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Summer 2023: Net Zero

Will Enhanced CO2 Tax Credits Breathe a New Life into Carbon Capture Projects?

Kingsley Sarfo Osei


  • Breaks down the types of Carbon Capture, Utilization, and Storage (CCUS) technologies and how they are used to address climate change.
  • Analyzes Section 45Q Tax Credit and the procedures for earning credits.
  • Discuses how deploying CCUS technologies is essential for the Unites States’ contribution towards achieving net-zero.
Will Enhanced CO2 Tax Credits Breathe a New Life into Carbon Capture Projects?
zhongguo via Getty Images

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Carbon dioxide (CO₂) is the most significantly emitted greenhouse gas (GHG) that traps heat in the earth’s atmosphere, which, according to predominant scientific findings, contributes considerably to climate change. CO₂ emissions come from industrial activities, such as fossil-based electric power generation, petrochemical plants, steel, and cement production. The largest source of GHG emissions from human activities in the United States is burning fossil fuels for electricity, heat, and transportation. After a COVID-19 impact slowdown, which saw an approximately 5% decrease of global CO₂ emissions, in 2022 global anthropogenic fossil CO₂ emissions rebounded by 5.3% compared to 2021, totaling 37.9 gigatons CO₂, just 0.36% below 2019 levels.

Decarbonizing fossil-based energy production and industrial processes to achieve net-zero carbon emissions by targeted dates is at the heart of most energy transition initiatives worldwide. While acknowledging the wholesale transition from fossil-based industrial processes to zero-carbon sources, such as solar and wind, may be inevitable in the long term, promoting technologies that decarbonize fossil-based energy sources is now a significant component of U.S. federal energy policy. Consequently, the Biden administration’s flagship infrastructure bill, the Inflation Reduction Act, 2022 (IRA), Pub. L. No. 117-169 (Aug 16, 2022), included significant enhancements to the existing tax incentive regime for developing and commercializing Carbon Capture, Utilization, and Storage (CCUS) technologies that have been in place since 2008 but have not resulted in the large-scale development and commercial scaling of CCUS technologies.

The IRA remarkably enhances the existing tax incentive regime or “carbon oxide sequestration credit” encapsulated in § 45Q of the Internal Revenue Services (IRS) Code in significant ways to boost the CCUS industry. Section 45Q was first enacted in 2008. It initially provided a certain amount of monetary credit for the removal of CO2 to be either permanently stored through transformative use, employed in enhanced oil recovery (EOR), or held in a geologic formation.

This article will examine how owners and developers of CCUS technologies constrained by the law and IRS guidance in taking full upfront advantage of § 45Q could instead monetize the incentive. The article will further examine the viability of existing CCUS technologies and how owners and investors should use a tax equity structure such as a “partnership flip” to optimally take advantage of § 45Q in instances where they are constrained to do so because they lack the requisite tax liability to take advantage of the incentives directly.

Types of CCUS Technologies

CCUS refers to technologies that remove CO2 from flue gases emitted from fossil-based industrial activities such as coal-fired power plants, oil refining, and cement production. Such technologies combine CO2 removal with either recycling the captured CO2 for commercial use or permanent storage. Even though worldwide, CCUS technologies for energy and industrial applications are evolving, commercially viable technologies can be classified into the following described categories.

Post-combustion CO2 capture technologies, as the name implies, employ the post-combustion capture process to separate CO2 exhaust gases created by burning fossil fuels such as coal and natural gas. In many energy and industrial applications such as thermal power and petrochemical plants, the exhaust gases that are emitted by combustion would be a mixture of CO2, nitrogen (N), and oxygenated compounds such as sulfur dioxide (SO2), nitrogen dioxide (NO2), and oxygen (O2). The exhaust gases are first treated to remove particulate matter and the oxides of nitrogen and sulfur. In most mature post-combustion CO2 capture or separation technologies, chemical adsorption reagents are used to cleanse the flue gas of its toxic mixture, typically consisting of CO2 and other oxygenated compounds such as SO2, NO2, and O2, before being released into the atmosphere. Aqueous monoethanolamide solutions such as amine are the most used reagents since they are more efficient in absorbing CO2. The post-combustion carbon capture process begins by scrubbing the flue gas in the vessel containing the absorber. The CO2-containing solvent is transferred to another vessel where the CO2 is released, and the solvent used can then be recycled into the process. The scrubbed CO2 is then compressed and transported.

