Let’s Find a Way to Get Tax Subsidies for Clean Energy Right

This blog was originally published on Bloomberg Tax. Reproduced with permission. Copyright 2023 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bloombergindustry.com

After years of procrastination, governments worldwide are finally providing substantial fiscal support to clean energy. This newfound enthusiasm is driven not only by the need to address climate change, but also by a desire to reduce dependence on volatile fossil fuel markets prompted by Russia’s invasion of Ukraine.

The Oxford Global Recovery Observatory and International Energy Agency estimate global fiscal commitments on green measures between $1 trillion and $1.2 trillion since 2020. The OECD Green Recovery Database estimates a roughly similar amount of 1.1 trillion euros in government spending allocated to environmentally positive measures since 2021, and more spending is planned.

The Inflation Reduction Act is the most ambitious energy package worldwide, but further support is in the pipeline. The European Commission has proposed its Green Deal Industrial Plan, with multiple direct grants, subsidized loans, loan guarantees, and tender-based schemes potentially reaching between 400 billion euros and 700 billion euros.

The EU is also working on a European Sovereignty Fund to provide more funding sources for clean industrial projects and will ease its state aid rules, giving member states more flexibility to support renewable energy and decarbonisation. France has designed a Green Industrial Plan. In Germany, the government has committed almost 100 billion euros to support the switch to renewable energy and electrification.

Overall, this is good news. This fiscal support will stimulate private investments in clean energy and foster innovation during the coming decade. Nonetheless, the tools used for this support—particularly the massive tax subsidies—come with risks. Governments must get it right to avoid a wasted opportunity.

Innovative Tax Credits

The new law redesigns and broadens tax incentives to make clean energy more attractive. For example, it redesigns the investment tax credit to encourage investing in clean energy and adapts the production tax credit to target the production of renewable power. It also extends the clean vehicle credit, the residential energy tax credit, and it increases the tax credits available for carbon capture.

Most of these tax credits will be in place for at least 10 years. This provides renewable project developers with a high degree of certainty, making it easier to engage in long-term investment plans. Furthermore, most of the tax credits don’t have a funding cap, reducing concerns about fast-exhausted budgetary appropriations.

Some of these tax credits will be transferable to other taxpayers, providing cash to developers at an early stage. Another attractive feature is direct pay for eligible entities, which will enable direct payments in lieu of a reduction in tax liability.

Unknown Fiscal Cost

The tax and climate law is already subject to a debate, which will prompt useful lessons for other countries. First, providing tax credits without funding cap could turn out to have a very costly impact on government coffers. The Congressional Budget Office has estimated that energy and climate provisions would cost $369 billion over 10 years.

Recent research has cast doubt on this figure. Goldman Sachs estimates that it could cost more than three times more than estimated by the CBO. Hence, the fiscal cost needs to be monitored carefully.

This fiscal cost won’t be a huge problem if the law turns out to be a cost-effective response to climate change. With its generous tax credits, the law lowers abatement costs—in other words, it will be cheaper to invest in renewable technologies. However, it’s not clear whether the law selects the most cost-effective technologies to reduce carbon emissions.

The impressive reduction in the levelized cost of electricity from solar panels and wind turbines should have reduced the need to subsidize investors, though the law still provides generous tax credits. But carbon capture and storage requires very costly tax credits and might not be a priority.

Still, on average, the new law is estimated to reduce CO2 emission from the power sector at an average abatement cost of $83 per metric ton. This is considerably less than recent estimates of the social cost of damages caused by a ton of carbon: $185.

Unintended Consequences

Another concern is that the law may not be as environmentally friendly as presented to lawmakers. It may unintentionally harm natural ecosystems, particularly in developing economies, due to the supply chain components of clean tech equipment.

For example, accelerating demand for key components in electric vehicle batteries—such as nickel, copper, and lithium—will require to boost the extraction of minerals, with a negative impact of deforestation and biodiversity, and often involves water-intensive practices. Erecting offshore wind turbines with tons of steel standing on the seabed carries similar risks for the biodiversity.

The law may also unintentionally have a regressive impact on income distribution. To mitigate such a regressive effect, the Biden administration introduced income-related eligibility conditions. For instance, to qualify for the clean vehicle tax credit, a taxpayer must make less than $75,000 (single), $112,500 (head of household), or $150,000 (joint filers). However, a loophole will make it possible for top-income households to benefit from the clean vehicle tax credit when they lease a vehicle.

Overall, the newfound enthusiasm of governments around the world is welcome. Never before have such large fiscal commitments been made to encourage clean energy. It unfortunately is unavoidable that some of this money won’t be spent effectively. Keeping track of implementation, making regular independent evaluations, and amending the law when necessary will help to reward this new enthusiasm with successful outcomes and increase the chance of getting affordable, secure, and clean energy.