In focus

The Inflation Reduction Act explained: the most important climate bill in US history?


It might not sound like big news, or even climate-relevant, on the face of it, but the US’ new Inflation Reduction Act has been considered a major development in global efforts to combat climate change. But what is it exactly and why is it so significant? Some of Schroders’ climate specialists explain.

What is the Inflation Reduction Act?

Marina Severinovsky, Head of Sustainability for North America at Schroders, says: “The Inflation Reduction Act aims to address inflation through policies that would reduce the cost of energy as well as the federal deficit. It is expected to raise an estimated $790 billion in revenue and savings from a new corporate minimum tax, improved tax enforcement, and prescription drug reform. In addition to spending on healthcare, $369 billion is earmarked for energy and climate change priorities.”

How significant is the Act in the fight against climate change?

US President Joe Biden has called it the “largest investment ever in combatting the existential crisis of climate change”.

Irene Lauro, a Schroders economist specialised in the environment, says: “The bill aims to reduce greenhouse gas emissions by 40% compared to 2005 levels, helping fight global warming. It will also help reduce the impact of physical climate risks and inflation in the medium term. Extreme weather events have become more frequent and more disruptive as a result of higher temperatures, meaning economic losses and swings in prices, notably food prices.

“By incentivising the transition to clean energy, the bill will help insulate the economy from the swings in oil and gas prices, reducing the volatility in energy inflation.”

David Boyce, Head of US for Greencoat Capital, a leading renewables investment manager which was 75% acquired by Schroders, says: “The US is the second largest emitter of CO2, accounting for 13% of global emissions. What the US does impacts the global picture. Portions of the Inflation Reduction Act are extensions of programmes that have been successful in spurring on the energy transition in the US, and this legislation will encourage more of those positive outcomes. 

“Many of the other provisions help to move needle even further. But the longevity of the commitment is also a signal. The US is firmly supporting a transition away from carbon and in a way that’s not a year-to-year political talking point. My hope is that its impact extends to pulling others along in the same direction.”

Isabella Hervey-Bathurst, a climate change investor at Schroders, says: “We expect to see an acceleration in the energy transition in the US as a result of this. Analysis by the REPEAT Project, an energy policy evaluation group, suggests the Inflation Reduction Act could cut 2030 CO2 emissions by an extra gigaton (one billion metric tons). This is enough to close two-thirds of the gap between what current policies, ie ’business as usual’, will achieve and where the US would need to be in 2030 to hit the target to cut emissions by 50% vs 2005.

“The modelling doesn’t account for potential follow-on action: companies, cities and states raising their decarbonisation ambitions as a result of the measures. Given the impact the policies will have on affordability of clean energy and other clean technologies, it is totally conceivable that there will be follow-on action from other players.”

Holly Turner, a sustainable investment analyst specialised in climate change, says: “I think the clear policy support for the social side of the energy transition around workers is an indication of the increased consideration of the ‘just transition’. However there has also been criticism that a total of USD60billion, 15% of the Inflation Reduction Act package, is too small.

“The second component is simply the level of assurance it could give to both US companies and other countries and their climate policies. There are potential spill-over effects.”

What is so significant about it?

IHB: “The bill boosts and extends the support for renewables, and introduces a number of new credits to support nascent climate technologies like energy storage and green hydrogen. The bill also contains some rather more overt industrial policy measures which promote the buildout of clean tech supply chains within the US and its free trade agreement partners."

Alex Monk, a fund manager focused on the energy transition, says: “It should provide both a) renewed certainty to companies operating in the space in the US, at a time wwhen there has been some significant uncertainty for some time now which has caused project delays and disruption; and b) some additional financial benefits in terms of tax incentives on both new energy transition assets and the production of equipment.

“The bill is clearly supportive for company earnings across various parts of the energy transition sector – such as solar, wind, storage, hydrogen, parts of the supply chain – and it can hopefully unlock some of the bottlenecks that have caused a lack of activity in certain parts of the market recently Wind  has been particularly disrupted, but other areas too where developers and operators had been pausing while waiting for this new support. It further supports the cost competitiveness of the technologies on a relative basis too.

