The 2022 annual results of 2,892 local government financing vehicles (LGFVs) reveal a rare decline in overall cash positions, relative to rising interest costs and debt levels. The current weakness of localities’ finances prevents Beijing from utilizing fiscal policy to support the economy. In fact, this is the primary reason that there has been no meaningful fiscal support for China’s recovery this year.

Recent public calls for help from Guiyang and Hohhot reflect widespread local government financing distress. These pleas should multiply in short order, increasing pressure on Beijing to promptly address the mounting debt crisis before it becomes irreversible. The critical question after a probable large-scale local debt restructuring is what role local investment will continue to play in the future of China’s economy.

We have been consistently warning about the risks of local government debt over the last three to four years. We have flagged the possibility of defaults on LGFV bonds as an amplifier of the debt crisis, which would require an immediate response from Beijing. The nature of the debt problem is well understood at this point. LGFVs alone hold over 59 trillion yuan in interest-paying debt and payables, around 50 percent of GDP. Other explicit and implicit local debts through schools, hospitals, and other institutions may bring the total closer to 100 percent of GDP. But the scope and implications of the local debt crisis are much wider and larger than conventional wisdom suggests.

Discussions of the problems of LGFVs are over a decade old, precisely because LGFVs have played such an important role in China’s growth model throughout the past decade. Restructuring local debt or “solving” the local government debt problem would change China’s entire economy. Any meaningful resolution of the local debt problem would likely trigger a significant structural slowdown in investment, and a sharp slowdown in economic growth for the next decade.

Public calls for Beijing’s assistance from the governments of Guiyang, the capital of Guizhou province, and Hohhot, the capital of Inner Mongolia, mark the beginning of the end of local governments’ rapid debt accumulation. Guiyang’s government claimed in a summary of work in 2022 that default could occur at any time, while Hohhot’s government cited heavy debt burdens and interest costs, claiming they had limited capacity to manage their debts. These are explicit cries for help from China’s localities, and they will likely be followed by others as the political costs of breaking the silence about debt weaken. At this point, China cannot allow local government investment to collapse, but similarly cannot finance this investment using current methods.

Picking the Bad Apples

LGFVs can negotiate debt extensions, or bully contractors and suppliers by defaulting on acceptances. But they cannot escape the annual interest payments on their existing debts. In February we measured localities’ coverage of interest payments with a broad measure of fiscal revenues, which we would argue is the most reliable barometer of financial risks within LGFVs (See Feb 16, “Running Out of Buyers in China’s Corporate Debt Market”). The top three cities on our list were Lanzhou, Guiyang and Liuzhou, which all experienced credit events in recent months. An LGFV in Kunming (the sixth on our list) was the most recent to report a technical default last Friday after failing to pay investors on a maturing bond, and then a separate LGFV in Kunming reported another technical default on Monday.

We surveyed the 2022 financial results of 2,892 LGFVs, as most of these reports are only released in late April. Using these results, we can update the table to see the latest city-level measures of financial vulnerability. The top 20 cities facing financial stress did not vary considerably from our previous list, but all of them are now facing worse conditions than last year, except for Guiyang (Table 1). In aggregate, given 205 cities with available financial data in 2022, half were making interest payments accounting for 10% or more of their fiscal resources (fiscal revenues, fund income, and net cashflows from LGFVs), a threshold we believe suggests difficulty in managing debt servicing costs. That ratio was one-third of all cities in our February survey of 318 cities using 2021 annual data. The other cities who have not yet reported results in 2022 are likely to end up as rotten apples, given that delays in publication typically suggest bad news is being withheld temporarily.

Only around one-fifth of our surveyed LGFVs have sufficient cash on hand to honor their short-term debt obligations and cover interest payments. Some of these loans will of course be rolled over this year, but addressing the local debt problem is now an urgent task for Beijing (See Apr 7, “The Urgency of Restructuring Local Debt”).

The central government has recently appointed Li Yunze, a veteran in the financial industry from China Construction Bank and, more importantly, an official with extensive experience in local affairs, to lead the newly established Financial Regulatory Administration (FRA). The leadership of the two new financial commissions under the Chinese Communist Party, which will oversee the country’s financial work and replace the FSDC (Financial Stability and Development Committee), has yet to be finalized. It would not be surprising to see officials with local experience leading key positions there to better address the local debt problem.

Given the establishment of a comprehensive new financial regulatory framework in the first half of this year, the long-awaited quinquennial National Financial Work Conference will likely be held sometime during the summer. It is highly probable that the main theme of the conference will revolve around developing plans to address local debt problems, with further details expected in the second half and implementation scheduled for later this year and early 2024.

Carrying a Heavier Backpack up a Steeper Hill

Deleveraging efforts resulted in a slowdown in LGFV debt growth in 2018. However, the COVID outbreak prompted Beijing to revert to fiscal stimulus during the pandemic years. As a result, interest-bearing debt incurred by LGFVs surged by 21% in 2020 and an additional 14% in 2021. While policies towards local debt growth have fluctuated in the short term, the overall trajectory still aims to control debt in the long term. Even with policy bank financing assisting in funding local investment in late 2022, growth of LGFVs’ total interest-bearing debt slowed sharply to just 9.1% last year. The total balance of debt held by our surveyed LGFVs rose to 54 trillion yuan from 50 trillion yuan at the end of 2021.

Against a slower growth of debt, one concerning development is the rise in the proportion of short-term debt, which reached 25.7% last year, the sharpest increase since at least 2018 (Figure 2).

LGFVs’ current financial conditions resemble those faced by property developers in 2017 and 2018. Even investors who believe in Beijing’s financial commitment to LGFVs do not expect those implicit guarantees to last forever, because of the size of the debt burden. Eventually, LGFVs may default. Consequently, investors are reluctant to assume duration risk and prefer to avoid long-term bonds issued by LGFVs to the extent possible. When property developers saw the same market conditions, they sold more bonds with put options embedded, providing investors with the flexibility to exit the bonds earlier. However, many of these puttable bonds were among the first to default in recent years. In today’s market, investors often opt for short-term LGFV bonds with maturities of less than one year, particularly in the openly traded bond market. The increase in short-term debt adds to LGFVs’ refinancing pressure as they have to continually roll over these debts.

One advantage of a rising proportion of short-term borrowing is that it is cheaper. LGFVs’ estimated borrowing costs fell for the third consecutive year to 5.36% in 2022, but they remain higher than the average corporate lending interest rate of 4.12%. The higher costs can be attributed to borrowing from shadow or informal banks. Additionally, monetary easing by the People’s Bank of China (PBOC) has helped to reduce LGFVs’ borrowing costs in the bond market, including official local government bonds and LGFV bonds.

Despite the decline in interest rates, total interest expenses still increased in 2022 along with the rise in overall debt levels. LGFVs paid 2.9 trillion yuan in interest on their debt last year, up from 2.7 trillion yuan in 2021 (Figure 3). It is likely that these numbers underestimate the real interest expenses, given LGFVs’ widespread recapitalization of interest expenses, where there are few details revealed within LGFV financial disclosures.

