The Inflation Reduction Act: A Race to the Top or Protectionism in High Gear?

This commentary has been adapted from remarks prepared by Joseph Majkut for a NUPI workshop on transatlantic cooperation on climate change and energy security held on February 8, 2023.

I’d like to begin with a couple of observations about the state of global climate policy. First, we should not ignore the success of the Paris Agreement. While it has flaws, the agreement provides an important signal for governments and industry. The goal is net-zero greenhouse gas emissions by midcentury. The debate over whether we should act to reduce emissions or make a transition to a net-zero energy economy is settled. Second, how to achieve that goal, how it is possible, and whether it is meaningful to target 1.5 degrees Celsius are all questions worthy of investigation.

The years since the Paris Agreement was signed have given us many developments in the pledges and policies that countries are undertaking. Most recently, the United States passed a series of laws which will lead to significant investments into clean energy innovation, infrastructure, and deployment. These are the bipartisan infrastructure law (or IIJA), the Chips and Science Act, and the Inflation Reduction Act (IRA). These laws, and the investments they aim to spur, will be the centerpiece of the U.S. approach to climate change. But they aim to do much more.

As the Economist reports in this week’s issue, “The idea is that, with government action, America can reindustrialize itself, bolster national security, revive left-behind places, cheer up blue collar workers and dramatically reduce its carbon emissions all at the same time. It is the country’s most ambitious and dirigiste industrial policy for many decades.”

This investment-led strategy aims to accomplish all of that, plus address the injustices experienced by communities of color, through standards about how, where, and under what conditions clean energy investments should be made. Key additional goals are that 40 percent of investment should go into environmental justice communities, labor standards should satisfy the unions, and supply chains should be domestic. The first of these two are matters for domestic politics. The second is a matter of international trade and diplomacy.

The Biden administration and its allies argue that this is the climate bill that could pass. They argue that to build climate ambition, we need to make investments that demonstrate the benefits of the energy transition, in economic opportunity and environmental progress, to domestic audiences. As those benefits are increasingly visible, the constituency for clean energy investment grows in number, power, and influence to overwhelm opponents of energy transition. Without substantial domestic benefits, the argument goes, the world would have to settle for less climate ambition from the United States.

It makes sense that countries want to capture the economic benefits of the energy transition. The energy transition will drive large and permanent changes in the flows of energy goods and draw a new map of energy supply chains. Within the next decade, the manufacturing value at stake will run in the hundreds of billions of dollars per year and account for millions of jobs. The industrial strategies that countries implement will determine how much of that pie they can capture.

The IRA includes significant provisions supporting only domestic supply chains, so that the materials of the energy transition will be made in the United States.

The drive to domesticate supply chains is most evident in the subsides for electric vehicles, which apply to manufacturing in the United States or a country with a free trade agreement with the United States. There, half of the $7,500 tax credit is awarded for vehicles where battery components are manufactured or assembled in a qualifying country. The other half is awarded for a mineral supply chain that is extracted and processed through qualifying countries. For both credits, the required value percentage will steadily increase over the next 10 years, reaching 100 percent of battery value and 80 percent of mineral supply by 2032. 

As my colleagues noted in a recent commentary:

These subsides mean that electric vehicles manufactured and assembled in Europe are ineligible for U.S. subsidies and auto manufacturers need to develop supply chains that do not depend on China. Will the industry be able to do that fast enough to keep the tax credits and allow for rapid deployment of EVs to accomplish climate goals? This question is not answered.

A white paper by the U.S. Treasury Department, released in late December, suggests that some overseas automakers might qualify for at least a portion of the credit that favors U.S. manufactured vehicles. The administration has also noted that, by March, the Treasury Department plans to propose guidance that would trigger the applicability of the EV critical mineral and battery component requirements. Relaxing the content requirements could make the tax credit applicable to imported vehicles, increasing the supply of EVs for rapid deployment and softening the blow for U.S. trade partners.

