A New U.S. Law Gives a Boost to Sustainability-Themed Investing

by Martin Grosskopf, MBA, MES, Vice-President and Portfolio Manager, AGF Investments Inc.

Despite its name, the Inflation Reduction Act may be the most important carbon-reduction initiative yet – and it should create long-term opportunities for investors in the global energy transition.

On August 16, 2022, President Joe Biden signed the Inflation Reduction Act (IRA) into law. Despite its name, the bill in reality represents one of the most significant governmental commitments to reduce carbon emissions in history. Most of the IRA’s baseline spend of about US$370 billion over 10 years is directed toward a vast array of investments in energy production and manufacturing, including climate technologies such as energy storage and green hydrogen, and it will promote the buildout of cleantech supply chains within the U.S. and its free trade partners, including Canada. Perhaps even more remarkable than all that money is what it signals – namely, that the United States, whose commitment to addressing climate change has for many years been open to question (to say the least), is fully on board the green transition train. Given that the U.S. is the world’s biggest, most liquid market, that means the IRA may be the most important carbon-reduction initiative yet. It should also provide a boost for thematic investing in companies targeting the key sustainability issues facing the world.

The IRA’s US$370-billion federal baseline spend could be just the beginning. According to research by Credit Suisse, the federal spend could potentially exceed US$800 billion over a 10-year period, more than double the Congressional Budget Office’s estimate and translating into a combined public and private spend that could exceed US$1.7 trillion. Already, many companies have committed to large investments on U.S. soil. For example, two electric vehicle battery manufacturers have committed to investing more than US$4 billion and US$2.5 billion, respectively. Such private sector commitments are largely due to the signing of the IRA.

The timing is also quite noteworthy. Even in the case of a recession, the IRA’s incentives will be continually accessible for qualifying cleantech projects, effectively creating a safeguard for companies positioned to reap the benefits of the tax credits regardless of the macroeconomic environment. Meanwhile, the U.S. is expected to be competitive in hydrogen, carbon capture and storage, solar PV and wind turbine – and Republican-leaning states are likely to benefit the most from private-sector investments that will take advantage of the IRA. Tennessee, for instance, is set to receive approximately US$18 billion, which will boost the state’s job numbers.

Similarly, Georgia, South Carolina and a host of other states that lean right-of-centre politically are also set to receive billions in private investments in cleantech. This likely ensures that regardless of which party takes the White House and/or controls Congress, the IRA should remain largely intact and provide stability for the next decade.

Solar and Wind Get a Much-Needed Lift
The IRA restores tax credits for solar and wind projects to their full rates and ensures these rates stay in effect for at least another 10 years; that will effectively remove the ambiguity arising from the previous series of two-year tax credit extensions, which were counterproductive to long-term business strategies and investments.

The IRA also includes funding for other renewable infrastructures, namely geothermal and hydropower. The technology-agnostic Production Tax Credit (PTC) is capped at US3 cents per MWh for utilities, depending on the greenhouse gas emissions from the power grid. The similarly agnostic Investment Tax Credit (ITC) is set at a 30% discount. Scaling up the production of electricity via renewable sources to the power grids may reduce emissions substantially and decrease associated costs.

Clean Hydrogen May Enter Period of Hypergrowth
The global green hydrogen market is expected to experience hypergrowth driven by increased demand for alternative energy sources and increased support by government incentives. According to the International Energy Agency, clean hydrogen is “currently enjoying unprecedented political and business momentum” and now is the time to scale up technologies and bring down costs to allow hydrogen to become an important component of the clean power-generation mix, along with solar and wind. The IRA provides a means to alleviate much of the cost, and that will drive immense growth. The law offers a 10-year Clean Hydrogen PTC based on the amount of qualifying hydrogen produced at a facility prior to January 1, 2033. The tax credit, broken up into four tiers, goes up to US$3 per kg depending on the carbon intensity of the produced hydrogen.

The IRA could dramatically increase demand. With government support, the demand trajectory is now projected to be some four to six times more than pre-IRA projections, according to McKinsey estimates.

Inflation Reduction Act Impact on Green and Blue Hydrogen Demand

Source: McKinsey, Sept 2022

Tax Credits for Electric Vehicle Consumers
There are U.S. consumer-based tax credits for electric vehicle (EV) models, including battery, plug-in hybrids and fuel cell EVs, within a price point depending on vehicle category, to help drive demand even further. Under the new provision, EV battery-critical minerals sourced from “foreign entities of concern,” such as China, will no longer qualify for the tax credit after December 31, 2023. The IRA also requires batteries to have 40% or more of the critical minerals sourced from the U.S. or a trading partner by 2024 to qualify for any tax credits. The sliding scale increases until 2029, when a much higher share of the critical minerals will have to be sourced from North America. If the battery meets the sourcing requirement, the consumer is eligible for a US$3,750 incentive. Similar rules apply to battery components; an additional US$3,750 could be credited to the consumer depending on where the battery components are manufactured.

These rules are designed to encourage realignment of the EV battery supply chains in favour of North American suppliers. Auto companies up and down the supply chain will need to explore whether and when to make changes to comply with these provisions. The IRA should create new much-needed EV supply chains and get EVs closer to cost parity with internal combustion.

Policy Tailwinds Support Multiple Sustainable Themes
We expect investors in sustainability to benefit from a growing universe of companies that can take advantage of the IRA, including existing holdings. The IRA provides huge investment opportunities in multiple sustainable themes. For instance, it provides approximately US$20 billion to support agricultural practices that will reduce greenhouse gas emissions and increase carbon sequestration. Also of note, the production tax credit for carbon capture, utilization and storage (CCUS) has been extended for 10 years and expanded to include additional qualifying facilities and increased credits. CCUS offers a way to remove carbon emissions from chemical reactions and is the only viable option to further decarbonize this process even after removing fossil fuels.

Sustainable investors will benefit from long-term tax incentives from the U.S. and other regions targeted for electric vehicles, hydrogen, solar and wind, as well as agriculture and other sectors. That makes the signing of the IRA a watershed moment not just for green policy, but also for investors looking for opportunities in the global energy transition.

Martin Grosskopf, MBA, MES,
Vice-President and Portfolio Manager,
AGF Investments Inc.