By Lalit Batra, Nishit Pande, Harsha Reddy, and Dinesh Madan
Under the Inflation Reduction Act (IRA) signed into law in 2022, solar projects may now opt for either an investment tax credit (ITC) or a production tax credit (PTC). What’s at stake for solar developers across the country is making a choice between an upfront investment-based incentive versus a production-based incentive applicable for the project’s first ten years of operations. This decision of whether to opt for PTC or ITC is a balancing act that depends on three primary considerations: expected capacity factor, investment (capital and financing) costs, and bonus eligibility.
Under the provisions of the IRA, the PTC and ITC would both be extended for projects placed in service during or after 2022. In 2025, the existing credits will be replaced by technology-neutral zero carbon emissions production or investment credits, which are similar in structure to the existing PTC and ITC. These credits would start to phase out for projects that begin construction either on or after 2032 or once the aggregate annual greenhouse gas emissions in the U.S. fall by at least 75% from 2022 levels, whichever is later.
This analysis builds on our previous reporting on how the IRA’s tax credits impact the economics of clean energy projects across the country, particularly hydrogen. These improved economics come from an extension and expansion of tax credits for renewables and other clean energy technologies, as well as the availability of several bonuses. Solar projects in a pre-IRA paradigm were eligible for only the ITC, a capital cost-based incentive. The ITC was specifically introduced for solar in 2006 to address high investment costs and significantly lower capacity factors as compared to wind.
Solar developers now have an option to select PTC in lieu of ITC under the IRA, but the decision is a balancing act which depends on plant capacity factor, investment (financing and capital) costs, and bonus eligibility.
- Under a no bonus scenario: Solar projects with higher capacity factors will likely see more benefits from PTC than ITC. Nonetheless, ITC will be more beneficial for solar projects with relatively higher capital costs.
- Under a single bonus scenario: As compared to a no bonus scenario, the relative advantage of opting for PTC over ITC starts declining for solar projects with higher capacity factors, while ITC becomes increasingly more favorable for projects with higher capital costs.
- Under a double bonus scenario: ITC is generally more beneficial as compared to PTC.
PTC or ITC: Which option is best for solar developers?
With recently increasing project costs due to supply chain constraints and other factors, developers will likely continue to see advantages in pursuing the ITC.
Assuming labor requirements are met, it will provide a 30% credit of total build costs upfront, immediately offsetting the initial investment cost. For example, for a solar project with Capex of $1.25/WAC, the ITC credit will be $375/kW. For a 200 MW solar plant, this credit would be $75 million. However, if the project location has higher resource availability and the project has high anticipated production levels, the 100% PTC provides an advantage in being able to realize tax credits consistently over a 10-year horizon—and this advantage may be more compelling than the upfront investment tax credit. For a 200 MW solar plant with 26% CF, Capex of $1.25/WAC, and COD of 2025, the net present value of PTC benefit at a discount rate of 8% is estimated to be approximately $450/kW or $90 million.
Figure 1 shows the relative advantage of opting for ITC vs. PTC over a range of capacity factor and capital cost (CapEx) combinations, for projects meeting labor requirements. For example, projects with CapEx of $1.25/WAC and capacity factors greater than 24% will view PTC as more beneficial than ITC, all else equal. For projects with CapEx of $1/WAC, the breakeven point is lower at approximately 20% capacity factor. Selecting the PTC option, however, comes with an inherent risk of curtailment, which can affect the project’s realized capacity factor and overall returns.
One additional dimension to consider in deciding between PTC and ITC is financing costs. Keeping in mind that the financing costs equals the discount rate, developers must be willing to wait for the deferred incentive of the PTC, which is provided over the course of 10 years, compared to the ITC that is realized immediately. Thus, with lower financing costs, the relative benefit of PTC increases as compared to ITC for the same capacity factor level, and vice versa. Figure 2 shows the relative benefit of PTC over ITC with respect to discount rates. For example, the threshold where PTC is more advantageous over ITC shifts from 22% to 26% when going from an 8% to 12% discount cost.
How do the energy communities bonus or domestic content bonus impact the decision?
The credits in the IRA can be augmented with several bonuses. For projects that pay prevailing wages and meet certain apprenticeship requirements, the base credits are multiplied by five. We assume most projects will realize these credits and this is factored into the assessments above, which results in a PTC starting at around real 2022 $26/MWh increasing with inflation and an ITC of 30%.
These credits can be further increased by two stackable bonuses of 10% each, which are based on prescribed additional sourcing and siting requirements. A sourcing bonus is available to projects procuring 100% of steel and iron and certain percentages of manufactured content from domestic sources. A siting bonus is available to projects constructed in “energy communities,” defined as regions with high unemployment and traditionally dependent on conventional energy projects, as well as regions where a coal plant was retired after 2009 and/or a coal mine was closed after 1999.
Figure 3 shows IRA bonuses and credits available for solar projects. Not shown are two additional “energy justice” bonuses provided to small projects over the 2023-2025 period.
ICF analysis shows that in the regions where solar projects have a higher capacity factor and lower CapEx, opting for PTC makes more sense than opting for ITC. However, with an increase in CapEx (>$1/WAC) and the ability to secure at least one bonus, the balance starts to tilt towards ITC, which becomes the better option of the two incentives. For example, as the CapEx increase to $1.25/WAC, assuming 26% CF and discount rate of 8%, the incremental ITC benefit over PTC for single bonus is approximately $10/kW, which increases to approximately $90/kW in a double bonus scenario. With the increase in CapEx to $1.5/WAC, incremental ITC benefit over PTC further increases to $110/kW and $215/kW in single and double bonus scenarios respectively. This is because the upfront ITC advantage is more pronounced with increasing CapEx. Therefore, under a two-bonus scenario, ITC becomes a significantly better option as compared to PTC. Figures 4 and 5 shows the relative benefits of PTC and ITC in all the three scenarios of no bonus, single bonus, and double bonus.
Additional factors in the PTC or ITC decision
While capacity factor, investment costs, and bonus eligibility are the most determinative factors of the decision between PTC and ITC, other factors may also need to be considered such as the level of risk for congestion and curtailment, which may affect production levels and may in turn reduce the benefits of the PTC option.
For example, the ITC and PTC have differential impacts on power markets to the extent that one emphasizes the degree of capital intensity versus production. The PTC creates additional downward pressure in electricity markets, all else equal because of its incentive to increase output.
As PTC becomes increasingly deployed, there will be more projects contributing to negative pricing in the market. This is because solar has zero variable costs, but the PTC means that there is an opportunity cost of not producing—and hence negative marginal costs. Investors are effectively indifferent between the two credit structures, as long as they maximize net present value. However, from the perspective of market conditions, our analysis shows that there are important implications for having different subsidies for solar.
This article has been sourced from ICF and can be accessed here