Pierre Conner, Executive Director, Tulane Energy Institute & Professor of Practice, Tulane University Freeman School of Business
Daniel F. Shantz, Entergy Chair in Clean Energy Engineering & Associate Dean for Research and PhD Programs, Tulane University School of Science and Engineering
Eric Smith, Associate Director, Tulane Energy Institute & Professor of Practice, Tulane University Freeman School of Business
Frédéric Gilles Sourgens, James McCulloch Chair in Energy Law & Faculty Director, Tulane Energy Law & Policy Center
Randel R. Young, Executive Director & Distinguished Research Fellow, Tulane Energy Law & Policy Center
In our first post in this series, we discussed the different approaches available to remove carbon (‘CO2’) – industrial capture from large concentration emissions and direct air capture from ambient air. We already discussed in broad outlines what revenue streams might be available to support carbon capture. In this context, we looked specifically at governmental incentives to discuss the primary economic incentives currently in use to remove CO2 by either process.
This obviously is not the whole, or indeed even the main story. To the extent that we want to produce CO2 by any means, there must be some market for carbon. Or, in reverse, someone must pay for carbon removal services. This post is the first of two that addresses nascent carbon markets. This post will focus on carbon as a waste product to be disposed of via carbon removal services. The next post will then focus on carbon as a traditional commodity – a feedstock for other processes. Neither of these two posts should be read on their own. They are two parts of a whole, as neither currently captures the techno-commercial nature of carbon to treat it only as a waste disposal function or only as a feedstock. Rather, we need to understand it through both lenses if we wish to make sense of the broader carbon management landscape and the opportunities for innovation and commercialization it offers.
This post, then, is concerned with the ‘traditional’ idea of carbon removal services. In this context, what we do with carbon is, largely, to store it in one form or another. We might sequester the CO2 in geological storage. We might use it as a medium for enhanced oil recovery – and here, too, sequester it in geological storage. We might find other forms of storage like weathered rock. Still, in the end, the point is not so much to use the carbon. It is to lock it away for a long enough period to count it as permanently disposed of for climate accounting purposes.
Contrast this with solutions that actually convert the CO2 into a form that is stable, more compact, and actually provide some value rather than just representing an unrecoverable cost.
A few examples come to mind. One option is to utilize captured CO2 to produce synthetic fertilizers such as Urea and, indirectly, Ammonium Sulfate. Another option is to produce chemical intermediates such as Methanol, which can ultimately be converted into olefins and plastics. Yet another, is to produce Carbon centric products such as synthetic graphite, used in Lithium-Ion batteries or carbon fiber, used in aircraft, wind turbines and EVs. Over 58% of new aircraft now utilize carbon fiber to reduce weight and improve structural integrity, while every EV uses synthetic graphite in its batteries as well as carbon fiber in its high-performance electric motors. We even use carbon fiber in the fabrication of wind turbine blades and are seeking ways to use even more of the material. In each case, economic benefits occur in addition to stabilizing captured CO2 and reducing emissions.
In this post, we will introduce several ways in which carbon functions as a commodity in nascent CO2 markets. As we will discuss, it may be possible to combine these different carbon markets to access multiple forms of revenue streams at the same time. The diverse ways to think about CO2 as a commodity therefore does not have to be exclusive.
Tax Benefits Attributable to Reduction of Carbon
As already alluded to in our last post, the main U.S. incentive to pay for carbon removal and sequestration is the so-called ‘45Q’ tax credit. The 45Q tax credit makes available $85 per ton of CO2 captured and stored by industrial capture processes and $180 per ton of CO2 captured and stored by direct air capture processes.
To understand what this means, it first is important to walk through how a tax incentive can work. The typical tax credit does not pay cash for a commodity – it would not exchange $85 in cash for a ton of CO2. Rather, it would reduce the tax liability of the entity entitled to take the credit by $85. This means that only entities with significant tax liabilities could avail themselves of the benefits of a tax credit. Typically, a CO2 producer would form a new company, a special purpose vehicle (SPV), for a carbon capture and storage project. The problem is that, as a new company, the SPV would have limited if any tax liabilities, typically due to the debt payments (the interest portion of which would also be deductible) it would have to make, effectively reducing its taxable income. Consequently, the typical way for a CO2 project to benefit from tax credits is to transfer them to other taxpayers who can use them in exchange for equity. This structure, facilitated by the partnership tax allocation rules in the U.S. Internal Revenue Code, is known as a ‘tax equity structure.’ Importantly, in a tax equity structure, equity is contributed before the tax credit is earned. This means that any uncertainty as to how many credits an entity will earn in a tax period will reduce the price that a tax equity investor might be willing to pay for the tax credit. As this uncertainty is comparatively more pronounced for new technologies, industrial capture would have to offer a significant discount to tax equity investors. This discount would increase even further in the direct air capture tax equity context.
