Inflation Reduction Act Implications for Renewables and Energy Transition

The Inflation Reduction Act of 2022 (the “IRA”) released by U.S. Senate Democrats on July 27, 2022, would dramatically reshape and expand tax credit incentives for a broad range of renewable energy resources and could transform the tax equity market for renewable energy. Among other things, the IRA would:

• create a two-tier credit that requires compliance with prevailing wage and apprenticeship requirements to capture the full available credit;
  
  
• include numerous adders depending on a project’s location and amount of U.S.-sourced content;
  
  
• expand existing incentives for solar and wind for at least 10 years;
  
  
• expand tax credits for carbon capture and creates a new credit for clean hydrogen production;
  
  
• implement a limited “direct pay” feature where tax credits can be treated as a cash refund from the government; and
  
  
• add a new transferability concept in which tax credits can effectively be sold, for cash, to third parties.
  

  The IRA is expected to advance in the Senate the week of August 1, 2022. Below is a more detailed summary of key provisions as well as our initial observations.  

Two-Tier Base Rate and Increased Rate Structure for Tax Credits

• Base Rate and Increased Rate – Similar to the previously proposed Build Back Better Act (“BBBA”), the IRA includes a two-tier “base” rate and “increased” rate structure for renewable energy tax credits. The “increased” rate is worth five times the value of the base rate, and is available if a project meets the prevailing wage and apprenticeship requirements described below.
  
  Observation: Although termed a “base rate,” the lower credit rate is effectively a penalty for failing to comply with new prevailing wage and apprenticeship requirements. The “increased rate” is similar to the credit rates available under current law (before application of existing phasedowns on the credit amounts).

• Prevailing Wage and Apprenticeship – The prevailing wage and apprenticeship requirements would be new to the Internal Revenue Code, but generally follow the framework proposed in last year’s BBBA.
  
  
  
  • To meet the prevailing wage requirement, the project owner must ensure that any laborers and mechanics employed by contractors and subcontractors are paid prevailing wages not only during construction, but also for any repairs or alterations that may be needed during the applicable tax credit period.
    
    
  • The term “prevailing wages” refers to wages at rates for similar work in the location of the project site as determined by the U.S. Secretary of Labor. Failure to satisfy the prevailing wage requirement can be cured by paying each worker the difference between the prevailing wage and the wage actually paid to the worker, plus interest and a $5,000‑per‑worker penalty (increased to three times the wage deficiency, plus triple interest, and $10,000 per worker if the discrepancy is intentional) to the Department of the Treasury.
    
    
  • The apprenticeship requirement obligates the project owner to ensure that a percentage of the total labor hours spent to construct the project are performed by “qualified apprentices” who participate in a registered apprenticeship program that complies with certain federal requirements. The percentage of labor hours required, as illustrated below, varies depending on the year in which the project begins construction.

   

  Construction of the facility begins:	Required apprentice labor hours:
  Before January 1, 2023	10%
  On or after January 1, 2023 and before January 1, 2024	12.5%
  On or after January 1, 2024	15%

   

  • Importantly, for residential solar and other smaller projects, projects with a maximum output of less than one megawatt automatically qualify for the “increased” rate irrespective of whether prevailing wage or apprenticeship requirements are met.
    
    
  • Projects that have already begun construction or that do so soon after the IRA becomes effective would also automatically qualify for the “increased” rate. The apprenticeship and prevailing wage requirements have a delayed effective date that first applies to projects 60 days after the date on which the United States Treasury publishes guidance for these new requirements.
    
    

    Observation: This grandfathering period will give project sponsors much-needed time to coordinate with Engineering, Procurement, and Construction (EPC) contractors and other service providers to make sure their projects comply with the new rules.

Extensions and Modifications of Existing Tax Credits

• PTCs – Production tax credits (“PTCs”) based on the quantity of energy produced and sold to an unrelated party over a 10-year period are retroactively extended for wind, biomass, municipal solid waste (landfill gas and trash), hydropower, marine and hydrokinetic and geothermal facilities that begin construction before 2025. The PTC for wind facilities is worth a base rate of 0.3 cents/kWh and an increased rate of 1.5 cents/kWh. The rates are adjusted for inflation, which would result in an increased rate of 2.6 cents/kWh for 2022.
  
  
  • Solar is added to the list of PTC-eligible technologies.
    
    Observation: PTCs may be a more attractive credit than ITCs (described below) for large-scale solar projects due to the amount of electricity they generate over 10 years. We expect many utility-scale solar developers to consider shifting to a PTC financing regime.
    
    
  • The PTC provisions are generally effective for projects placed in service after 2021. Projects placed in service in 2021 or earlier do not benefit from any PTC rate increase.

• ITCs – Investment tax credits (“ITCs”), which are calculated as a percentage of the cost of a project, are extended for solar, fiber-optic solar, fuel cell, microturbine, combined heat and power, small wind energy, and waste energy recovery property where construction begins before 2025. The ITC for solar projects is a base rate of 6% or an increased rate of 30% of the taxpayer’s cost of the energy property.
  
