Tax Credit Choice for Solar and Wind Power in the Inflation Reduction Act

The Inflation Reduction Act has invigorated incentives for clean energy, including the investment tax credit and production tax credit. Wind and solar projects can choose between the two: What influences this choice, and what are the implications?

Before the IRA, both the solar ITC and wind PTC had been scheduled to step down over time. COVID-19 relief legislation in December 2020 set the PTC to 60 percent of its statutory rate for wind projects that started construction in 2020 and 2021, with a planned expiration in 2022. The same legislation set the ITC to 26 percent for solar projects starting in 2021 and 2022, 22 percent in 2023, and 10 percent thereafter.

How the Inflation Reduction Act Has Changed the Investment Tax Credit and the Production Tax Credit

To assess the choice between the ITC and PTC, it is necessary to review the other changes that the IRA made to these two incentives. First, the IRA restored the ITC and PTC to their full statutory amounts—30 percent and 2.75 cents per kilowatt-hour (in 2023$), respectively. Second, the credits will remain at those levels for projects that commence construction by 2032 (if not later) if projects meet the requisite standards for prevailing wages and apprenticeships. Third, the IRA established 10 percent bonus credits both for meeting domestic content requirements and for establishing in an energy community. For the PTC, each bonus credit adds 10 percent of the PTC value, but for the ITC, each bonus credit adds 10 percentage points—a 33 percent increase in value.

Perspectives and Implications of the Choice between the ITC and PTC

Project Sponsors

The project sponsor would prefer the tax credit that provides greater present value. Whether a 30 percent ITC is worth more than a 10-year PTC of 2.75 cents per kilowatt-hour depends primarily on three project factors: capital cost, capacity factor, and discount rate. A higher capital cost increases the benefit of the ITC, whereas a greater capacity factor increases the amount of electricity produced and thus the PTC’s value. A higher discount rate (determined by the cost of capital) will diminish the present value of the PTC. Additionally, if the project qualifies for bonus credits, the credits are proportionately more valuable under the ITC.

In allowing projects to choose their preferred tax credit, the IRA has made both the ITC and PTC more beneficial. However, for utility-scale solar and onshore wind projects with low capital costs or high capacity factors, the PTC is significantly more generous. Consequently, the switch to the PTC for utility-scale solar projects is likely to cause substantial growth in clean power.

Tax Equity Investors

Tax equity investors are essential for efficient use of the tax credits and deductions for projects that are led by independent power producers, giving influence to tax-equity perspectives on the choice between the tax credits. The demand for tax equity is expected to grow with the increased incentives in the IRA from approximately $20 billion in 2022 to $50 billion by 2025. Furthermore, because the current pool of financiers has limited spare capacity, a large portion of the incremental demand must be met by new entrants.

The ITC has multiple advantages for tax equity investors, particularly new entrants. First, the timeline is shorter. The tax benefits accrue within five years, the majority of which are realized in the first year. Therefore, an ITC investor needs fewer years of predictable future tax liabilities. Second, given that the ITC is based on a project’s capital cost, it entails less investment risk than the PTC, which depends on electricity generation over a 10-year period.

For established tax equity investors, these advantages are less significant, and the PTC may even be their preferred structure. The disadvantage of the ITC’s short timeline is that investors must make successive investments to offset their tax liability. Because each investment entails a transaction cost, the aggregate transaction costs of ITC investments may favor the 10-year PTC.

Both the ITC and PTC options may help increase the supply of tax equity. The ITC, with its favorable structure for investors who have less predictable tax liabilities, could expand the investor pool in the long term. The PTC—the favored choice of many solar projects that otherwise would have taken the ITC—consumes less tax liability in the early years, thus increasing the near-term supply of tax equity investment.

Regulated Utilities

In regulated markets, utilities are allowed to own power-generation assets, but federal law has limited the appeal of owning ITC projects. Tax normalization rules have required that utilities spread the ITC value over the operating life of the asset, thus diminishing the present value of the credit and increasing the cost of electricity generation.