In its Q1 monetary policy report last week, the PBOC reiterated Governor Yi Gang’s golden rule on appropriate interest rate levels, stating that rates should be slightly lower than growth (r below g). Rates that are too low may encourage speculation, while rates that are too high may make debt unsustainable. While we agree with the PBOC’s application of this rule, the sustainability of LGFV debt requires far lower interest rates than overall economic growth. Most LGFV spending and investment aims to provide affordable public services rather than generate significant financial profits. LGFVs only have a median return on assets (ROA) of 1% in 2022, a ratio that is not only declining but well below the median ROA of 4.6% for A-share listed firms last year.

This is a key reason why we anticipate Chinese interest rates must gradually decline over the long term, in order to make local debt burdens sustainable. Monetary policy will need to be set based on the weakest elements of China’s financial system, particularly localities and their LGFVs, rather than the stronger sectors of the economy.

Rising Spending and Investment Obligations Deplete LGFVs’ Cash Positions

The most significant development in LGFV finances in 2022 was a decline in overall cash positions, from 8.7 trillion yuan at the end of 2021 to 7.8 trillion yuan, primarily due to net cash outflows of nearly 1 trillion yuan among surveyed firms (Figure 5). The last time LGFVs experienced a decline in cash was 2018, as deleveraging intensified, but this was a more modest decline of 58 billion yuan.

Stronger investment cash outflows in 2022 were responsible for the drop in cash positions. Net investment outflows reached 5.3 trillion yuan last year, nearly double the level in 2018 and up from 4.6 trillion yuan in 2021 and 4.8 trillion yuan in 2020. The increase in investment cash outflows is a result of LGFVs’ higher capital expenditures (capex) of 4.2 trillion yuan, as they were tasked with supporting growth in the second half of 2022. Infrastructure investment growth accelerated to 9.4% last year from just 0.4% at the end of 2021, with double-digit growth throughout the second half.

Another factor contributing to LGFVs’ rising capex was direct land purchases. Local governments utilized LGFVs to boost transactions in the land market last year to offset the decline in purchases by property developers.

Net financing cash flows dropped slightly to 5.1 trillion yuan as Beijing continued efforts to prevent local governments from accumulating new implicit debt. However, policy bank financing in the second half helped offset the slowdown in shadow bank borrowing. The People’s Bank of China (PBOC) provided 740 billion yuan to fund infrastructure investments through policy banks, while commercial banks extended another 3.65 trillion yuan in credit lines to facilitate these policy bank loans last year.

Operating cash reported a net outflow of 734 billion yuan last year, nearly doubling the outflows seen in 2021, further impacting LGFVs’ cash positions. One key reason for the larger operating cash deficit was weaker direct support from local governments. Other operating cash flows, which typically include any real financial support that local governments can offer to LGFVs, only increased by 7.8% last year to 9.1 trillion yuan. This represents the slowest growth since at least 2017, compared to a 12.6% increase in 2021.

Larger debts and smaller cash positions have impacted LGFVs’ capacity to honor debt and interest payments. The median cash coverage ratio for short-term debt fell to 0.46 last year from 0.69 in 2021, with only 567 firms, or less than one-fifth of the surveyed sample, featuring a ratio above 1.0, indicating that their current cash position can fully cover short-term obligations. In 2021, this number was still 924 firms (one-third) and nearly half of the surveyed sample between 2018 and 2020. Similarly, only 687 companies have a cash flow coverage ratio for interest payments greater than 1, just over half as many as in 2021. Nearly four-fifths of LGFVs do not appear to have sufficient cash flows to cover interest payments.

Keeping Up with the Joneses: LGFVs and the Land Market

One of the most significant consequences of the property market’s two-year rout for localities was the decline in land sales revenues, which were 2.0 trillion yuan lower in 2022 than the previous year, and will decline further this year, given payments on land purchases are made with a one-year lag. As private developers have withdrawn from the market and state-owned developers slashed their land purchases, local governments have suffered. To create an illusion of prosperity in the land market and attract buyers, as well as to artificially inflate land sales revenues, local governments tasked LGFVs to buy considerable volumes of land last year (Figure 7).

Last November, the Finance Ministry had to issue a statement instructing local governments to stop using LGFVs to artificially inflate land transaction numbers, but this barely worked. LGFVs accounted for half of land purchases in 2022, compared to 33% in 2021 and 17% in 2020.

In LGFVs’ annual reports, land is typically categorized as inventory, property investment and intangible assets. Our surveyed samples saw total inventory increase by 11.4% to 44.4 trillion yuan by the end of 2022. This marks the first time since at least 2018 that inventory growth has accelerated.

The primary issue with LGFVs purchasing land is that they are not genuine developers. While some LGFVs are involved in the property industry, they are focused on land development rather than constructing and selling houses. The large volume of LGFV purchases is actually extending the adjustment of the housing market, by slowing the transformation of land into new residential properties. This has contributed to the ongoing decline in new starts by over 20% this year. According to data from the China Real Estate Information Company (CRIC), LGFVs only commenced construction on 38% of the land they acquired in 2021, which is significantly lower than the industry average of 67%, including state-owned and private developers. This ratio further declined to just 8% in 2022, coinciding with the decline in the industry average to 31%.

Restructuring and Growth

The most important variables impacting China’s economic growth over the next two years will be the success or failure of local government debt restructuring, and Beijing’s approach to the role of local government investment within China’s economy in the future. The current course, which China has used as an intrinsic element of its growth model over the past two decades, has reached its terminus, with more and more localities likely to follow the path of Guiyang and Hohhot in requesting bailouts. A collapse in local government investment would be comparable to the economic impact of the crisis in the property market.

Beijing has historically exercised control over the economy through the allocation of credit to state-owned enterprises and by channeling fiscal policy through local government investment. Local debt issues jeopardize these traditional levers of control. For China to again be able to rely upon fiscal policy to deliver growth, Beijing urgently needs to restructure local government debt. LGFVs’ financial results in 2022 highlight that no solution will emerge from localities themselves. Beijing would like to take its time with a deliberative process over the summer, but rising calls for help among localities may eliminate that luxury as more urgent actions to stabilize local finances are required.

 

US export controls designed to freeze-in-place China’s leading edge chip development are a powerful brake on Beijing’s ambitions to become self-sufficient in foundational technologies. But this should not obscure the fact that China is building significant capacity in semiconductor markets that rely on mature process nodes – including in sensors, power semiconductors, and microcontrollers found in every day consumer electronics, vehicles, and medical devices. This note takes a closer look at which semiconductor segments still lie beyond the reach of US regulators and where Chinese chipmakers and state backers may focus their resources. We also assess how China’s expanding market share in these mature technology segments could trigger regulatory actions by the US aimed at steering supply chains away from China.

This note was prepared in cooperation with Jan-Peter Kleinhans and Julia Hess at Stiftung Neue Verantwortung.

