Squaring Off Between Carbon Taxes And Renewable Energy Incentives

Some European renewable energy producers are concerned that the EU may lose green energy investments to the United States in the wake of recently enacted U.S. legislation.

The Inflation Reduction Act (IRA, P.L. 117-169) boasts a roster of renewable energy tax incentives, including a new clean hydrogen production tax credit (section 45V) tied to the amount of greenhouse gas emissions released during the hydrogen manufacturing process.

Clean hydrogen producers are particularly pleased with the U.S. credit, but they recently were concerned about proposed rules out of the European Commission that they believed could stifle production. The commission wanted to classify hydrogen as fully renewable — and eligible for subsidies and other incentives — only if it is produced by renewable electricity.

European lawmakers were concerned that renewable hydrogen production could monopolize renewable electricity generation and leave little left for consumers, so the commission proposed draft rules in May requiring that renewable electricity must be produced within the same calendar hour that renewable hydrogen is produced.

That proposal, known as the additionality principle, had Europe’s largest hydrogen lobby — Hydrogen Europe — up in arms because it believed the standard was “disproportionate” and would make European renewable hydrogen less competitive, especially compared with U.S. hydrogen. European lawmakers heard their concerns, and on September 14 the European Parliament approved an amendment eliminating the additionality principle.

Then there’s the issue of tax credits. The IRA has attracted a lot of attention because it significantly expanded — in some cases more than tripled — existing tax credits for carbon capture and it offers new production tax credits for hydrogen and zero-emission nuclear power that are expected to significantly lower the cost of new, renewable energy technology.

Mark Hutchinson, CEO of Fortescue Future Industries, told the Financial Times that the EU, which is negotiating its own Green Deal, needs to step up its incentives or risk that the United States will receive the majority of green capital. Meanwhile, Hydrogen Europe is forecasting that the IRA will present “a huge challenge for Europe.”

The IRA is an experiment in reducing the cost of new, renewable energy technology to lower the United States’ carbon emissions. The act is important for what it doesn’t do: It doesn’t rely on a carbon tax or carbon price to reduce emissions.

Carbon pricing is far from universal — about 46 countries formally implement a carbon tax — but the IMF, U.N., and other large international bodies think it is a solution to global warming.

However, the IMF is warning that carbon prices are currently too low to be effective. It estimates that the global average of $6 per ton of CO₂ must rise to $75 by 2030.

Meanwhile, the U.S. government is projecting that the IRA’s incentives will significantly reduce the country’s emissions, but not to the level required by the Paris Agreement. Both carbon taxation and renewable energy subsidies raise the question of what can be done to fill in the respective gaps.

Three recent examples from the United States, Australia, and Canada show that it’s easier said than done to incorporate a robust, hybrid approach.

United States

Shortly after taking office, President Biden brought the United States back into the Paris climate agreement and vowed to reduce the country’s carbon emissions from their 2005 levels between 50 and 52 percent by 2030.

The major question was how that could be accomplished. Carbon tax proposals have never made significant progress in Congress, so a national carbon tax never was a realistic option. Congressional Democrats briefly flirted with the idea in the Build Back Better Act, which was the predecessor to the final solution, the IRA.

The IRA is essentially a giant stimulus for clean energy technology and production in the United States. On the carbon capture side, the law dramatically increases the section 45Q tax credit for various forms of carbon capture, use, and sequestration projects.

For example, the credit for carbon capture and storage from industrial and power generation facilities has increased from $50 per metric ton to $85. For direct air carbon capture and storage, the credit more than tripled, from $50 to $180 per metric ton.

The act also makes it much easier for carbon capture, use, and sequestration projects to qualify for a section 45Q credit. Previously, direct air capture facilities had to remove 100,000 metric tons of CO₂ to qualify.

Now the threshold has been reduced to 1,000 metric tons. The law also makes it easier for facilities to benefit from the credit because they can receive it as a direct payment rather than as a reduction in their tax liability.

Another big change involves investment tax credits and production tax credits for solar, electric, and wind power. The law earmarks $10 billion in credits for the creation of clean technology manufacturing facilities, such as those for electric vehicles, wind turbines, and solar panels.

A new clean electricity credit under section 48E provides a credit of up to 30 percent, plus 10 percent bonus, for facilities that are placed in low-income communities or meet other parameters.

