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Carbon Capture Projects Incentivized By Tax Credit Guidance: Section 45Q

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The federal income tax credit for carbon capture and sequestration, Internal Revenue Code section 45Q, was enacted to incentivize investment in carbon capture and sequestration, just as federal tax credits have supported the growth in wind and solar project investment. 

The carbon capture credit statutory provision was significantly revised and enhanced in 2018 but the legislation left interpretation of many key provisions up to Treasury and the IRS.  In 2020, after a clamor from both legislators and their constituents for much-delayed guidance on the 2018 provisions, Treasury finally released numerous pieces of guidance, including a Notice, a Revenue Procedure, proposed regulations and, just in time to beat the change of administration, final regulations.  Moreover, the Taxpayer Certainty and Disaster Tax Relief Act of 2020 extended the deadline for beginning construction for qualifying projects by two years to January 1, 2026, giving developers some breathing room for projects that have been delayed due to the lack of guidance, pandemic issues or other reasons. 

These developments, together with the general push for ESG investments, can be expected to make 2021 the year that carbon capture project development takes off.  Last year, we reported that there were announced plans to build more than 20 large carbon capture facilities, with many more under study.  That number is now over 30.

Section 45Q offers a credit against federal income tax liability in a specific dollar amount per metric ton of carbon that is captured and either sequestered, used in enhanced oil recovery (EOR) or put to some other commercial use.  For carbon oxide that is sequestered, the credit can be as high as $50 per ton.  For carbon oxide used in enhanced oil recovery or other commercial use, the credit reaches $35 per ton.  For projects that capture millions of tons of carbon, the credit can be very valuable.

Qualifying captured carbon need not come solely from emissions from power plants.  Captured carbon oxide that is a by-product of any industrial production process, such as petrochemicals or LNG liquefaction, is eligible for the credit.  There is also a nascent industry that uses technology to pull carbon dioxide directly out of the ambient air, referred to as “direct air capture,” and carbon oxide captured in this manner also qualifies for the credit.  Thus, the carbon capture tax credit may be available across a wide spectrum of industry activities. 

EOR is the most common use for captured carbon and so, for many, the most important guidance issue was the extent to which the IRS would require credit claimants to comply with certain extensive EPA monitoring, reporting and verification rules that had previously not necessarily applied to EOR activities.  To the relief of many, the promulgated regulations have now provided for an alternative to compliance with such EPA rules for taxpayers who choose to report under standards of the International Organization for Standards (ISO 27916).

A striking feature of the credit is that there is a mechanism to permit it to be transferred from the party that owns the carbon capture equipment to the taxpayer that sequesters or uses the captured carbon oxide.  This provision facilitates tax equity investment in carbon capture facilities.  Final regulations have clarified the mechanism for making the transfer but have put time pressure on the election by restricting the ability to make the transfer through an amended return.

In addition to sequestration of carbon oxide through burying or use in EOR, section 45Q also offers the credit for utilization of the captured carbon through photosynthesis, conversion to a material or chemical compound or use for “any other purpose for which a commercial market exists as determined by Treasury.” The IRS has, in the final regulations, chosen to define commercial markets very broadly as any “market in which a product, process, or service that utilizes carbon oxide is sold or transacted on commercial terms.”

Although commercial markets in which the captured carbon can be utilized are broadly defined, the amount of carbon oxide utilized (and thus the amount of the credit available to a taxpayer) is by statute required to be determined by performing an analysis of the amount of the captured carbon so utilized through an analysis of lifecycle greenhouse gas emissions (an “LCA”). In general, an LCA systematically evaluates the environmental impact of a product, activity or process over its entire lifecycle by comparing it to the environmental impact that would have occurred had the captured carbon oxide not been used.

There are many open questions regarding the method of performing an LCA for the wide variety of products and processes in which captured carbon oxide may be used.  The final regulations reference DOE and ISO standards but application of these standards, and the appropriate baselines and boundaries for analysis, will remain unclear until taxpayers begin testing their LCAs with the government agencies.

Apart from regulatory guidance, the legislative outlook for the section 45Q tax credit is encouraging.  The GREEN Act passed by the Democrat-controlled House of Representatives in July 2020 and the ACCESS 45Q Act introduced in December 2020 would have created a direct payment option for the carbon capture tax credit, among other enhancements.  While these provisions did not pass the previous Congress, President Biden and leadership in both houses of Congress have made clear that promoting clean energy incentives is a top priority.

In summary, the lack of regulatory agency guidance on a number of issues with respect to the carbon capture tax credit delayed many investment decisions.  Now that guidance has been provided, watch for a big upswing in investment in carbon capture projects in 2021 and potential legislative enhancement as well.

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