The Cost of Fighting Climate Change: More Drilling

Last week’s surprise budget deal, which includes about $370 billion in measures to combat global climate change, was sealed with improved terms for US oil and gas exploitation.

Subsidizing clean energy while promoting oil and gas drilling may be contradictory and inefficient, but it seems to be the only way the US can enact meaningful climate policy changes under current political conditions. The urgency of the IRA’s important environmental measures makes them worth the cost of a Faustian bargain with the oil industry. 

The climate measures in the Inflation Reduction Act (IRA) are a scaled-down version of those in the Build Back Better Act (BBBA), which failed to pass. But the IRA’s “Energy Security” provisions make the new bill much more favorable to US oil and gas industry interests.

While the BBBA called for an outright drilling ban on the US outer continental shelf, the IRA calls for immediately reviving the expired 2017-2022 offshore leasing program. Moreover, the IRA would condition the government’s ability to issue renewable energy rights of way on an expansive federal oil and gas leasing program.

The IRA would also alter the fiscal regime federal oil and gas leases. Royalties – the most significant fiscal charge on production – would be lowered for both onshore and offshore drilling from 18.75 percent at present to a minimum of 16.67 percent (with a cap of 18.75 for the next ten years). By contrast, specific charges including minimum bids and rental rates would be increased and indexed to inflation, and new charges for bidding and bonding would be introduced.

In exchange for expanded drilling, the IRA offers some critical provisions to combat climate change. 

The bill would impose a charge of a $900-$1500 per metric ton on extraction-related methane emissions that exceed a minimum level. According to the US Environmental Protection Agency, methane emissions from petroleum production account for about 3.5 percent of US greenhouse gas emissions, although recent studies suggest that may be an underestimate.

The IRA offers about $260 billion in environmental tax credits, the most important of which are the renewable energy production tax credit (PTC) and investment tax credit (ITC). The PTC provides a subsidy of up to 2.6 cents per kilowatt hour of renewable energy produced for a project’s first 10 years, and the ITC provides an investment tax credit of 10-30 percent of a renewable energy project’s capital cost. In the absence of federal carbon pricing, these two credits form the core of the US energy transition policy. 

The IRA preserves several BBBA measures that should greatly improve the performance of energy tax credits by making them more flexible. 

The IRA would retroactively extend the PTC, which expired at the end of 2021, through December 31, 2025. It would also extend the ITC, which is currently set to phase out by the end of 2024, through the end of 2025.  The new clean electricity production and investment credits would also allow firms to choose either the ITC or the PTC (though not both)—including the solar industry, which has not been able to use the PTC since 2006. 

Flexible use is important to preserving energy tax credits’ effectiveness. The PTC tends to offer a deeper subsidy than the ITC, especially as equipment prices fall, but the ITC can outperform for high-cost projects.

The new tax credits will also be more fungible. Tax-exempt entities can claim refunds, while for-profit generators can sell the credits.  This eliminates the need for less profitable energy companies to seek “tax equity partners” that provide funding in exchange for tax credits, which can sharply raise capital costs.

The IRA would link energy tax credits to federal labor standards and domestic content. Companies meeting minimum domestic content requirements would be eligible for deeper subsidies, but companies that fail to meet minimum wage and employment standards would be eligible for a much lower credit levels.

Responding to concerns about energy transition and climate justice, the bill would also offer more generous credits to projects in “energy communities” highly reliant on fossil fuels and low-income and disadvantaged communities. 

In addition to the energy investment and production credits, the IRA expands or creates a host of new environmental tax credits for electric vehicles, residential and commercial buildings, certain manufacturing, and carbon sequestration.

The fate of the IRA is still uncertain, and many of its provisions could stir opposition from the left or the right. But even if it passes without substantial amendment, further climate measures will be needed soon:  The bill would reduce US carbon emissions by 40 percent by 2030, which falls short of the 50 percent reduction from 2005 levels that the US committed to in the Paris climate accord