Key Takeaways

• US fabless chip designers depend almost entirely on foreign foundries for contract-manufacturing of legacy chips: 80% of foundry capacity for 20-45nm process nodes is located in China and Taiwan. For 50-180nm process nodes, China and Taiwan together control around 70% of foundry capacity globally.
• An attempt by the US and partners to outpace China in building out manufacturing capacity for trailing edge process nodes would require considerable time and resources, as well as political tolerance of higher prices. In the next 3-5 years China is due to add nearly as much new 50-180nm wafer capacity as the entire rest of the world.
• China’s tech indigenization efforts, the threat of US export controls, and OEM supply chain diversification could help Chinese chipmakers grow market share in segments that do not rely on node shrinkage, such as microcontrollers and automotive semiconductors.
• Chinese firms designing cutting-edge semiconductors for markets like smartphone processors and autonomous driving are still producing well below the high performance computing thresholds set by US export controls, but will remain heavily dependent on foreign-owned foundries to manufacture such chips.

Navigating US Chip Controls

The US has ramped up semiconductor export controls aimed at China over the past year. In August 2022, the US implemented a multilateral agreement to restrict electronic design automation software for cutting edge chip development. Then, on October 7, 2022, the US rolled out a comprehensive package of export controls  that restricted sales of high-performance computing chips to China and targeted critical chokepoints in semiconductor value chains—software and chip manufacturing equipment—to arrest China’s development in leading edge chips. By early 2023, the United States had negotiated an understanding with Japan and the Netherlands (both critical to the SME controls) to restrict the export of tools needed to produce logic chips at 14nm and below.

If rigorously enforced, mounting US-led restrictions could severely curb China’s ability to scale up leading edge chip development and make advancements in “force-multiplying” semiconductor technologies, including supercomputing and cloud artificial intelligence (AI) accelerators.

The heaviest restrictions in the Oct. 7 controls are centered on high performance computing chips. There are just a handful of companies globally that design such state-of-the-art chips. These include US-based Nvidia’s H100 and AMD’s MI250, as well as Chinese start-up Biren Technologies’ BR100. If cutting-edge chips with US-origin technology meet the compute performance thresholds in the Oct. 7 controls, the US can block the sale and production of these chips to any Chinese entity. This could have a profoundly negative impact on Chinese companies designing cutting-edge chips for cloud computing, deep neural networks, and other applications that require massive amounts of computing power—an alarming prospect for China as the United States is embarking on a new innovation era in areas like generative AI.

Below the Radar

The US has (for now) set relatively high compute performance thresholds for these restrictions. For example, one of the thresholds is 4800 TOPS * bits (tera operations per second). Chinese companies designing cutting-edge chips for markets like mobile chipsets (e.g., UNISOC, Xiaomi, Oppo, and Vivo) or autonomous driving chips (e.g., Horizon Robotics) could stay well below such thresholds.

For example, UNISOC’s current state-of-the-art mobile chipset T820 has an integrated AI accelerator with 8 TOPS at 8 bits precision, resulting in 64 TOPS * bits—far below the US-regulated 4800 TOPS * bits threshold. The same goes for Horizon Robotics’ autonomous driving chip, Journey 5, which has a compute power of 128 TOPS at 8 bits precision, resulting in 1024 TOPS * bits. So long as the United States maintains a relatively high compute performance threshold, these firms will still be able to compete in international markets for years to come, albeit with a lingering risk that Washington can adjust the regulatory parameters at any time.

In addition to setting compute performance thresholds in designing China-wide restrictions, the Oct. 7 controls and US negotiations with its partners have focused on the critical inputs needed to produce advanced logic chips at or below 14nm. These controls directly impact China’s ability to fully indigenize production of server, laptop, graphic and smartphone processors — a market where a product’s competitiveness relies heavily on shrinking the node feature size of the chips powering the device. For example, Apple’s A16 processor for the iPhone 14 Pro (16 billiontransistors on a 4nm node) has one hundred times more transistors than Apple’s A4 processor in the iPhone 4 (149 million transistors on a 45nm node).

When Size Doesn’t Matter

The Oct. 7 controls deal a heavy blow to China’s chip ambitions but there are still many types of chips that do not depend on or even benefit from node shrinkage (e.g., how many transistors can be squeezed onto a square millimeter of silicon). This is true for power semiconductors, analog chips and microcontrollers, where China still has ample room to grow. A wide range of applications, including cars, medical devices, Internet of Things, drones, industrial automation, robotics, and precision agriculture rely mainly on chips manufactured on “mature nodes” where Chinese foundries like SMIC and Hua Hong are rapidly building out capacity.

Classifications like “legacy”, “mature” or “trailing-edge” node production can be somewhat misleading in describing fabs manufacturing chips for power semiconductors, image sensors or microcontrollers. Mature node feature sizes (such as 28nm, 45nm or 90nm) can still be considered “state of the art” in their respective markets.

The Foundry Capacity Challenge

Below we break down foundry and non-foundry capacity at 20-45nm (key for microcontrollers) and 50-180nm (important for power semiconductors, IoT chips and sensors) process nodes. The distinction between foundry and non-foundry is critical: China’s and Taiwan’s capacity comes from foundries for contract manufacturing, meaning they offer their skills and manufacturing capacity to any firm designing chips. In contrast, the United States’ share of trailing-edge wafer capacity comes almost exclusively from Integrated Device Manufacturers (IDMs), such as Texas Instruments, that design and manufacture their own chips in their own fabs. As shown in Figure 1, US chip designers depend almost entirely on foreign foundries to manufacture chips on 20-45nm nodes.

Data on announced fab investments as of March 2023 show that around 60% of worldwide manufacturing capacity for 20-45nm process nodes is located in China and Taiwan, with 27% in China alone. Once new fabs that are scheduled to come online are included, China and Taiwan together could account for close to 80% of 20-45nm foundry capacity globally over the next 3-5 years.

The picture looks very similar in mature nodes at 50-180nm: China currently controls around 30% of 50-180nm manufacturing capacity globally, and that could climb to 35% global capacity within the next 5 years (Figure 2) if all fabs in China that have been announced as of March 2023 are built according to plan. Within a decade, China could control around 46% of 50-180nm global foundry capacity for fabless chip designers.

China’s expanding mature node wafer capacity carries important implications for both Chinese and foreign OEMs. For China’s domestic manufacturers of electric vehicles, industrial robotics, drones, IOT appliances, medical devices and other products, China’s low-margin and high-volume growth in legacy chip manufacturing lowers the cost of production and helps insulate Chinese OEM supply chains from external shocks.

At the same time, China’s growing capacity and cost-competitiveness encourages foreign OEMs to source cheap legacy chips from China while focusing resources on cutting-edge tech development. This dynamic could fuel concerns among US policymakers about supply chain dependencies on China in “legacy tech” areas. A recognition of these risks was behind a $10 billion allocation in the US Chips and Science Act for legacy chip manufacturing. But if the United States and partner countries want to outpace China in this market segment, it will take time, resources and a political tolerance of higher prices. For perspective, in the next 3-5 years China is due to add nearly as much new 50-180nm wafer capacity (900.000 wspm) as the entire rest of the world (1.1 million wspm).  