“We would stress though that while this is clearly supportive, policy is just one driver of the energy transition and other forces have been in play. Residential solar, for example, has not been impacted much at all by the previous stalling of policy and demand has remained very strong. This is because of the underlying forces of consumer demand and cost effectiveness.

“We would also stress that remaining disciplined on valuations when assessing companies from an investment is crucial. We think it is important to ensure that we are still investing in the quality businesses, with strong sustainability practices, at sensible valuations.”

What are the climate provisions in a bit more detail?

MS: “The bill aims to reduce greenhouse gas emissions in two main ways: electrifying things that currently run on fossil fuels and generating more electricity using renewable and clean energy sources. It includes a $7,500 tax credit for new electric vehicles and tax credits for low-carbon renovations to homes, like installing heat pumps and rooftop solar panels. The US Postal Service – the largest source of federal emissions second to the US military – gets $3 billion to buy zero-emission vehicles

“It also puts $6 billion towards reducing emissions from hard-to-decarbonise industries like cement, chemical and steel plants.

“The new bill expands production and investment tax credits for wind, solar and energy storage – with a 10-year time horizon, which allows for long-term planning and should avoid some of the boom and bust cycles that have plagued the industry for years.

“For electricity generation: the bill contains $30 billion in grants and establishes tax credits for states and electric utilities to adopt clean energy and energy storage – important for maintaining the stability of the grid with higher levels of intermittent renewable sources.

“This includes support for hydrogen and carbon capture technology, as well as new tax credits to keep nuclear plants running.

“It includes $60 billion to support clean energy manufacturing intended to accelerate production of solar panels, wind turbines, electric vehicles and heat pumps.

“The bill also establishes a programme to reduce leaks of methane, a super-potent greenhouse gas,from natural gas production by fining companies for each ton emitted.

“It includes $60 billion in support for environmental justice initiatives, like improving public transportation in underserved communities and reducing air pollution at ports.”

What sort of investments is this news relevant to and why?

DB: “Clearly there is a direct link from the extension of the successful production and investment tax credit programmes to the actual physical plants that will be constructed across the country over the next decade.  Those are capital intensive activities which will require direct investment into what will be a reshaping of the electric supply in the US.

“The longevity of what’s in the Act is also key. By having a longer runway to act, it should provide the certainty to private capital to focus attention to this sector and think about not only the projects that will be built, but also the development of these assets and the technologies that feed into them as well as nurturing investment into the domestic production of equipment.”

Mark Lacey, a fund manager specialised in the energy transition, says: “The Inflation Reduction Act imposes a 15% alternative minimum tax (the “corporate AMT”) on US corporations with financial accounting profits exceeding a certain threshold. This provision is expected to impact large corporations that have previously reported high income on their financial statements but have significantly reduced – or even eliminated – their cash tax liability.

“Other parts of the Inflation Reduction Act which impact conventional oil and gas producers include significant tax credits for conventional carbon capture (increasing from $50/ton to $85/ton), direct air carbon capture, as well as hydrogen and biofuels credits.

“For the large integrated companies, the fact that the Act includes carbon capture, biofuels and hydrogen tax credits is actually a net positive for these companies and now provides a good platform for these companies to accelerate their renewable investment plans.

“However for the smaller, independent exploration and production (E&P) companies, they are considerably more exposed to the 15% AMT and higher leasing costs. And some are very exposed to the legislation’s plan to impose an initial fee of $900/ton of excess methane emitted from many facilities, including wells, processing equipment, storage tanks and pipelines.”

“Established E&P companies already pay cash taxes and have already made intensified efforts to detect and fix methane leaks in anticipation of coming Environmental Protection Agency regulations.

“However over 35% of US onshore oil and gas production still comes from over 15,000 small independent private operators. These are the companies which we believe are going to bear the full financial impact of the new legislation.”

Was this expected?

DB: “Yes and no. Despite ups and downs of prior legislation and the partisan vote on the Act, the reality is that renewable energy enjoys broad based support in the US. New wind and solar projects are built all across the country – bringing capital investment, jobs, property tax and economic stimulus to communities in red and blue states alike. The uncertainty always comes down to action – how and when this support manifests itself.”

 

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