Tax Incentives for Innovative Energy-Efficient Technologies

Howard Geller

1999

Note: This report has been updated. Click here to view the new executive summary or to view the full report as a PDF document.

Executive Summary

As part of his Climate Change Technology Initiative (CCTI), President Clinton has proposed a set of tax credits to stimulate the commercialization and sales of innovative energy efficiency and renewable energy technologies. This report reviews previous experience with tax credits for energy efficiency measures, outlines principles to follow when designing new tax credits, provides comments on the energy efficiency tax credits proposed by the Clinton Administration as well as by members of Congress, and estimates the potential carbon savings that could result from the proposed tax credits.

Review of Previous Energy Efficiency Tax Incentives

Tax incentives were enacted during the 1970s to stimulate adoption of both residential and industrial energy efficiency measures. The Energy Tax Act of 1978 included a 15 percent tax credit up to a maximum of $300 for residential conservation and renewable energy measures including insulation, storm windows and doors, weatherstripping, and furnace modifications. During 1978-85, there were about 30 million claims for the residential tax credit, amounting to nearly $5 billion in lost revenues for the U.S. Treasury. Studies indicate that most of the energy efficiency measures probably would have been installed anyway, meaning a very high "free rider" level.

The Energy Tax Act of 1978 also included a 10 percent tax credit for specified energy efficiency measures installed by businesses. The measures covered included heat recovery equipment, waste heat boilers, energy control systems, and economizers. The Act was amended in 1980 to add cogeneration equipment. This credit cost the Treasury approximately $5 billion during 1978-82. Due primarily to the small magnitude, the credit had little effect on corporate decision making. Again, most of the measures probably would have been installed anyway. Both of these tax credits applied to conventional efficiency measures and therefore did not encourage technological innovation.

Principles for New Energy Efficiency Tax Incentives

Based on the previous experience with tax credits as well as the current policy, market, and technological context, we suggest adopting the following principles in crafting new energy efficiency tax incentives. These principles are meant to yield the greatest "bang per buck," assuming that the funds "available" for these tax credits is limited.

• Stimulate commercialization of advanced technologies

• Establish performance criteria and pay for results

• Pay substantial incentives

• Choose technologies where first cost is a major barrier

• Be flexible in terms of who receives the credit

• Complement other policy initiatives

• Select priorities but "hedge bets"

• Allow adequate time

Review of Administration and Congressional Energy Efficiency Tax Incentive Proposals

The Clinton Administration has followed some but not all of these principles in the set of energy efficiency tax credits it has proposed, which were introduced in Congress by Rep. Matsui and 20 co-sponsors (H.R. 2380).

Vehicles

Cars and light trucks are an obvious target for tax credits since innovative, fuel-efficient vehicles are under active development worldwide. Manufacturers have announced plans to introduce these vehicles but market acceptance is uncertain and first cost could be a barrier. The Administration has proposed extending the current credit for electric and fuel cell vehicles (10 percent up to a maximum of $4,000) through 2006. In addition, Rep. Collins has proposed extending the tax credit for electric and fuel cell vehicles through 2008 and making it a flat $4,000 (H.R. 1108). Sen. Rockefeller has proposed tax credits to promote alternative fuels as well as extending the credit for electric and fuel cell vehicles through 2010 (S. 1003). The Rockefeller bill also increases the maximum credit to $5,000 for electric vehicles with an extended range. We support these proposals, including the increased incentive for vehicles with extended range.

Hybrid vehicles combine a small energy storage system, such as a battery, and an internal combustion engine, thereby overcoming the range problem inherent in all-electric vehicles. After discussions with the "Big 3" automakers, the Administration proposed tax credits for hybrid vehicles starting in 2003 without any fuel efficiency or emissions thresholds. Instead, the credits are based on the capacity of the energy storage system and the amount of braking energy recovery from the regenerative braking system. In our view this proposal is flawed. We believe tax credits for hybrid vehicles should include: (1) minimum fuel economy thresholds reflecting significant efficiency improvements relative to typical vehicles in any size class; (2) requirements that criteria emissions at least meet the prevailing standards for gasoline-fueled cars; and (3) eligibility beginning in 2000 or 2001.

New Homes

The Administration has proposed a tax credit to encourage construction of very energy-efficient new homes. The credit would equal $1,000, $1,500, and $2,000 for new homes that are 30, 40, and 50 percent more energy efficient, respectively, than the 1998 International Energy Conservation Code (IECC). A number of issues need to be addressed, however, in order to make the new homes tax credit practical and prevent a high level of free riders and other unintended consequences such as promotion of homes with electric resistance heating. These issues include definition of prescriptive paths to compliance and fuel-neutral performance tradeoff procedures, and language to prevent overstatement of the energy savings in new homes containing an electric heat pump.

Besides the Administration's proposal, Rep. Thomas has introduced a bill (H.R. 1358) that provides a flat $2,000 credit for new homes 30 percent more efficient than the 1998 IECC. The Thomas bill proposes that the builder be eligible for the credit, which is reasonable as long as legitimate compliance is demonstrated. But the Thomas bill allows self-certification by builders, which could lead to high levels of fraud and abuse. Also, many of the issues that need to be addressed with the Administration's proposal also need to be addressed with the Thomas bill. In addition, we believe the multi-tier approach is preferable because it would encourage and reward higher levels of energy performance.

Building Equipment

The Administration has proposed a 10 percent credit up to $250 for central air conditioners and heat pumps with a seasonal energy efficiency rating (SEER) of at least 13.5 and a 20 percent credit up to $500 for central air conditioners and heat pumps with a SEER of at least 15.0. This tax credit could help to increase the market share and reduce the first cost premium for high-end units that currently have only approximately a 1 percent market share. The Administration also proposed a 20 percent credit up to $1,000 for natural gas-fired heat pumps—systems that provide both heating and cooling using an engine-driven or absorption cycle. After years of research and development (R&D), gas-fired heat pumps are poised for commercialization. We support both of these proposals.

