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Clean Energy Tax Credit Practitioners Ask Banking Agencies to Revisit Basel III Proposed Regulations, Affordable Housing and Community Development Industries Press for Lowered Capital Requirements to Match Risk Profile

Published by Peter Lawrence on Monday, February 5, 2024 - 9:01AM

Changes proposed in the Notice of Proposed Rulemaking on the finalization of Basel III Rules (proposed regulations) published in September 2023 could impede clean energy tax equity investment, prompting the clean energy investment community to voice concerns. By the Jan. 16, 2024, comment period deadline for the proposed rules more than 200 commenters submitted letters detailing the negative impact the proposed regulations could have on clean energy tax credits and historic tax credit (HTC) investments. In short, the changes proposed by the proposed regulations would increase the large bank capital requirements for non-community development equity investments that are not publicly traded by 400%, including tax credit equity investments for renewable and clean energy. 

While capital requirements for low-income housing, new markets and some HTC equity investments that qualify as community development equity investments under part 24 (Eleventh) of the National Bank Act remain unchanged at 100% risk weighting, stakeholders, including Novogradac’s New Markets Tax Credit (NMTC) Working Group, Low Income Housing Tax Credit (LIHTC) Working Group and the Historic Tax Credit Coalition (HTCC) took the opportunity to comment on the need to review the risk weighting assigned to these equity investments. These comment letters stressed the historically low risk profile of NMTC, LIHTC and HTC investments–as evidenced by low to non-existent recapture rates and their “loan-like” qualities–and how this fact supports a lowering of their risk rating. Ensuring continued and increased bank support of renewable and clean energy, NMTC, LIHTC and HTC by appropriately rating these equity investments would ensure these incentives continue to provide important community development benefits.     

Increasing Capital Requirements for Certain Bank Activities Safeguards the Banking System

The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation (collectively, the agencies) jointly released July 2023 the proposed Basel III regulations and included proposed changes to the risk weighting for non-publicly traded equity. The Basel III framework came about as a response to the financial crisis of 2007 through 2009. The internationally agreed upon set of measures was developed by the Basel Committee on Banking Supervision. Since its inception, the committee has released a series of international banking standards known as Basel I, II and III. The Basel III framework builds upon and strengthens Basel II, providing capital and liquidity standards for the global banking system.   

Currently, certain equity investments carry a 100% risk weighting unless in aggregate they exceed more than 10% of a bank’s capital, at which point the marginal equity exposures carry a 400% risk weighting, also known as the 10% non-significant equity threshold test. The test applies to all public and non-public equity exposures, except for community development investments that qualify under part 24 (Eleventh) of the National Bank Act, which carry a 100% risk weight regardless of the threshold test. Among various changes, the proposed regulations remove the non-significant equity threshold test. The 100% risk weighting for community development investments, like the LIHTC, NMTC and some HTCs, remains unchanged. The clean energy community has been vocal about the proposed removal of threshold test as it threatens non-community development tax equity investments–like clean and renewable energy investments–by quadrupling the capital requirements for all such investments regardless of the level of exposure relative to the bank’s capital. 

The proposed increase from 100% to 400% risk weighting for clean energy equity investments could threaten banks’ abilities to make equity investments (explained in more detail below). In addition to submitting comment letters through its NMTC and LIHTC Working Groups, Novogradac partners met with the Federal Reserve in December 2023 to discuss the implications of the proposed regulations on renewable energy investment, as well as investment in affordable housing, community development and historic preservation.

Renewable Energy Stakeholders, House Members Make Their Concerns Clear

Prior to the Jan. 16, 2024, comment submission deadline, 107 House members submitted a letter to the agency heads, first praising their dedication to “safeguarding the strength and resilience of the banking system” and then detailing how damaging the increased risk weighting assigned to renewable energy tax equity investments would be. As pointed out in the House letter, increasing the risk weighting for non-community development tax equity investments from 100% to 400% would apply the same risk weighting to tax equity investments, like those in renewable energy facilities, as that for traditional private equity. Stakeholders provided evidence demonstrating why clean energy tax equity investments are less risky than private equity, so weighting them the same is not supported by the data. These sentiments were echoed in the comment letters submitted, including those from Solar Energy Industries Association (SEIA), American Council on Renewable Energy (ACORE) and American Clean Power Association (ACP)

Across the letters submitted, the commenters stressed the low-risk nature of clean energy tax credit equity compared to traditional private equity. Further, if the agencies allow the proposed regulations to be finalized without change, the increase in the risk weighting for clean energy tax equity investments will hinder the implementation of the provisions in the Inflation Reduction Act (IRA). Each of these commenters noted the current $20 billion annual market for tax equity must increase to more than $50 billion to meet the energy goals of the IRA. The demand that would be created by the new IRA incentives would also be impeded by a 400% risk weighting. As noted in ACP’s comments (both in their original and supplemental letters), while there are other sources of financing available–transferability and direct pay were singled out as emerging options–these sources would supplement rather than replace traditional tax equity. Transferability is expected to attract $4 billion in 2023 and $10 billion in 2024. While this is a sizeable contribution, it is estimated that the if the proposed regulations are finalized as proposed, annual tax equity investments in the clean energy sector could shrink by 80% to 90%.  From conversations ACORE has had with tax equity investors, prior to the proposed new rule, investors were prepared to scale renewable tax equity investments to $22 billion in 2023 and $25 billion in 2024; projections were reduced to $10 billion in 2024 and $5 billion in 2025. 

