Without Sufficient Guardrails, the Hydrogen Tax Credit Could Increase Emissions

April 3, 2023 | 12:50 pm
Storm gatheringJames Murnan/NOAA
Julie McNamara
Senior Energy Analyst

Last year’s Inflation Reduction Act (IRA) included a clean hydrogen production tax credit (known as “45V”) that is one of a slew of new incentives intended to help catalyze the next and necessary phase of advancing the nation’s clean energy transition as a whole. Unless the government adopts a similarly holistic perspective when implementing the tax credit, though, the incentive could wind up doing more harm than good.

The framing is consequential. Solutions considered in isolation can often appear to yield steady progress in curbing carbon pollution and yet, when those same solutions are considered within the full context of the energy transition, their actual contributions can turn out to be insufficient or, worse, entirely misaligned, resulting in a system-wide increase in emissions.

That’s the nightmare scenario we’re facing now as federal regulators establish guidelines for implementing the new hydrogen tax credit. If the credit is based on a narrow evaluation of the impact of hydrogen production, it will appear to be driving the deployment of clean hydrogen when considered in isolation. In reality, though, when we factor in impacts across the energy system as a whole, that “clean” hydrogen could be increasing emissions overall.

Ultimately, where and how the federal government defines the hydrogen tax credit’s evaluation boundaries will make the difference between spending $100 billion to drive climate progress—and spending $100 billion to undermine it.

It’s not surprising to see companies lobbying to try to optimize this lucrative credit for their profits rather than ensuring the produced hydrogen is genuinely low-carbon, but it is astounding to see regulators at risk of following suit.

Given the magnitude and pace of carbon emissions reductions required to meet climate targets, it is untenable to knowingly enable a wide-scale regression in climate progress; dressing up such a regression as clean energy progress is nothing short of unforgivable.

To ensure that the hydrogen production tax credit is indeed a durable contributor to the near- and long-term clean energy transition, regulators must institute guardrails that consider impacts to the energy system as a whole from the outset. The costs will be too great otherwise.

Aligning hydrogen production with the clean energy transition

Right now, hydrogen is not advancing the clean energy transition. It is overwhelmingly produced by a process known as steam methane reforming (SMR), which is heavily carbon-polluting, and the resulting hydrogen is primarily consumed as a feedstock for industrial purposes, such as oil refining and fertilizer production, not as a way to displace fossil fuels.

For hydrogen to achieve its potential as a valuable—albeit limited—contributor to climate progress, its production must be cleaned up and, because it is so energy-intensive to make compared to other decarbonization solutions, it should be prioritized strategically for use only when and where there are no better alternatives.

The IRA’s 45V hydrogen production tax credit focuses solely on the first part of the equation: decarbonizing the hydrogen production process. It does this by deeply subsidizing low-carbon hydrogen production, putting the price of clean hydrogen within range of today’s heavily polluting form—and in some scenarios, not only out-competing SMR pricing, but potentially meeting or exceeding the actual cost of clean hydrogen production itself.

Because the $3 per kilogram top tier of the tax credit is high enough to independently drive hydrogen production without any demand pull, and because it’s entirely divorced from strategic frameworks informing where and how hydrogen should best be deployed, it’s all the more vital that the hydrogen the credit incentivizes is truly climate-aligned and adds to the clean energy transition overall.

Defining “carbon intensity” in the 45V tax credit

The Treasury Department, which is developing the implementation requirements for the tax credit, has one metric available to it to ensure such alignment: the carbon intensity of the hydrogen produced.

While this metric appears limited on its surface, the underlying statute explicitly states that the carbon intensity is to be assessed based on a lifecycle analysis inclusive of upstream impacts. Furthermore, it goes out of its way to provide a definition by reference for “lifecycle greenhouse gas emissions” that unambiguously includes indirect emissions impacts, too.

When it comes to hydrogen production, these two points matter—a lot.