If carbon was purely a tax commodity this would significantly reduce its value. A producer typically cannot sell CO2 for $85 per ton. The producer can sell the benefits of a reduction in taxes, however, that it might be able to achieve in the future for an infusion of cash into the SPV today. The value of that infusion is a fraction of the tax credit sticker. This reduces the value of the tax credit structure significantly.
One way around this problem is for a legislator or regulator to make available two options. One is to allow the transfer of credits to unrelated parties after they have accrued. The other is to offer a direct-pay option. In the first scenario, an entity can sell the credits earned (as opposed to transferring potential credits ahead of time). In the second scenario, an entity can elect to receive a cash payment thus obviating the problems of tax structuring altogether. In this context, the transaction becomes much more like a typical sales transaction.
The key benefit of a tax credit structure is that the producer can also make money with the commodity in question. That is, the SPV can earn real income over and above the value of the tax credit. The SPV does not sell CO2 to the government. Rather, it receives a tax break for the CO2 produced. This means that the producer of the CO2 can access multiple revenue streams for the CO2 subject to the tax credit unless the underlying legislation provides otherwise.
The 45Q credit, conceptually, has undergone several changes. These changes have gone beyond changing the sticker value of the credit. They have affected transferability and direct pay options. As of today, there are comparatively fewer restrictions on transferability and direct pay options regarding 45Q credits than there have been in the past. This transforms CO2 into much more of a traditional commodity to be bought by the government and much less of a tax commodity in the sense of a benefit requiring tax equity structuring. This is helpful to CO2 project developers and financiers.
Yet, even in this scenario, carbon is not an ordinary commodity. The producer cannot sell CO2 to the government because it has positive value. The producer can sell CO2 to the government because the government is willing to incur fiscal expenditures for the public good of reduced CO2 emissions. CO2 essentially remains, therefore, a ‘negative commodity.’ It has no intrinsic value as a commodity. It is valued, rather, by reference to the cost of the externality it would impose on society if not captured. Worryingly, the fiscal expenditure incurred, under 45Q, was never coherently linked to the social cost of CO2 or its removal. Thus, in the beginning of the Biden administration, the social cost of carbon was set at $51 per ton. Later, the Biden administration proposed an increase of the social cost of carbon to $190 per ton. Neither figure matches the $85 per ton. The Trump administration is unlikely to put any social cost on carbon. The pricing mechanism for CO2, therefore, is not stable or directly related to the public good removal it is expected to achieve.
Carbon as a tax commodity is worth quite a lot. Yet, it is not worth as much as one might imagine. It is linked to the availability of fiscal expenditure. It further requires some belief in the correlation between the public benefit achieved and the fiscal expenditure made. As administrations change – or change their policies – this will not always be a given. If CO2 remains a tax commodity only, it is unlikely to create a robust marketplace without some other way to market the CO2 produced or captured. So, in essence, the creation of a tax commodity should only be viewed as an early catalyst for the creation of a “quasi” CO2 market. It does not create the market if other economic options do not exist. It is thus not a robust public structure to create a long-term carbon market in isolation.
Carbon as a Regulatory Cost
Another way to create an environment in which carbon removal services can find a customer off taker is through regulation. The regulation would demand that large-scale emitters like power plants must meet specific carbon emission benchmarks. Failure to meet the benchmarks would carry specific consequences ranging from the assessment of a fine to the denial of operating permits. The point of these adverse consequences would not be the consequence itself, but rather, it would be to set an effective incentive for affected industry to contract for CO2 removal services (or bring CO2 removal capabilities in house). So long as the cost of compliance is both below the cost of non-compliance and the business can comply and continue to earn an acceptable return on investment to cover the capital costs of infrastructure upgrades, the regulatory environment would create a carbon removal services market.