Moreover, even if the US chose to focus on steering the sourcing of legacy chips away from China, it would still have to reckon with risks to chip manufacturing in Taiwan—critical to US and partner foundry capacity—due to the possibility of a cross-Strait crisis. Assuming planned fab expansions come to fruition within the next five years, Taiwan will continue to be home to 39% of 20-45nm and 24% of 50-180nm foundry capacity globally.

China’s Attempts to Move up the Chip Value Chain

Beyond capacity buildouts, there are other factors to consider when assessing China’s competitiveness in mature process node manufacturing. Here we examine the growth drivers and barriers for China in moving up the value chain in three distinct semiconductor markets: general purpose microcontrollers, automotive semiconductors, and mobile chipsets for smartphones and tablets.

General purpose microcontrollers

Microcontrollers are essentially tiny computers on a single chip that are used to measure, sense, control and compute almost everything in our environment. They are indispensable to modern consumer electronics, cars, agriculture, energy grids, hospitals and countless other applications. Global microcontroller sales reached $20 billion in 2021 and the leading (by revenue) five suppliers controlled 82% of the market. No Chinese company sits among the ten largest microcontroller suppliers (Figure 3).

Most modern microcontrollers are produced on mature nodes at 20-180nm and have computing frequencies several orders of magnitude lower than, for example, mobile chipsets (measured in megahertz versus gigahertz, respectively). Competition in microcontrollers is mainly driven by three factors:

• Features and level of integration: The more features a microcontroller offers, the more versatile the product. Modern microcontrollers are highly integrated devices using multiple interfaces, communication protocols, digital and analog inputs and outputs, timers and much more.
• Development environment and support: Microcontrollers are programmed with specialized software. The better the software stack (measured by ease of use, documentation, support services, etc.), the easier it is for developers to program the microcontroller. This dynamic also creates lock-in effects: developers who are familiar with certain microcontrollers and their software stack may be reluctant to switch to an unfamiliar supplier.
• Cost: Since microcontrollers are often used for simple tasks, compared to high-performance cloud accelerators or mobile chipsets, costs are a competitive differentiator.

Chinese microcontroller suppliers are starting from a low base in market share but have several advantages that could propel growth. First, the rise of China’s consumer electronics, home appliances and Internet of Things companies, such as DJI, Haier or Xiaomi, are already expanding the total addressable market for Chinese microcontroller suppliers. Second, Chinese companies, along with foreign companies trying to preserve their market share in China, may be more compelled to source from domestic microcontroller manufacturers due to the threat of US export controls and with state pressure rising on firms to advance “self-reliance” policies. Third, supply chain disruptions are encouraging Chinese and foreign companies alike to seek out a more diverse set of suppliers.

Integration and interoperability will be critical to Chinese firms’ ability to grow microcontroller market share. The product strategy of China’s largest microcontroller supplier, GigaDevice is a case in point. The company’s GD32 microcontrollers are compatible (and often directly interchangeable) with Europe’s STMicroelectronics’ STM32 microcontrollers. During the pandemic-era global chip shortages, GigaDevice used its “pin-compatible clones” to fill in supply gaps left by STMicrolectronics, which at the time was reporting a production lead time of 52 weeks and longer for most STM32 microcontrollers. GigaDevice timed the product slip-in strategy well: the company’s microcontroller revenue tripled, from $122 million in 2020 to $363 million in 2021. That said, Chinese microcontroller companies are not all mere copycats: Espressif, which went public on the Shanghai Stock Exchange in 2019, develops competitive microcontrollers produced on TSMC’s 40nm node and has rapidly gained popularity due to the product’s Wifi and Bluetooth integration.

Automotive  Semiconductors

Modern cars contain hundreds of semiconductors, including microcontrollers, power semiconductors, sensors, and memory chips. The transition to electric vehicles is set to turbocharge demand for automotive semiconductors: a typical electric vehicle contains more than $1,000 worth of semiconductor content, compared to around $330 in semiconductor value for conventional vehicles, according to the US International Trade Commission.

Not surprisingly, the largest (by revenue) automotive chip suppliers in the world are in Europe, Japan, and the US, where suppliers compete across multiple sub-segments in well-established auto manufacturing hubs (Figure 4.) For now, Chinese automotive chips are used in international markets for simpler functions, such as seat control, water pumps or lighting, but China’s first-mover advantage in NEVs creates new opportunities for China’s automotive chipmakers to move up the value chain.

Key barriers to entry must nonetheless be crossed for China’s automotive chipmakers to make a serious dent in this fast-growing market, namely:

• Safety-certification: Automotive chips need to meet several safety certification requirements to be eligible for sale to automotive OEMs. This requires a strong understanding and close coordination with the design and manufacturing process. Moreover, automotive OEMs push their supply chain toward “zero defects” (defect rates for modern vehicles are in the range of 10 defective parts per billion).
• Long product life cycles: Since the average life cycle of a car is around 15 years, automotive chip suppliers need to guarantee supply and performance of specific chips for several years in the production cycle. As a result, automotive OEMs place a lot of trust in their chip suppliers and employ extensive qualification processes before a new supplier is incorporated into the supply chain.

Chinese companies have seen the most growth so far in the automotive microcontroller market, with more than 20 Chinese companies, including BYD, ChipON, Geehy, and GigaDevice, developing automotive-grade microcontrollers. While Chinese-made automotive microcontrollers are mostly used today for simple functions, there are several factors that could move Chinese firms up the value chain to grow domestic and global market share. These include:

• Growing presence of Chinese OEMs: More than 80% of China’s EV market is controlled by domestic companies, such as BYD, Wuling, Changan and Geely. These Chinese EV OEMs are more likely than foreign auto OEMs to source from domestic auto chip suppliers. For example, ChipON (founded in 2012 and planning an IPO) has developed its own IP for automotive and industrial microcontrollers and has received funding from several Chinese automotive OEMs. As in Europe and Japan, China is counting on close collaboration between Chinese car OEMs and domestic auto chip suppliers to grow both sectors in tandem.
• Automotive chip shortages: While many semiconductor markets experience oversupply, automotive chips have so far been the exception. Many automotive chips are expected to remain in short supply throughout 2023, potentially even longer. As a result, automotive OEMs are trying to source from multiple suppliers to boost supply chain resilience. This creates an opportunity for new auto chip suppliers, including Chinese firms, to enter the market.
• Geopolitical buffer: Chinese auto OEMs may be concerned about the potential for US-led export controls to spread to certain types of automotive chips with US-origin technology (for example, by targeting silicon-carbide power semiconductors). This creates another incentive for Chinese auto OEMs to look to domestic auto chip suppliers to ensure business continuity. Foreign automakers looking to protect market share in China and become more competitive in the NEV space may also be compelled to source from local Chinese suppliers. For example, Volkswagen Group and its software company CARIAD announced a joint venture with Horizon Robotics in October 2022. China’s state-backed investments to draw in foreign investment  may also include conditions obliging foreign auto OEMs to raise local technology content.

