New ​‘clean’ hydrogen rules will favor some regions more than others

The U.S. clean hydrogen industry may be vanishingly small, but thanks to new proposed rules from the Biden administration, the geography of the emerging sector is coming into focus — and not everyone is pleased with it.

Late last month, the Biden administration laid out its rules for the 45V hydrogen production tax credit. It’s the world’s most lucrative incentive for using water and carbon-free electricity to produce ​“green” hydrogen, a fuel that could help decarbonize essential industries like steelmaking and shipping.

But to get the subsidy, hydrogen producers must follow the world’s strictest rules for when, where and how the clean power they use is generated and consumed, to ensure that clean hydrogen doesn’t end up causing more climate harm than it solves.

Those newly proposed rules are known as the ​“three pillars.” Canary Media has covered the ins and outs of the three pillars — why they’re needed, how they could work and who’s been for and against them — over the past year as environmental groups and some industry players lobbied the government to adopt the approach.

The pillars boil down to three key requirements hydrogen producers must comply with to receive the most lucrative tax credits: use zero-carbon power delivered from where it’s generated to where it’s consumed and tracked on an hour-by-hour basis, which comes from newly built resources rather than existing ones, to ensure that existing zero-carbon power isn’t diverted from the grid to be used for hydrogen production.

Energy experts have demonstrated in multiple studies and models that these stipulations are necessary to ensure clean hydrogen production actually helps to decarbonize the economy. Without such strict rules, they warned, hydrogen producers would receive billions in federal subsidies for a ​“clean” fuel that actually makes emissions worse.

Now, as the U.S. Treasury Department prepares to defend its proposed rules against challenges from fossil fuel companies, utilities and others that oppose them, the entire industry is trying to understand just how this approach will work in practice.

One clear and early implication is that, under the three-pillars structure, certain regions of the country will win, and others will lose. That’s because cost-effective green hydrogen production will be driven to the places where new renewable power can be built at the lowest cost and produce as much power as possible — and most likely barred from regions that lack those characteristics.

This logic can be frustrating on both a conceptual and political basis, however, particularly for states with large existing nuclear and hydropower resources that won’t pass the rule requiring that hydrogen use carbon-free electricity from resources built no earlier than three years before hydrogen production begins.

Meanwhile, the Midwest and the Southwest U.S. — and in particular states like Texas, which combine rich and fast-growing renewables potential with much of the country’s preexisting hydrogen infrastructure — are likely to benefit the most from the coming wave of clean hydrogen production.

But regardless of state-level economic development goals, the weight of expert analysis indicates that this outcome — in which production coalesces in the states with strong renewable resources — is the only one aligned with the goal of establishing a cost-competitive and truly clean hydrogen industry over the long haul.

Still, these political considerations will likely play a role in how the proposed rules are finalized.

​“I think that the guidance coming out is not the end of the discussion — it’s really the start,” said Kyle Hayes, a partner with law firm Foley & Lardner. ​“We’re probably in for a very heavy comment period” over the next 60 days, as the Treasury Department fields challenges and collects support from various energy analysts and industry players with a stake in the outcome.

Why the Biden administration’s proposed rules will favor some regions over others 

The regional impacts of the three-pillars guidance bring the likelihood of creating ​“tensions between environmental concerns and economic outcomes” among different regions seeking a piece of the emerging hydrogen industry, said John Bistline, a program manager in the Energy Systems and Climate Analysis Group at the Electric Power Research Institute, a nonprofit organization largely funded by U.S. electric utilities. (Bistline spoke to Canary Media prior to Treasury’s release of its guidance.)

That tension is made clear in EPRI’s work modeling the impacts of the 45V tax credit under a variety of scenarios. That research found that only a structure that incorporated all of the ​“three pillars” would yield an industry that won’t actually increase overall grid carbon emissions — a finding in line with more than a half-dozen studies from academic and nonprofit institutions.

But EPRI’s research made clear that such rules would also determine which parts of the country could produce green hydrogen that can compete with the fossil-gas-derived ​“gray” hydrogen that currently accounts for almost all of the country’s roughly 10 million metric tons of annual hydrogen production.

Simply put, regions that can rapidly build new wind and solar power will fare much better than regions that can’t. In places with the highest-quality wind and solar resources, tax credits could cover about 90 percent of the production costs of green hydrogen, according to EPRI’s analysis; in the regions with the least favorable clean-energy resources, tax credits could cover less than half of those costs.