On the production side, some of the IRA’s offerings include a new 10-year production tax credit for clean hydrogen under section 45V, which offers up to $3 per kilogram of clean hydrogen. And a new credit for clean electricity production under section 45Y offers a credit of 1.5 cents per kilowatt of clean electricity.

Other major credits include a zero-emission nuclear power production tax credit under section 45U and a new clean fuel production credit under section 45Z.

“Tackling climate change is not just a problem of incentives, but also a problem of technology,” Aaron Bergman of Resources for the Future, and former lead for Macroeconomics and Emissions at the U.S. Energy Information Administration, told Tax Notes. “Moving technology costs down is vital,” he explained.

“The IRA attempts within the current political context to create better incentives encouraging people to use cleaner energy, and to have better technology that will enable us to have greater decarbonization in the future,” Bergman added.

The credits extend for at least 10 years, ensuring that clean energy producers won’t need to worry whether lapsing credits will be renewed in the tax extender process.

Energy provisions have been rather vulnerable in that regard; of 40 temporary tax provisions that expired at the end of 2021, about a fifth of those were energy-related.

“One aspect of U.S. policy that has impeded a ramp-up of investment is the temporary, start-stop nature of these subsidies. We tend to expand the subsidies for a few years and then run out and they’re extended and maybe there’s a gap, and that kind of uncertain policy environment really interferes with investment,” Thornton Matheson of the Urban-Brookings Tax Policy Center told Tax Notes.

“So that’s one good thing that the IRA does.”

The act also makes it easier for taxpayers to monetize their tax credits through two key features: a transferability provision and a direct-pay provision. The first provision allows taxpayers to transfer all or part of their tax credits to a third party in exchange for cash. The direct-pay option allows some renewable energy companies to claim their credits on their tax returns as refunds and receive the amounts as cash.

But what do these provisions mean from an emissions standpoint? The Energy Department estimates that the Inflation Reduction Act will reduce the country’s emissions about 40 percent from their 2005 levels.

This tracks with analysis by Energy Innovation Policy and Technology LLC, which found that the act’s provisions could reduce emissions up to 43 percent below 2005 levels by 2030.

If the United States were to maintain its status quo, it would reduce emissions by 24 to 35 percent, according to the Center for American Progress and the Rhodium Group.

Although the IRA is certainly better than the status quo, the law’s green energy provisions do not fully take the United States to where it wants to be.

“The question is, where are we going to get the other 10 percent reduction? I think having a carbon tax, or carbon fee, would be a very good way to get the last 10 percent. The subsidies in the IRA can create space for that,” Matheson said.

A carbon tax layered on top of the IRA’s existing climate provisions may not need to approach the $75-per-ton amount cited by the IMF.

The Brookings Institution has calculated that a $25-per-ton carbon tax that rises by 1 percent per year would reduce emissions from their 2005 levels to between 17 and 38 percent by 2030. That’s well above the 10 percent gap left by the IRA.

This is important because the act alone may not be enough to reduce America’s reliance on fossil fuels, which account for nearly 80 percent of the country’s energy consumption.

“Typically, economists believe — and the evidence shows — that when the price of something goes down, people buy more of it. While a carbon tax would raise the cost of energy from fossil fuels, which is most of the energy that we consume, the IRA’s subsidies will ultimately reduce the cost of energy, particularly electricity. So they will not encourage energy conservation,” Matheson said.

“They will favor clean energy, so certainly in that respect, they’ll provide a benefit. But if people are consuming more energy, some of that energy will come from fossil fuels, and I think that’s a major weakness of subsidizing clean energy versus taxing dirty energy.”

Australia

Meanwhile, Australia had a carbon tax but repealed it in 2014. Now the government is considering how it can mobilize incentives, such as its current emissions credit scheme, to reduce greenhouse gas pollution.

However, those incentives may not be enough without a stronger tax strategy.

On September 8 the Federal Parliament passed a climate change law that requires the government to reduce the country’s emissions by at least 43 percent from their 2005 levels by 2030 and reach net-zero by 2050. As part of the law, the government must provide annual climate change statements to track its progress.

But a major question is how Australia will lower its emissions. Australia is centering its emissions strategy partly on its technology investment roadmap, a plan that resembles the United States’ plan and includes the development of hydrogen capabilities and carbon capture and storage.

