ANALYSIS: Tradeoffs in the Inflation Reduction Act of 2022 between climate protections and fossil fuel interests could be dire for offshore wind projects and for solar and wind projects on federal lands. Congress seems to be driving with both feet pressed firmly on the gas pedal and the brakes at the same time. The devil is in the details.

Key Highlights of the Bill – Climate & Energy Incentives

The bill on the whole is good for the environment and good for the economy. This landmark legislation – the most comprehensive U.S. initiative to mitigate climate change yet – seems poised to pass Congress and be signed into law by President Joseph R. Biden, Jr. later this month with relatively few major changes. Beyond the climate and energy provisions are significant measures to lower prescription drug prices and to close the carried-interest "loophole" that has benefited private equity, real estate, and hedge fund managers.

The bill extends existing renewable energy tax credits – production tax credits (PTC) and investment tax credits (ITC) – and contains other important climate and energy provisions. Standalone energy storage (with normalization opt-out for large projects), biogas property, microgrid controllers, dynamic glass, and small interconnection facilities (though not transmission lines) would become eligible for the ITC. Bonus tax credits are available for certain projects located in brownfield and coal-mining communities or for small wind and solar projects placed in service in certain low-income communities. Bonus credits are also available for some investments if additional goals are met for domestic content and labor standards (prevailing wages and apprenticeships to create skilled jobs and domestic manufacturing capacity). The Internal Revenue Code Section 45Q tax credit for carbon capture and sequestration (CCUS) would be extended, though the bill lowers the minimum amount of carbon oxide that must be captured to qualify. The bill provides up to a 1.5 cent/kWh PTC until 2032 for existing zero-emission nuclear power facilities that have not already claimed the PTC under Section 45J.

The bill would impose a 15% corporate alternative minimum tax on companies with adjusted financial statement income over $1 billion. The new corporate alternative minimum tax might lead to greater participation in tax equity markets, if more large corporations seeking tax shields become investors in partnerships that own renewable energy projects. Other provisions of the law allow the transfer of partnership interests to unrelated third parties to make it easier to monetize energy tax credits. Broadening the depth and liquidity of tax equity markets could reduce slightly the cost of tax equity, helping project sponsors and lowering the cost of capital for eligible projects.

In a departure from traditional incentive mechanisms, the bill shows a policy migration away from tax credits based on different types of renewable technology to credits based on emissions avoidance or reductions. The bill would ultimately provide a 10-year PTC or an ITC (but not both) for electricity generation facilities with a zero greenhouse gas emissions rate. This technology-agnostic tax credit would also cover retrofitted plants placed in service after 2024, so long as the existing facility had not previously qualified for an energy credit. Emissions do not include amounts sequestered through carbon capture technology. Similarly, clean hydrogen incentives are tied to reductions in lifecycle greenhouse gas emissions rates (measured in kilograms of CO2e per kilogram of hydrogen) rather than overly-prescriptive technology choices. Other provisions of the law would reward reductions in methane emissions, including in relation to biogas and agricultural waste-to-energy plants, and monitoring and control of fugitive emissions tied to oil and gas production.

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Subsidies also flow to manufacturers of equipment for renewable and clean energy manufacturing, including electric vehicles and trucks. Buyers of new or used EVs or alternative fuel vehicles would also receive refunds. Clean fuels, including biodiesel and sustainable aviation fuel, also receive economic incentives. On December 31, 2024, existing fuel credits would transition to the Clean Fuel Production Credit.

But some unfortunate surprises are buried deep in the 725-page bill now in front of Congress. These provisions would support expanded investment in domestic oil and gas exploration and production, especially on federal lands and in offshore federal waters. Those provisions run counter to the Biden-Harris Administration's goal of reducing U.S. greenhouse gas emissions by 50% by 2030. The pending Inflation Reduction Act remains critical to that effort. If the bill is enacted as currently written and the desired investments, incentives and innovations come to pass, then meeting that climate goal will remain conceivably within reach. Without the bill or similar legislation, reaching that ambitious climate goal is likely impossible.

New Rules for Energy Leases on Federal Lands and in Offshore Waters

A small, easily overlooked provision of the bill could have a big impact, though not necessarily in the way its authors might intend. Just over two pages long, Section 50265 jeopardizes the development of billions of dollars of planned offshore wind projects and renewable power projects on federal land. And it adds to the complexity and uncertainty of obtaining federal environmental permits even as both Democrats and Republicans proclaim the need to streamline the entitlement process.

