Breaking It Down

Tax Credit Incentives for Carbon Sequestration: Potentially the Most Impactful U.S. Policy to Battle Climate Change
By Bryen Alperin, Gary Blitz, Sarah Grey, Steve Whittaker, John Koenig, John Pierce, and Jason Kuzma | May 03, 2022

The Bipartisan Budget Act of 2018 expanded the 45Q tax credit, the most important federal incentive for encouraging private investment in the development and use of carbon capture technologies and facilities. Tax credits for the capture and long-term, permanent storage of carbon oxides generate a competitive financial return and have a positive environmental impact on the world.

In addition, reducing CO2 emissions mitigates climate change and help keep the increase in global average temperature to well below 2°C, above pre-industrial levels. Keeping global average temperature below 2°C, above pre-industrial levels, is a fundamental goal of the Paris Climate Agreement, the highest environmental, social, and governance (ESG) priority issue facing investors.

Tax Credit Basics and Tax Equity
A tax credit reduces a company’s tax liability dollar-for-dollar. The U.S. government uses tax credits to incentivize certain types of projects that produce economic, environmental, or social benefits. Common tax credit programs include affordable housing, rehabilitation of historic properties, low-income census tract economic development, wind energy, solar energy, and now, carbon sequestration projects. For these projects, the tax credit is an important source of capital, but many project developers do not have enough taxable income to take advantage of the tax credits themselves. In such cases, the developer may monetize the tax credit by attracting a tax equity investor (TEI), usually a corporate tax-paying project partner.

Tax equity is a term that is used to describe an equity ownership interest in a qualified project, where an investor receives a return, based not only on project cash flows, but also on tax benefits. In such a transaction, a partnership is typically formed between the project developer and TEI to not only facilitate the investment but allocate and distribute the corresponding tax benefits and project cash flows. The specifics of each partnership vary by project, tax credit type, and transaction structure.

Tax equity investors can have demanding requirements in terms of indemnities and guarantees that often surpass the credit quality of sponsors and other transaction parties. Tax credit insurers provide a project and its investment a large, rated balance sheet that can support the indemnities independent of the sponsor’s or counterparty’s financial strength. Tax credit insurance is very flexible and can be customized to each project and transaction. The coverage can extend to three main risk categories: structure, credit qualification, and recapture:

1. Transaction structure – Ensuring the investment structure is such that the tax credits will flow through to the tax equity investor as intended. As contracts evolve, this type of coverage assures investors that resulting structures will be respected as passthrough vehicles to realize tax credit benefits under the law.

2. Requirements for Qualification for the CCS Credit and Determination of the Credit Amount – IRS guidance outlines many statutory requirements that projects must satisfy to qualify for tax credits. In particular, construction milestones and equipment testing can hamstring project success.

3. Forward Looking Requirements and Recapture of Tax Credits – CCS tax credit guidance contains many forward-looking requirements and mechanisms for the recapture of tax credits if those requirements are not met. In particular, the long-term permanent storage or proper utilization of carbon oxides must satisfy stringent guidelines or the generated tax credits may be clawed back.

Tax equity investing provides companies two basic benefits: the ability to mitigate tax liabilities, and the opportunity to invest in projects that promote certain social or governmental objectives such as renewable energy production, or carbon mitigation for addressing climate change.

The Importance of Carbon Capture and Decarbonization
Climate researchers and scientists have long stressed the critical nature of curbing carbon emissions to slow the effects of climate change. Yet even as research confirms the need for aggressive strategies to shift away from emissions-heavy industries, our modern societies are increasingly reliant upon them to function. In the United States, industrial sectors (such as metals and minerals, chemicals, refineries, and others), along with coal-fired and natural gas-fired power plants, account for approximately 50% of the country’s total CO2 emissions. More than 833 million metric tons of CO2 per year are vented directly into our atmosphere by U.S. industry alone.

Decarbonizing these high emissions-generating industries in the short term is extremely difficult, which is why long-term strategies and technologies that remove emissions like carbon capture and sequestration (CCS), are critical. Every credible climate model — including those from the Intergovernmental Panel on Climate Change and the International Energy Agency — includes capture and permanent geological storage of carbon as a key requirement to achieve global emissions reduction targets by 2050.

Section 45Q is a key part of the U.S. government’s effort. It is a bipartisan acknowledgment of the role CCS plays as a solution to climate change. Democrats and Republicans, fossil fuel companies, unions, and environmentalists have supported 45Q’s expansion as an investable program — one that benefits the environment and creates economic opportunities through the development, construction, and ongoing utilization of these technologies.

Section 45Q awards tax credits to owners of capture technology equipment for every metric ton of carbon oxide sequestered. Everything from power plants and refineries to large-scale industrial sites that emit significant amounts of CO2 are viable sources for capture and sequestration projects. These projects may be retrofitted into existing facilities or incorporated into new developments. The carbon capture development may be led by the facility’s operators, or independent development parties.

