What are YieldCos?
YieldCos are an emerging asset class of publicly traded companies that are focused on returning cash flows generated from renewable energy assets to shareholders. These assets largely consist of solar and wind farms that have entered into long-term energy delivery contracts with customers. Many YieldCos are able to distribute a high percentage of their cash flows by utilizing tax incentives to minimize tax liabilities. As of January 2016, there were 20 publicly traded YieldCos, 16 of which had IPO’d since the beginning of 20131.
What are the Potential Advantages of Investing in YieldCos?
- Yield: The average dividend yield of listed YieldCos was 6.2% in 2015. YieldCos achieved this high yield by generally distributing 70-90% of available cash flows to shareholders2. (past performance is no guarantee of future returns)
- Dividend Growth: YieldCos are designed to offer the potential for dividend growth by acquiring new cash flow generating assets. 14 YieldCos2 increased their dividends payments in Q4 of 2015 over Q4 of 2014, amounting to an average dividend growth of 15%3.
- Lower Volatility: YieldCos generally consist of fully developed assets that have entered into long-term contracts to deliver electric power to customers. By mitigating development risk and price uncertainty, YieldCos seek to avoid a few of the riskier aspects of traditional renewable energy investments.
- Diversification: YieldCos offer investors a source for alternative income that has historically demonstrated low correlations to fixed income, traditional equities, MLPs and REITs.
- Tax Efficiency:
- Unlike MLPs, the majority of YieldCos are structured as corporations, not partnerships. Therefore, they distribute 1099s to shareholders, rather than K-1s.
- YieldCos can be held in ETFs, Mutual Funds, and Closed End Funds structured as Regulated Investment Companies (“RICs”), without subjecting the funds to fund-level taxation, which is not the case with MLPs.
- Due to net operating losses, cash distributions are often considered return of capital, which lowers an investor’s cost basis. Taxes are often paid upon sale of the asset at the long-term capital gains rate.
What are the Potential Risks?
- Conflict of Interest: Undue influence of a YieldCo’s parent company could subject the YieldCo to conflicts of interest. The risk can be mitigated by the existence of an independent board.
- Tax Policy: Reliance on tax incentives to minimize tax liability could result in distribution cuts if tax policy changes.
- Geography: Due to YieldCos’ reliance on renewable energy sources to generate electricity, changing weather patterns can result in fluctuations in output. Investing in YieldCos with multiple projects, or selecting a diversified basket of YieldCos, can potentially moderate this risk.
- Valuation: Valuations are heavily based on multiples of cash available for distribution (“CAFD”) and expectations of future distribution growth. Changes in either of these factors or the external interest rate environment can impact a YieldCo’s value.
What is a YieldCo's Structure?
A YieldCo is created when an energy company (the “parent”) spins off a completed renewable energy project or number of projects that have begun producing stable cash flows. In most cases, the parent company continues to hold a majority interest in the YieldCo and sells a minority stake to public shareholders in an initial public offering.
Typically, subsidiaries of the YieldCo are responsible for the day to day operations of each of the projects. The cash flows earned from each of the projects moves up the corporate structure from the subsidiaries managing the projects to the YieldCo. A high percentage of the cash remaining at the YieldCo level (often referred to as cash available for distribution, or CAFD) is distributed to the YieldCo’s shareholders.
An independent Board of Directors pursues opportunities to acquire additional assets from the parent company to the YieldCo. Any conflicts of interest between the parent company and the YieldCo are expected to be mitigated by this independent Board of Directors.
How are YieldCo's Taxed?
YieldCos are structured to avoid double taxation which occurs once at the corporate level on earnings and a second time at the shareholder level on dividends. YieldCos, however, are not exempt from corporate level taxation like REITs or MLPs. Therefore, they strive to achieve tax efficiency through the utilization of tax incentives to minimize taxable earnings at the corporate level.
Most renewable energy projects do not generate taxable income for years after they begin operations because depreciation expenses exceed revenues. Based on current tax laws, in instances where a YieldCo is able to offset all revenues with depreciation expenses, it will not owe corporate taxes. In addition, excess depreciation beyond current year revenues can be carried forward for up to 20 years as a tax-loss carryforward, which can be used to offset future tax liabilities. YieldCos will typically continually acquire new assets in order to maintain high annual depreciation expenses.
Without current-year earnings, cash distributions to shareholders are considered a return of capital. Return of capital lowers the cost basis of an investment and is taxable at the capital gains tax rate upon sale of the shares.
How do YieldCo's Compare with MLPs?
In many respects, YieldCos mirror the investment characteristics of midstream-energy MLPs. The table below highlights the similarities and differences between the two structures5:
