Basel III: Endgame and Tax Equity Investments: Risk Allocation in Green Energy and Climate Change
February 7, 2024 by Andrew Lloyd Bellah
Proposed changes to regulations affecting banks in the United States could potentially jeopardize wind, solar and other renewable energy projects that have relied on tax-equity financing to get off the ground, drawing criticism to regulators charged with the long-term stability of the financial system. The proposed rules, which require banks to hold greater reserves against direct investments in clean energy projects, play into a broader debate over whether a transition to sustainable energy and mitigating the existential risk of climate change fall within the purview of the Fed and other financial regulators.
Ever since the Board of Governors of the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation announced last summer their intent to issue joint-rules increasing capital requirements for banks, Wall Street has raised numerous objections to the proposed reforms. Among these concerns is whether the rules would hinder the banks’ ability to finance large-scale projects necessary for the next generation of clean energy production.
The joint rulemaking by the United States’ lead banking regulators seeks to implement the latest recommendations of the Basel Committee on Banking Supervision, an international committee of the world’s leading economies based out of Basel, Switzerland charged with protecting and promoting global financial stability. Among other reforms, the latest Basel Accords, dubbed “Basel III: Endgame,” propose modifications to the capital requirements, or minimum loss-absorbing reserve capacities, that a bank must hold against certain equity investments, including solar and wind energy projects.
In the United States, equity invested into qualifying clean energy projects can accrue tax credits for investors, especially those accruing after enactment of the Inflation Reduction Act like Investment Tax Credits (“ITCs”) up to 30% of the eligible cost of the project; accelerated depreciation deductions; and interest deductions. Along with consistent, reliable cash flow expectations from energy projects and rates of return averaging between 6% and 8%, these so-called “tax equity” investments are particularly attractive for banks and other large institutions typically engaged in the business of making direct loans to finance projects.
J.P. Morgan Chase and Bank of America, two of the largest banks in the U.S., are estimated to participate in more than 50% of the approximately $20 billion annual tax-equity investment transaction market, according to analysts at Norton Rose Fulbright. Last year, J.P. Morgan, BoA, and Wells Fargo were involved in one of the largest tax-equity financings ever assembled for a single asset: $1.2 billion for an offshore wind project in Massachusetts called Vineyard Wind 1. “Closing on a tax equity package has always been a central element to achieving financial success for the first-of-its-kind [project],” commented Tim Evans, partner and Head of North America for Copenhagen Infrastructure Partners (CIP), one of the main developers of the project. “With this investment, Vineyard Wind 1 moves Massachusetts closer to its goal of reducing greenhouse gas emissions by 50% by 2030.”
Basel III: Endgame’s implementation would alter how banks would have to hold loss-absorbing reserves against these investments, recognizing that direct exposure to a project through an equity investment, instead of through a loan, could carry a different risk profile for a bank. Under the U.S.’s current regulatory framework, disparities in risk exposure arising from different investments that a bank might make are reflected in “risk-weights”, or ratios of how much capital a bank has to hold against the value of that investment. For example, single-family home loans are assigned a risk weight of 50%, meaning that against a $1,000,000 mortgage, a bank would have to hold $500,000 in reserves in case that loan defaulted.
Risk-weights for equity investments follow a similar approach under the current framework: a bank’s total risk-weighted assets for equity exposures are calculated by multiplying the adjusted carrying value of each equity exposure by a specified categorical risk-weight percentage. However, there is a critical carveout in the current regulations for “non-significant” equity investments: if the aggregate amount of non-publicly traded equity exposures falls below 10% of the bank’s total reserves, banks are allowed to apply a simple 100% risk-weight to those investments. For example, assuming that a bank’s total investments in tax equity projects, like solar panel arrays or wind farms, do not exceed 10% of its ability to sustain a loss on these projects and other non-equity investments, a bank like J.P. Morgan or Bank of America would have to hold reserves equal to the total value of those investments. If a tsunami wipes out an offshore wind farm that J.P. Morgan invested $1,000,000 into in exchange for tax credits and a pro-rata share of the project’s cash flow, the bank should hold $1,000,000 against the chance of that loss, regardless of the probability of it occurring.
Controversially, the Basel III: Endgame framework eliminates the “nonsignificant” carve out, instead assigning a 400% risk-weight to equity investment exposures. The rationale for this drastic change is that banks would be less exposed to risk if they financed projects through loans, rather than equity investments. Using the example above, if a bank made a $1,000,000 loan to a developer to finance an offshore wind farm that was subsequently wiped out by a tsunami, the bank could still collect from the developer what it’s owed on that loan – the developer would sustain the loss in equity. Therefore, the Basel III: Endgame proposal requires that a bank would have to hold a greater amount of capital against direct exposures to risk through equity investments, rather than indirect exposures through loans.
