HR 6 Renewable Energy Tax Credits

Section 1302 of HR6, as represented in the Conference Committee Version, 11/18/2003

Reviewed by Doug Koplow, Earth Track, Inc.

(c) 2004, Earth Track, www.earthtrack.net

HR6, The Energy Policy Act of 2003, vastly expands eligibility for renewable energy production tax credits under section 45(c) of the tax code. The Joint Committee on Taxation estimated the cost of these provisions at $3.04 billion. On an outlay equivalent basis (which JCT does not prepare), these tax breaks are worth approximately $4.7 billion to recipient industries. Earth Track has generated estimates that come very close to the JCT numbers. However, because our estimates did not adjust the tax credits for inflation and relied on energy resource projections (developed by the US Energy Information Administration) that assume no tax credits, the real cost of these provisions could be substantially higher. Another way to view this outcome is that the government will lose $3 billion of revenues to achieve the same energy mix EIA predicts will occur anyway. Also of great concern: the many waste streams soon to be classified as "municipal solid waste." The proposed definition is so broad that pretty much any combustible byproducts -- including hazardous waste -- from industry, mining, and agriculture will qualify. While impossible to quantify without a great deal of additional research, the tax losses could be quite large.

Fiscal costs aside, the proposed changes are poorly thought out if they are to achieve a range of supposed objectives of the bill. By allowing existing biomass facilities to access the credit, the language generates a windfall to owners of existing plants (predominantly paper mills) without any increase in alternative energy supplies. Similarly, by providing large subsidies for landfilling or burning a wide range of recyclable materials, and for producing virgin materials, HR 6 will needlessly undermine the economics of municipal recycling programs already struggling to survive around the country. Hardest hit will likely be paper, the largest fraction of the municipal waste stream. Virgin paper production seems poised to obtain a windfall of up to $1.1 billion for energy recovery technologies they have been deploying for close to 30 years.

Finally, the new section 45(c) credits pose a threat to sustainable production systems across the country by removing virtually all constraints on the types of biomass that are eligible for subsidized burning. Massive tracts of single-crop production, large concentrated animal feedlot operations, unsustainable timber harvest practices, even the burning of old growth forests will not only continue to escape appropriate regulation but now receive direct federal subsidies as well.

• JCT cost estimates appear substantially too low. If renewables growth with no tax credits yields a revenue loss estimate on par with JCT, it is likely that actual losses from these provisions will exceed the current estimates by many hundreds of millions of dollars.

• Subsidies to existing plants provide little energy gain at a high cost. Existing biomass plants, already economic in the current market environment, are nonetheless eligible for five years of tax credits for practices they have been doing for decades. While there is some uncertainty as to whether statutory language will allow plants where biomass does not comprise 100% of the input fuel to claim tax credits, Washington insiders have confirmed that the sponsors did intend for industries such as paper mills to access the provision. Should this occur, the revenue loss would exceed $800 million ($1.3 billion outlay equivalent), more than 80% of which would accrue to the paper and lumber industries. Because virgin paper production is the main source of biomass energy recovery, fiber recycling will be hurt. The gains are concentrated: of the more than $1 billion in subsidies flowing to paper and lumber, a single corporation (International Paper) is positioned to receive subsidies worth more than $400 million.

• Many eligible resources are not renewable. HR6 provides virtually no constraints on where the biomass may come from in order to obtain the production tax credit. Thus, timber from old growth forests, from steep slopes (creating erosion problems), from clear-cuts, and from homogenous agricultural, silvicultural, and feedlot operations all receive subsidies. This is likely to:

• Harm small farmers and organic farming. Only large farms will have enough animal wastes to build a power plant; transport costs will make burning less economic for smaller farms. Subsidies to burning over composting worsen relative economics for small farmers, and for organic farmers for whom natural soil fertility is a key economic advantage.

• Harm recycling. Recycling is economic if the net value of recovered materials is less than the cost of alternative disposal options such as landfilling and combustion. HR 6 provides subsidies to disposal (both landfill gas and combustion of a wide range of wood and paper products get the tax breaks), undermining the economic value of recycling. Affected sectors include wood pallets, and construction and demolition debris. Paper recovery (the largest fraction of the waste stream) will be harmed both by tax credits to burning many types of waste paper (anything that is not "commonly" recycled), and by up to $1.1 billion in subsidies to pre-existing energy recovery and conversion operations inside of paper mills. Access to subsidies for waste-to-energy plants is not constrained by appropriate requirements to pull easily-recyclable or potentially toxic materials prior to combustion.

• Surprise beneficiaries: hazardous "municipal solid waste." While MSW may not mean the same thing to all people, it is rare that this definition is stretched quite so far as in HR 6. The bill adopts what is actually a much broader definition for "solid waste," and includes, well, almost everything: pollution treatment sludges and "other discarded material, including solid, liquid, semisolid, or contained gaseous material resulting from industrial, commercial, mining, and agricultural operations, and from community activities," excluding only raw sewage and return irrigation flows. Can it be hazardous waste? Sure looks that way: hazardous waste is a sub-category of the definition of solid waste. What about coal mining residues not normally burned? Could be; these would seem to be solid byproducts from the mining industry. If HR6 passes, look for an onslaught of tax cases as firms work to cram their wastes into the eligible group.