The government also maintains a voluntary emissions reduction fund, which allows Australian businesses to earn credits for storing carbon dioxide or lowering their emissions. It has three main parts:

• an emissions reduction credit scheme, which allows registered emissions reduction projects to receive carbon credit units for meeting their targets;
• an auction system that allows businesses to purchase emissions reduction credits; and
• a safeguard mechanism to ensure that companies do not undermine the emissions reduction fund by generating significant emissions in other parts of the economy.

But that credit scheme is under independent review in the wake of allegations that companies have gamed the system. By several accounts, the time is ripe for the Australian government to further consider how it can use tax incentives — aside from a carbon tax — to meet its climate goals. Some hydrogen industry stakeholders already have some ideas.

In a 2021 submission to the government, the Australian Hydrogen Council suggested that the government consider:

• offering tax credits and incentives for investments in export hydrogen production and distribution that requires research, development, or demonstration;
• reducing current tax write-off periods for hydrogen infrastructure from one year to three years;
• increasing the effective rate of research and development tax offsets from their current 8.5 percent rate to 20 percent and raising the R&D expenditure threshold from AUD 100 million to AUD 500 million (the government has since increased the threshold to AUD 150 million); and
• allowing immediate tax deductibility of salary and wage costs tied to the construction of hydrogen production and distribution projects.

It remains to be seen whether any of these provisions will appear in anticipated climate legislation that is expected to lay the groundwork on how Australia will continue to reduce its emissions.

Canada

In Canada, Nova Scotia battled the federal government for months over a planned carbon tax and used the IRA as an example of why the province doesn’t need a carbon tax.

But the federal government essentially rejected the idea that incentives alone are enough to reduce emissions.

Canada, which has a C $50-per-metric-ton carbon tax, plans to increase it to C $170 per metric ton by 2030. The government has said that the provinces cannot opt out of carbon pricing. Under the Greenhouse Gas Pollution Pricing Act, all the provinces and territories must either comply with the federal carbon pricing system or maintain their own systems that meet federal benchmarks. The government had requested alternate plans by September 2.

Four provinces — New Brunswick, Newfoundland, Nova Scotia, and Prince Edward Island — objected to the government’s mandate.

Nova Scotia had been particularly vocal in its opposition. In August, the government of Nova Scotia submitted an alternative plan to the federal government, explaining why a carbon tax would hurt Nova Scotia and why a series of alternatives would be better for the province.

Nova Scotia was concerned that a carbon tax would impose significant financial burdens without promoting substantial change in rural Nova Scotia, where residents must rely on cars for transportation.

Nova Scotia is also concerned about affordability, particularly in the current inflationary climate. The federal government maintains that most Canadians will receive those tax payments back in the form of rebates; Nova Scotia says those reimbursements are small comfort for citizens who cannot afford upfront costs.

Canada aims to reduce the country’s emissions by 40 percent below their 2005 levels by 2030 and reach net-zero emissions by 2050. Nova Scotia argued that it could surpass the federal standard without implementing a carbon tax. In October 2021, Nova Scotia passed the Environmental Goals and Climate Change Reduction Act, which requires the province to attain net-zero emissions by 2050, but imposes a stricter 2030 target: a 53 percent reduction of emissions from their 2005 level.

The act also requires Nova Scotia to phase out coal-fired electricity generation by 2030 and ensure that at least 80 percent of its electricity is supplied by renewable energy by 2030.

Nova Scotia argued that if Canada wants to be even more aggressive in reducing emissions, the government should copy the United States and provide incentives that green the grid, beyond what the government is already doing.

The federal government is starting to expand on such incentives; in July it enacted an investment tax credit for carbon capture, use, and storage, and halved the corporate tax rate for some zero-emission technology manufacturers as part of its Budget 2022.

“Invest in green hydrogen to put Canadian development on an even playing field with European programs and with the U.S., as their Inflation Reduction Act will immediately make green hydrogen a competitive source of energy compared to its fossil fuel alternatives,” Nova Scotia said in its August letter.

But the federal government rejected Nova Scotia’s plan, as well as an alternative the province submitted in September, which demonstrates that Canada’s carbon tax is here to stay. However, it leaves unanswered questions about whether and how additional tax incentives may fit into the country’s strategy.