However, these modifications – eliminating the “non-significant” carve out for equity investments and delineating investments into direct and indirect exposures – take for granted the value of tax credits available to banks as equity investors in green energy projects that are not available to them as lenders, as well as how banks allocate risk across their overall portfolio of direct and indirect investments to protect themselves against the disparate risks of direct exposure.
First, the current tax credits that accrue with equity investments in clean energy projects, enhanced under the Inflation Reduction Act, make these investments more feasible for banks to engage in at scale because their essential structure is designed to protect against anticipated risk exposures. Returning to the offshore wind example: a $1,000,000 equity investment into an offshore wind project might be wiped out but a tsunami, but it might also just not return a profit: current tax benefits protect banks as equity-investors against these risks by allowing deductions for cash flow losses and providing a credit fixed to the overall cost of the project. In contrast, banks as lender-investors would have to scramble after a likely bankrupt developer to recover losses without any ability to deduct those losses from their tax obligations. Tax credits and benefits, especially those provided for equity investments in clean energy projects under the Inflation Reduction Act, fundamentally alter how a bank considers the relative risks of an equity investment or a loan.
Second, the reality of how banks negotiate equity investments with developers of clean energy projects cuts against the overall risk of a bank’s exposure to direct and indirect risks across its portfolio of investments. This is the rationale that underpins a “non-significant” carve out: banks realize that equity investments carry a different set of risks (cash flow losses, construction delays, tsunamis) than loan investments (default, late payments, bankruptcy) and price those risks accordingly while negotiating with developers, hence why the upward bound for equity exposures under the current regulatory framework is 10% of a bank’s capital. Banks are incentivized to invest in clean energy projects at scales that promote efficiency and predictability, minimizing risks to cash flow, and return a net value to the bank on par with or greater than a loan; in simpler terms, why would a bank invest in equity if it could collect more interest in a loan? Most projects would realistically fall into the latter option. Along with the upward bound of 10% under the non-significant carve-out, banks are incentivized under the current framework to choose their investments wisely and avoid risk.
The contradiction in Basel III: Endgame’s approach to equity investments in clean energy is more evident when placed vis-a-vis comparable categories of equity investment that retain simple capital risk-weights from the current regulatory framework, such as low-income housing tax credit (“LIHTC”) investments and investments in small businesses. Risk-weights for these categories of equity investments are left in place on the basis that such investments “generally receive favorable tax treatment and/or investment subsidies that make their risk and return characteristics different [from] equity investments in general.” Nonetheless, tax equity investments in renewable energy are granted less leeway under Basel III: Endgame. Tax benefits and credits, whether for clean energy projects, low-income housing, or small businesses, are choices made by law and policymakers to alter the financial calculus of investment. Basel III: Endgame’s elimination of the existing regulatory framework for facilitating tax of equity investments in clean energy projects is at best shortsighted on the part of regulators.
Finally, the risk-weights assigned to investments should be attuned as much to long-term risks to the stability of the financial system as short-term risks to individual banks and projects. To understand the effect of the proposed rules on a transition to a sustainable economy, it is important to understand risk allocation, the process of identifying risks, and determining how and to what extent they should be shared, as it relates to climate change and finance. Regulatory incentives that facilitate clean energy investments have the potential to offset exposures to fossil fuel industries and investments that accelerate climate change, which represent some of the greatest existential risks to the long-term stability of the global financial system. The role of the Federal Reserve and other financial regulators, then, concerns climate change as much as it presents a risk that has the potential to inflict irreparable and irreversible harm on not only the financial system but broader segments of the global economy. If the latest Basel Accords truly intend to be the “Endgame” of macroprudential regulation and international cooperation, then their design and implementation for the world’s largest financial institutions should take into account not only how risk manifests itself to banks today and tomorrow, but well into the future.
 The Basel Committee on Banking Supervision, Basel Committee Charter: Purpose and Role, (last updated June 2018).
 Tax Equity Advisors, Tax Equity, (2018).
 Keith Martin, Solar tax equity structures, Norton Rose Fulbright (Dec. 14, 2021).
 Veselina Petrova, Vineyard Wind 1 receives funding from USD-1.2bn tax equity package, Renewables Now (Dec. 21, 2023).
 Vineyard Wind, Copenhagen Infrastructure Partners and Avangrid Announce Largest Single Asset Tax Equity Financing and First Large-Scale Offshore Transaction in the U.S., (Oct. 25, 2023).
 Basel Committee on Banking Supervision, Basel III: Finalizing post-crisis reforms, Bank for International Settlements (Dec. 2017).
 Thomas Dee and Eric Scheriff, Basel III and the Looming Threat to the Tax Equity Market and Clean Energy Industry, Capstone (Oct. 2, 2023).
 88 FR 64028: Regulatory Capital Rule: Large Banking Organizations and Banking Organizations With Significant Trading Activity, (Aug. 18, 2023).
 Brunetti et al., Climate Change and Financial Stability, The Board of Governors of the Federal Reserve System (Mar. 19, 2021).