The following chart indicates how important high-quality wind and solar power is to making green hydrogen cost-competitive with fossil-fuel-derived hydrogen. This chart depicts a ​“dedicated generation scenario” under which hydrogen is produced only by clean energy that’s directly serving the electrolyzer, not connected to the grid at large, which is a much more restrictive way to source clean energy than obtaining it from the grid.

Even without being able to tap clean energy that is generated elsewhere on the grid, hydrogen producers building their own wind farms in the Midwest could expect to match the average gray hydrogen cost of $1 to $1.50 per kilogram, the analysis found. Those building their own solar power in the Southwest would be within striking distance of that cost.

In these cases, the Inflation Reduction Act’s tax credits for new wind and solar development, designated as ​“IRA” on the chart above, combine with the most lucrative 45V tax credits to deliver a double incentive punch.

The simple lesson is that green hydrogen production in parts of the country with high wind and solar power potential will cost less and create lower emissions than hydrogen produced elsewhere. And the corollary to that lesson is that hydrogen producers will flock to those areas as a result.

Why clean power is so vital to a healthy hydrogen industry 

Proponents of the three-pillars structure don’t see this as a flaw. Rather, they call it a reflection of the underlying economic and environmental factors that will support a healthy clean hydrogen industry.

Many of the companies that have thrown their support behind the three-pillars rules already have plans to build out the renewable energy resources needed to power their planned electrolyzers. Energy company AES and industrial-gas producer Air Products aim to invest about $4 billion in a Texas hydrogen production facility matched with about 1.4 gigawatts of new renewable energy. Intersect Power, a renewable energy developer with more than $6 billion in project finance lined up for solar and battery projects, plans to build renewables to supply the clean hydrogen facilities it has under development, which will have a combined 3 gigawatts of production capacity.

“Developers will locate their projects where they can find renewable energy to make their hydrogen green,” said Beth Deane, chief legal officer at Electric Hydrogen, a startup developing electrolyzer technology that’s expected to be used by green hydrogen developers including Intersect Power and New Fortress Energy. ​“They will operate those projects to follow the variable resource so they can optimize their capital investment. This will lead to a lower cost of hydrogen over time.”

These imperatives will also drive investment in resources that stand a stronger chance to compete economically once the 45V tax credits expire, Deane said. That’s a long way off — hydrogen producers that start construction anytime before 2033 are allowed to claim the credit for 10 years after that, which means some may be earning credits well into the 2040s.

Once those tax credits drop away, however, multiple models suggest that the most important cost variable will be cheap electricity — and every forecast of electricity costs sees wind and solar power outcompeting fossil fuels.

“Over time, hourly and locational matching will put both manufacturing and project development on a roadmap to reach cost parity with fossil fuels,” Deane said, ​“so when the 45V credit goes away, there’s a true possibility for sustainable green hydrogen.”

The political downside to tying clean hydrogen to wind- and solar-rich areas

The problem with structuring the 45V tax credit in this way is that it may leave large swaths of the country out of the emerging hydrogen economy — a fact that’s already drawing criticism from politicians and corporate interests opposed to the three-pillars guidance.

“We need to build hydrogen in different parts of the country,” said Frank Wolak, CEO of the Fuel Cell and Hydrogen Energy Association. If the rules require that the renewables used to power clean hydrogen production are newly built, ​“you force the hydrogen to be developed by a potentially small group of players in very geographically limited areas. That doesn’t do much for diversifying the delivery of hydrogen across the United States or expanding the group of players” participating in the market.

That view is shared by groups that oppose the three-pillars approach, including the U.S. Chamber of Commerce, clean energy trade groups including the American Clean Power Association and the American Council on Renewable Energy, and companies such as utility holding company NextEra Energy and fuel cell and electrolyzer manufacturer Plug Power. These groups argue that the three-pillars framework will stifle investment in clean hydrogen and undermine the Biden administration’s pledge to support jobs and economic development across the country.

Tying hydrogen tax credits to areas with strong renewable energy potential may also conflict with the Biden administration’s other showcase policy push to encourage clean hydrogen production — the $7 billion in hydrogen hub development funding announced in October. While some of the seven regions provisionally picked to receive portions of this funding are in wind- and solar-power-rich areas — Texas, California and the Midwest among them — others in the mid-Atlantic, Appalachian and Pacific Northwest regions aren’t as well suited to adhere to the three-pillars guidance.

These regional-competitiveness concerns loom behind some of the high-profile opposition voiced by key Democrats in Congress. In October, eight Democratic senators wrote to the Biden administration expressing their support for the three-pillars structure that Treasury eventually chose as the basis for its 45V rules.

