Recent Congressional action extends tax credits, reach of “Jones Act”
by David Cole, Debra Duncan, Shay Kuperman, John Michael, and Danielle Patterson at Vinson & Elkins L.L.P.
Today, the U.S. has one offshore wind project in commercial operation – the 30-megawatt Block Island Wind Farm off the coast of Rhode Island – but there are more than a dozen major offshore wind projects in various stages of development across the U.S. These projects have the potential to provide thousands of jobs in the U.S. and a significant amount of clean, reliable energy to many of the country’s biggest cities, given the proximity that the offshore wind installations would have to coastal population centers.
The U.S. has long been a leader in onshore wind technology, and now, by extension, there is an emerging offshore wind industry. Offshore winds are considered by many industry observers to be abundant, strong, and more consistent in force than onshore winds. The “cost of energy” for offshore wind projects has also continued to decrease steadily, which has increased the competitiveness of offshore wind when compared to other energy sources.
The offshore oil and gas industry has played a key role in the early development of U.S. offshore wind projects. Design engineers, equipment suppliers, fabricators, and vessel operators who traditionally service the offshore oil and gas industry were involved in developing the Block Island Wind Farm and are also involved in the new projects under development. The collective experience with U.S. offshore oil and gas projects readily translates to offshore wind projects, which present many of the same operational, commercial, and legal issues and challenges.
Set forth below are four key factors to consider in connection with the development of a U.S. offshore wind project, each of which can impact the cost and scheduling of a project.
1: Lengthy Permitting Process
In the U.S., offshore wind projects may be sited in either state or federal waters. State waters extend three nautical miles from the respective state’s shoreline (for Texas and the Gulf Coast of Florida, the respective state waters extend out nine nautical miles), and federal waters then extend from the outer boundaries of state waters to 200 nautical miles from shore.
Offshore wind installations wholly sited within state waters are subject to state regulations and are, therefore, generally not required to submit to the federal permitting process. Offshore wind installations sited in federal waters fall under the purview of the Bureau of Ocean Energy Management (BOEM), an agency within the U.S. Department of the Interior. BOEM is charged with issuing leases for areas within federal waters that are suitable for offshore wind projects, as well as reviewing, approving, and permitting any proposed projects within the leased area.
Once BOEM has awarded a lease, for each offshore wind installation that the leaseholder proposes, the leaseholder must submit a site assessment plan, and later, a construction and operations plan, to BOEM for review and approval. Part of the BOEM approval process is the preparation of an Environmental Impact Statement to assess the physical, biological, and social impacts of the proposed offshore wind project and all reasonable alternatives (including an alternative that the project not be pursued), and any proposed mitigation.
Due to the regulatory landscape in the U.S., the permitting process to-date has been slow and lengthy, and has been viewed as a limitation on the development of the country’s offshore wind resources. As of January 2021, BOEM has issued 16 leases for areas within federal waters to developers and has received construction and operations plans for 10 U.S. offshore wind projects from the developers. However, BOEM has thus far only fully approved one project. Several industry observers expect the Biden Administration to seek to streamline the permitting process for U.S. offshore wind projects.
2: Availability of Installation Vessels
Regardless of whether an offshore wind project is sited in state or federal waters, vessels are needed to support the pre-construction, construction, operations and maintenance (O&M), and decommissioning phases of the project – and most of these vessels will need to comply with the U.S. coastwise laws known as the “Jones Act.”
The Jones Act and related regulations restrict the waterborne transportation of “merchandise” and passengers between two points in the United States to U.S.-flagged vessels that are built in the U.S., owned/operated by U.S. citizens, and manned by U.S. citizens. Therefore, Jones Act-qualified vessels are needed to carry construction components, equipment, and contractor crews between a U.S. port and an offshore wind project site that is a point in the U.S.
Most near-shore sited projects within state territorial waters are considered points within the U.S. Outside of those territorial waters, the Outer Continental Shelf Lands Act (OCSLA) extends U.S. federal jurisdiction to any points on the U.S. outer continental shelf (OCS) laying beneath the federal waters that extend 200 miles from shore. However, due to conflicting federal agency interpretations, uncertainty had been created as to whether OCSLA extended the application of the Jones Act to renewable energy projects sited on the OCS, such as offshore wind farms, in the same way that OCSLA applied the Jones Act to installations on the OCS for the exploration and production of oil and gas.
That uncertainty – which was presenting particular challenges to developers planning the construction phases of U.S. offshore wind projects – was eliminated recently by Congress’ passage (overriding a presidential veto) of the National Defense Authorization Act for Fiscal Year 2021, which now makes clear that all federal laws, including the Jones Act, apply to “installations and other devices permanently or temporarily attached to the seabed, which may be erected thereon for the purpose of exploring for, developing, or producing resources, including non-mineral energy resources” (emphasis added).
However, in the near term and until Jones-Act qualified vessels are built, the installation of any offshore wind turbines in U.S. waters will likely be performed by foreign vessels because there are no available Jones Act-qualified vessels with the capabilities to install the larger turbines that developers are planning as project sizes grow. A vessel that is stationary and in the act of pure lifting or installation does not need to meet Jones Act qualifications. However, such a stationary, foreign installation vessel still requires Jones Act-qualified “feeder” vessels to transport the turbines and related components from a U.S. port to the offshore wind project site.
As turbines and related components increase in size, this could also constrain the availability of Jones Act-qualified “feeder” vessels until more U.S.-flag vessels can be built or reconfigured.