Rather than own ITC assets, a utility could sign a power purchase agreement with an independent power producer, which is not subject to normalization requirements. However, whereas a regulated utility earns a rate of return on the assets it owns, this is not the case for a power purchase agreement. Indeed, a power purchase agreement is considered a liability on the balance sheet of a utility.

ITC projects thus have been less attractive in regulated markets. Utility ownership is more expensive to ratepayers, and power purchase agreements are unappealing to utilities. In allowing solar projects to elect the PTC, which is not subject to normalization, IRA removed a disincentive to adding solar capacity in regulated markets.

Economic Distortions Created by Two Tax Credits

The Investment Tax Credit May Increase the Total Cost of Electricity Production

In subsidizing only the capital cost, the ITC can distort how projects weigh capital costs against capacity factors and maintenance costs. Therefore, the ITC has the potential to increase total levelized costs, inclusive of the subsidy cost to the government.

For example, to achieve a higher capacity factor than would be justified without the ITC, renewable energy projects could decide on technology or geography that involves excessive capital costs. A solar project might include equipment that allows panels to track the sun’s movements, or renewable projects could choose higher-cost locations that are windier or sunnier.

Additionally, projects could spend inadequate amounts on equipment maintenance. One study on wind projects by Joseph E. Aldy and others finds that projects with an investment subsidy generate 10 percent less electricity than they would have with a production subsidy. Two-thirds of this reduction likely is attributable to projects being less available to generate power, a consequence of reduced maintenance spending.

Post-IRA, cost distortions from the ITC may be modest, as an increasing number of projects choose the PTC. Additionally, solar projects have less equipment risk than wind projects, so reduced power generation from diminished availability is a less significant problem. However, two caveats are important. First, offshore wind has high capital costs, making these projects likely to choose the ITC, and high equipment risk, which increases the availability effect from underspending on maintenance. Second, cost distortions from the ITC are limited by the unsubsidized proportion of capital costs, which is reduced by the bonus credits in the IRA.

The Production Tax Credit May Reduce the Value of Electricity Production

Because the PTC subsidizes the quantity of power generation irrespective of the price of power, the PTC may incentivize lower-value electricity, also known as levelized avoided costs. Note that price of power here refers to the private value of electricity; the social value of electricity also would depend on the emissions profile of the displaced power generation. The PTC can reduce the private value of electricity production by distorting decisions that are made by projects for when to generate and where to locate.

Solar and wind power have zero marginal costs of generation, so projects without a PTC typically produce power whenever the prevailing electricity price is positive. With a PTC, projects may find it profitable to generate power even when prices are negative. The aforementioned wind study found that negative prices likely explain one-third of the difference in electricity generation between projects with production incentives versus investment incentives. Accordingly, utility-scale solar projects that choose the PTC should cause more negatively priced electricity.

Before projects choose when to generate power, they must decide where to locate. In selecting a site, utility-scale solar and wind projects weigh the costs of generation at a given location against the prospective revenues and subsidies (from the ITC or PTC and renewable energy credits). Unlike the ITC, the worth of the PTC varies greatly by location because of the large regional differences in capacity factors. Without a PTC, a project in a high-resource location could be unprofitable if energy and capacity values there are low. However, the same project with a PTC—if curtailment does not significantly reduce output—may be profitable even with minimal revenues.

By incentivizing the quantity of electricity generation rather than the value of the electricity, the PTC may skew projects toward high-resource locations. Because of the constraints on tax equity supply, the PTC may deter the installation of projects in locations where the value-to-cost ratio would be higher.

Increasing the Value of Electricity Production

The likely selection of the PTC accelerates the importance of technology and policy responses to low-value power. Energy storage and flexible demand can help address the time-related components of low electricity prices. Energy storage can transfer a portion of low-value electricity to times when prices are higher, and flexible loads can be moved to be coincident with peak solar generation. To help equalize electricity prices across space, increased transmission capacity is needed. Expanding transmission would require policy changes that address permitting delays in building new transmission lines and that provide incentives for implementing grid-enhancing technologies which increase the capacity of existing lines.

Conclusions