The comment letters illustrate that tax equity is a critical source of financing for renewable energy projects and the proposed Basel III rules would jeopardize the industry. Each noted that clean energy tax equity investments have similar risk profiles to loans, and, historically, have positive returns. Therefore, rather than compare tax equity to private equity, a more apt comparison is tax equity to community development equity investments. For these reasons, commenters recommend the agencies release an amendment to the proposed regulations that provide a grace period, allowing agreements for tax equity investments for clean energy executed prior to the final rule becoming effective be held to existing capital requirements. Additionally, the final rule should assign a 100% risk weight, similar to community development investments, to renewable energy tax equity investments. To accomplish this, ACORE, ACP and SEIA propose two new exposure types be added to the 100% risk weight category: 

  1. investments that meet the stringent criteria set by the OCC to qualify as loan equivalent, and 
  2. the investments that qualify for the proportional amortization method (PAM) of equity accounting under Financial Accounting Standards Board rules.

Basel III Public Comment Period Used as Opportunity to Press Agencies to Lower Risk Weighting of LIHTC, NMTC and HTC Equity Investments

Though scrutiny of the Basel III proposed regulations has focused on the 400% risk weighting for clean energy tax equity investments, community development stakeholders have taken the opportunity to argue that community development equity investments should be lowered given their low risk profile. While the proposed regulations maintain the same risk rating for LIHTC, NMTC, HTC and other public welfare equity investments as authorized under part 24 (Eleventh) of the National Bank Act, those existing capital requirements do not appropriately reflect the risk associated with those equity investments. Novogradac’s NMTC Working Group and LIHTC Working Group along with HTCC, believe that the decision to maintain this risk rating is due, in large part, to the strong financial performance of these investments, the low risk profile and the public policy objectives of incentivizing public welfare investment. However, while community development stakeholders appreciate the sentiment, they all submitted evidence to demonstrate that the risk weighting should be lowered. 

NMTC, LIHTC and HTC practitioners have long thought the assignment of 100% risk weighting to tax equity investments into these types of projects has not reflected the actual low levels of risk associated with these investments. The currently proposed risk weight of 100% for community development equity investments fails to incorporate both the low risk of NMTC, LIHTC and HTC equity investments and the underlying policy incentives. Lending is generally perceived as a safer activity than equity investment due to lending’s repayment priority over equity, and this perception is reflected in the overall risk ratings contained in the proposed regulations. However, community development tax credit equity exposures are uniquely secure, as evidenced by the programs’ nonexistent tax recapture rates and generally shorter risk duration. An examination of IRS data shows a LIHTC recapture rate of less than 0.1% for tax years 2008 through 2019; NMTCs were even safer with no incidence of NMTC recapture during tax years 2008 through 2020. Novogradac’s Historic Tax Credit Recapture Survey found a recapture rate of less than 0.75% on a dollar volume basis. As tax credit equity investments are more “loan-like” in nature–for instance, in the case of the NMTC, these investments more closely resemble a fixed-income investment (where the income takes the form of a highly predictable stream of tax benefits) than a traditional private equity investment where variable cash flow and speculative capital appreciation constitute the investors’ return–the agencies are urged to reduce the 100% risk weighting for NMTC, LIHTC and HTC equity investment to 50% in recognition of the strong performance of these tax credits and the importance of supporting robust community development investment in low-income communities. This threshold is consistent with what is available to statutory multifamily mortgages, more accurately reflects the risks of these investments, and would encourage investment in community development.  

What’s Next?

Banking institutions have until July 2025 to comply with the new requirements and there will be a multiyear transition period. Given the sheer number of submitted comments, it is plausible the proposed regulations could see some changes before being finalized. Commentary indicates the proposed changes are already threatening investment in clean energy, investments that are necessary to meet the goals of the IRA to accelerate clean energy investments.  Michael Barr, vice chair for Supervision of the Federal Reserve Board, acknowledged the tax credit community’s concerns, noting in a speech last fall that all comments, additional data and viewpoints were welcomed regarding the proposed changes, as they wanted to, “…ensure the rules accurately reflect risk.” 

The IRA will be instrumental in ensuring the United States meets the Biden administration’s domestic climate goals and the nation’s international climate commitments. Enacting the Basel III rules as proposed would hinder the IRA by squelching tax equity investments in the renewable energy sector. Further, community development tax credit practitioners believe that all community development credits should be treated similarly and have their risk weighting reduced to 50% to promote continued and robust investment in low-income communities and affordable housing development, and accurately reflect their low-risk nature. 

Novogradac’s NMTC Working Group, LIHTC Working Group and Renewable Energy Working Group will continue to monitor the progression of the proposed regulations towards a final state. Novogradac will also continue to engage the agencies, especially as they consider the hundreds of comments submitted regarding the proposed regulations. To engage more directly, consider joining the working groups–forms for the NMTC Working Group, LIHTC Working Group and RE Working Group can be found online. 


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