But a group of 11 other Democratic senators came out against the three pillars. In December, those senators were joined by Tom Carper (D-Delaware), chairman of the Senate Environment and Public Works Committee and lead author of the 45V tax credit, who wrote in a statement that Treasury’s proposed guidance may jeopardize ​“the clean hydrogen industry’s ability to get off the ground successfully. Fortunately, the Biden Administration has made it clear that there will be opportunities in the days ahead to revise the rule.”

Rachel Fakhry, who leads the hydrogen and energy innovation portfolio at the Natural Resources Defense Council, noted that the senators who have come out against the three pillars have something in common. Most represent states that have significant existing carbon-free energy resources — hydropower in the Pacific Northwest and New York and nuclear power in Illinois, Ohio and mid-Atlantic states — that won’t be eligible under the rules requiring newly built renewables as part of the three-pillars guidance.

“You have the Cantwell team,” including senators Maria Cantwell and Patty Murray of Washington state, ​“that really wants existing hydro to qualify, because they want to divert a lot of their hydro from the grid to hydrogen,” she said. ​“You have the team from Illinois that wants nuclear to qualify because Constellation is a powerhouse there,” she added, citing the heavy presence in Illinois of Constellation Energy, the power-generation-owning spinout of Exelon Corp. and the country’s single largest nuclear power plant owner.

But there’s good reason for leaving these existing assets out. Diverting existing carbon-free hydropower or nuclear from the grid to run hydrogen electrolyzers, which are extremely power-hungry, would make grid decarbonization far more difficult. And because about 20 to 30 percent of the energy content of every watt of electricity going into making hydrogen is lost in the conversion process, the value of the clean hydrogen produced doesn’t make up for the clean electricity diverted from the grid at large.

Potential workarounds for nuclear and hydropower

This political pressure — and the logic of allowing carbon-free power from sources besides new wind and solar farms to be used to make green hydrogen — has led the Treasury Department to propose some ways for existing carbon-free power to qualify for the 45V tax credit. One relatively clear-cut example is ​“uprating,” or allowing existing resources to expand their generating capacity and then using that additional capacity to power hydrogen production, Fakhry said.

Another potentially more controversial proposal is to allow for ​“avoided retirements” to qualify as new power. A number of nuclear power plants across the U.S. are struggling to stay open amid declining revenue for their energy and grid value. Under an avoided-retirement provision, nuclear power plant operators could claim that they can only remain open — and continue to provide their carbon-free power to the grid at large — if they can sell some of that power to hydrogen producers with access to the full value of the 45V tax credit.

“There’s good reason to support nuclear plants that might not otherwise be able to stay online. If that 45V tax credit is a mechanism to keep those clean electrons on the grid for 30, 40, 50 more years, that’s a good thing,” said Alex Piper, senior associate with the U.S. program of decarbonization think tank RMI. (Canary Media is an independent affiliate of RMI.)

“The issue is, how can we demonstrate that the requirements for relicensing meet the three-pillars standard in this context?” he said. ​“Certainly we do not want full diversion of nuclear energy to the 45V tax credit.”

Analysis from research firm Rhodium Group released on Thursday indicated the potential harm that an overly loose ​“avoided-retirement” structure could pose.

According to its model, if all of the roughly 28 gigawatts’ worth of existing nuclear plants with licenses set to expire through 2035 were permitted to redirect their electricity production to be used solely for hydrogen production, the U.S. grid could see a net increase in carbon emissions of between 33 million and 358 million metric tons due to more fossil-fueled electricity coming online to replace the nuclear energy. A similar calculation for the roughly 13 gigawatts’ worth of hydropower facilities set to be relicensed through 2035 would yield an emissions increase of 23 million to 165 million metric tons.

“These estimates represent aggressive interpretations of how the IRS might account for incrementality but point to the potential risk of a blanket approval of all relicensed facilities,” the Rhodium Group noted.

The Treasury Department has suggested another option: allowing power grids that have an extremely high proportion of carbon-free generation to allow existing zero-carbon generation in excess of grid demand to qualify for the highest tier of 45V tax credits. Its proposed guidance suggests that up to 5 percent of the carbon-free electricity on such grids could be allowed to meet that target.

But even on U.S. grids that reach the high levels of carbon-free electricity being targeted by the Biden administration, poorly designed rules could still cause ​“a huge increase in net systemwide emissions,” according to Rhodium. So when it comes to any rules that allow flexibility for existing zero-carbon resources to provide power to hydrogen production, ​“caution is highly warranted.”