Mobile Chipsets

The raw computing power of mobile chipsets in smartphones and tablets is well below the compute performance thresholds set out in the Oct. 7 US controls. But since mobile chipsets depend heavily on node shrinkage for performance gains, Chinese mobile OEMs cannot escape their heavy dependence on foreign foundries to manufacture leading-edge chips. For example, Chinese mobile chipset manufacturer UNISOC depends on TSMC’s 6nm EUV manufacturing for its flagship T820 mobile chipset. Despite this significant vulnerability, there is room for Chinese mobile chipset makers to increase their market share.

Competition in smartphone chipsets is mainly driven by cost, performance, and fast-paced innovation. Apple is the exception on cost: while Apple’s iPhones capture less than 20% market share, Apple has made 80% of the profits in the global smartphone market since 2015. With the exception of Apple, cost tends to have a substantial impact on the competitiveness of smartphone manufacturers and the chipset market more broadly.

The global mobile chipset market today is led by Mediatek (Taiwan) and Qualcomm (US), followed by UNISOC (China) and Samsung (Korea). Apple does not sell its own mobile chipsets on the open market. After smartphone manufacturer Huawei was targeted with hard-hitting US export controls starting in 2019, UNISOC gained market share at the expense of Huawei-owned HiSilicon. The company’s global mobile chipset market share more than tripled, from less than 3% in 2019 to more than 10% in 2022. UNISOC’s biggest customers are Chinese handset OEMs Oppo, Vivo, and Xiaomi. These companies are also investing in in-house chip design and could see their market share grow in the mobile chipset space within the decade. Samsung has more recently begun using UNISOC chipsets in its entry-level tablets and smartphones.

Looking forward, Chinese mobile chipset designers will face hurdles in keeping pace with foreign competitors due to multilateral restrictions on cutting-edge chip design software. In August 2022, the Wassenaar Arrangement imposed licensing restrictions on electronic design automation (EDA) tools that are capable of designing next-generation transistor structures (Gate-All-Around Field-Effect Transistors or GAAFETs). As a result, US EDA suppliers, such as Synopsys and Cadence, have been shipping restricted versions without GAAFET-capabilities to Chinese customers since November 2022. Without access to these crucial chip design tools, Chinese mobile chipsets designers will likely be stuck at (roughly) 3nm process nodes.

Beware of US Entanglements

Chinese semiconductor companies have room to expand in areas so far untouched by US-led export controls, but the risk of US entanglements looms for any OEM considering the adoption of Chinese-made chips. For as much as the Oct. 7 controls focused on high-performance computing and cutting-edge logic chips, they also exposed US anxiety about supply chain dependencies on China more broadly.

For instance, the Oct. 7 controls went beyond restrictions on the production of leading-edge logic chips, where China remains far behind the US and partners, to also cover (largely commoditized) memory chips, where China had been gaining market share. Specifically, the US tied advanced memory chips (defined by the US as chips with 128 layers or more for NAND and 18nm half-pitch or less for DRAM) to weapons of mass destruction (WMD) end-use to justify comprehensive licensing restrictions on manufacturing tools and software.

Japan and European partners are aligning with the US on export controls targeting advanced logic chip production but are unlikely to adopt the US national security argument for memory chips. Even so, the US was able to leverage unilateral export controls to knock China’s YMTC out of the competitive 3D NAND flash memory market. YMTC was steadily gaining market share (capturing almost 5% of global NAND sales by some estimates) until it was hit by the Oct. 7 controls and subsequently added to the BIS Entity List in Dec. 2022. Chinese state-backed funders have since thrown YMTC a USD $7 billion lifeline but cash infusions do little to solve the firm’s challenge in sourcing non-US-origin software and tools.

The memory chip example raises a critical question for both Chinese and foreign OEMs trying to weigh the pros and cons of sourcing chips from China: will US-led controls extend into other commercial areas where a national security argument can be stretched to undercut Chinese tech competitors, even if those companies are operating well below US-defined performance compute thresholds in more mature market segments?

As geopolitical competition between the United States and China intensifies (in part from growing US-led tech and investment controls), some US policymakers are drawing attention to China’s “coercive leverage” in supplying inputs (including legacy chips, active pharmaceutical ingredients, solar cell and battery technologies, and critical materials) that pervade consumer and industrial applications. This concern is translating into calls for tighter controls to steer supply chains away from China.

The US has an expanding toolkit to address its supply chain concerns. These include:

• The tightening of existing export controls on China-based, foreign-owned fabs: South Korean leading edge memory chipmakers Samsung and SK Hynix could have their one-year licenses revoked (or threatened to be revoked) if the US assesses that these firms are not moving quickly enough to diversify advanced memory chip production away from China. At the same time, prematurely shuttering Samsung’s and SK Hynix’s memory fabs in China would risk significant price fluctuations and disruptions to the global memory chip market.
• Scaling up export controls and sanctions against Chinese tech entities: A number of justifications may be used against Chinese OEMs and chip suppliers, including sanctions violations, dual-use applications, data security and cybersecurity concerns, and human rights abuses. SMIC is already on the BIS Entity List, but could face tighter restrictions still. A pending US move to further restrict export licenses on Huawei, already battered by the foreign direct product rule (FDPR), illustrates how a sliding scale of controls can reach into mature tech markets.
• Expanding list-based export controls to less sensitive technology areas: The caveat here is that partners could be reluctant to align with the US on controls in commoditized markets. This would increase the risk of foreign firms growing their market share in China at the expense of US companies. This is one of the key considerations Commerce BIS regulators are supposed to factor in when crafting restrictions.
• Tightening conditions on US chip industrial policy: The US CHIPS Act of 2022 gives considerable authority to the Secretary of Commerce to adjust guardrails and claw back funding from recipients. The March 21 Commerce Notice of Funding Opportunity contained several key provisions, including stringent restrictions on recipients’ ability to expand manufacturing capacity in China (not to exceed 5% and covering an additional category of “semiconductors critical to national security” to account for materials science breakthroughs in China). Recipients are also not permitted to “knowingly engage in any joint research or technology licensing effort with a foreign entity of concern that relates to a technology or product that raises national security concerns.” This is an intentionally broad provision designed to get companies to first report relevant transactions to Commerce, which will then use that information to refine the restrictions.
• Restrictions aimed at safeguarding US Information and Communication Technologies (ICT) supply chains: The recently-introduced White House-backed, bipartisan RESTRICT Act deliberately takes a comprehensive approach to targeting foreign entities of concern tied to any US ICT products or services that could pose a risk of sabotage or subversion, catastrophic impacts on critical infrastructure, election interference, subversion of democratic processes, or (a catch-all) risk to the national security of the US or safety of US persons.
• Procurement and investment restrictions tied to subsidy support: The US Merger Filing Fee Modernization Act of 2022required firms pursuing M&A deals with foreign entities of concern to disclose to the Federal Trade Commission information on any subsidies received by that foreign entity. The EU is ahead of the US in this trend: the Foreign Subsidies Regulation, which entered into force in early 2023, empowers the European Commission to investigate whether any company operating in the EU has received any form of direct or indirect financial subsidy from a non-EU country. If the Commission concludes such support has had a market-distorting effect, it can impose mitigating measures, block deals, and even force the dissolution of tie-ups.
• Inbound and outbound investment screening: The US and a number of partner countries are examining whether investments, such as mergers, acquisitions, or partnerships, have the potential to increase critical supply chain dependencies on China. If such risks are identified, deals could be blocked on national security grounds. A looming executive order from the White House is expected to prioritize semiconductors as the US takes its first steps toward developing a notification and potential blocking mechanism for outbound investments in “force-multiplying” technologies.

