Everyone’s a winner: Inside the US inflation reduction act

Jim Wright
Fund Manager Premier Miton Global Infrastructure Income Fund

Jim Wright, Fund manager for the Premier Miton Global Infrastructure Income Fund flips the bonnet on the US Inflation Reduction Act and considers how it may increase US utility company profits, save money for customers, and accelerate the switch to renewable generation. A rare win-win-win scenario.

 

What is the US inflation reduction act?
The Inflation Reduction Act of 2022 (the Act) is a United States federal law which aims to curb inflation by reducing the national debt deficit, lowering prescription drug prices and investing into domestic energy production while promoting clean energy. As a listed infrastructure fund manager, it is this final part that has got me very interested.

The act itself was just passed in August 2022, so it is an incredibly new piece of legislation. The provisions in the Act relating to the US energy market extended and increased subsidies for many forms of clean energy generation and technology.

As investors in US regulated electricity utility stocks, we are encouraged by these changes and believe these may drive out three key benefits.

Benefit number one
The Act introduces a major change to the energy tax credit regime. An energy tax credit is a government incentive that reduces the cost for businesses to use alternative energy resources. Those who meet the criteria are reimbursed when paying income taxes, with the credit amount either reducing the total sum owed in tax or being added to a refund. Under the inflation reduction act, tax credits can be sold to third parties without restriction.

What does this mean, and why is it important?
Tax credits are a subsidy mechanism. Although regulated utilities generate significant taxable income, they largely offset this through accelerated depreciation, so they are not big cash taxpayers.
Accelerated depreciation is the set of tax rules that allow US businesses to deduct from their taxable income the declining value of business-related investments, such as equipment and machinery, faster than the value of those assets’ decline.

Following the passing of the Inflation Reduction Act, US regulated utilities companies can now fund new clean energy projects on their balance sheets and create an income stream through selling tax credits linked to that clean energy project to investors.

Xcel Energy, an American utility holding company based in Minneapolis, estimates that this process of selling tax credits related to green energy investment may reduce the cost of wind projects by 50 to 60%*, indicating how valuable tax credits will be in encouraging a switch to renewable energy generation.*Source: Xcel Energy, Q3 2022 Earnings presentation.

Benefit number two
Digging deeper into tax credits and here we need to understand the distinction between Production Tax Credits (PTC) and Investment Tax Credits (ITC).

  • Production Tax Credits (PTC) are a ten-year, inflation adjusted tax credits based on the volume of electricity generated by certain types of renewable or zero carbon emission projects.
  • The Investment Tax Credit (ITC) is an income tax credit for certain types of renewable and clean energy projects based on the capital cost of the project.

What the inflation reduction act changes
The Act allows developers to claim either Production Tax Credit (PTC) or the Investment Tax Credit (ITC) for solar energy projects.

Whereas in the past wind projects received the PTC, solar projects were only eligible for the ITC. We have seen the initial capital cost of solar projects decline but their output has increased as they have become more efficient.

As PTCs, are based on the volume of electricity produced, they have become more valuable than ITCs, which are a function of the capital cost of a project. A key difference and one that may benefit end consumers is that for utility companies the benefit of an ITC has to be amortized or spread over the life of the associated asset, whereas the savings from the PTC can be passed through to customers, in the here and now, as the electricity is generated.

Xcel Energy has estimated that the solar PTC reduces the cost of solar projects by 25-40%*, with customers benefitting directly from this lower cost of renewables. *Source: Xcel energy, Q3 2022 Earnings presentation.

Benefit number three
The Inflation Reduction Act has created an Investment Tax Credit for energy storage. This reduces the cost of investment in energy storage by electricity utility companies.

Importantly for customers of utility companies, the Act also exempts storage tax credits from the normal tax amortization rules and allows them to be passed through to customers as they are received. This means the customers feel the benefits immediately.

Battery storage projects can be used to reduce the volatility in the levels of energy generated from wind and solar sources, meaning that the transition from fossil fuel generation becomes smoother and more widespread.

A win-win-win scenario
Working through the three key stakeholders in the Inflation Reduction Act, utilities companies, customers, and central government – how do they all win?

Customers: When solar or wind power are added to an electricity utility company’s portfolio, the benefits of the tax credits that have been extended by the Inflation Reduction Act reduce the cost of renewable generation, potentially protecting customers from bill increases.

For central governments this will help accelerate the transition to green energy having further helped moved wind and solar power from nascent and expensive a decade ago to mainstream and low-cost today.

And for the utility companies in addition to tax credits lowering the upfront capital cost of clean power or incentivising renewable electricity output, investment in green energy can create additional returns on invested capital, through the ability to sell tax credits linked to a clean energy project to outside investors.

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Risks

The performance information presented on this page relates to the past. Past performance is not a reliable indicator of future returns.

The value of stock market investments will fluctuate, and investors may not get back the original amount invested.

Forecasts are not reliable indicators of future returns.

Investments are often in large-scale projects whose profitability can be affected by supply problems or rising prices for raw materials or natural resources. Changes in the wider economy and government regulation can also have a significant influence.

Reference to any particular stock does not constitute a recommendation to buy or sell the stock.

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Whilst every effort has been made to ensure the accuracy of the information contained within this document, we regret that we cannot accept responsibility for any omissions or errors. The information given and opinions expressed are subject to change and should not be interpreted as investment advice. Reference to any particular stock or investment does not constitute a recommendation to buy or sell the stock / investment.

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Issued by Premier Miton Investors. Premier Portfolio Managers Limited is registered in England no. 01235867. Premier Fund Managers Limited is registered in England no. 02274227. Both companies are authorised and regulated by the Financial Conduct Authority and are members of the ‘Premier Miton Investors’ marketing group and subsidiaries of Premier Miton Group plc (registered in England no. 06306664). Registered office: Eastgate Court, High Street, Guildford, Surrey GU1 3DE.

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