Diving into the Inflation Reduction Act’s tax credits and the ambitious plan to reshape the US energy sector

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The following is a contributed article by Mona Dajani, partner and global co-head of Energy, Infrastructure, Mobility, Renewables & Water, Pillsbury Winthrop Shaw Pittman LLP

With the U.S. Senate’s recent approval, the Inflation Reduction Act of 2022 is likely to become reality and a remarkable achievement.

The compromise reached by Senate Majority Leader Chuck Schumer, D-N.Y., and Sen. Joe Manchin, D-W. Va., touches on many issues — corporate taxes and prescription drugs among them. Dominating headlines is the $369 billion in energy and climate change investments — an unprecedented level of federal support for the clean energy transition.

As the dust settles, it’s becoming increasingly clear that this will indeed be a breakthrough opportunity for the U.S. to lead in that transition. Tax incentives in the plan would stabilize federal energy policy, incentivize domestic manufacturing, and benefit communities impacted most by the changing energy landscape. Importantly, the plan takes an all-of-the-above energy approach (so long as it’s carbon-neutral) to developing the U.S. energy system of the future.

This is welcome news to a sector that faced setbacks in 2022. According to American Clean Power, U.S. solar and wind installations were down in the second quarter from a year ago by 53% and 78% respectively — not because of a lack of demand, but over policy uncertainty and supply chain bottlenecks. Again capital has had to wait on the sidelines until the rules became clear — a boom-bust story all too familiar to onshore wind developers.

The IRA would revamp tax incentives crucial to accelerating the energy transition. The Investment Tax Credit (ITC) would be extended through 2024, along with new credits for carbon capture, clean hydrogen and some nuclear technologies. In 2025, these tax credits change to emissions-based, technology-neutral tax credits available to any power generation that’s net-zero, potentially a lifeline to fossil fuels if they can demonstrate robust carbon capture.

Power producers would have the flexibility to use either the ITC, the Production Tax Credit (PTC) or sell credits to unrelated third parties for cash. Previously, a tax investor buying a credit was required to have an ownership interest in the facility receiving the credit. Now, these credits can be sold directly to anyone with tax liabilities. This could be seen as a workaround to a direct payment option — where operators receive cash in lieu of a tax credit — largely missing from the plan.

Taken together, power operators would have more options than ever to maximize their facilities’ economic potential. These tax credits would stay in place until 2032 or when the U.S. achieves a 75% reduction in greenhouse gas emissions from 2022 levels, at which point they would phase down over several years. This long-term stability removes one of the biggest risk factors for the sector.

Year    Billions of Dollars

2022   

0
2023    19.7
2024 35.7
2025 45.9
2026 50.9
2027 48
2028 40.8
2029 42.9
2030 43.7
2031 41.5
Total 369
Breakdown of new clean energy investment by year — much of it in tax credits that leverage further private investment — in the Inflation Reduction Act of 2022. Source:  Penn Wharton Budget Model 

Another key tax feature is the ability to stack tax incentives. Along with a base ITC of 30%, power producers can add on:

  • An additional 10% ITC (or a 10% increase in equivalent PTC), by using a certain percentage of steel, iron and manufactured products produced in the United States
  • 10% for facilities in census tracts with retired coal infrastructure, or that post-1999 had high employment levels by the coal, oil or natural gas industry
  • 20% for small wind and solar projects in low-income communities

Equally important, for projects over 1 MW, 80% of the base ITC and PTC hinges on using apprenticeship programs and paying prevailing wages for project construction and operations, for five years for the ITC and 10 years for PTC. For example, the ITC base of 30% would drop to 6% if wage requirements are not met. This may raise development costs and the risk of recapture if a facility claims the full credit initially, yet doesn’t fulfill the wage standards.

Taken together, these tax credits make up the backbone of the plan’s priorities. These are calculated measures to foster a domestic clean energy supply chain, invest in communities looking to find their economic identity in the energy transition, and create well paying jobs across the United States.

In addition to these broader aspirations, the plan would boost clean hydrogen and carbon capture. The hydrogen PTC would provide a tax credit of up to $3 per kg for the first 10 years of operation, dramatically improving the economic appeal of green hydrogen from renewables while maintaining some incentives for blue hydrogen from natural gas. It could be paired with tax credits for the renewable projects used to produce the green hydrogen. Electricity facilities that use carbon capture to reduce their emissions at least 75% would qualify for tax credits. This technology-neutral approach could ease a difficult energy transition and nudge the entire energy sector towards net-zero.

The robust electric vehicle industry would also see its tax incentives extended, albeit with new domestic requirements, fostering this new source of demand for electric power. A $7,500 tax credit for buyers is split in two tranches — $3,750 is unlocked if the materials are sourced from a country in a free trade agreement with the U.S., and the other $3,750 awarded if the battery is assembled in North America. Fuel cell vehicles also qualify. New upper income limits on the incentives were one sticking point to getting Manchin’s approval.



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