Under this provision, for the next decade after the new law takes effect, no right of way could be granted for wind or solar energy development on federal lands unless a quarterly lease sale is held that results in issuance of an oil and gas lease, if any acceptable bids have been received, within the 120 days prior to the proposed wind or solar energy right of way being issued. Every time a wind or solar right of way is to be issued by the Bureau of Land Management (BLM), for each project that applies and has met the permitting requirements under the National Environmental Policy Act (NEPA) and other laws, a separate determination would be required about the status of oil and gas leases sold under BLM's lease program. That determination would not depend on the quality, value, compliance or merit of any energy project, just on the calendar and the progress of wholly unrelated administrative actions.

In addition, at least 2 million acres of federal lands (or, if less, at least half the acreage for which expressions of interest have been submitted from potential bidders) must have been offered for oil and gas leases in the year before each proposed wind or solar right of way is issued. In practice, assuming sufficient expressions of interest are received by BLM, that means at least 20 million acres of federal lands must be offered in total for new oil and gas leases over ten years on a quarterly basis. Any interruption or suspension of oil and gas lease sales over the next decade for any reasons (including, apparently, if necessary environmental approvals cannot be obtained, if courts block the sales, if sellers express interest but fail to bid, or if a future administration suspends any oil and gas lease programs) would bring development of all new solar and wind power projects on federal lands to a screeching halt.

Offshore wind projects would face similar risks. Given the earlier stage of development of the U.S. offshore wind industry, the very large scale and complexity of offshore wind projects, and the lengthy, multi-year permitting process they must undergo, the dependence of their federal leases on the sale of unrelated leases for offshore oil and gas drilling may be a more existential threat. Under the proposed law, no lease for offshore wind development could be issued by the Bureau of Ocean Energy Management (BOEM) in federal waters any time in the next ten years unless, at the time of each new lease of an offshore wind area, BOEM has within the prior twelve months also offered to sell a new oil and gas lease and, if any acceptable bids have been received for any offered tract, issued a lease. In addition, no less than 60 million acres of federal waters on the outer continental shelf must have been offered for oil and gas leases in the prior year, or no new offshore wind leases could be issued. In effect, over 600 million acres of federal waters must be offered (though unsold areas could be reoffered) for new oil and gas exploration and production. Failure to maintain the required annual pace of offshore oil and gas leases would block all subsequent offshore wind leases.

Misunderstood Circumstances, Unintended Consequences

Mandatory new oil and gas leases might not materially expand fossil fuel production. But tying them to new wind and solar leases could slow down the permitting for renewable projects and throw up roadblocks to new renewable energy investments. The issuance of all federal energy leases and rights of way must comply with NEPA review of environmental impacts and mitigants. Under the new bill, only developers of new wind and solar projects would face an extra requirement unrelated to their renewable projects, and completely outside the developers' control: that the issuing agency (BLM or BOEM) also be offering and issuing new oil and gas leases recently and on an ongoing basis. That regulatory uncertainty could significantly chill investment in renewable projects on federal land and, especially, offshore wind, undercutting the other provisions of the bill meant to stimulate such investments.

To put these numbers in perspective, the public lands required to be opened to new oil and gas drilling leases would total 20 million acres over a decade, an area bigger that the land area of the State of Maine. The new ocean areas to be opened to offshore drilling would equal 60 million acres (an area nearly as large as the State of Wyoming), each year for ten years.

BLM oversees about 245 million acres of federal public lands (including lands that are managed for outdoor recreation, development of oil, gas, coal, and renewable energy resources, grazing and timber production, cultural heritage and sacred sites, and supporting wildlife habitat and ecosystem functions). In response to President Biden's Executive Order 14008 (January 27, 2021), the Department of the Interior (DOI) issued a report in November 2021 reviewing federal oil and gas leasing and permitting practices. According to the report, which was critical of existing BLM leasing practices including low royalty rates and poorly managed or unproductive leases, DOI calculated that federal onshore oil and gas production accounts for approximately 7% of domestically produced oil and 8% of domestically produced natural gas.

BLM currently manages 37,496 Federal oil and gas leases covering 26.6 million acres with nearly 96,100 wells. The proposed new law seeks to increase that acreage under lease by 75% over ten years. Of the more than 26 million onshore acres currently under lease to oil and gas companies, nearly 13.9 million (or 53%) of those acres are non-producing, according to the DOI report. The oil and gas industry has a substantial number of unused permits to drill onshore. As of September 30, 2021, the oil and gas industry held more than 9,600 approved permits that are available to drill. In fiscal year (FY) 2021, BLM approved more than 5,000 drilling permits, and more than 4,400 are still being processed. DOI then analyzed 646 parcels on roughly 733,000 acres that had been previously nominated for leasing by energy companies. Of those, DOI reduced the expected area to be offered under final sale notices by 80% to approximately 173 parcels on roughly 144,000 acres, working together with local and tribal communities.