Entering a Dark Forest

US-led restrictions on China’s chipmakers will force Beijing, local governments, and corporate boardrooms to make some tough decisions as they consider where best to focus their money, talent, and time in order to get China’s chip industry out from under Washington’s thumb. The highest levels of government may tout self-reliance as the number one task for Chinese chipmakers trying to break free of US-origin tech entanglements. But semiconductor value chains are simply too complex and interconnected for any one country to become entirely self-sufficient. And there are no short cuts when it comes to developing cutting edge chips.

A strikingly sober assessment of China’s chip industry published by the Chinese Academy of Sciences (CAS) noted that China has mistakenly assumed it could develop its chip sector without investing in basic R&D to develop next generation transistors. China, the article notes, “the US turned off the lighthouse” and “we have now entered a dark forest” when the United States decided to choke off supplies of critical software and tools. Beijing is now scrambling for a solution, with calls ranging from boosting basic R&D and industrial policy funding to appointing “supply chain chieftains” to oversee the industry’s development.

But more funding, restructuring, and talent poaching is unlikely to bridge the large gaps in China’s development of cutting-edge chips. China has already committed to investing around $150 billion between 2014 and 2030 to grow its chip industry. And yet Chinese semiconductor firms are producing only around 7% of the chips China consumes —far short of Beijing’s target to achieve self-sufficiency rate of 70% by 2025. On top of high technical barriers, intensifying export controls, and intricately woven supply chains favoring the US and its security partners, China must also contend with tightening fiscal pressures, amid a structural economic slowdown, and a record of waste and corruption in its Big Fund industrial policy as it tries to formulate a policy response.

The temptation to follow the path of least resistance is likely to grow as China’s economic stresses deepen. There is a vast commercial chip market where Chinese chipmakers (for now) are free to compete and where Chinese industrial end-users will be geopolitically motivated to boost domestic chip content. US tech companies trying to preserve market share via “in China for China” policies face a web of competing pressures as a result: growing state pressure in China to adopt homegrown chips, heat from US policymakers trying to decouple US-China tech supply chains, and competition from foreign firms whose host governments have little interest in extending restrictions into more commoditized market segments.

 

Congress took a major step forward in decarbonizing the US economy when it passed the Inflation Reduction Act (IRA) in August 2022, but on its own the IRA is not enough to achieve the US’s climate commitment under the Paris Agreement. Our analysis shows it will likely only drive emissions down to 32-42% below 2005 levels in 2030—well short of the Paris Agreement target of a 50-52% reduction. However, a whole-of-government approach that includes aggressive policy action across Congress, federal agencies and the executive branch, and states and subnational actors, could put the target within reach.

Before the IRA was passed, we assessed a suite of policy options that could achieve the target, including congressional action along the lines of the IRA, in our October 2021 Pathways to Paris report. In light of passage of the IRA as well as a host of other shifts in the US energy system, we take another look at whether the Paris target is achievable and what policies could help us get there. In this update to Pathways to Paris, we find that ambitious federal and subnational policies can push emissions down to 41-51% below 2005 in 2030. Bold federal action, including stringent standards on power plants and light-duty vehicles, is necessary to achieve these levels, but states and other subnational actors also have a critical role to play. But this outcome isn’t guaranteed, clouded by legal risk, non-cost barriers, and politics—making rapid and assertive action all the more important in order to achieve the US’s 2030 climate target.

How far down the path are we?

In October 2021, we published Pathways to Paris: A Policy Assessment of the 2030 US Climate Target. In that analysis, we modeled a “joint action” scenario in which Congress, federal regulators, and subnational actors all took ambitious steps to drive down greenhouse gas (GHG) emissions. That scenario resulted in a 45-51% reduction in net GHG emissions below 2005 levels in 2030, illustrating that concerted work across all levels of government could actually lead to the US achieving its Paris climate target, a 50-52% reduction below 2005 levels.

Since our original report, meaningful action has been underway. In particular, in November 2021, Congress passed the Infrastructure Investment and Jobs Act (IIJA), often referred to as the bipartisan infrastructure deal. Then, in August 2022, Congress passed the Inflation Reduction Act (IRA), representing the single largest federal investment in decarbonization in American history.

Taken together, these two bills put in place the lion’s share of policies we included in the congressional component of our joint action scenario. With these congressional actions, the US is on track for a 32-42% reduction in GHG emissions below 2005 levels in 2030—bending the US emissions curve down toward deeper decarbonization, but still not enough to achieve the Paris Agreement target.

In addition to major congressional action, a number of other factors are different today from 18 months ago, among them:

• The Supreme Court in West Virginia v. EPA constrained the Environmental Protection Agency’s regulatory flexibility for CO₂ emissions from power plants.
• The Biden administration has reached its two-year mark in office, and despite some climate regulatory wins, many major climate-relevant federal regulations are still outstanding.
• Russia’s war in Ukraine has resulted in greater near-term volatility and long-term uncertainty in fossil fuel markets.
• Macroeconomic growth projections have trended downward and high inflation persists.
• Time keeps ticking, and we’re 18 months closer to the 2030 deadline.

Some of these factors can facilitate faster decarbonization, while others limit emissions reductions. In this note, we reconsider our original joint action scenario, adapt it in light of these new circumstances, and consider whether the US Paris commitment is still in reach.

What does joint climate action look like today?

To model a new joint action scenario, we start with our Taking Stock 2022 (TS2022) GHG projections, which include all relevant federal and state climate policies on the books through June 2022, and add the Inflation Reduction Act. This approach is consistent with our previous IRA analysis. As in TS2022 and past IRA work, we model three emissions pathways: a low-emissions pathway that pairs cheap clean energy technologies with relatively expensive fossil fuels and baseline economic growth; a high-emissions pathway with expensive clean tech, cheap fossil fuels, and more robust GDP growth; and a mid-emissions pathway that splits the difference. Much more detail about these assumptions and the policies already included in our modeling can be found in the TS2022 technical appendix.

We present results for two cases in this note. Our new joint action scenario includes an array of actions by US federal agencies and climate-leading states and assumes no new action by Congress. Our federal action scenario reflects only the subset of policies in the joint action scenario that involve the federal government, such as appliance standards and Clean Air Act regulations. We present a full list of the policies we model in the appendix to this note. In general, they follow closely the federal executive and subnational policies included in our original joint action scenario. Notable changes from this list include:

• We developed revised new and existing source performance standards for electric generating units (EGU) based on the Supreme Court’s West Virginia v. EPA ruling, taking an inside-the-fenceline approach to establishing the best system of emission reductions.
• We implemented new non-GHG public health regulations for the power sector, including changes to the Cross-State Air Pollution Rule and emission standards for hazardous air pollutants at EGUs.
• We omitted carbon pollution standards for industrial sources since their adoption in the first Biden term is unlikely.