That’s because the primary pathway proposed for low-carbon hydrogen production–carbon-free electricity powering electrolysis–can have wildly different carbon intensity values depending on where those analytical system boundaries are drawn.

Electrolysis, which uses electricity to split water into hydrogen and oxygen, releases no carbon emissions at the point of production. However, the electricity powering that electrolyzer can release emissions, and because of how energy-intensive electrolysis is, those emissions can add up—fast. In fact, running an electrolyzer on today’s average grid mix would result in hydrogen with a carbon intensity more than twice as high as traditional fossil fuel-based SMR—the heavily polluting process we’re racing to replace.

That’s why it is so important that the tax credit’s carbon intensity calculation also consider the emissions from the electricity sources powering the electrolyzer.

But, as important as those considerations are, even that broader perspective is insufficient.

It also matters whether or not the carbon-free energy an electrolyzer uses is additional to the clean energy already on the grid.

That’s because electrolyzers will increase system-wide electricity use—potentially a lot—and if more carbon-free electricity is not brought online to compensate for that increase, then the system will have simply shifted existing carbon-free energy from one user to another while fossil gas and coal plants ramp up to cover the gap.

This won’t be a problem in the future when renewable energy predominates. But right now there is little slack in renewable energy buildout and use. Unrestricted electrolyzer deployment threatens to divert and devour our nation’s fledgling clean energy progress, driving up system-wide pollution, stalling fossil fuel plant retirements, and slowing adoption of the foremost climate change solution: directly electrifying fossil fuel end uses with ever-cleaner electricity. And this isn’t just hypothetical. Large industry players are already lining up projects that, if allowed to proceed without guardrails, could result in exactly these outcomes. All of which means that it is critical that we include indirect emissions in the final carbon intensity calculation, too.

Here’s how the Treasury Department can design the tax credit guidance to make sure that happens.

Effective implementation guidance needed

There are three key requirements to ensure that implementation of the hydrogen tax credit appropriately anchors evaluation of the carbon intensity of electrolytically-produced hydrogen in the full system context: (1) additionality of the clean electricity claimed by electrolyzers to the clean energy transition overall, (2) deliverability of that claimed electricity to the actual point of electrolyzer use, and (3) time-based matching of electricity supplied and electricity used.

  1. New clean energy supply: Adding electrolyzers to the grid will significantly increase electricity demand. For the current power sector transition to continue driving down fossil fuel use, even more renewable energy than is already coming online will need to be added to account for this new load. Otherwise, existing carbon-free resources will simply be diverted to electrolyzers resulting in no actual incremental clean energy progress and, in fact, potentially significant regression in power sector efforts to ramp down the use of coal and gas plants.
  2. Deliverability: When an electrolyzer is powered by a behind-the-meter, or on-site, renewable energy project, there is no question regarding whether that resource directly powers the electrolyzer. But when the electrolyzer is tied to the broader grid, even if it directly contracts for new, incremental clean power, if supply and demand are in different regions or separated by transmission constraints then the electrolyzer would actually force an increase in generation wherever it’s located—and that marginal generator may be more heavily polluting than the resources being displaced by the contracted supply. A deliverability requirement, such as is included in many renewable portfolio standards today, would guard against that.
  3. Time-based matching: Electrolyzers benefit from high-capacity use. All else being equal, projects will want to run more than less. Incremental, deliverable electricity will be required to serve that use. But it’s also critical to ensure that the hours when electrolyzers are consuming electricity are the same hours as when the procured carbon-free resources are producing. If not, the mismatch is likely to be filled by fossil fuels. For instance, an electrolyzer running in Florida can cheaply contract for solar energy sufficient to cover its annual electricity consumption. However, without constraints, that electrolyzer will run day and night, meaning in reality, a significant share of its actual annual electricity use will be covered by gas generators overnight. Using hourly tracking systems implemented or under development by M-RETS, PJM, and others can address this.