Section 45(c) of the tax code provides tax credits to producers of qualifying energy resources that are currently worth 1.8 cents/kWh of qualified energy produced. This credit is adjusted annually for inflation. When the credit was first implemented, eligible energy resources really were renewable. There was wind, and what biomass was allowed included only carefully chosen crops that could be sustainably grown and harvested to produce electricity (referred to as "closed-loop"). Though the economic allure of these subsidies has generated near continual efforts by Congress to broaden what counts as a "qualified energy" source, with the exception of poultry waste this pressure had been more or less successfully resisted.

This restraint has now evaporated. HR 6 dramatically expands access to this subsidy for pretty much anything that grows and can be burned, or was excreted by (or on -- all animal bedding is also eligible) commercially harvested animals. True, there are a handful of exceptions. Really old biomass, which goes instead by the name "fossil fuel," is generally excluded by Section 1302 (though it may count as "MSW," and does receive lavish subsidies in Section 1345). Similarly, really contaminated biomass wood products can't be burned for a subsidy -- though even here, "regular" hazardous waste, as well as contaminated landfill gases, can both access this tax credit.

Early versions of these tax credits made distinctions about how particular biomass resources were produced, recognizing that many biomass sources are more extractive "biomining" than renewable and sustainable production cycles. With the current language, the method of production is irrelevant, as is, under all but a handful of situations, the scarcity or alternative uses of the resource. Amazingly, a clever entrepreneur can now earn a tax credit for burning old growth timber or mixed municipal solid waste.

Section 45 tax credits are justified on the grounds that they represent federal investments to spur energy innovation and diversification. So much for the theory. HR 6 provides new tax credits for existing industrial capacity that never had access to them before (primarily paper mills); extends tax credits to facilities once eligible, but for whom eligibility expired (closed-loop biomass); and expands the basis on which the credits can be earned to a much larger group of tax-exempt entities than previously. Existing constraints on "double-dipping" (where a single facility accesses multiple subsidies for the exact same actions) are greatly reduced in HR 6. Use of government grants or subsidized loans used to reduce access to tax credits in a pro-rata fashion. Now, the maximum reduction is 50%. The bill also exempts the tax subsidies from consideration in alternative minimum tax calculations (the AMT was instituted for the primary purpose of ensuring that highly subsidized sectors at least paid some taxes) for the first 4 years of eligibility. Publicly-owned entities (which don't pay taxes) can more easily take advantage of tax credits through subcontracting operations or leasing portions of the facility to private entities.

Exhibit 1 provides a summary of the expected fiscal impact from section 45(c) renewable energy production tax credits. Our estimates are quite similar to JCT: roughly $3.1 - $4.7 billion depending on the evaluation metric used. As noted above, this is likely to be a low estimate since many waste streams that potentially meet the "municipal solid waste" definition have not been estimated, and because installed capacity reflects baseline assumptions rather than higher growth under tax credits.

Exhibit 2 breaks the estimate out into components. Over half of the subsidies flow to programs of dubious benefit to either environmental quality or energy diversification. These include subsidies to waste-to-energy plants, landfill gas combustion, and to biomass conversion at existing facilities. Subsidies to wind, solar, and geothermal are relatively modest in comparison. Additional data exhibits showing plant-level detail on biomass tax credits; summary of biomass tax credits by company, industry, and state; and derivation of landfill gas values are all available in PDF format.  These exhibits can be helpful in understanding where our total values come from.

Exhibit 1: Summary of Expected Tax Losses Resulting from HR 6, Section 45(c), "Credits for Electricity Produced from Certain Renewable Resources"

Exhibit 2: Summary of Component Estimates by Energy Source

B. Anticipated Impacts

This expansion in section 45 eligibility contravenes many aspects of sound land management, recycling, and small scale and organic farming of both plants and animals. Many of the subsidized fuels are byproducts from environmentally damaging or inefficient production methods. These include concentrated animal feedlot operations (animal wastes) and large scale monoculture (pretty much any residue that comes off of farmed land). Timber and forestry residues of virtually any origin are also eligible. As noted above, old growth timber is fine; as are all sorts of slash from timbering. There are no requirements to leave some trees in place to protect wildlife, or to make trees on steep slopes ineligible because cutting will trigger widespread erosion.

Subsidized burning will also worsen the economics of recycling and reuse relative to combustion, despite the fact that burning is usually the lowest value materials recovery option. Wood pallets (among the largest use of domestic hardwood), many grades of paper (so long as they are not "commonly" recycled, whatever that means), and most types of construction debris will now be eligible for a tax credit if burned, but not if recycled or reused. The two main solid waste management methods competing with recycling -- waste incineration and landfilling -- both get tax subsidies. Disposal and burning already get access to tax-exempt bonds, and now will receive production tax credits as well; yet environmentally-preferable recycling gets neither.

