S. 2095 Sect 45c credits

Legislation Version Dated Feb. 12, 2004

Reviewed by Doug Koplow

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

S. 2095, the current version of the Energy Policy Act of 2003, vastly expands eligibility for renewable energy production tax credits under section 45(c) of the tax code. The expanded provisions will generate subsidies of $2.3 billion (revenue loss basis) to $3.6 billion (outlay equivalent basis). An extremely broad definition of "municipal wastes" to include all manner of wastes from commercial, municipal, industrial, agricultural, and mining operations will likely drive this total substantially higher, though little is currently known about these waste streams. S. 2095 includes a number of modifications from language in its predecessor bill, HR 6. On the positive side, landfill gas subsidies have been eliminated, some eligibility windows (e.g., for municipal solid waste) have been shortened, and tax credit rates are no longer scaled for inflation which reduces their long term cost. On the negative side, however, many environmentally damaging sources remain, and some receive a higher tax credit rate than in HR 6.

In fact, the expanded eligibility for tax credits seem to provide little leverage for increased energy diversity and independence. 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 producing or burning a wide range of recyclable materials, S. 2095 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 more than $1 billion for energy recovery technologies they have been deploying for close to 30 years.

(One positive note here:  the Senate Energy Committee's latest venue for attaining subsidies for energy producers is by slapping most of the tax subsidies from S. 2095 onto the Senate's "Jumpstart Our Business Strength (JOBS) Act" (no bill number as of April 5th).  Subsidies to open loop biomass no specifically exclude "spent chemicals from pulp manufacturing."  This language would seem to exclude black liquor, one of the main sources of subsidy to virgin paper under S. 2095.  Even though paper would remain eligible to claim tax credits for burning black liquor under the overly broad definition of municipal solid waste, it would not get them on already existing plants.)

The new section 45(c) credits also pose a threat to sustainable production systems across the country by removing virtually all constraints on the types of biomass that 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 not only continue to escape appropriate regulation but now receive direct federal subsidies as well.

• 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 obtain tax subsidies. 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. S. 2095 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 to 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 to recycling. Recycling is economic is the net value of recovered materials is less than the cost of alternative disposal options such as landfilling and combustion. S. 2095 provides subsidies to disposal (combustion of a wide range of wood and paper products get the tax breaks), undermining the economic value of recycling. Thankfully, subsidies to landfilling (through tax credits for landfill gas) that had been included in the bill's predecessor (HR 6) have been removed. Recycling sectors that will be affected by the Section 45(c) credits 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 $1.36 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 S. 2095. 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. If the energy bill 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 electricity produced. This credit has historically been adjusted annually for inflation, but S. 2095 would remove this adjustment for most of the new sources. 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. S. 2095 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 1301 (though it may count as "MSW," and does receive lavish subsidies in Title XIII, Subtitle E of the bill). Similarly, really contaminated biomass wood products can't be burned for a subsidy -- though even here, "regular" hazardous waste can 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. S. 2095 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 utilities than previously. Previous attempts to curb "double-dipping" (when a single facility accesses multiple subsidies for the exact same actions) are greatly weakened in S. 2095. Reductions due to the use of subsidized public financing or alternative minimum taxes are much smaller. 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, which range from $2.3 to $3.6 billion. Because these values include no subsidies to landfill gas (eliminated from S. 2095) or to other solid waste streams, they are lower than what JCT had estimated for HR 6. Our figure should be viewed as a lower bound for two reasons. First, it excludes the wide range of "solid" waste streams that can be burned for credit. Second, because the growth projections used to estimate the subsidy uptake for most of the other eligible sources rely on modeling by the Energy Information Administration that do not take into account the accelerated growth that might occur as a result of the subsidies.

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 and 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 and a summary of biomass tax credits by company, industry, and state are available in PDF format.

Exhibit 1: Summary of Expected Tax Losses Resulting from S. 2095, Section 45(c) ,

"Credits for Electricity Produced from Certain Renewable Resources"

(as defined by S. 2095 dated 2/12/2004)

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 constituent solid waste accesses the credit. There are no requirements that WTE plants must pull and recycle certain constituents prior to burning, either for recycling (metals, glass, high grade paper) or for hazardous reduction (heavy metals).

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 S. 2095. As small farms are unlikely to have enough of either crop byproducts or animal wastes 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, S. 2095 decides that somehow it's the taxpayer's responsibility to pay for part of the controls.

C. Tax Credit Eligibility for Existing Biomass Facilities

S. 2095 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. JCT's cost estimates (done for HR 6) 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 1301, p. 773) 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 1301 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.

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. S. 2095 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. So too are waste water treatment plant sludges. We will be analyzing the likely fiscal impacts of these sections in a separate summary to be released later.