IRS Must Defer to Industry Pacts for Carbon Capture Tax Credits
In this Bloomberg Law article, Sam Kamyans, Jarrod Gamble and Amir Azinfar discuss the IRS rules surrounding tax credits for carbon capture under Section 45Q of the tax code.
The carbon capture industry is developing transportation hubs where multiple emitters send captured carbon dioxide through a shared pipeline system. Because several emitters are delivering molecules of CO2 to a single pipeline system, matching a single unit of CO2 to the specific emitter that delivered it poses technical challenges.
It also raises questions about how to apportion tax credits for carbon capture under Section 45Q of the tax code.
Industry participants have developed contractual solutions to apportion sequestration and leakage among multiple users across a hub-and-spoke system that results in the same Section 45Q value relative to a pipeline system that only takes one emitter’s CO2. The emitters rely on data from a pipeline operator’s metering and measurement equipment to compute their 45Q tax credit.
The IRS should recognize and defer to these type of contractual solutions in the tax credit context, absent clear abuse. Doing so would ensure continued progress and bankability in the Section 45Q tax credit market and comfort both CO2 emitters and operators alike. Fortunately, the rules implicitly recognize this, allowing the IRS wide latitude to provide confirmatory guidance.
A hub-and-spoke model is familiar for participants in a common carrier oil and gas system and has similar issues that can be resolved contractually. For instance, if 10 emitters each send 100 tons of CO2 to be sequestered in a single well, and a year later 100 total tons leak, how do the 10 emitters bear the tax credit loss of that leakage? Several stakeholders involved in developing large-scale shared CO2 use or sequestration pipelines have asked the IRS to clarify this point.
In shared pipelines, multiple emitters deliver CO2 to the same pipeline system. The operator collects and sequesters it or uses it for enhanced oil recovery. None of the parties know whose CO2 has been sequestered or used for enhanced oil recovery—they just know that x tons were captured, and y tons were injected in either sequestration wells or enhanced oil recovery projects.
The difference between the two amounts represents line loss. Only amounts associated with the latter have any attached credit value. Recognizing CO2 fungibility in shared pipelines is consistent with the existing statutory framework and accompanying guidance that views CO2 from a net aggregate volume perspective, rather than molecules whose identities are traced in an unbroken chain of title from emission to sequestration.
Taking sequestration as an example, Section 45Q is available based on the total volume of sequestered CO2, without tracing an emitter’s CO2 to the sequestered CO2. Another example involves recapture (the notion that CO2 that leaks results in a clawback of Section 45Q), whereby leaked CO2 is tracked on a “last-in-first-out” basis, meaning that the leaked CO2 is unlikely to be the same sequestered CO2 molecule.
Treasury regulations say recapture should be allocated on a pro rata basis among taxpayers claiming Section 45Q credits, but the IRS also should defer to reasonable contractual allocations. This approach is also consistent with Section 45Q’s broader policy objective of encouraging reduced emissions.
Carbon emitters and pipeline operators typically agree to allocate leakage and losses proportionately, based on each emitter’s percentage of total system use—this is consistent with Treas. Reg. 1.45Q-5(g). Line loss shouldn’t be an IRS concern because credit value is determined by CO2 that is actually sequestered or used in enhanced oil recovery.
An agreement for a system operator to compensate an emitter for CO2 leaked doesn’t alter that no credit arose for line loss, or that a credit was recaptured. On a net basis, the IRS determined Section 45Q value is based only on tonnage put underground.
Similarly, intermingling CO2 in the shared pipeline for enhanced oil recovery or sequestration doesn’t alter the credit value, because the IRS bases its value off the amount of tons for each activity, which the system operator tracks and reports.
A pipeline operator typically will allocate the risk of line loss and leakage contractually to emitters across the system on a pro rata basis. The amount of Section 45Q credits available to an emitter are limited to the volume of CO2 captured and later sequestered or used in enhanced oil recovery.
The parties are legally obligated to measure, monitor, certify, or report volumes and compliant use to relevant governmental agencies. This is why parties often insist on robust cooperation and information sharing provisions to ensure any line loss or leakage is promptly identified and measured.
However, to the extent that captured volumes of CO2 are delivered to the pipeline system but lost prior to the injection, or leak within three years after injection, Section 45Q credits won’t be available. In these instances, the emitter may seek contractual recourse against the pipeline operator directly under the offtake agreement for line losses or leakage above a negotiated threshold.
Recognizing reasonable contractual solutions allows shared pipeline parties the flexibility to negotiate reasonable commercial positions, obtain fair Section 45Q value, and won’t prejudice the IRS and Treasury, provided taxpayers otherwise comply with the regulatory framework.
As long as the system operator apportions line loss and leakage reasonably and consistently across the system, and further monitors sequestered volumes, the IRS should recognize all parties are acting within Section 45Q’s legal framework and establish a safe harbor to erase any taxpayer concerns.