The Administration has proposed tax credits for both highly efficient electric and gas-fired water heaters. In the case of electric water heaters, a 20 percent credit up to $500 is proposed for heat pump water heaters (HPWHs). HPWHs have been manufactured on a limited basis for around 20 years but have never caught on due to high first cost, limited availability, and reliability problems. In the case of natural gas water heaters, the Administration has proposed a 10 percent credit up to $250 for units with an Energy Factor of at least 0.65 and a 20 percent credit up to $500 for units with an Energy Factor of at least 0.80. Very few gas water heaters are sold with an Energy Factor of 0.65 or greater today due in large part to their first cost. We support the HPWH proposal and recommend that the gas water heater credit be extended to high-efficiency water heaters in integrated space and water heating systems.

Fuel Cell Cogeneration Systems

The Administration has proposed a 20 percent credit up to a maximum of $500 per kilowatt (kW) for fuel cell cogeneration systems installed in buildings. Fuel cells are a very promising distributed generation technology offering very low emissions and high electrical conversion efficiencies. The 20 percent tax credit could be valuable for promoting early adoption and helping to move the technology "down the learning curve." But since relatively small fuel cell cogeneration systems might be used in households, we suggest lowering the minimum size threshold from 5 kW to 2 kW.

Combined Heat and Power (CHP) Systems

The Administration has proposed an 8 percent investment tax credit for qualifying CHP systems adopted by businesses. We suggest increasing the credit amount and restricting eligibility to smaller systems (under 50 megawatts [MW]). Specifically, we recommend a 10 percent credit for units 10 to 50 MW, a 15 percent credit for units 1 to10 MW, and a 20 percent credit for units 50 kW to 1 MW. This should reduce the level of free riders and do more to stimulate the adoption of CHP systems that are relatively costly today.

Other Potential Energy Efficiency Tax Incentives

There are other innovative buildings technologies besides air conditioners, heat pumps, water heaters, and fuel cells that conceivably could be promoted through tax credits. If there is interest in expanding the package, we view high-efficiency refrigerators, ground-source heat pumps, and transformers as the next most logical products for which to offer tax credits.

Targeted tax credits also could help to stimulate the introduction of energy-saving innovations in some of the most energy-intensive industrial processes. We see the opportunity for tax credits in the paper and pulp, steel, and aluminum industries, where major innovations are now available or on the horizon. In this case, eligibility could be based on achieving a minimum level of efficiency or reducing energy intensity below some threshold.

Potential Impacts

The Treasury Department estimates that the energy efficiency tax credits will cost the federal government $8.3 billion and renewable energy credits $1.2 billion during 2000-2009. Over the lifetime of products qualifying for the credits, carbon emissions would decline by 100-150 million metric tons (MMT). The Treasury Department also estimates that consumers and businesses will realize energy savings worth $22-33 billion.

The Energy Information Administration (EIA) estimates that the energy efficiency tax credits will only cut carbon emissions 1.6 MMT in 2010. The EIA analysis appears to understate carbon emissions reductions from some of the technologies. Also, the EIA analysis does not take into account the synergistic effects of technology research, development, and demonstration (RD&D), deployment efforts, and tax credits. And the EIA's modeling tool has other serious deficiencies including overstated costs for new and improving technologies, limited technology "learning effects," and the inability to adequately model new technologies.

Both the Treasury Department and EIA analyses consider only the direct effects of the tax credits—impacts from measures actually receiving credits. But economies of scale, technology learning, and market development could lead to indirect impacts many times greater than the direct impacts, as the Treasury Department and the U.S. Department of Energy (DOE) acknowledge. While very speculative, we offer some estimates of plausible indirect effects assuming that the credits along with RD&D and related deployment efforts are successful in stimulating introduction of and growing markets for the various advanced energy-efficient technologies.

We estimate that all units qualifying for the energy efficiency tax credits would reduce carbon emissions by about 4.0 MMT per year (i.e., the direct impact). It should be noted that this estimate includes reductions from any free riders. With growing adoption of the advanced technologies following the phase-out of the credits, the avoided carbon emissions could reach around 14 MMT per year by 2010 and 29 MMT per year by 2015. The latter value is equivalent to 2 percent of U.S. carbon emissions at the present time. Also, we estimate that the cumulative reduction during 2000-2015 could reach approximately 160 MMT.

Conclusion

Tax credits, if properly structured, could play a valuable role in stimulating the introduction and initial sales of important energy efficiency technologies such as hybrid and fuel cell vehicles, highly efficient heating and cooling systems, and very efficient new homes. The Clinton Administration has made a constructive proposal that includes tax credits for a variety of innovative energy efficiency technologies. However, we recommend that certain modifications be made to the Administration's proposals in order to maximize the benefits while minimizing the potential for free riders and other adverse effects.

Since the funds available for tax credits are limited, so will be the direct impact on emissions from the adoption of products qualifying for credits. But that is not an appropriate way to look at the potential impacts. If the credits along with complementary policies and programs are successful, than the sales and market penetration of the advanced technologies will grow after the incentives phase out, leading to indirect emissions reductions many times greater than the direct reductions.

We urge policy makers to test this theory in the real world independent of concerns about the rate of climate change or the Kyoto Protocol to limit future greenhouse gas (GHG) emissions. Put simply, tax credits for innovative energy efficiency and renewable energy technologies could have positive impacts on U.S. businesses, consumers, air quality, and public health, as well as help to reduce GHG emissions and global warming. These credits should be included in any broad-based package of tax cuts and incentives enacted in the near future.

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20pp., 1999, $12.00, E991