3: Project Construction, Operations and Maintenance
In light of the increased costs – including the costs associated with utilizing Jones Act-qualified vessels – and increased risks in both the construction and operations of offshore wind projects as compared to onshore projects, investors and other financing sources considering a U.S. offshore wind project should give special focus to these areas through due diligence and deal documentation.
Construction risks for an offshore wind project exist both from a timing perspective and a cost-overrun perspective. The likelihood of construction delays necessitates more time and focus spent negotiating development and construction milestone deadlines as well as performance excuse and remedies for failure to meet the milestones.
Milestone deadlines appear in a number of project documents, including interconnection agreements, offtake agreements and engineering, procurement and construction agreements. Investors will need to ensure that these project agreements contain sufficient timelines and cushion for delays for the expected, as well as performance excuse for the unexpected, far beyond what one might see in the onshore space.
On the flip side, investors need to weigh how long they are willing to commit (and consequently tie up) their capital for a project that may likely encounter numerous delays, and which of those delays will permit the investor to walk away from a beleaguered project. From a cost perspective, focus should be spent on the engineering, procurement and construction contracts. The complexity of offshore wind project construction, including the onshore and offshore component parts, coupled with the risks of these construction projects, may result in multiple construction contracts being required without a fully “wrapped” project.
Additionally, investors and other financing sources should pay particular attention to the terms and conditions of the O&M agreements for an offshore wind project, and the technical and financial wherewithal of a project’s O&M provider. A heightened level of O&M expertise is required for offshore O&M providers and performance is riskier than its onshore counterpart. Additionally, in the U.S., fewer contractors are available to provide these services. Accordingly, financial players will want to ensure that a qualified O&M provider is engaged early in the project’s construction phase and engaged for a sufficient duration post commercial operations. As more U.S. offshore wind projects reach commercial operations, one should expect increased demand for the limited O&M providers and therefore likelihood for volatility in O&M costs for a project unless and until additional service providers enter the market.
4: Tax Credits
Offshore wind projects located in U.S. waters are eligible for the production tax credit (PTC) or the investment tax credit (ITC). The PTC is generally for utility-scale wind projects and the credit is calculated based on the kilowatt-hours of electricity produced and sold during the first 10 years of electricity generation from the project. The ITC is a one-time credit available in the year in which the project begins commercial operation and is calculated as a percentage of the total project cost. Taxpayers can elect either credit regime for a project but a project cannot be eligible for both. Because offshore wind projects are extremely capital-intensive, the ITC is likely to be more attractive than the PTC.
Both PTC and ITC are subject to phasedown provisions for projects that began construction after 2017, and both credit regimes are set to expire for projects that have not begun construction by the end of 2022, which reflects a recent two-year extension granted by Congress. Specifically, for offshore wind projects, Congress extended the ITC (but not the PTC) for five years (until 2025) and eliminated the phasedown provisions. Thus, offshore wind projects that begin construction by the end of 2025 will continue to be eligible for the ITC at the 30% pre-phasedown rate.
4a: Beginning Construction
Under IRS guidance, taxpayers may establish that construction has begun either through physical work (which may be offsite work) or by paying or incurring at least 5% of the total cost of the project. Taxpayers also generally must establish continuous efforts thereafter to complete the project. Because U.S. offshore wind project developers face longer delays in bringing projects to completion due to logistical difficulties and more stringent permitting and environmental requirements, the Internal Revenue Service has provided a 10-year safe harbor (instead of the four-year period generally applicable to onshore wind and solar projects) to complete a project after construction begins and lock in the ITC rate without having to demonstrate continuous efforts towards completion.
The availability of tax credits is important in attracting project capital in the form of “tax equity” financing from large institutional and corporate investors with capacity to use the tax credits. Thus, developers that do not have sufficient taxable income to use the credits currently can monetize the credits. The Block Island Wind Farm was financed in part by tax equity investments by GE and Citi. Because a substantial portion of the economic return from a wind project derives from the tax credits, the five-year extension of the ITC for offshore wind and the 10-year safe harbor are welcome news for the industry.
Despite some of the challenges raised above and others to be encountered by the offshore wind industry, there is significant optimism that the industry will expand significantly in the U.S. over the next decade. The growth of the U.S. offshore wind market provides an opportunity for traditional oil and gas companies, and the contractors that support them, to diversify their portfolios, and allows many of them to utilize their existing competencies to compete in the renewable energy sector. The recent legislation extending the tax credits and the application of the Jones Act to U.S. offshore wind projects provides developers, investors, and lenders with some needed clarity and certainty when evaluating projects, particularly as BOEM considers new potential leases offshore the U.S. Gulf and Pacific Coasts.
About the Authors
Based in V&E’s Houston office, partner David Cole represents corporations, private equity funds, partnerships, and high net worth individuals in domestic and international tax matters, including investments in renewables, tax controversy, and transfer pricing.
Based in V&E’s Washington, D.C. office, counsel Debra Duncan advises clients on the federal income tax consequences of structuring transactions, with particular emphasis on investments in clean and renewable energy projects qualifying for federal tax credits.
Based in V&E’s Houston office, partner Shay Kuperman advises on mergers and acquisitions, strategic joint ventures, investments and project development across the energy industry, and he frequently advises energy companies, financial investors and project developers.
John Michael, Houston-based partner and head of V&E’s Maritime & Offshore practice, represents clients in corporate, finance, and commercial matters relating to the marine industry, and regularly advises clients on the “Jones Act”.
Based in V&E’s Houston office, partner Danielle Patterson’s practice focuses exclusively in the energy and infrastructure industries across a broad spectrum of sectors, including upstream and midstream oil and gas and renewable power.