  
  • New technologies, including energy storage technology with a minimum capacity of five kWh, linear generators, and microgrid controllers would be ITC eligible.
    
    Observation: This would be a significant development for storage facilities in particular. Current law permits storage facilities paired with electricity-generating facilities to qualify for an ITC (potentially subject to a haircut), but does not provide a tax credit for standalone storage or storage with a nonrenewable energy input.
    
    
  • The cost of certain “interconnection property” (e.g., transmission upgrades) associated with an ITC-eligible project would now be treated as qualifying property for purposes of the tax credit.
    
    Observation: Previous legislative proposals had included the concept of a standalone ITC for transmission assets. This approach appears to represent a middle ground between a broader credit and a credit for property associated with an otherwise ITC-eligible project.
    
    
  • ITC provisions are generally effective for projects placed in service after 2021, though the provisions related to new technologies, including energy storage, apply to projects placed in service after 2022. Projects placed in service in 2021 or earlier do not benefit from any ITC rate increase.

• Carbon Capture and Sequestration – The IRA would both extend the existing credit under section 45Q for carbon sequestration for projects that begin construction before 2033 and increase the credit value as illustrated in the table below.[1]
  
  
  • Consistent with PTCs and ITCs, the 45Q credit would take on a two-tier approach. The credit amounts would be significantly increased, especially for carbon oxide captured through direct air capture.

    The revised credit amounts would be as follows:

     

    End Use	Base	Increased Credit	Current Law
    Traditional Carbon Capture Carbon Oxide Used or Utilized	$12	$60	$35
    Carbon Oxide Sequestrated	$17	$85	$50
    Direct Air Capture Carbon Oxide Used or Utilized	$26	$130	$35
    Carbon Oxide Sequestrated	$36	$180	$50

     

    Observation: The credit amounts were increased in recognition of the complexity of the capture processes, especially those involved in direct air capture, where significant technological hurdles still exist.
    
    

  • The IRA would significantly reduce the minimum capture amounts required to qualify for the credit, some as low at 1,000 metric tons annually.
    
    Observation: The minimum capture requirements are significantly below the existing requirement, some of which require the capture of 500,000 metric tons of carbon oxide annually. The objective of this change appears to be to encourage the deployment of carbon capture technology on a larger scale and more quickly than is currently being accomplished.
    
    
  • The revised 45Q provisions are effective for facilities or equipment placed in service after 2022.

New Tax Credits

• New PTC and ITC – The IRA would create two new classes of technology-neutral tax credits—one effectively a PTC (“45Y Credits”) and the other effectively an ITC (“48D Credits”)—for property (i) used for the generation of electricity, (ii) which is placed in service after 2024 and (iii) which emits zero greenhouse gases.
  
  Observation: The existing PTC and ITC regime, set to phase out under the terms of the IRA after 2024, effectively serves as a ramp-up period until projects shift to this new tax credit regime.
  
  
  • Similar to PTCs, 45Y Credits have a 10-year credit period with a 0.3 cents/kWh base rate and an increased rate of 1.5 cents/kWh (adjusted for inflation).
    
    
  • Similar to ITCs, 48D Credits have a base rate of 6% or an increased rate of 30% of the taxpayer’s cost of the energy property.
    
    
  • Certain storage facilities qualify for 48D Credits at the same rates as described above for the ITC.
    
    
  • The 45Y Credit and the 48D Credit will each begin to phase down 25% per year for projects that begin construction after the first calendar year beginning the later of 2032 or the year in which the Secretary of the Treasury determines that annual greenhouse gas emissions in the United States are 25% or less of what they were in 2022.
    
    
• Clean Hydrogen – The IRA also includes long-awaited and significant incentives for the production of clean hydrogen under a new section 45V. The incentives include both a PTC and an ITC option. Similar to PTCs for other technologies, the tax credit will be available for 10 years beginning on the date the facility is placed in service. As an alternative, the taxpayer may elect to take an ITC equal to a percentage of the cost of the facility. The credit amounts would vary depending on the level of greenhouse gas that is removed and is subject to the same two-tier “base rate” and “increased rate” regime of PTCs and ITCs.
  
  Observation: The provisions are designed to enable both blue hydrogen and green hydrogen to qualify for the credit. Blue hydrogen is hydrogen produced from gas or coal through steam methane reformation and green hydrogen is hydrogen produced using renewable energy.
  
  
  • The base rate PTC is $0.60 a kilogram multiplied by a percentage that varies depending on the level of greenhouse gas that remains after the hydrogen production process. The PTC is adjusted for inflation. The base rate for the ITC is 6%, subject to similar limitations as illustrated below. In both cases, the credit amount would be multiplied by five if prevailing labor and wage standard requirements are met. Thus, the maximum credits are $3 a kilogram in the case of the PTC, and 30% in the case of the ITC.