To model these policy scenarios, we use RHG-NEMS, a version of the National Energy Modeling System developed and used by the Energy Information Administration to produce its Annual Energy Outlooks. We modify EIA’s base version of NEMS by incorporating our own cost and performance assumptions for clean energy technologies, and we further modify both algorithms and inputs to reflect recent trends in technology development and deployment. RHG-NEMS also incorporates Rhodium Group’s Industrial Carbon Abatement Platform. Finally, we extend RHG-NEMS to project GHG emissions for all sectors of the US economy across six key GHG categories, following EPA and UNFCCC accounting standards. This allows us to quantify the impacts of policies beyond energy system CO₂ using the same framework as the EPA GHG inventory.

Joint action can still drive the US to its Paris goal

This aggressive set of policies pursued as quickly as possible by federal agencies and climate-leading states can reduce US GHG emissions to 41-51% below 2005 levels in 2030, a 9-10 percentage point reduction beyond what the US is on track for with the IRA alone (Figure 1). In the low-emissions joint action case, this policy portfolio enables the US to achieve its Paris climate commitment, while in the mid-emissions case, the target is within spitting distance. In the high-emissions case, we find higher emissions than in our previous analysis, primarily due to higher total GDP and higher overall clean energy prices in the new high case compared to the last iteration.

The IRA drives the biggest reductions in the power sector, but the joint action scenario can help drive down emissions across a broader swath of the economy (Figure 2). To be sure, the joint action scenario pushes further on the power sector, yielding an additional 62-157 mmt reduction in GHGs by 2030. The power sector achieves 65-85% clean generation in 2030, up from 60-82% with only the IRA in place.

The transportation, industry, and carbon removal sectors each experience at least as much reduction as the power sector in the joint action scenario, depending on the emissions pathway. In transport, more aggressive EPA light-duty vehicle (LDV) regulations further accelerate electrification of the LDV fleet, as do accelerated state zero-emitting vehicle targets. Taken together, sales of electric vehicles (EVs) reach 46-61% of all LDVs in 2030, up from 19-57% with only the IRA. Federal medium- (MDV) and heavy-duty vehicle (HDV) standards and climate-leader state MDV and HDV targets, low-carbon fuel standards, and investments in transit funding also drive down transportation sector emissions.

In industry, the largest portion of GHG reductions comes from EPA finalizing an impactful standard for methane and other harmful pollutant emissions from oil and gas operations. Direct building emissions drop owing to a combination of accelerated federal appliance standards and states upping their energy efficiency resource standards. Agriculture and waste reductions are also driven by climate-leader state targets, while increases in carbon removal result from federal investment in forests and working lands.

All told, the policies in the joint action scenario can reduce average household energy bills by $287-348 in the year 2030 on top of savings from the IRA alone (Figure 3). Much of this saving comes from reductions in household expenditures on gasoline and diesel for their vehicles, with additional savings from lower electricity bills and less spending on home heating fuels. In our original Pathways to Paris report, we found roughly $500 in savings accruing to the average household. In our previous analysis of the IRA, we found that the policy would reduce household energy bills by $27-112 in the year 2030. These savings are already included in our baseline, so they no longer appear as bills savings from the joint action scenario. We also now include material public health regulations in the power sector which, on their own, tend to increase the rates consumers pay for electricity, requiring EGUs to retrofit with pollution control equipment. Despite the application of the additional regulations, consumers see lower energy costs in the future alongside cleaner air. This is in part thanks to IRA incentives that reduce the cost of compliance.

Federal executive action, including new power plant, clean vehicle and methane regulations, is an essential driver of all of the outcomes in our joint action scenario. Federal policy alone can drive emissions down by 6 percentage points in each case, to 38-48% below 2005 levels in 2030 (Figure 4). Failure to promptly adopt the federal executive policies included in the joint action scenario, or neglecting to push for maximum achievable ambition in these policies, or substantial implementation delays after finalization put the US’s 2030 climate target very much at risk and will set the US off course on its long-term decarbonization pathway. As we detail below, there is still uncertainty in the impacts of the IRA, and federal action can help reinforce the achievement of these outcomes.

This should not minimize the importance of state and subnational actions. Federal action alone is insufficient, and the 2030 target is entirely out of reach if states and other subnational actors neglect to adopt aggressive new policies to advance decarbonization. As in our last analysis, a true, whole-of-government approach is urgently required to achieve the US’s Paris Agreement target.

Challenges and risks remain

While this analysis demonstrates that the US 2030 target is still within reach, achieving a 50-52% reduction in GHGs compared to 2005 will hardly be a slam dunk. Even with a boost from IIJA and the IRA, a lot needs to happen fast for the US to achieve the pathway we’ve identified. Just as we noted in our previous report, risks to achieving the target abound, including court challenges to new regulations and the prospect that technology deployment may not be able to scale up at the pace required to meet the target. Headwinds such as permitting and siting bottlenecks, workforce shortages, rapidly shifting supply chains, and other factors may affect the pace of decarbonization. Another clear risk is a lack of consistent prioritization of climate action in leading states and at the federal level over the rest of the decade. If the 2024 election results in White House leadership that doesn’t treat climate change as the serious threat that it is, then many of the actions we include in our analysis are at risk of delay or abandonment, putting the target out of reach. The same holds for states. Consistent leadership and prioritization of climate action in state governments will be critical to the fate of US GHG emissions.

Federal, state, and/or subnational actors can also pursue and implement policy actions not considered in our joint action scenario and make meaningful contributions to achieving the 2030 target. We review a wide variety of options, everything from clean product standards to carbon pricing, in our previous report. The joint action scenario does not reflect any additional climate action in Congress. Just as with the IRA, Congress could surprise on the upside and enact additional decarbonization policies, but again, future elections will greatly impact prospects.

It remains true that even if the US cuts GHG emissions in half in 2030, that’s only halfway to the additional target of net-zero emissions by 2050, leaving at maximum 20 years to get the rest of the way. Beyond new regulations and deployment policies, continued investment in innovation and scale-up of emerging clean technologies in this decade is needed to expand the frontier of future emission reduction options. If technologies such as clean hydrogen, clean fuels, a broad suite of carbon removal approaches, and clean dispatchable electric generators are commercially available at scale by the end of this decade, then it will be much easier to maintain decarbonization momentum in the next one.

Onward

With this analysis, we reaffirm that joint action by states and the federal government can put the 2030 target of cutting US emissions in half within reach. Now it’s up to government leaders and regulators to act, who can build on the legislative achievements of the last Congress by taking new actions to drive down GHG emissions and cut costs for consumers. Time is of the essence. With so much to do and less than eight years to do it, it’s time to hunker down and keep on working towards the implementation of robust, durable decarbonization policy for the US. In the meantime, we’ll continue to monitor progress toward these goals and update our projections, including modeling the joint action scenario as part of our upcoming Taking Stock 2023 report.

