophistication to execute, and most of those investments came from five large banks during the study’s sample period. Tax equity dollars are in short supply, giving tax equity investors bargaining power.

“Tax equity investors are changing real operations by forcing the firm to act in a way that increases their claim and does not maximize the sponsor’s equity claim.”— Daniel Garrett

Behind the Pursuit of Higher Generation

At tax equity-funded wind power plants, the study identified a fundamental trade-off between production efficiencies and revenues. While cash equity sponsors in such plants want higher net profits, tax equity investors chase greater production amounts because they bear the marginal benefit of generation but not necessarily the marginal cost.

That is because returns for tax equity investors in wind plants increase with higher production quantities, but not from high electricity prices because production tax credits are paid per unit of generation and are not a function of the price at which electricity is sold. In fact, bidding lower prices into power auctions may drive increased utilization of the plants.

Wind plants have lower revenue per megawatt because they fetch lower-than-average electricity sale prices, which in turn lowers returns on common equity. Cash equity investors may settle for those lower bid prices in order to accommodate the production incentives for tax equity investors, the paper reasoned.

Cash equity sponsors, or project promoters, also disproportionately bear maintenance costs in operating renewable energy plants, where “the marginal benefit may be smaller than the marginal cost,” Garrett said.

The study also found a strong negative association between the presence of tax equity and low production months resulting from maintenance shutdowns or other downtime events. “When you have a tax equity investor, your likelihood of producing almost nothing during a month is extremely low,” Garrett said.

The study included two quasi-experiments to analyze the effects of tax equity investments. In one, projects that received tax equity investments recorded more energy generation as a share of capacity. The second experiment involved the Southern Company of Atlanta, Georgia, where efficiencies improved when the utility roped in tax equity investors to recover after an unrelated, large drop in income in 2018.

Are Tax Equity Investors Worth Their Cost?

The presence of tax equity investors increases operating costs and reduces operational flexibility for the project sponsor, the study said, using the example of a typical 100-megawatt wind plant in 2023.

According to Garrett, the presence of tax equity investors also increases project costs of renewable power plants. “They seem to buy fancier and more expensive turbines and solar installation features,” he said. For instance, tax equity-financed plants are more likely to buy a GE turbine that costs approximately $1.4 million per megawatt instead of Vestas turbines that cost $1.29 million per megawatt, he added.

“Tax equity investors are changing real operations by forcing the firm to act in a way that increases their claim and does not maximize the sponsor’s equity claim,” Garrett said. “We will get less investment because those equity claims are just a little bit less valuable with tax equity than they would be without. It could be that something like 3% of firm value is being destroyed by restrictions on operational flexibility.”

Policy Takeaways

Clean energy investment in the U.S. in 2024 was an estimated $500 billion, or a fourth of the total globally, the paper stated, citing International Energy Agency data. According to Garrett, their paper assumes importance in an emerging policy environment for renewable energy.

Garrett also called for policymakers to revisit the tax equity approach for renewable energy. “This policy tool has some weaknesses and we probably shouldn’t be using it for everything,” he said. “If we’re going to really pare down our green investments and subsidies, we don’t want to focus on just one approach. We probably want to have a portfolio of different approaches to subsidies.”