In August, the U.S. Senate passed The Inflation Reduction Act of 2022 (IRA). This sweeping legislation is expected to raise $737 billion, require total investment of $437 billion, and result in a deficit reduction of more than $300 billion over a decade by addressing the corporate tax rate, prescription drug prices, IRS tax enforcement, Affordable Care Act subsidies, and climate change investments. Within these areas, the IRA will make its largest investment in the energy industry, so I’d like to focus on its expected impact there.
Political and social discourse around the policy response to climate change has largely focused on investment in the renewable energy space. Thus, it is interesting that, when Bloomberg identified companies most likely to benefit from the IRA, it rated companies focused on oil & gas alongside those focused on renewable energy. This is not surprising when digging deeper into the IRA - its provisions show how funding both facets of the energy industry — oil & gas and renewable energy — is necessary to support sustainable energy sources and thus realistically reduce inflation over the long run. Let’s take a deeper dive into the IRA:
Business Incentives and Tax Credits
The IRA includes various tax credits for energy production, including investments in wind, solar and geothermal energy; battery storage and biogas; nuclear energy, hydrogen energy from clean sources; biofuels; and technology that captures carbon from fossil fuel power plants. It also includes bonuses for companies based on worker pay and for the manufacture of steel, iron, and other components in the U.S. Finally, it includes incentives for businesses to deploy lower-carbon and carbon–free energy sources.
Buying Back Strategic Petroleum Reserves
It is obvious that the oil & gas industry is currently experiencing high demand for energy resources. Based on the data generated by Bloomberg, major oil companies posted record profits in the second quarter of 2022, surpassing the 2008 high. BP (British Petroleum) had an "exceptional" result in oil refining and trading that easily topped the highest estimates. In addition, Exxon and Chevron also reported their highest-ever profits. However, these major oil companies are in no rush to drill new wells and materially increase production — even Strategic Petroleum Reserves are at their lowest level since 1985 — because uncertain energy and climate policies muddy long-term capital return profiles. As one of the main provisions of the IRA, Biden guarantees the buyback of Strategic Petroleum Reserves at a fixed price in the near future. This is in hope of incentivizing oil production and bringing some certainty to the oil & gas industry – despite burgeoning climate change legislation.
Mandate more federal oil-and-gas lease sales
According to the Act it requires the administration to offer 2 million acres of onshore federal land for lease per year within 120 days of issuing any wind or solar rights of way. It also requires an oil and gas lease sale of no less than 60 million acres in federal offshore waters as a requirement to issue an offshore wind lease in the flowing year. While the acreage requirement provisions are inline with historical lease sales figures, they notably prevent the administration from stalling future federal oil and gas lease sales. This provision is important for two major reasons. First, oil production from federal lands and waters provides approximately 24% of total U.S oil production, so it is important to keep a stable flow of leases to ensure long-term energy security of the U.S. with a stable supply of domestically sourced oil and gas. Second, recall back in 2021, President Biden signed an executive order to impose a temporary moratorium on oil and gas leasing activity in the Arctic National Wildlife Refuge (ANWR); withdrew offshore areas in Arctic waters and the Bering Sea from oil and gas drilling and revoked the permit for the Keystone XL pipeline. It took 40-year high inflation and EU energy crisis for Biden administration to acknowledge the importance of holistic approach when comes to energy policy.
Green Hydrogen Tax Credits
When visualizing clean energy, many people think of solar panels and wind turbines. These are excellent for generating the electricity used in homes, however, there are drawbacks. For example, some processes, like making steel, call for higher temperatures than traditional electric furnaces can deliver. Hydrogen energy is a very good energy carrier with high energy per unit mass properties – thus, it could play an important role in curbing industrial emissions and potentially powering cars, trucks, and ships.
Most hydrogen energy produced today is gray hydrogen. In the next decade, we believe that production will shift to blue and green hydrogen if the cost declines significantly. The IRA provides a $3 USD/kg tax credit for producing green hydrogen, making it more competitive only in some areas of the U.S. However, even with this credit, blue hydrogen remains the cheaper option. (See Figure 1 below).
Though shifting to green and blue hydrogen means that hydrogen will no longer be produced with fossil fuels, fossil fuels will still be necessary for hydrogen storage and transport. Hydrogen is a low-density gas at room temperature. It may be transported by pipeline, in which case it must be compressed or mixed with natural gas. Alternatively, it can be chilled to a liquid state and transported by ship. This interdependence between fossil fuels and renewable energy sources is emblematic of a larger phenomenon: any disruption of building out renewable energy infrastructure will delay and shift the weight to the oil & gas industry. Thus, the oil & gas industry will continue to benefit from increased production of carbon-free, carbon-low, or carbon-neutral energy sources like green hydrogen.
To achieve meaningful carbon reduction, nuclear energy must be part of the solution. At present, 93 nuclear reactors provide about 20% of the U.S.' electricity portfolio. This energy comprises about half of the country’s carbon-free electricity, more than the share of wind and solar combined. However, since the end of 2017, six nuclear power plants have been retired, with three more reactors scheduled to retire in the coming years.
The IRA of 2022 hopes to slow down the early retirement of major nuclear power plants by providing a production tax credit for existing nuclear energy units – similar to the one received by wind and solar farms.
One reason nuclear power plants retire early is that they struggle to be price competitive – natural gas is cheap and abundant and solar and wind costs have come down since they were introduced. The tax credit seeks to address this issue by providing resources for nuclear power plants to operate and stay open while the industry develops technology to reduce costs.
Another reason cited by opponents for early retirement of nuclear power plants is that it’s risky to place them close to large cities.They believe these plants could become targets for terrorist attacks or impacted by natural disasters. To address this, industry leaders suggest future nuclear power plants be placed at retired coal mines. This would require significant capital investment in research with a planned roll-out in the 2030s.
Electric Vehicle Tax Credits
The IRA includes several provisions related to electrical vehicles (EVs): consumers may earn up to $7,500 per vehicle in consumer tax credits for their purchase of new EVs or a $4,000 tax credit for used EVs. In addition, companies will receive billions in new funding for EV production and the U.S. Postal Service will receive $3B to buy EVs and battery-charging equipment.
Though this feels like an important step towards decreasing dependence on fossil fuels, it poses a few challenges.
In protest of Chinese labor abuses, the U.S. will require automakers to shift away from Chinese-made and/or sourced materials. After 2023, vehicles with batteries that have Chinese components will not receive the credit, while critical minerals also face limitations on sourcing. As a result, automakers are concerned this requirement could jeopardize the collective target of EV cars comprising 40-50% of total sales in the U.S. by 2030. Also, this lag before adoption of North American-made battery components would also render the credits effectively useless for that period.
In addition, not all cars or families are eligible for the credit. Cars that cost more than $55,000, pickups and SUVs that cost more than $80,000, and families with adjusted gross incomes of more than $300k won't be eligible.
Examining the Inflation Reduction Act illuminates the complexity of transitioning from fossil fuels to renewable energy sources. Readers of our Energy Challenges series will recognize a common thread: the transition to more environmentally-friendly facilities and practices will be reliant on investment in both the renewable energy space and in the oil & gas industry. It will be interesting to see how these broad changes will play out in the next few decades. If you are interested in learning more about private investment in energy, we encourage you to read our Energy Challenges series (linked above) and/or reach out to your relationship manager.
This is the third article in our 2023 Capital Markets Forecast. We provide considerations for trade-offs in private capital to help clients reach their goals in a cycle where successful active management is likely to matter more than ever for clients to reach their goals.