On the other hand, precombustion capture technology removes CO2 from fossil fuels before combustion. For example, in a coal plant gasification process, the plant’s feedstock would be partially combined chemically with O2 or oxidized in steam and O2/air under high temperatures and pressured to form a synthesis gas (syngas). This syngas is a mixture of hydrogen (H), carbon monoxide (CO), CO2, and smaller amounts of other gaseous components, such as methane. The syngas can then undergo a water-gas shift reaction whereby carbon monoxide interacts with water vapor to form carbon dioxide and hydrogen: CO + H2O CO2 + H rich gas mixture. The concentration of CO2 in this rich gas mixture can range from 15–50%. After that, the CO2 can then be captured, separated, transported, and ultimately sequestered, and the H2-rich fuel can be combusted. The technology required for pre-combustion capture is widely applied in fertilizer manufacturing and hydrogen production.

The third category of CCUS in the market is oxy fuel combustion CO2 capture technology. In this CCUS process, the bulk of the nitrogen from a fossil-fired fuel source is removed from the air before combustion. The resulting combustion products will have CO2 content up to about 90% (dry basis). The flue gas impurities, predominantly O2, N2, and Argon (Ar), may be removed by reducing the flue gas (at moderate pressure) to a temperature where the CO2 condenses and the impurities do not. Oxyfuel combustion may be employed with solid fuels such as coal, petroleum coke, biomass, and liquid and gaseous fuels.

Storage of Captured CO2

The International Energy Agency, in its Clean Technology Scenario, uses the energy system pathways whereby the CO2 emissions trajectory is reduced by around three-quarters from today’s levels by 2060 and CCUS deployment reaches 115 gigatons of CO2 (Gt CO2) with 93% of the captured CO2 permanently stored. As to whether those ambitious targets would be met remains unknown. However, 2019 estimates put projects under development to have capacity to capture and store 40 million tons of CO2 per year. Thus, the rapid acceleration of global capacity for CCUS is required to get us near those ambitious targets. Another aspect to reaching these ambitious targets involves ensuring that where the storage of the captured CO2 is not integral to an onsite commercial use function of the CCUS technology, such as converting the captured CO2 to produce, for instance, ammonia sulfate fertilizer, the captured CO2 would be compressed and transported by pipeline, ship, rail, or truck to be injected into deep geological formations (including depleted oil and gas reservoirs or saline aquifers). To accelerate the progress of the commercial-scale adoption of CCUS technologies, besides legal and policy initiatives, investments in geologic or saline aquifers storage and related infrastructure such as transport, i.e., pipelines, ship, barge, and rail, are imperative.

Deployment of CCUS Technologies in North America

CCUS development and deployment worldwide are becoming more viable because of their technological evolution and incremental policy initiatives adopting them to address climate change. In North America, most CCUS technologies are either in the pilot or experimental stages. Notable commercial-scale projects cited for their promise are the Boundary Dam coal power plant in Saskatchewan, Canada, and the Petra Nova plant in Texas. While the Boundary Dam Project is ongoing, the Petra Nova Project was suspended in 2020. Petra Nova was a coal-based project that relied on CO2 captured for utilization for EOR, a tertiary technique designed to ultimately produce 30–60%, or more, of the reservoir’s original oil in place. This CCUS project, undertaken by NRG Energy and JX Nippon Oil to retrofit one of the boilers at their WA Parish Generating Station with a post-combustion CCUS, targeted a CO2 capture rate of approximately 90% from a slipstream of flue gas to use or sequester about 1.4 million metric tons annually. The project was taken offline in May 2022 due to the generally deteriorating economics of CO2 capture including the unattractive § 45Q tax credit in place at that time and depressed oil prices that resulted in lower CO2 prices for EOR. See Corey Boettiger, Is the Petra Nova CCS Restart Bullish for Coal Carbon Capture?, Factset (Feb. 16, 2023).

