Frequently Asked Questions

Q. What are renewable and alternative technologies and why should we be encouraging their use through tax incentives?

A. Fossil fuels are nonrenewable. That is, they draw on finite resources that will eventually dwindle and become too expensive or too environmentally damaging to retrieve. In contrast, renewable energy resources – such as wind and solar energy – are constantly replenished and will never run out.

Renewable energy provides important environmental and economic benefits. These technologies are clean sources of energy that have a much lower environmental impact than conventional energy technologies. In addition, most renewable energy investments are spent on materials and workmanship to build and maintain the facilities, rather than on costly energy imports. Renewable energy investments are usually spent within the United States; frequently, in the same state and, often, in the same town. This means your energy dollars stay home to create jobs and fuel local economies, rather than going overseas. Meanwhile, renewable energy technologies developed and built in the United States are being sold overseas, providing a boost to the U.S. trade deficit.

Investments in renewable energy can go a long way to increasing our domestic energy independence and security.

Q. Don’t these incentives give renewable technologies an unfair competitive advantage over traditional forms of energy and technologies?

A. No. Tax incentives designed to promote the purchase or use of alternative and renewable energy technologies are, in fact, balancing out a competitive disadvantage that occurs naturally in the marketplace. The costs of pollution and other negative environmental externalities are not incorporated into the costs of traditional energy technologies. Therefore, these goods do not cost as much as they would if they were priced at their full social cost. Renewable technologies, on the other hand, are associated with far fewer environmental externalities. However, these clean technologies are more expensive because they are relatively new.

By providing incentives for the purchase of alternative or renewable technologies, policymakers are leveling the playing field and making these environmentally-friendly products more appealing to the consumer, who is most concerned with the bottom line – what it costs. In so doing, they are reaping a significant reward – a cleaner and healthier environment. These incentives are essentially rewarding consumers for the environmental benefits associated with alternative and renewable technologies – benefits that the market system regrettably ignores when making pricing decisions.

Q. How are tax incentives typically structured so as to maximize the environmental benefit?

A. There are two major approaches to renewable energy tax credits: production credits and investment credits. Production tax credits provide credits based on the amount of energy produced each year. A prime example is the current federal wind production tax credit of 1.5 cents per kilowatt-hour (kWh). Investment tax credits provide credits based on the amount of money invested in a project. An example of this approach is New York’s green building tax credit which allows qualifying developers to deduct up to 25% of the cost of purchase and installation of rooftop solar systems from their income taxes. For both approaches the credit can be provided against personal or business income tax or property tax. Investment tax credits also lend themselves to sales tax incentives.

Both approaches have challenges and benefits. The production-based approach essentially pays for performance – the more renewable energy produced, the greater the environmental benefit; the more market development benefit, the greater the tax credit. Production tax credits also maintain the incentives for controlling costs of the project. For the developer, the best-case situation is still a cheap project with high production. On the other hand, production tax credits require regular metering of the amount of energy produced. This requires metering equipment and regular paperwork. These costs can make production tax credits impractical for small systems.

The investment-based approach provides incentives up front when most renewables projects need it the most. Renewable energy projects tend to have high up-front costs associated with equipment and installation, but low fuel and operation costs. Whether it’s a solar system for a home or a wind farm, the challenge is often just pulling together the cash to build the project, and this is where an investment tax credit kicks in. On the other hand, an investment tax credit can encourage price inflation. If manufacturers know that customers will get an incentive equal to a percent of the price, they may be inclined to increase the price by nearly that amount, essentially canceling out the credit. To guard against this, many investment-based incentives have cost caps based on the size of a system.

Q. What are some of the pitfalls of using tax incentives, and how can we minimize them?

A. Regardless of the credit approach, if the tax incentive is not carefully tuned to the development of the market for renewables, it may have little long-term effect or, worse, set the market back.

One of the major problems with many tax credits is that they don’t include an exit strategy. If a tax credit is initially successful and the market for renewables starts to develop in a state, the question then becomes, what happens when the tax credit is gone? An exit strategy is a plan for leaving the market as self-sufficient as possible after the tax credit is gone.

A prime example of what can happen in the absence of an exit strategy can be found by looking back at the history of federal incentives for solar hot water heaters. These incentives were large enough to bring about a substantial number of new installations as well as the growth of a sales and installation industry. However, when the incentives were suddenly ended in the early 1980s, the demand for the systems vanished and the industries went out of business. Maybe even more damaging, however, was the fact that, in the absence of a service industry, the existing installations started to fail, seriously tarnishing the public perception of the reliability of solar hot water heaters. The industry’s road to recovery from this disaster has been difficult.

One solution is to set a schedule of declining incentives. Ramping down the incentives over time kick-starts the market initially and then weans the industry from the incentives. Setting a schedule allows the industry to plan around the incentive changes. Of course, the schedule does not have to be based on time. For instance, the incentives offered for renewables in New Jersey decline as certain amounts of renewables (measured in megawatts) are installed in the state. This attunes reductions in the incentives to growth in the market, a highly effective and efficient strategy.