Credits are awarded to capture technology operators over a 12-year period beginning with injection in varying dollar amounts based on one of two methods of sequestration: Carbon Capture and Sequestration (CCS) or Carbon Capture Utilization and Sequestration (CCUS). In comparison with pure CCS technology, CCUS permanently stores carbon and is used for some commercial application, with revenue associated to the activity. Section 45Q allows these CCUS credits to be transferred to other entities able to monetize the credits, allowing for flexibility in business and investment opportunities for organizations bringing these projects to fruition.

Who Qualifies?
The statute defines a qualified facility as:
1. an industrial facility that emits up to 500,000 metric tons of CO2 a year and puts at least 25,000 tons to commercial use

2. a power plant that emits 500,000 metric tons or more of CO2 a year; or

3. a direct air capture facility, or any other facility not described in (a) or (b), that captures at least 100,000 metric tons of CO2 per year.

In other words, an electric generating plant would have to capture at least 500,000 metric tons of carbon oxide per year to qualify. Any other type of facility — a cement plant or a natural gas processing facility, for example — would have to capture at least 100,000 metric tons of carbon oxide per year.

It is anticipated that tax equity investors would size their investment by discounting the net benefit streams (tax credits and deductions) expected from the carbon capture project, using their target Internal Rate of Return (IRR) as the discount rate, similar to how wind tax equity investments are sized.

CCS: Pure Sequestration Through Dedicated Geological Storage
Under a pure carbon capture and sequestration strategy, facilities and operators sequester anthropogenic carbon oxide deep underground where it cannot contribute to climate change. Captured carbon oxide, virtually exclusively CO2, is transported from emissions sources to geologic formations where it can be safely injected into depleted oil or gas reservoirs, saline water-bearing strata thousands of feet deep and below all sources of potable water.

At the depths used for sequestration, the injected CO2 is no longer a gas, but a dense fluid that is retained and secured by layers of impermeable rock barriers and natural formations.

CCUS: Creating Beneficial Use of Carbon Emissions
In CCUS projects, captured carbon emissions are put to work in a variety of applications to benefit other businesses and industries. By far, the most common commercial use of CO2 is through enhanced oil recovery (EOR), where captured CO2 is injected into the earth to improve oil extraction, thereby reducing the carbon intensity of the fossil fuel production. The injected CO2 mixes with the oil, making it less viscous so that it flows more easily. As the oil is produced, the CO2 comes out of solution with the oil and is recaptured and reinjected into the reservoir for another cycle of EOR. EOR projects using an efficient recycle scheme effectively store all injected CO2. EOR projects that use naturally sourced CO2 — that is, CO2 not captured from industrial emissions — do not qualify for 45Q credits.

Other potential applications of CO2 for permanent sequestration include production of advanced materials, mineralization in products such as concrete, and usage of CO2 in algae or bacteria growth.

For CCUS projects that use and store anthropogenic carbon via EOR or use it in other processes and materials, 45Q will award up to $35 per metric ton of CO2 captured, before growing by an inflation adjustment factor. The CCUS 45Q credit began at $12.83 in tax year 2016 and will grow to $35 per metric ton in tax year 2026 via linear interpolation. Beginning in tax year 2027, the 45Q credit for CCUS projects is the product of $35 and an inflation adjustment factor — the same inflation adjustment factor each year as pure CCS.

History and Future of Carbon Capture in the United States
The United States has been a leader in the commercial capture, transport, and storage of CO2. The first carbon capture-based projects date back to the 1970s, with the Terrell Natural Gas facility in Texas, which provided the first CO2 feedstocks for enhanced oil recovery in the United States. As of January 2020, the United States is home to 10 of 19 large-scale carbon capture projects currently operating around the globe.

EOR, using captured anthropogenic CO2, is seen as a positive step toward a lower carbon future. Capturing the emissions generated during production and using them instead of sourcing alternative CO2 feedstocks, can ultimately result in fossil fuels and other products that are less carbon-intensive than those produced using normal methods.

Thoughtful investors understand that hydrocarbon fuels (oil and gas and coal) that are compatible with the existing infrastructure are needed for the next decade, as the world will continue to need oil in the near term. Therefore, reducing the carbon intensity of these fuels and their associated production processes is an effective step toward reducing our carbon footprint. Essentially, CCUS and EOR provide an ‘‘on-ramp’’ for future capture and sequestration projects, accelerating innovation and enabling CCS to scale by driving down technology costs similar to what has been achieved in the solar industry with the solar investment tax credit.

A Sustainable Path Forward
The 45Q tax incentive for carbon capture projects is just one of many tax equity investments that can be considered socially responsible or sustainable, better known among investors as ESG investments and sometimes referred to as impact investments.

ESG investments — and tax equity investments in general — not only provide businesses with opportunities to offset financial liabilities and meet fiscal obligations through relatively low-risk investment programs, but also allow companies to meet growing shareholder demands for corporate sustainability. Tax equity investments, like 45Q and others, represent the elusive win-win: a smart investment strategy that responds to corporate stakeholder demands while contributing to the well-being of our communities at large.

Authors: Bryen Alperin, Gary Blitz, Sarah Grey, Steve Whittaker, John Koenig, John Pierce, and Jason Kuzma

(Printed in Issue 1, 2022 of Carbon Capture Magazine, View Carbon Capture & Storage Directory)