In most mature post-combustion CO2 capture or separation technologies, chemical adsorption reagents are used to cleanse the flue gas of its toxic mixture.

In early February of this year, the owners announced that the facility will resume operations. This decision was ostensibly influenced by the increased CO2 capture credits for EOR sold for utilization, which has gone up from around $12 per ton to $60 per ton. Additionally, oil prices have nearly doubled from $40 per barrel of crude oil in 2020 around the time Petra Nova shut down to $80 per barrel currently, resulting in higher prices that can be fetched for the captured CO2.

On the other hand, the Boundary Dam project in Canada has been operating since 2014. This project is in the Canadian province of Saskatchewan and is an integrated demonstration project designed to capture one million metric tons of CO2 annually. It is a post-combustion CCUS with its primary purpose to capture CO2 to be EOR for the Weyburn Oil Field, also located in Saskatchewan. It is, however, deemed to have sub-optimally performed because the CO2 capture rate as of 2021 was less than 37% of the official target of 90%. Further, and to cite as an example, this CCUS project was retrofitted into 110 MW, installed capacity to Unit 3 of the six-unit, 563 MW coal-fired plant and is reported to have prevented the emission of 442,126 tons of CO2 in a 12-month window, less than half of the one million tons of the projected equipment’s capability.

However, the improved incentives provided by IRA examined below are expected to boost the economic viability of CCUS. Among other incentives, the increases in tax credits and lowering of the annual capture requirements, among others, are expected to significantly improve the economics of many projects accelerating widespread commercial scaling.

Evolution of the Section 45Q Tax Credit

Section 45Q was first introduced to the IRS Code in the Energy Improvement and Extension Act of 2008 (Division B of Pub. L. No. 110-343) as a CO2 removal and storage tax credit. It was the meaningful first and the original attempt to incentivize the deployment of CCUS technology in the United States. It attempts to legislatively incentivize the deployment of “clean coal” technology that is cleaner, more efficient, and environmentally responsible for reducing its CO2 emissions. To qualify for tax credits, captured CO2 must be stored underground in certain geologic formations, used for CO2 enhanced oil recovery (CO2-EOR), or utilized in other projects that permanently sequester CO2.

Carbon capture project developers can receive the § 45Q tax credit as a fully refundable direct payment as if it were an overpayment of taxes.

As initially intended, § 45Q provided a tax credit for each metric ton of qualified CO2 captured and sequestered in secure geological storage or used commercially, such as a tertiary injectant in an oil or natural gas extraction process. However, the limitations of the incentives were evident from the economically unfeasible overall low cap of 75 million tons of qualified CO2 captured by all projects and the relatively unattractive value of, for example, $50 a ton for sequestered industrial or power emissions and emissions captured from the atmosphere and sequestered CO2 stalled interest in developing projects to claim the credit. As a result, in 2018, the Bipartisan Budget Act of 2018 made substantial amendments to the tax code. Among many significant changes, the amendment extended the credit to taxpayers who use carbon capture equipment to capture and sequester suitable CO2 at a qualified facility; eliminated the 75-million-ton program limitation for claiming § 45Q credits; and increased the value of the § 45Q credit from $20 to $50 per metric ton for secure geologic storage projects and from $10 to $35 for CO2 EOR projects.