Various governments around the world have tried to build carbon removal markets on this model. Closest to home, the Biden administration applied such an approach to CO2 emissions from gas-fired power plants. The regulation would have required gas-fired power plants to remove 95% of CO2 from their emissions. Such a requirement would have significantly spurred the carbon removal industry given that thermal generation now would be premised on the ability to provide a cost-effective means of compliance. The European Union is following a broadly similar approach in its Net Zero Act, Industrial Carbon Management Strategy, and Clean Industrial Deal. Unfortunately, and often overlooked is the inability of modern democracies to enforce effective penalties for non-compliance when the public is not convinced of the purported harm resulting from non-compliance.
The regulatory approach mimics many of the tools used by the first generation of sweeping environmental legislation. For instance, the Clean Air Act set regulatory standards that at the time appeared difficult if not impossible to meet with then-current technology. It thus aimed to forcefully create new technology by way of regulation. This attempt was initially successful, but now faces significant pushback, worldwide, due to adverse economics. It is an analogue in the current environment.
The analogue may however be deceiving. Carbon removal presents a problem that may well be more complex than earlier emission problems. While CO2 removal is possible, as discussed in our earlier post, it is itself highly energy-intensive. It is also expensive to a point that it could impose significant disruptions if costs were imposed directly on the end-consumer. This in turn would also make the adopting States significantly less competitive in a global marketplace that is already undergoing significant trade realignments. The consequences of increasing trade barriers to protect domestic industry undergoing expensive decarbonization measures and increasing the cost of goods and services domestically without also increasing productivity are not to be under-estimated.
It is precisely because governments have recognized (or begun to recognize) this dynamic that regulatory carbon markets are typically paired with some sort of other support mechanism, be it in the form of a tax benefit, emission trading scheme, or other support mechanism that provides public payments to offset the cost of CO2 reductions on the end-consumer. The cost of regulatory compliance is too significant to be absorbed by the existing consumer base.
In addition, governmental catalysts for carbon removal services are arguably more appropriate from the perspective of fairness to the end-consumer. The end-consumer does not have an effective choice to avoid emissions. Large scale emissions are, more times than not, hardwired into previous infrastructure decisions. These decisions cannot be undone without destroying significant parts of the economy (and thus hurting the end-consumer). To force the end-consumer to pay for carbon removal services is thus to pass on a cost that the consumer had little choice or ability to avoid. It is acceptable for a consumer to pay a price when the price is correlated to an exercise of agency – the price so paid reflects the marginal utility to the consumer of a particular good or service. Because large-scale infrastructure decisions are both sticky and beyond any specific consumer’s agency, a price increase to reflect carbon removal may not in fact reflect the marginal utility of emitting and removing one more pound of CO2 for the average consumer.
To make the point differently, the removal of CO2 is perceived, by a portion of the populace, a public good, not a good that can be apportioned to a specific consumer due to the benefit earned or detriment avoided by that consumer. Say a person sells their car and bikes everywhere instead and their neighbor drives a pickup truck from their front door to their mailbox and all further points. The actions of each person benefits both equally because any avoided emissions by the first inure to everyone’s benefit, not just to that person. Similarly, CO2 removal is a public good not a private good. That means that CO2 removal pricing is going to be hard to measure on a marginal utility scale. The regulatory route therefore faces important policy hurdles when cost of compliance is significant as measured by the increase in cost of a needed good or service (energy). The regulatory approach therefore needs to be combined with other approaches and is not a viable stand-alone approach to CO2 management, even in a police state.
Carbon as an Offset Credit
Another variation of carbon removal services by regulation is to allow emitters to purchase offsets instead of having to reduce their own emissions. A pure regulatory approach reduces emissions at the source point and at the source point only. It therefore forces specific technology approaches to Decarbonization for production processes. An offset approach does not follow such an approach.
An offset approach is based on the idea of comparative advantage. Some parts of the economy are going to have a comparative advantage in decarbonizing sooner than others. They may not currently use that comparative advantage because there is no incentive for them to do so. The status quo is “just fine.”
