Plugging 21st century technology into a 19th century grid system

Gilbert E. Metcalf , 26 January 2009

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In a recent speech at George Mason University, US President Barack Obama said he wanted to build a “smart” electric grid that would deliver “clean, alternative forms of energy to every corner of our nation.” This is one element in the new administration's larger plan to increase renewable sources’ share of electricity production to 10% by 2012 and 25% by 2025.

The challenges to meet these goals are large. While over 8% of our electricity currently comes from renewable sources, nearly three quarters of that is conventional hydropower – a power source that will be difficult to expand given limited remaining hydro sources in the US. The Obama team seeks significant growth in wind, solar, and other renewable sources. To get to a 10% penetration level by 2012 will require a quadrupling of the generation share for these sources over the next four years. This will be a challenge.

If history is any guide, federal tax policy will be central to the administration's policy. A recent report from the US Energy Information Administration documents that the single largest source of support for energy in the federal budget is the tax code, accounting for nearly two-thirds of all federal support. Subsidies include production and investment tax credits for renewable energy production, accelerated depreciation, depletion allowances for oil and gas, and a host of other provisions. Recent analyses by the Congressional Budget Office (2005) and Ernst and Young (2007) provide estimates of the effective tax rate on energy capital investment. The CBO report looks at broad capital categories and does not attempt to account for energy-specific provisions of the tax code. The Ernst and Young report reports effective tax rates on energy capital at a more disaggregated level but also does not account for the most significant energy subsidies in the tax code. Both reports suggest relatively high effective tax rates for energy investments but both neglect key provisions of the tax code directed to new energy investments.

Negative effective tax rates on new energy capital investments

In Metcalf (2009), I measure the effective tax rate on new energy capital investment at a highly disaggregated level and incorporate the most important energy provisions of the US tax code. The results suggest that previous estimates of the effective tax rate on energy capital investments are too high and shed some light on recent investment and planning activity in the US.

First, once we take account of energy-specific tax provisions effective tax rates on certain electricity generation investments are very low. The effective tax rate on new nuclear power construction that is eligible for a 1.8 cent per kWh production tax credit is -100%. That means that if a project requires an after-tax return for investors of 10% (for example), the project need only earn a before-tax return of 5%. Tax benefits, including the production tax credit as well as generous depreciation allowances, will double the return. Effective tax rates are also negative for wind, solar, and advanced coal production (integrated gasification combined cycle or IGCC) that can be modified to capture and store carbon emissions (see table below).

These negative effective tax rates are driven primarily by the production and investment tax credits. Removing the credits but maintaining other tax benefits including the rapid tax write-off of the assets drives the effective tax rates up to 12-39%, depending on the technology. These tax benefits help to explain the explosion in wind investment in the past few years. US wind capacity grew by 50% in 2007 and is projected to have grown by a similar amount in 2008. Meanwhile applications for combined construction and operating licenses for nuclear power plants were filed for nine projects totalling fifteen units with 18.5 GW of capacity between March 2007 and June 2008.

Table 1. Marginal effective tax rates on new energy investments in the US

 
I. Electric Utilities  
Generation  
Nuclear -100%

Coal (PC)

39%
Coal (IGCC) -12%
Gas 34%
Wind -164%
Solar Thermal -245%
Transmission and Distribution  
Transmission Lines 34%
Distribution Lines 39%
2. Petroleum  
Oil Drilling (non-integrated firms) -14%
Oil Drilling (integrated firms) 15%
Refining 19%
3. Natural Gas  
Gathering Pipelines 15%
Other Pipelines 27%

Source: Metcalf (2009). Notes: Negative numbers indicate subsidy at the margin. PC stands for Pulverised Coal and IGCC stands for Integrated Gasification Combined Cycle.

Plugging 21st century technology into a 19th century grid system

The importance of these tax incentives for investment is well documented. Wiser and Bolinger (2008) chart the sharp declines in wind investment that occurred in the various years in which Congress allowed the production tax credit to briefly expire. The current production tax credit for wind expires at the end of 2009 and we can anticipate efforts to extend it.
Second, tax rates are surprisingly high on transmission and distribution capital: 34% to 39%. Recent legislation – not accounted for in Table 1 – lowers the effective tax rate on some smart metering equipment from 34% to 25% but the rate is still higher than the tax rate on most oil and gas capital investments.

Why does this matter? The Obama plan to ramp up the production of renewable electricity will be plugging 21st century technology into a 19th century grid system – a grid system that would look uncomfortably familiar to George Westinghouse and Thomas Edison, electricity pioneers from the past. Without the build-up of a modernised and truly nationwide electric grid, much of the investment in remote wind farms and solar power plants will be for naught.

Already many wind and solar plants aren’t being used to their full potential because the electricity they generate can’t be moved to where it is needed. With wind, solar, and other non-hydro renewable sources accounting for only 2% of the nation's electricity, the consequences are not yet being felt. But if we are to reach penetration levels of 15% to 20%, a smart grid will be necessary. We will also need investment in a transmission backbone – a high voltage interstate highway system for electricity – to move solar and wind power from prime production areas in the Midwest and Southwest to major population centres. It won't be cheap. A recent analysis by the National Renewable Energy Laboratory estimates the need for an investment of $60 billion over ten years in grid capacity to achieve a goal of 20% wind power in the US.

When electricity was deregulated in many parts of the country, policymakers were forced to grapple with the legacy of stranded energy projects – power plants built before deregulation that could not recover their costs in the newly deregulated market. We are now creating a new form of stranded energy. Wind farms and solar thermal plants are best built in areas with plentiful and reliable amounts of wind and sun. These tend to be in areas far from population centres, where the electricity is needed. Without major improvements in and expansions to the current grid, those projects will be stranded, too. A power grid that can't transport green electricity to the nation's growth centres is the ultimate bridge to nowhere.

A comprehensive energy policy will include a carbon price (either cap and trade or a carbon tax) and some rationalisation of marginal effective tax rates across different types of energy investment. It is arguable whether production and investment tax credits for renewable energy will be necessary if a credible and sustained carbon price is put in place, but policies to ensure investment in the transmission grid will be essential. More R&D and careful scrutiny of state and federal policies that govern new grid investments are essential, but so is a tax code that offers the right financial incentives to make those investments.

Editors' note: This column is a Lead Commentary on Vox's Global Crisis Debate where you can find further discussion, and where professional economists are welcome to contribute their own Commentaries on this and other crisis-linked topics.

References

Congressional Budget Office. "Taxing Capital Income: Effective Tax Rates and Approaches to Reform," 2005. Washington, DC: CBO.

Ernst & Young. "International Comparison of Depreciation Rules and Tax Rates for Selected Energy Investments." 2007. Washington, DC: Ernst & Young.

Metcalf, Gilbert E. "Taxing Energy in the US: Which Fuels Does the Tax Code Favor?" 2009. New York: The Manhattan Institute.

National Renewable Energy Laboratory. "20% Wind Energy by 2030," 2008. Washington, DC: Department of Energy.

US Energy Information Administration. "Federal Financial Interventions and Subsidies in Energy Markets 2007," 2008. Washington, DC: EIA SR/CNEAF/2008-01.

Wiser, Ryan and Bolinger, Mark. "Annual Report on Wind Power Installation, Cost, and Performance Trends: 2007," 2008. Washington, DC: US Department of Energy



 

Topics: Energy
Tags: clean electricity, Renewable energy, tax policy, US

Professor of Economics, Tufts University