This early attempt at flexibility has angered Capitol Hill. Senator Joe Manchin (D-WV) was explicit about his intent for the bill. “This administration has misaligned the purpose of the [IRA]. The IRA is for energy security, and it’s been touted by the administration as strictly an environmental bill,” Countries that are looking for their industries to get special consideration will need to consider the goals of the law’s drafters.

In other sectors, the IRA’s provisions aim to draw investment into the United States. The technology neutral production tax credit and investment tax credit make many emerging and developing clean energy solutions highly competitive and attractive. Subsidies could make the cost of green hydrogen in the United States nearly zero. According to S&P reporting, the investment subsidies for wind and solar power combined with the production subsidies for green hydrogen production could subsidize green hydrogen production at up to $4.50 per kilogram—higher than the estimated cost of production in parts of the United States.

Will hydrogen produced in the United States under this regime be easily traded with Europe? Or will the European Union stand up its own production?

For carbon capture and storage, the IRA extends and updates the 45Q tax credit for carbon capture and storage (CSS). Prior to the IRA, CCS developers could earn up to $50 for every metric ton of CO2 sequestered and up to $35 if the captured CO2 was utilized for industrial or other purposes. Under the IRA, these subsidies are increased to $85 and $60 per metric ton of CO2 sequestered, respectively. 

The tax provisions in the IRA, both for investment into clean energy facilities and production of clean energy, will modestly accelerate U.S. emissions reductions. Modeling from the Rhodium Group predicts U.S. emissions will fall by 32–42 percent by 2030, under the influence of the IRA. That represents an additional 7 percent over the reductions expected without the legislation. The number is moving in the right direction, even if it’s at a relatively high cost.

But the energy transition cannot occur within only one country’s borders; how the rest of the world reacts to the IRA both through trade and through their own climate policies will have significant implications for global decarbonization efforts. The IRA seeks to both attract and unleash capital across energy technologies and to onshore clean energy supply chains. One big question is how other countries react to the IRA and whether the bill will act as a model for supporting decarbonization efforts.

The subsidy model set by the IRA will be difficult for most countries to match, given the degree of spending the United States has committed itself to. However, other countries are likely to respond as they look to accomplish their own decarbonization goals and to protect their manufacturing base. Whether and how allied countries, including the European Union, will alter their policy environment to improve their domestic competitiveness for clean energy investment is to be seen.

That approach, where countries are competing to offer the most generous subsidies or the most permissive permitting environment, risks being inefficient, costly, and unsuitable as a model for all but the richest countries. When the tools available are generous tax credits and anticompetitive barriers, then a race to the top suddenly looks like a race to the bottom.

Another response would see allies stand up trade barriers, to protect their own supply chains from lower-cost goods from the United States. This is not a proposal that we have seen yet but might be worth watching for.

These reactions could have important implications for the global energy transition. A policy which is exclusively devoted to domestic manufacturing and consumption will do little to help reduce emissions or improve energy security for allies or the world. The United States will need to find mechanisms for sharing the opportunity created by the IRA to develop and deploy low-carbon technologies to reduce global emissions.

One path forward might require the United States, allies, and competitors to commit to a new set of trade norms. Support for domestic industries that runs counter to existing trade norms might be the new normal during this stage of the energy transition. Can countries come to international agreement over the conditions under which domestic favor is allowed? Once a country has some degree of supply, perhaps it can either reduce domestic subsidies or evenly apply them to imported goods.

As my former colleague Nikos Tsafos observed, “Of all of the policy dilemmas presented by the energy transition, the question of how much to do at home versus abroad tops the list as the thorniest one.”

Joseph Majkut is the director of the Energy Security and Climate Change Program at the Center for Strategic and International Studies in Washington, D.C.

The program would like to thank Energy Security and Climate Change Program senior fellow Jane Nakano and research associate Allegra Dawes for their assistance with research and drafting.