Even though the 2018 amendment to § 45Q was welcomed by the CCUS industry, uncertainty pertaining to, for instance, forfeiture of the credits of projects that previously earned credits led to a tepid acceleration of projects under consideration. Considering this and several industry concerns, in 2020, the U.S. Treasury Department and the IRS released clarifying guidelines. See Revenue Ruling 2021-13 (Rev. Rul. 2021-13). Among other things, these final regulations laid out the procedures to determine adequate security measures for the geological storage of qualified CO2, exceptions for assigning or attributing third-party taxpayers to claim tax equity transactions, the definition of carbon capture equipment, and standards for measuring utilization of qualified CO2.

The New IRA Enhancements

The IRA is a significant stimulus for CCUS investment, as it expanded and extended the § 45Q tax credit. Specifically, the IRA increased the tax credits’ values, extended eligible projects’ construction deadlines, provided a direct payment option for receiving a credit, and has further broadened transferability provisions for the tax credits. The following is a more specific discussion of the enhancements.

First, the IRA increased the tax credit value for CO2 captured from industrial and power-generation facilities and sequestered in storage in saline geologic formations from $50 to $85 per ton. The tax credit for CO2 captured from industrial and energy-generation carbon capture utilization increases from $35 to $60 per ton and for CO2 by direct air capture (DAC) sequestered in saline geologic formations, from $50 to $180 per ton. The credit can be realized for 12 years after the CCUS equipment is placed in service and will be inflation-adjusted beginning in 2027 and indexed to the base year 2025.

Second, the construction window for building CCUS projects is extended seven years to January 1, 2033. This change means that projects must begin physical work by January 1, 2033, to qualify for the credit. Carbon capture project developers can receive the § 45Q tax credit as a fully refundable direct payment as if it were an overpayment of taxes. For-profit, tax-paying entities can only realize the direct pay option for five years after the carbon capture equipment is in service. Tax-exempt entities such as states, municipalities, tribes, and cooperatives can realize the direct payment option for 12 years after the carbon capture equipment is in service.

Third, IRA allows an owner of a qualified CCUS project to monetize § 45Q credits by selling any portion of its § 45Q credits to third parties for cash or (in specific years) seeking direct payment for § 45Q credits from the Treasury. Recipients of the § 45Q tax credit may transfer all or any portion of the credit value to any third-party, tax-paying entity in exchange for a cash payment during any part of the 12-year credit window. The cash payment received by the original recipient of the § 45Q credit will not be taxable.

Lastly, the IRA broadens § 45Q’s existing definition of the qualified facility by lowering the annual carbon capture threshold requirements. Under the revised definition, a qualified facility includes any CCUS facility placed on an electric-generating facility that captures 18,750 tons of carbon annually and has a capture rate of at least 75% as measured by a functional electric generating unit’s—as opposed to the entire electric developing facility’s—baseline CO2 production. Specifically, the capture threshold for credit-eligible power generation facilities decreases from 500,000 tons of CO2 emitted annually to 18,750 tons. The capture threshold for industrial facilities falls from 100,000 tons of CO2 emitted annually to 12,500 tons. The capture threshold for DAC facilities reduces the amount of CO2 capture requirements from 100,000 tons captured per year to 1,000 tons. Power generation facilities seeking to qualify for the credit must meet a capture design capacity requirement of not less than 75% of the CO2 from an electricity-generating unit that will install capture equipment.

Monetizing the Tax Credits

Though the IRA makes the credit easier to claim by lowering capture volume requirements, implements a direct pay for a period of five years, and enables the credit to be transferred to other parties, the thresholds for filing claims largely benefit established revenue-generating companies that have significant tax burdens to reduce. Thus, most developers of CCUS technologies cannot claim the tax credits since they lack the tax liability required to absorb them. As such, federal tax guidelines allow a developer to monetize the tax credits, allowing it the option of exchanging its credits for monetary payments from tax equity investors with an adequate tax liability to absorb the tax credits. Developers and investors often execute monetization strategies through partnership flips and sale-leaseback transactions.

