Earlier this year, I published an article analyzing how President Trump’s corporate income tax cut would affect the financial returns of commercial solar PV projects.
I used my company’s PV design and sales software to calculate that Trump’s tax cut could range from very positive for cash-financed solar projects (up to 27 percent increase in NPV), to slightly positive for a loan-financed project. I fully expected that solar salespeople would be excited by the results of my analysis.
I was wrong. Comments on the article showed that, while some professionals were enthusiastic about the results of my analysis, others had the opposite reaction; they feared the tax cuts would hurt solar returns.
When I spoke at the 2018 NABCEP Continuing Education Conference, the positive and negative reactions to my analysis were even stronger. Some audience members were excited about the granularity of my analysis, while others vehemently disagreed with my entire approach to presenting solar returns.
I soon realized that by trying to analyze corporate tax cuts, I had inadvertently waded into the biggest controversy in commercial solar financial analysis: When forecasting solar returns, should the avoided cost, also known as “solar savings,” be taxed or not?
Some background may be needed to better understand the debate. When forecasting the savings of a project, solar professionals often consider the following factors:
- What is the property owner’s current electricity consumption and bill?
- How much of a property owner’s electricity consumption would a solar installation offset?
- How much of a property owner’s utility bill would the solar installation offset (this is known as the solar installation’s “avoided cost of energy”)?
- What is the depreciation schedule of the solar asset?
- What is the property owner’s tax rate?
For a property owner going solar, the financial return of a solar project can roughly be summarized as follows:
Project Savings = Avoided Cost of Energy – Financing Costs +/- Tax Effects
The last term is the center of the controversy: should the utility bill savings (i.e., avoided cost) of a commercial solar project be taxed? Companies that install solar reduce their cost of electricity. By reducing this operational cost, they become more profitable, which means they owe more in taxes. Should the taxes they now owe be subtracted from the returns of the solar project?
At the time I wrote the article, my position was, “Yes, the additional tax liability should be subtracted from the total returns on a solar installation.” In my opinion, this was consistent with the tax treatment of depreciation and the interest rate on loans. Since depreciation is an accounting cost, it lowers your taxes, which is a benefit that most analysts include in the financial returns of solar. The same is true with interest on loans — these are tax deductible, and their tax benefit is often included when projecting solar returns. In my analysis, I chose to apply similar tax treatment to avoided cost.
Many solar practitioners have a different view of how to tax avoided cost. In their experience, it is often complicated to find the appropriate tax rate to apply to avoided cost. Often, the income statements and tax situations of commercial property owners are complicated.
Moreover, the client may not wish to share such sensitive information at an early stage of the sales process. Furthermore, property owners often perform their own independent tax analysis, so if you include the tax effects in your proposal, then there is the risk that the tax payment is, unfairly, being counted twice.
Finally, the argument that I personally find most compelling, is that property owners frequently want to compare capital investments on an apple-to-apple basis.
Take, for example, a trucking business. When the business is trying to decide whether to purchase a more fuel-efficient truck, it is unlikely that they are considering the tax effects of how much money they are going to save on gas for that truck. Or, take a bank that is debating whether to purchase a new software application: they typically will not analyze the tax effects of the financial savings they incur by having more productive employees. Why should solar be analyzed any differently?
The tax treatment of the avoided cost of energy is more than just an academic debate for industry publications and forums. It can substantially affect the returns of a solar installation, depending on your prevailing tax rate and method of financing.
At Aurora, we recently upgraded our software to allow our clients to choose whether/how they want to tax the avoided cost of energy. Let us examine a hypothetical project for a company in California, which has both federal and state income taxes. Using Aurora, I designed a 1.4 MW single-tilt array. For simplicity, I assumed that the system was cash-purchased.
I then analyzed the project. Figure 1 below shows my results when I assumed avoided cost is taxed; Figure 2 shows how the results change when I assumed avoided cost is not taxed.
California Project, Avoided Cost Is Taxed
California Project, Avoided Cost Is Not Taxed
Changing the avoided cost tax treatment results in reducing the payback period by almost 1.25 years. It also improves other metrics, like the net present value (54 percent increase) and the internal rate of return (six percentage points) of the project.
Clearly the stakes are high — a 54 percent improvement in the returns of solar could mean the difference between a client choosing to invest in solar versus some other project. And given that there does not seem to be an official requirement for how exactly to perform commercial solar financial analysis, it makes sense that you would want to present solar on the same basis that the business analyzes other investments. At Aurora, we have added a simple checkbox that allows our customers the flexibility to choose how they treat the avoided cost of solar. We also encourage our customers to clearly state their assumptions using our editable sales proposal templates.
I do not expect that the debate over the tax treatment of avoided cost will end anytime soon. However, next time you see me at a conference, if you disagree with my results, let’s not argue — feel free to change the assumptions and perform your own analysis. Just make sure to disclose the assumptions you use!
I would be delighted to hear your thoughts on the best tax treatment of the avoided cost of energy for commercial projects.
Samuel Adeyemo is the chief operating officer at Aurora Solar. Aurora’s solar design software is used to design and sell over 50,000 solar installations per month.