To unlock this comparative advantage means to allow stakeholders to make money from the possession of that advantage. They should be able to sell their cheaper decarbonization efforts for a profit to those who would have a much harder time decarbonizing at the current state of their technology. For example, much of Guyana is pristine rain forest representing a huge carbon sink. Should Guyana be able to sell a portion of that sink to a desert dweller in Western Africa? In the US, this approach was successfully employed during the phasedown of tetra ethyl lead consumption in gasoline during the mid-1980s. The point of an offset mechanism is to drive cost of decarbonization to the lowest total cost for any decarbonization milestone. Rather than planning how to decarbonize the economy, therefore, credit offsets offer a market mechanism that follows price signals to achieve decarbonization goals.
There does appear to be a snag in an offset mechanism. How does one set up an offset structure if the goal is to drive emissions to zero across the entire economy? At some point, the decarbonization efforts will leave only hard-to-decarbonize sectors. At this point, therefore, offsets are running out of room. There are two answers to this question. The first looks at a technological environment, in which the only rational thing to do is to impose a regulatory mandate for all remaining technologies. Offsets will have run their course of usefulness by buying the maximum amount of time to decarbonize the remaining hard-to-decarbonize processes. They can offer nothing further and must end as a policy tool.
The second answer looks to direct air capture. If the situation is such that direct air capture is cheaper than the cost of an alternative way of engaging in the relevant process or production without emissions at the source, one could continue offsets. The offsets now would be provided by direct or air capture providers. To return to the thought experiment from our first post, we estimated that if one were to pass current direct air capture prices on to a consumer, the price of a gallon of gasoline would jump above $9. This would be an outrageous figure. Yet, if the choice is to pay $9 per gallon of gas or buy an electric vehicle for $30,000 the answer may change. Say I own a car that gets 36 mpg and that I drive 13,500 miles per year. I would need 375 gallons of fuel. The additional cost of fuel attributable to direct air capture is $2,250 per year, or $187.50. This might likely be less than a lease payment on a $30,000 electric vehicle. Here, an offset by direct air capture may be a better policy choice than an outright ban of internal combustion engines for the average consumer (even if admittedly both options are horrendous to the point of being politically and economically ill-advised at that point in time). The example is thus intended as a thought experiment and not a policy suggestion.
Offsets in principle are stackable with other policy tools. If removal of CO2 is considered a public good, public support through fiscal expenditure to support at least part of its costs is certainly defensible and may even be appropriate (though the proportion of fiscal expenditure to direct participation in carbon removal costs will be heavily context-dependent). It can also be combined with removal mandates in some sectors in which costs of such a mandate could be internalized comparatively easily even if they are otherwise harder to decarbonize (say for example emissions from the use of rocket-grade kerosene on one’s next space tourism flight). As in the earlier discussion, cost and required public support for compulsion both need to be in place to ensure adequate enforcement.
Conclusion
In this post, we have walked through three different approaches to paying for carbon removal. We have seen that each of them is difficult to sustain on its own before prices are drastically reduced. We have also seen that they can each be combined to find a hybrid path between different carbon management solutions. Depending upon local, regional, and national circumstances, different approaches may well be more prudent.
The elephant in the room, however, remains: markets for carbon removal are incredibly fragile if all we have is a regulatory marketplace. The price of carbon removal is high. Its energy intensity is not negligible. Passing costs to consumers will lead to significant pain given that the price we pay avoids losses but does not otherwise increase productivity or utility. There are thus no ideal regulatory solutions.
This means that we must look to one additional piece to this puzzle: we must find a way to make carbon useful as a feedstock rather than just as a waste product. That is the topic of next week’s post. This is not, however, going to be a magic bullet. The volume and cost of carbon removal likely exceeds the volume and value of CO2 as feedstock alone. Yet, the point is not to find any single value that alone justifies carbon removal. Instead, the point is to find one more means to distribute the cost of carbon management and thus reduce the amount to be funded through fiscal expenditures, regulatory efforts or offset burdens. That is an easier lift. And as we will argue next week, it is to some degree possible.
This paper represents the research and views of the author(s). It should not be construed as legal or investment advice. It does not necessarily represent the views of the Tulane Energy Institute, Tulane Energy Law & Policy Center, or Tulane University. The piece may be subject to further revision.
