Federal Tax Strategies to Encourage the Adoption of Combined Heat and Power

R. Neal Elliott, P.E., Ph.D.

November 2001

Executive Summary

Significant interest has been expressed over the past few years in providing incentives for combined heat and power systems (CHP) through the use of the tax code, both nationally and at the state level. Since the late 1970s, a number of tax incentives have been used to promote investment in energy technologies. These have included both renewable energy and energy efficiency investments, including CHP. These incentives often are intended to support new technological developments until they become cost competitive.

These incentives typically have fallen into three general categories: investment tax credits (ITC), production incentives, and accelerated depreciation. While there are lessons to be learned by CHP proponents from past experiences with tax incentives, the state of the CHP market is substantially different from the energy efficiency and renewable energy markets in the 1970s and 1980s. CHP is a mature technology that, except for market and regulatory barriers, is currently proven and cost effective. In this environment, modest tax credits have been shown to encourage investment when coupled with the removal of market impediments such as siting.

Current interest has focused on ITCs and accelerated depreciation. Six bills have been introduced into the 107th Congress that have included tax incentives for CHP. All six have included some form of ITC, while only one (H.R. 1045) has included shortened depreciation. In addition, significant discussions have occurred in the Senate about shortening depreciation for CHP facilities.

Impact of the Tax Code
The tax situation of a particular taxpayer and the nature of the facility may impact how much benefit is received from a particular incentive. For example, at least two portions of the tax code may limit the ability of businesses to take the credits: the Alternative Minimum Tax (AMT) and Section 38(c), which imposes a maximum limit on business-credits allowable to a particular taxpayer. In addition, different facilities may benefit differently from an incentive depending upon their particular circumstances.

Many CHP experts feel that third-party investors will make a majority of future CHP installations. Under these arrangements, an entity other than the ultimate customer for the asset finances, installs, owns, and/or operates the CHP facility. These arrangements can be beneficial because they can free up the customer's capital, transfer non-core staff from the company, and allow the customer to focus on its core business, be it hospitality or chemicals. These arrangements can take many forms ranging from lease agreements to metered sale of energy service (e.g., electricity, steam, or chilled water).

Use of third parties to develop, finance, or otherwise participate in a project may facilitate full use of tax incentives for CHP. As noted above, in many cases, the ultimate consumer may be unable to benefit fully from tax credits or accelerated depreciation (e.g., because of a lack of sufficient taxable income, the AMT, or business credit limitations). Certain devices exist (e.g., sale-leasebacks) that may allow the benefits to be shifted to a third party who can fully utilize the credits or depreciation.

In addition to meeting the cost of the CHP system, district energy systems face another challenge: meeting the cost of a thermal distribution system. Unlike power output, there is not always the infrastructure necessary to distribute thermal output to end-users. Thus, in order to encourage thermal power CHP, thermal distribution infrastructure should be eligible for the ITC or accelerated depreciation as an integral part of the CHP system. International District Energy Association (IDEA) seeks inclusion of thermal distribution facilities in the definition of CHP assets for the ITC.

Political Considerations
Many tax policymakers do not like tax credits for philosophical and ideological reasons. They view ITCs and other credits as a distortion of the tax code, not useful in properly measuring income and causing additional complexity that does not provide equitable benefits to all parties. Also, many tax economists believe that ITCs and production credits may distort investment decisions. When credits are temporary, investments may be accelerated to take advantage of the incentive, followed by an abrupt discontinuation of investment after the tax credit expires. This phenomenon can lead to financial problems for the suppliers, as occurred with discontinuation of solar energy credits in the 1980s.

The revenue cost of a particular proposal may affect its political viability. This is particularly true in the current legislative climate where any reduction in revenue likely must be matched with a corresponding increase in revenue or reduction in spending. As a result, in addition to political considerations regarding a particular tax incentive directly, passage of any incentive likely will be dependent on political resolve to pass the required offsets.

Environmental non-profit organizations are supportive of tax incentives as long as the incentives carry with them efficiency or environmental conditions that restrict qualification for the credits to certain "environmentally clean" assets. While the standards for environmentally clean can vary, the current bills appear to have settled on an overall 60% system efficiency (higher heating value [HHV]-basis) as the appropriate threshold. This efficiency level exceeds the highest available electricity-only generation technology, combustion turbine combined-cycle power plants.

Some industry groups argue that any qualification standards for "environmentally clean" CHP systems should be applied only to tax credits and not to depreciation adjustments. They believe that faster depreciation is closer to actual economic depreciation and therefore modifications to the depreciation rate are necessary to better reflect income.

Conclusion
Because of CHP's environmental and efficiency advantages, proponents argue that tax incentives should be provided to insure CHP's movement into the mainstream market. The best form and the appropriate details for such incentives are somewhat subjective. The two most discussed options-accelerated depreciation and ITCs-have had mixed success historically, provide varying benefits and drawbacks for different groups, and are subject to certain political and policy concerns.

While plausible arguments can be made for either ITCs or shortened depreciation period, unfortunately neither offer the clearly best formula for encouraging CHP investment. The ultimate choice is a political one.

18 pp., 2001, $12.00, IE015

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