One thread of objection to the above requirements has come from vested interests with clear financial windfalls premised on particular implementation strategies—see, for example, nuclear owners wanting time-based matching but not additionality, or high-solar-potential utilities wanting additionality but not time-based matching.

Setting aside these transparently self-serving protestations, however, the primary point of objection to the above has not, in fact, been that the argument is incorrect. Instead, it is a suggestion that this level of rigor could slow the near-term build out of electrolyzers and thereby stunt the nation’s clean energy transition as a whole, concluding that rigor should only be ramped up over time.

Such a position implicitly greenlights a clean energy subsidy driving a substantial increase in emissions. According to one estimate, by 2030, loose implementation could result in a “clean” hydrogen sector emitting more than double the 100 million metric tons (MMT) the fossil fuel-heavy hydrogen sector emits today. Those new emissions would be equivalent to running 26 more coal plants.

But beyond that, if one can get beyond that—and the Treasury Department shouldn’t, given the clear statutory requirements of the law—this approach would also fail on two more critical fronts.

First, near-term hydrogen deployment under looser implementation requirements threatens to drive development of hydrogen production projects and adoption of hydrogen end-use applications that are entirely misaligned with the strategic prioritization ultimately required—and at the extremely steep cost of delaying the actual solutions and investments needed.

Second, this approach banks on the assumption that the federal government will strengthen these implementation guidelines in the future, which very well may not come to pass. Planning for future standard-strengthening ignores the decades-long history of howls from industry killing the best-laid regulatory update plans. As we’ve seen time and again, when profits are on the line, industry will use its influence to push back. If—if­—a phase-in period were to be adopted, it would have to include an iron-clad transition date from the outset, not simply some future intention to evolve.

Which means that, ultimately, it’s imperative to get it right from the start, even if getting it right results in some slowing of deployment, because the alternative is that we get it wrong for a long time to come.

What about other hydrogen production pathways?

Concerns about evaluating the carbon intensity of electrolytically derived hydrogen have dominated the hydrogen tax credit implementation discussion for good reason: It’s the likeliest pathway to receive the top tier of the tax credit, it’s at the greatest risk of derailing the power sector transition if it’s improperly implemented, and other pathways have alternative tax credits available to them that could prove more lucrative than the tax credit’s lower tiers, especially the 45Q carbon capture and sequestration (CCS) credit for SMR projects coupled with CCS.

Still, there are also some real accounting concerns with these other pathways, which could similarly enable the production of climate-misaligned, polluting forms of hydrogen advanced under the guise of “clean.” Carbon intensity calculations for these pathways must fully and rigorously include upstream emissions, including methane leaks.

One loophole that threatens to cut across all pathways is accounting around biomethane, or “renewable natural gas.” By some carbon intensity accounting frameworks, biomethane can result in negative carbon intensity values—meaning, effectively, that its very production results in a net removal of carbon from the system. Beyond the often-flawed assumptions leading to such negative scores, the existence of negative carbon intensity values can also lead to pernicious gaming behaviors by hydrogen producers, making it critical that—at an absolute minimum—the Treasury Department bar producers from offsetting positive carbon intensity values with negative values to qualify for a given credit tier.

The long tail of weak implementation

Despite its real potential to be a valuable contributor to the nation’s economy-wide clean energy transition, hydrogen ultimately has a high bar to clear—both in its production and its end uses.

The clean hydrogen production tax credit is intended to ease the path for producers that are able to clear the first hurdle, with large incentives for climate-aligned hydrogen production. But reality will only match that vision if regulators make sure the tax credit is implemented in such a way that guarantees that what we are rewarding for being low-carbon is, in fact, low-carbon.

The imperative is all the greater given that there is no parallel policy guiding strategic hydrogen deployment, which significantly increases the risk that near-term production subsidies will drive hydrogen uptake in applications that are not, ultimately, aligned with the requirements of a system-wide clean energy transition.

If the end uses are inadequate and the “clean” hydrogen is dirty? That would be a colossal, indefensible waste of time and money both.