For waste-to-energy (WTE) plants, all WTE processes can access the credit. There are no pre-conditions for the plants to pull and recycle certain constituents prior to burning, either for recycling (metals, glass, high grade paper) or for hazardous reduction (heavy metals). For landfill gas, any land-applied organic waste fraction will generate tax credits, despite environmentally-harmful characteristics of landfill gas, a high leakage rate even from landfills with collection systems, and the detrimental impact that such credits have on recycling.  A more even-handed approach would have been to appropriately regulate air emissions from all landfills.  The marginal cost of adding energy recovery to landfills already appropriately controlling their air pollution is extremely low and economic without public subsidy.

A similar dynamic will occur on the composting side of things. Smaller, organic farms focus heavily on soil management to improve crop yields and reduce environmental impacts. Yet this advantage is undermined by subsidies to burning wastes from cows, pigs, chickens and sheep; and all sorts of field residues that are found in HR 6. (The bill probably subsidizes all animal wastes, but only four are specifically listed).  As small farms are unlikely to have enough of either crop byproducts or animal excrement to fuel an electric generating station, the subsidy will disproportionately benefit large farms, once again undermining the small farmer that all of our farm subsidies are supposedly protecting. Rather than treating the mega-farm operations as businesses, and requiring them to invest in appropriate pollution controls of whatever type on their own dime, HR 6 decides that somehow it's the taxpayer's responsibility to pay for part of the controls.

C. Tax Credit Eligibility for Existing Biomass Facilities

HR 6 allows existing biomass burners to earn a reduced tax credit (1.2 cents/kWh) for a shorter period of time (five years versus ten) on electricity produced and sold to an independent party beginning January 1, 2004. JCT's cost estimates show relatively low numbers for expected revenue losses in 2004 and 2005. This suggests that their analysts are assuming few existing facilities will access the credit, since the rules require sales of power to an independent party.

A quick analysis of the potential value of this credit (see plant-level data) demonstrates the folly of this assumption. In fact, nearly every mill can obtain tax credits worth well in excess of $1 million. In total, over 80% of the subsidy to existing facilities will flow to the paper industry. Over the five years of eligibility, the tax credit provides a boost to this industry of more than $1 billion. With that much at stake, the paper mills will get creative to meet the third party sales requirements:

• Most mills already sell surplus electricity to the grid. It would take little extra effort to sell all of their output to the grid, pocket the tax credit, then repurchase power (from ostensibly unrelated sources) to cover their internal needs. While such an exchange would incur some transaction costs, the mill would still likely be better off from the deal than they would by ignoring the tax credit and continuing operations unchanged. From the perspective of the Treasury, whether the mill gets the full credit, or ends up sharing it (via the power sell/buy prices it gets) with other transactional participants is irrelevant, as the gross taxes paid will decline the full amount of the credit.
• The rules governing existing plants (section 1302 (b)(3)(B)) specifically state that "if the owner of such facility is not the producer of the electricity, the person eligible for the credit allowable under subsection (a) shall be the lessee or the operator of such facility." This language will allow all kinds of complicated sale/leaseback arrangements to separate power generation from other aspects of mill operations. Language of such agreements will likely have an option period that ends after five years, allowing the mill to repurchase the assets under certain conditions, but should the retroactive credit be extended, allow them to continue operating as things were. This won't be the first time, and firms such as this one are ready to provide similar services again.

It appears likely that any biomass facility can obtain a pro-rata share of the tax credit even if other fuels are also used at the plant. Section 1302 of HR6 provides detailed information on what fuels are eligible for the tax credit, discusses the issue of co-firing in detail with respect to closed-loop biomass, but remains largely silent on the co-firing issue for open-loop. This reading suggests 100% of biomass co-firing will get the tax credit, though our summary numbers assume more conservatively that only if biomass comprises 50% or more of the fuel input (heat-rate basis) will the credit be available.

One of the largest unknowns of this section involves what types of waste streams will ultimately meet the definition of MSW applied to the bill. HR 6 reads "The term 'municipal solid waste' has the meaning given the term 'solid waste' under section 2(27) of the Solid Waste Disposal Act (42 U.S.C. 6903)." And what does section 2(27) actually say?

The term ''solid waste'' means any garbage, refuse, sludge from a waste treatment plant, water supply treatment plant, or air pollution control facility and other discarded material, including solid, liquid, semisolid, or contained gaseous material resulting from industrial, commercial, mining, and agricultural operations, and from community activities, but does not include solid or dissolved material in domestic sewage, or solid or dissolved materials in irrigation return flows or industrial discharges which are point sources subject to permits under section 1342 of title 33, or source, special nuclear, or byproduct material as defined by the Atomic Energy Act of 1954, as amended (68 Stat. 923) (42 U.S.C. 2011 et seq.)

How big are these waste streams? And how hazardous? 42 U.S.C. 6903 treats hazardous waste as a subset of solid waste, so these waste streams are clearly eligible. Most of the agricultural byproducts are already picked up by language governing open-loop biomass. However, industry and mining are both potentially large sources for combustible waste streams, often hazardous, that can now be burned at a subsidy. Please provide any information on these waste streams and the likely magnitude of the subsidies if you have it.