Bloomberg Tax
Aug. 17, 2022, 8:45 AM

Tax Credits in US Climate Deal Bring Paris Accords Goals Closer

Thornton Matheson
Thornton Matheson
Urban-Brookings Tax Policy Center

The Inflation Reduction Act includes a host of new fiscal measures—mostly tax cuts—to reduce US greenhouse gas emissions and build resilience to climate change. According to official estimates, green tax credits will expand by $270 billion over the 10-year budget window, along with roughly $117 billion in spending increases and $20 billion in additional fossil fuel charges.

The Senate estimates that the legislation will reduce US greenhouse gas emissions to 40% of their 2005 levels, roughly doubling the reduction already achieved. An additional 10% reduction will therefore be needed to achieve the 50% goal that the US committed to in the 2015 Paris Accords.

The largest tax credit increases are for the renewable energy investment tax credit ($65 billion) and production tax credit ($62 billion), which together form the core of US energy transition policy. The bill also creates or expands green tax credits for renewable energy equipment manufacturing ($37 billion), commercial and residential buildings ($37 billion), nuclear power ($30 billion), alternative fuels ($21.8 billion), and electric vehicles ($14.2 billion).

Historically, the investment tax credit has provided a credit of up to 30% of capital costs, mostly for solar energy. The production tax credit has provided a subsidy of up to 2.5 cents per kilowatt hour of renewable energy produced for a project’s first 10 years, mostly for wind power. Credit eligibility varies by type of energy source, and both the investment tax credit and production tax credit have lapsed and been renewed numerous times. This has created discontinuities and uncertainty for clean energy producers that has interfered with investment.

The legislation retroactively extends the production tax credit—which expired at the end of 2021—through Dec. 31, 2025. It also extends the investment tax credit, which is set to phase out by the end of 2024, through the end of 2025, and expands its coverage to energy storage, biogas, electrochromic glass, and microgrid controllers. After 2025, energy tax credits will transition to the technology-neutral clean electricity production and investment credits.

Under the new regime, producers can choose either the investment tax credit or the production tax credit (though not both) for any project that generated zero-carbon energy. This flexibility is important to maximizing energy tax credits’ effectiveness. The production tax credit tends to offer a deeper subsidy than the investment tax credit, especially as equipment prices fall, but the investment tax credit can outperform for high-cost projects.

The new tax credits will be more fungible, which could substantially lower clean energy producers’ capital costs. Currently, energy companies with insufficient taxable profits seek “tax equity partners” that provide funding in exchange for tax credits—an expensive source of financing. Under the bill, taxable companies can instead sell the credits to more profitable firms, while public and nonprofit energy producers can obtain a cash refund.

The bill links tax credit rates to federal labor compensation standards. The base amount of each credit will be reduced by 80%, but energy companies can obtain the full investment tax credit credit rate of up to 30%, or the full production tax credit rate of up to 2.5 cents per kwh, by paying workers prevailing local wages and meeting registered apprenticeship requirements.

Higher credit rates can be obtained by meeting domestic content rules and/or investing in “energy communities” with high exposure to the fossil fuel industry. Domestic content rules require that certain iron, steel, and manufactured inputs be produced in the US. Energy communities include those with significant oil, gas, and coal employment, as well as communities affected by coal mine and power plant closures.

Meeting either of these requirements entitles energy companies to receive an additional investment tax credit of up to 10%, or a 10% higher production tax credit. Companies that qualify for both can obtain a total investment tax credit of up to 50% or a production tax credit of up to 3 cents per kwh. Currently, the average US cost of electricity is 10.75 cents per kwh.

The legislation also responds to growing concerns about climate justice, with increased tax credits and budgetary spending targeted to disadvantaged communities. In 2023 and 2024, solar and wind projects with a maximum capacity of 5 megawatts established in low-income and Native American communities can qualify for a bonus investment tax credit of 10% to 20%.

Manufacturers of clean energy equipment also will have access to expanded credits under the proposal. An additional $10 billion of advanced energy project credits will be allocated, including $4 billion targeted at energy communities. This investment tax credit of up to 30% benefits projects that reequip, expand, or establish manufacturing of a variety of energy-related products, including renewable energy and alternative fuel production equipment, energy storage systems, and electric vehicles.

The new advanced manufacturing production credit will subsidize wind and solar power equipment. For example, offshore wind turbines will receive a subsidy equal to 10% of their sales price, and photovoltaic wafers for solar panels a subsidy of $12 per square meter.

The bill also includes a handful of fiscal charges on fossil fuels, including an innovative fee of $900 to $1,500 per metric ton on methane emissions from petroleum extraction, which account for at least 3.5% of US greenhouse gas emissions. Now that the bill is law, the US has become only the second country in the world to impose a methane fee after Norway.

The Congressional Budget Office estimates that the methane fee will raise about $6.5 billion over the budget window. The legislation also reintroduces and makes permanent Superfund taxes on oil at the rate of 16.4 cents per barrel, indexed to inflation ($11.7 billion). Similarly, it makes permanent Black Lung Disability Trust Fund taxes on coal of $0.55-$1.10 per ton ($1.2 billion).

Layering tax subsidies for renewable energy equipment on top of tax subsidies for renewable energy itself will provide a deep sectoral stimulus with the potential to transform the US energy industry. The legislation can reduce US electricity costs by about 6% over the coming decade. To deliver the remaining 10% reduction in US carbon emissions needed to meet Paris goals, imposing modestly higher fossil fuel charges will augment the power of renewable energy subsidies to deliver a zero-emissions future.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Thornton Matheson is a senior fellow at the Urban-Brookings Tax Policy Center, where her work focuses on business and environmental tax policy. She previously was a senior economist in the tax policy division of the International Monetary Fund’s Fiscal Affairs Department and a financial economist for the US Treasury Department’s Office of Tax Analysis.

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