The IRA also includes changes that could result in significant adjustments to how § 45Q credits are monetized, potentially diminishing the need for complicated tax equity structures to harvest the benefits of § 45Q credits, which could expand the investor marketplace for CCUS projects. Most importantly, the IRA allows an owner of a qualified CCUS project to monetize § 45Q credits by selling any portion of its § 45Q credits to third parties for cash or (in specific years) seeking direct payment for § 45Q credits from the Treasury.

To qualify as an owner, Rev. Rul. 2021-13 requires that the investor own at least one component of CO2 capture equipment in the “single process train” of carbon capture equipment at a facility. Under a “single process train” construct, all components of the CCUS facility that make up an independently functioning process capable of capturing, processing, and preparing CO2 for transport will be treated as a single unit. Thus, qualifying as an owner allows the developer, who otherwise does not have an adequate tax liability, to exchange its credits with the investor qualified as an owner for monetary payments. In such an instance, the owner or developer of the CCUS project, unable to claim the credit, seeks out tax equity investors and forms a special purpose vehicle (SPV), usually a limited liability partnership, to own and operate the CCUS asset.

The “partnership flip” tax equity structure is expected to be the preferred transactional structure for CCUS owners and investors to monetize § 45Q tax credits. Partnership flip structures allow developers to monetize the credit by allocating it to tax equity investors with sufficient tax liability or exposure to use the generated credits.

Developers may make an election under § 45Q(f)(3)(B) to allow a contractor that disposes of, injects, or utilizes the qualified CO₂ to claim the credit, in effect transferring the credit.

To effectuate an assignment to monetize a § 45Q tax credit, typically, a developer seeks out tax equity investors and forms a project company, usually a limited liability SPV, to own and operate the credit-generating CCUS asset. The project company is taxed as a partnership, allowing the developer and investors to allocate tax attributes and cash distributions flexibly. Most of the taxable income, losses, and § 45Q tax credits are initially allocated to the investors. The SPV will get a priority equity distribution and be taxed as a partnership, allowing the tax attributes and cash distributions to be flexible between the owner and investor. Most taxable income, losses, and § 45Q tax credits are initially assigned to investors. But once investors hit a target rate of return, the tax and cash allocations “flip,” and most of the taxable income, losses, and remaining § 45Q tax credits are allocated to the owner.

The credit-generating asset for the § 45Q tax credit is the carbon capture equipment. For equipment placed in service on or after February 9, 2018, the developer is the entity that owns the equipment and physically or contractually ensures the sequestration of the captured CO2. The “contractually ensures” language allows developers to contract or subcontract the CO2 disposal, injection, or utilization and claim the tax credit, provided certain conditions are met. Developers also may make an election under § 45Q(f)(3)(B) to allow a contractor that disposes of, injects, or utilizes the qualified CO2 to claim the credit, in effect transferring the credit. The flexibility and transferability of the credit ensure that developers and investors can design flexible partnership structures or other arrangements to optimally allocate the § 45Q tax credits to parties that can utilize them.

Steps in the Right Direction

The established scientific verdict on the catastrophic impact of climate change on life on our planet is concerning. Combined with other climate solutions, deploying CCUS technologies widely and commercially could be essential for the United States’ global contribution towards achieving net-zero CO2 emissions from fossil emissions sources. The close collaboration between the public and private sectors in IRA with the government creating the legal and policy frameworks to incentivize private sector investment in “greening” coal through deploying and scaling CO2 capture technology is a step in the right direction. While previous tax credit levels were sufficient only to incentivize a handful of domestic carbon capture projects, the significant increases under IRA in the credits can jumpstart abandoned projects like the Petra Nova CCUS project. The clarifying IRS guidelines and tested transactional structures like partnership flips may allow nimble financing arrangements between developers and owners to optimize the benefits of the new tax regime. Perhaps the coal industry, which makes up a significant baseload capacity in the United States, which has declined because of concerns about its contribution to climate change, might see a resurgence because evolving CCUS technologies could be deployed to scale as incentivized by IRA.