DOI also examined offshore leasing areas, noting that the Outer Continental Shelf accounts for 16% of all oil production and just 3% of natural gas production in the United States, mostly in the Gulf of Mexico. Due to market conditions and industry drilling strategy, the offshore acreage under lease by BOEM has declined by more than two-thirds over the last 10 years. Offshore drilling is expensive, challenging and, given low oil and gas prices over most of the last decade until recently, less competitive than many onshore resources. Of the more than 12 million offshore acres under lease today, about 45% is either producing oil and gas or is subject to approved exploration or development plans, which are preliminary steps leading to production. The remaining 55% of the leased acreage is non-producing, "indicating a sufficient inventory of leased acreage to sustain development for years to come," according to DOI.

In fact, the most recent BOEM lease sales have drawn little interest, with only a small fraction of the tracts offered for lease attracting bids. In BOEM's most recent sale (No. 257 in November 2021) only 1.7 million acres received bids out of nearly 81 million acres offered. Only 33 companies participated in the sale. The prior sale (No. 256 in November 2020) attracted bids from 17 companies for just over half a million acres out of almost 80 million acres offered. This is not a new trend. For instance, Sale No. 247 (March 2017) offered almost 50 million acres for offshore oil and gas drilling. Less than 1 million acres attracted bids from 24 companies. In each of these sales, the average number of bids per block being offered was...about one. Almost all blocks have just a single bidder. Everyone wins, but very little is actually sold. And many leased tracts are never developed or prove too speculative.

Requiring that an additional 60 million acres a year – five times the total area of all existing federal offshore oil and gas leases – be offered for new offshore oil and gas leases as a precondition to new offshore wind leases being issued, and that onshore lease areas be similarly expanded as a condition to new solar and wind energy projects on federal lands, assumes that there is sufficient industry interest to develop those oil and gas leases, that doing so would materially increase the domestic supply of oil and gas at a competitive price, that the nation's energy security would be enhanced by mandatory expansion of oil and gas lease areas, and that the BLM and BOEM have the resources, personnel and policies in place to significantly increase and administer the federal oil and gas leasing program and associated environmental reviews. None of these assumptions are likely correct. Even if they were, there is no logic to holding up offshore wind development or onshore wind and solar projects to find out.

Other provisions of the bill might make new oil and gas drilling leases less attractive, regardless of market conditions. The bill would increase royalty rates for onshore and offshore federal oil and gas leases to be more commensurate with the royalty rates changed by many states for drilling leases on state public lands. More stringent regulation of carbon oxide, nitrogen oxide (NOx) and methane gas emissions, potential requirements for CCUS (encouraged in the bill generally, with lower standards and more generous credits), and demand erosion for hydrocarbons may make new federal leases even less attractive over the coming decade.

Reinstatement of 2021 Offshore Oil & Gas Lease Sale

And that's not the only Easter egg in the bill for fossil fuel development in federal waters. What else happened to the most recent lease sale by BOEM? Sale No. 257 was originally held in January 2021, rushed to market in the waning days of the Trump Administration. President Biden's Executive Order 14008, in addition to directing the DOI review, temporarily paused offshore oil and gas leases. A federal district court in Louisiana enjoined the suspension and the sale went through in November 2021, only to be set aside again by the United States District Court for the District of Columbia in January 2022 (Friends of the Earth, et al. v. Debra A. Haaland, et al.). The D.C. federal court ruled that BOEM had not complied with statutory requirements for environmental review of the lease areas before issuing the leases.

A few paragraphs in Section 50264 of the Inflation Reduction Act would reinstate Sale No. 257 and also direct BOEM to proceed with other specified oil and gas lease sales, notwithstanding the court's determination that BOEM failed to comply with NEPA with respect to the relevant lease areas. President Biden would be unable to suspend the issuance of those new offshore oil and gas leases.

Want Fries With That?

Congress has often embraced compromises that contain subsidies and incentives for both renewable energy and fossil fuels. The Energy Policy Act of 2005, enacted under President George W. Bush, extended the Production Tax Credit and Investment Tax Credit for wind and solar power, respectively, added tax credits for oil, gas and coal, mandated blending subsidies for biofuels and ethanol, and expanded access to federal lands and offshore waters (and lowered royalty rates) for oil and gas wells and other energy activities, although stronger greenhouse gas reduction measures were defeated. It was an all-of-the-above energy menu shaped by competing concerns about energy security, economic growth and environmental quality. But Congress did not try to pick winners and losers by showing a preference for one energy technology or source over another.

Now, for the first time, if these fossil fuel provisions remain in the bill, the development of renewables like solar power and onshore and offshore wind energy is being held hostage to the granting of millions of acres of new oil and gas leases on federal land and the continental shelf for at least the next decade. What is unusual is not that the proposed Inflation Reduction Act simultaneously stimulates investment in both "dirty, old" and "clean, new" energy technologies. What is new is that one is contingent on the other and, specifically, that renewables could be blocked if more areas are not opened up on public lands and offshore waters – consistently, at scale and for many years – to expanded oil and gas development. It is like telling your obese uncle, who is trying to break bad habits and eat a healthier diet, that each order of fresh fish and salad must be accompanied by a large bowl of nacho cheese fries topped with sour cream. Otherwise, no healthy food for him.