  CO2 Per KG of H2 Remaining After Removal	PTC Credit Percentage	ITC Value
  Not greater than 4 kg and less than 2.5 kg	20%	1.2%
  Less than 2.5 kg and not less than 1.5kg	25%	1.5%
  Less than 1.5 kg and not less than .45kg	33.4%	2%
  Less than .45kg	100%	6%

  
  
  • The IRA would facilitate the pairing of clean hydrogen facilities with wind and solar farms for which PTCs may be claimed apart from the clean hydrogen tax credits. It would do so by relaxing a PTC rule barring sales between related parties, opening the door to common ownership of both the hydrogen facility and any renewables project that powers it.
    
    Observation: This provision would effectively permit two separate tax credit streams to support an integrated project and could significantly boost financing for hydrogen facilities.
    
    
  • The hydrogen production credit would be not available for hydrogen produced at a facility which includes carbon capture equipment for which the credit under section 45Q is claimed, even if in a prior taxable year.
    
    
  • The provisions are applicable for hydrogen produced after 2022.

Direct Pay and Transferability Alternatives to Tax Equity

• Direct Pay – The IRA, like the BBBA, would provide a “direct pay” feature which allows certain taxpayers to receive a cash payment from the United States Treasury instead of claiming the tax credits. The payment is treated as a tax refund. Unlike the BBBA, however, access to direct pay under the IRA is largely limited to certain tax-exempt entities (including municipalities and other state and local governmental entities). As a special rule, taxpayers that are not tax-exempt entities can elect into direct pay with respect to the clean hydrogen credit, the carbon sequestration credit, and the advanced manufacturing credit. In that case, however, the IRA would limit such taxable entities’ ability to claim direct pay to the first five years of the credit period rather than the entire credit period.
  
  Observation: As with the transferability feature described below, a direct pay feature makes it easier for owners of renewable energy projects to monetize the value of the tax credits. However, the direct pay feature appears to be of limited value to taxable entities since it only covers certain credits (clean hydrogen, carbon sequestration, and advanced manufacturing), and does not cover the full tax credit period, meaning a taxable entity without sufficient tax appetite would still need to find a way to monetize the tax credits for the balance of the tax credit period. It may be that the five-year limitation is intended as a ramp-up period while tax equity markets develop for these newer technologies.
  
  
• Transferability – The IRA introduces a brand-new transferability feature which was not in the BBBA or any other recent legislative proposals related to renewables. The transferability feature would permit a taxpayer to sell the tax credits to an unrelated party for cash. The transferability feature would be effective for years beginning after 2022.
  
  Observation: The transferability feature in the IRA could reduce the complexity involved in monetizing the tax credit by allowing a buyer with enough tax appetite to simply purchase the tax credits directly without otherwise acquiring a long-term ownership stake in the project (i.e., as in a typical tax equity financing). However, like direct pay, this method fails to monetize a project’s depreciation benefits, and it is also unclear whether the price a buyer would be willing to pay under this structure would necessarily result in a better value for the sponsor than a tax equity financing. Assuming the IRA becomes law, the market will dictate whether this is more advantageous than tax equity.

Tax Credit Adders

• Similarly to the BBBA, in addition to the “increased” rate, the IRA would provide for further “bonus” credits or adders in certain situations, including:
  
  
  • Domestic Content – A 10% adder to the PTC or the ITC for projects which incorporate a sufficient amount of products (i.e., steel, iron or “manufactured product”) produced in the United States. As illustrated in the table below, the required adjusted percentage of domestic content with respect to manufactured products increases over time, with a temporarily reduced requirement for offshore wind facilities.

  Construction Begins:	Adjusted Percentage:	Adjusted Percentage (Offshore Wind):
  Before January 1, 2025	40%	20%
  On or after January 1, 2025 and before January 1, 2026	45%	27.5%
  On or after January 1, 2026 and before January 1, 2027	50%	35%
  On or after January 1, 2027 and before January 1, 2028	55%	45%
  On or after January 1, 2028	55%	55%

  
  
  • Energy Community – An up-to-10% adder to the PTC and the ITC for certain “energy communities” (generally brownfield sites, certain areas with significant current or historic employment relating to coal, oil, or natural gas, and certain areas in which a coal mine or a coal-fired electric generating plant has closed).
  • Low-Income Community – An up-to-20% adder to the ITC for solar and wind projects located in certain low-income communities, low-income residential buildings, or on Indian land.

 

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[1] Under current law, beginning in 2025, the credit is $50 a metric ton for carbon that is sequestrated and $35 a metric ton for carbon oxide which is used either in enhanced oil recovery or which is utilized in certain processes. The credit extends for 12 years after the carbon capture equipment is placed in service. To be eligible for the credit, construction of the facility must begin prior to 2027.