Incentives for Clean Hydrogen Production in the Inflation Reduction Act

Clean hydrogen can be a key component to decarbonization, particularly in the industrial sector. Beyond its current use in chemicals and refining, hydrogen has potential new and expanded uses in, for instance, process heat, iron and steel, electricity generation and transportation. However, current hydrogen production technologies yield significant carbon emissions, and little economic incentive has existed to expand the use of hydrogen to new areas. But that has begun to change, with the US Congress recently placing large bets on a future hydrogen economy. Last year’s Infrastructure, Investment and Jobs Act (IIJA) contains $9.5 billion funding for hydrogen, including $8 billion for hydrogen hubs. And this year’s Inflation Reduction Act (IRA) contains two provisions that will subsidize clean hydrogen production. The first is a new tax credit (section 45V of the tax code) where the value of the credit is based on life cycle emissions. The second is a substantial increase in the value of the existing tax credit for carbon sequestration (section 45Q of the tax code), which is used to make “blue” hydrogen.Each of these tax credits can reduce the price difference between clean hydrogen and more carbon-intensive alternatives. To better understand the cost-effectiveness of these policies, this price difference can be converted into an implicit carbon price. As we will see, the values so obtained are significantly higher than many estimates of the social cost of carbon and may thus appear uneconomic. However, the goal of these tax credits is not solely to correct for the lack of a price on carbon but also to aid the deployment of nascent hydrogen technologies. Such deployment can have spillover effects, disseminating knowledge and potentially lowering costs in the future, an additional externality that, although difficult to quantify, may justify the higher implicit carbon prices.These tax credits have different impacts depending on the form of hydrogen production. Fossil-fuel based production generally uses natural gas (although it can use other fuels as we discuss later). This process produces greenhouse gas emissions from the carbon dioxide released as the hydrogen is extracted from the natural gas (or other hydrocarbon). To be clean hydrogen, these emissions must be captured. On the other hand, electrolysis, the production of hydrogen from water using electricity, produces no direct greenhouse gas emissions. However, electrolysis consumes large amounts of electricity that can lead to both high costs and high lifecycle emissions if the electricity is purchased on the wholesale market. Costs could be lowered, however, by using lower cost electricity, either through a direct connection to a generator or by only producing hydrogen when the price of electricity is low.Both forms of hydrogen production are potentially eligible for the 45V tax credit, but they must demonstrate low life cycle emissions to do so, with the magnitude of the credit depending on the level of emissions. In the case of fossil-fuel based production, beyond the direct emissions, the largest component of the life cycle emissions is upstream methane leakage; for electrolysis, it is the emissions associated with electricity production. The Treasury Department will have to issue a regulation on how to calculate these life cycle emissions, which will have a major impact on the subsidies available to hydrogen producers and the competitiveness of various forms of hydrogen production.In contrast to the 45V tax credit, only hydrogen producers using carbon capture, utilization and storage (CCUS) are eligible for the 45Q tax credit. This tax credit is available irrespective of the life cycle emissions and, as we will see, can be more valuable than the 45V tax credit. Producers are not allowed to take both tax credits.We will analyze the impacts of these tax credits on the costs of hydrogen production using a set of hydrogen production models from the National Renewable Energy Laboratory (NREL). We will see that the 45Q tax credit is sufficient to make some forms of fossil fuel–based hydrogen production competitive with current high-emission production on a levelized cost basis. The high cost of grid electricity and the associated emissions, on the other hand, make it hard for electrolysis to compete. However, electrolyzers that source cleaner and cheaper electricity can qualify for high levels of the 45V tax credit and compete with fossil-fuel based hydrogen production. In the long run, costs for electrolyzers are expected to decrease, and the grid should be less carbon intensive, making electrolyzers competitive more broadly.In this report, we will review various forms of hydrogen production and the changes to the tax law made by the Inflation Reduction Act. We will calculate the implicit carbon prices and discuss the calculation of life cycle emissions. Next, using the NREL models, we will discuss the impacts of the tax credits on the levelized and marginal costs of hydrogen production and see how they depend on upstream methane leakage rates and the carbon intensity of electricity production. We will also examine in detail how the relative competitiveness of the various forms of production depends on natural gas and electricity prices. We conclude with a discussion of the broader hydrogen economy.