Energy Security & Price Volatility

Oil and gas lobbyists and other supporters of the fossil fuel provisions, including Senator Joe Manchin (Democrat from West Virginia), stress the need for continued development of conventional hydrocarbons to maintain energy security and domestic fuel supplies. Political pressure to address those concerns along with inflation is strong (as the Inflation Reduction Act's euphemistic rebranding of the energy and climate provisions of the Biden-Harris Administration's original, more ambitious Build Back Better bill suggests). Hence, the bill is a long-awaited compromise between Senator Manchin, Majority Leader Chuck Schumer (New York) and other Democratic leaders in the Senate in coordination with the House Democratic leadership.

A supply/demand imbalance in global oil and gas commodity markets due to a combination of geopolitics (Russia's invasion of Ukraine), strong demand recovery from the pandemic lows of the past year or two, and very tight domestic refining capacity have led to volatile and recently very high gasoline prices, renewed demand for coal, and an increase in natural gas prices. Gasoline prices have since retreated materially over the past month, but anxiety at the pump (and the ballot box) remains high. The wholesale U.S. spot price for natural gas (Henry Hub) has risen sharply from $3.75/MMBtu in January 2022 to a high of $9.46/MMBtu at the end of July, though options prices imply that gas prices should come back down to around $4.75/MMBtu by the second quarter of 2023. Energy prices in Europe are significantly higher and could rise even further and faster if there are additional disruptions in supplies of Russian natural gas to Germany, Italy and other European countries that depend on it. U.S. exports of liquified natural gas (LNLN 0.0%G) and coal are seen as a near- to medium-term salve to Europe's energy challenges, and that would require significant investment in U.S. upstream and midstream capacity.

Of course, investments in new oil and gas wells, gas liquefaction plants, export terminals, pipelines and storage tanks today will do little or nothing to address prices or volumes over the next one or two years. We may be at the top of the market, with commodity prices falling rapidly as high prices erode demand. Commodity boom/bust cycles are endemic to the oil and gas industry. New capital investments on this scale may simply be too risky at this stage of the business cycle for many investors.

Longer term decarbonization trends globally are strong and, with passage of legislation like the Inflation Reduction Act, those trends would be reinforced. The "energy transition" to renewable power, alternative fuels, energy efficiency and storage, hydrogen and electrification of transportation and transit is still gathering steam. Over time, as the transportation sector electrifies and the power grid greens, and with geopolitics driving up energy prices globally, there will likely be additional demand destruction for fossil fuels, making new leases even less attractive.

Consequently, many investors fear the risk of making large new capital expenditures in oil, gas and coal assets that may become obsolete, stranded investments. Private equity, institutional investors and energy funds have shown a high degree of restraint and discipline in the current cycle in allocating capital, preferring operating assets with stable cash flows to risky, capital-intensive E&P projects. Some investors have an eye on potential future regulation and, for some, ESG sentiments. Market factors still dominate their thinking, though, especially with ongoing supply chain disruptions for materials and skilled labor and challenging forward price curves due to price volatility, uncertainty and rising interest rates that lower discount rates and thus the net present value of future cash flows.

Energy Incentives: Something for Everyone

The main thrust of the Inflation Reduction Act is to promote cleaner and greener energy sources and technologies so as to reduce the greenhouse gas emissions that contribute to global climate change. The legislative process often requires compromises to function. The bill supports continued investment in fossil fuels – chiefly oil and gas – and supports communities and companies adversely affected by the transition away from coal to cleaner energy sources. The bill also helps other communities that have been disproportionately impacted by energy operations.

There are criticisms even from the bill's supporters of the provisions that encourage more fossil fuel exploration and production, especially on federal lands. Whether they will survive or be modified or cut by amendment in the Senate or the House, or in a possible House-Senate conference committee remains to be seen. As this is a reconciliation bill, the rules (though different in the Senate from the House) limit amendments. Senators Schumer and Manchin have separately agreed that this bill will be followed by further legislation streamlining the federal permitting process. Perhaps that legislation can provide an avenue to remedy some of the imperfections in the current bill.

Most environmentalists, utilities, labor unions and clean energy advocates strongly support the bill's passage, noting its net climate benefits and the economic stimulus for innovative technologies and renewables. On balance, the reductions in carbon dioxide, methane and other greenhouse gases vastly outweigh the impact of the fossil fuel provisions. Perfection should not be the enemy of the good.

Originally Published by Forbes

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