This nonpartisan, independent research was conducted with support from the William and Flora Hewlett Foundation, the Heising-Simons Foundation, and the Energy Foundation. The results presented in this report reflect the views of the authors and not necessarily those of supporting organizations.

Clean hydrogen is a set of early-stage technologies that have the potential to be a “Swiss Army knife” of long-term decarbonization in the US. It can advance US decarbonization by replacing traditional hydrogen in current industrial applications in the near term and substituting for a variety of fuels and feedstocks in the long run, but will require significant policy and investment support to scale up to the levels needed. The clean hydrogen production tax credit included in the recently passed Inflation Reduction Act (IRA) is a meaningful step towards securing a spot for clean hydrogen in the US economy. Now, the Internal Revenue Service (IRS) is grappling with implementing regulations for the credit, trying to decide how to account for greenhouse gas (GHG) emissions from electricity generation used to make electrolytic hydrogen (one type of clean hydrogen, often called green hydrogen).

In this note, we discuss the trade-offs for the decisions the IRS has in front of it. For green hydrogen to play a role in a decarbonized future, the US needs to get experience building and installing electrolyzers at an unprecedented scale today in order to establish a domestic industry and drive down costs. Adhering to restrictive rules to claim the credit in the near term may hamper the ability of this industry to grow, reducing the range of clean hydrogen opportunities down the road. At the same time, policymakers need to provide clarity on a future path that ensures green hydrogen actually reduces long-term GHG emissions. One model that could be useful for the US is the GHG accounting approach for green hydrogen that the European Commission recently set out, which is a phased approach over time to more restrictive rules. In the US, near-term flexibility on these rules is likely to lead to modest increases in overall GHG emissions over the next few years, but standing up a green hydrogen industry that ultimately adheres to strict rules in the future can ensure that green hydrogen can play a meaningful role in deep decarbonization.

Clean hydrogen’s potential in a decarbonized energy system

Clean hydrogen has the potential to play an important role in a decarbonized economy as a fuel, feedstock, and energy storage medium across multiple sectors. In previous Rhodium research before the IRA was passed, we assessed the near- and long-term opportunities for effectively scaling up clean hydrogen. The biggest emissions reduction opportunities in the near term come from switching the current roughly 10 MMT of annual US hydrogen demand away from conventional fossil fuel-based production to cleaner production methods. This demand is driven by industrial processes—refineries, ammonia production, and methanol production chief among them. Today, almost all of this hydrogen is produced via the steam methane reformation (SMR) process, which converts natural gas into hydrogen and emits around 100 MMT of CO₂e annually or just under 2% of US net GHG emissions (Figure 1). Reducing these emissions by transitioning to clean hydrogen production can make a small but measurable difference in the US decarbonization trajectory.

Over time, deeper emission reductions can come from substituting clean hydrogen for incumbent fossil fuels in new use cases, including as an industrial fuel or feedstock and as a transportation fuel for difficult-to-electrify applications like heavy-duty trucking. The biggest emissions benefits from clean hydrogen materialize when its use is expanded to these future applications, compared with a relatively small emissions impact of decarbonizing existing hydrogen consumption today.

Several technological pathways can produce hydrogen with meaningfully lower greenhouse gas (GHG) intensities. Two of the most commonly discussed are retrofitting SMRs with carbon capture and producing hydrogen via electrolysis. In the former, CO₂ can be captured at various points in the process of converting natural gas to hydrogen, yielding a production emissions intensity that’s as much as 99% lower than uncontrolled SMR production—though the most economic opportunities for carbon capture at these facilities will likely yield less emissions abatement. Our previous research has indicated that carbon capture on current SMR facilities (also called blue hydrogen) can play a role in near-term decarbonization; however, this note focuses on electrolytic hydrogen produced with low-emissions electricity, commonly referred to as green hydrogen. Green hydrogen uses electricity in the presence of a catalyst to split water into hydrogen and oxygen, emitting no CO₂ at the point of production. However, CO₂ and other GHGs may be emitted from generating the electricity used in the process.[1]

This future for green hydrogen is far from guaranteed, and it’s not clear how big of a role green hydrogen specifically will play. But we know for sure that it won’t help decarbonize the US energy system unless three things are true:

1. Green hydrogen is available
2. Green hydrogen is low-emissions
3. Green hydrogen is cheap, at least at price parity with SMR production

Policy support for green hydrogen

For green hydrogen to play a role in a future decarbonized energy system, the US needs to start getting experience building and installing electrolyzers quickly. It takes time for new technologies to propagate through the market as developers work to establish supply chains, train labor, and learn to navigate bureaucratic processes. This increase in hydrogen deployment is also necessary to reduce costs and ensure a cheap supply of green hydrogen.

How fast can electrolyzers scale up? One useful example comes from the meteoric rise of wind and solar. During their fastest 10-year periods of scale-up this century, utility-scale wind installations grew by an average of 42% per year, and utility-scale solar installations grew by an average of 97% per year. Even if electrolyzers are on the same path as solar, they’re only on track to provide less than 20% of current hydrogen demand in ten years. Like with wind and solar, aggressive or, in this case, even modest scale-up won’t happen with market forces alone—policy support will be necessary to increase the availability of green hydrogen.

A hydrogen production tax credit (PTC) was adopted as part of the Inflation Reduction Act (IRA) in 2022 and is an important policy we identified in our previous note as key to hydrogen scaling up. Alongside a suite of other tax credits, especially the clean electricity production and investment tax credits, the hydrogen PTC (also called the 45V tax credit, after its section in the tax code) can drive down the cost of clean hydrogen to be cost-competitive with SMR-produced hydrogen.

The 45V tax credit is especially important for green hydrogen. If green hydrogen can demonstrate very low lifecycle GHG emissions, it can qualify for up to $3/kg in tax credits. That level of tax credit can drive meaningful deployment of electrolyzers. The key question the IRS is currently trying to address is how to calculate that GHG footprint—which we’ll return to later in this note.

Despite this significant supply-side push, there haven’t been any major demand-side drivers enacted to incent or require the transition to green hydrogen. For green hydrogen to play a meaningful role in long-term decarbonization, it must move beyond just replacing current SMR production. However, creating the green hydrogen market necessary for decarbonization requires sufficient demand-side policy that incentivizes that change. For the green hydrogen market to really scale, these policies will need to exist in the form of sectoral standards or sector-based or economy-wide carbon policies.

Trade-offs in scaling green hydrogen

Delays in installing electrolyzers in the near term will result in a slower overall scale-up of electrolyzer capacity and, therefore, fewer emissions benefits in the long run. When assessing trade-offs of policy implementation, it’s important to understand the balance of considerable long-term emissions reduction benefits vs. short-term impacts. This brings us back to the importance of the IRS decisions around implementing the 45V tax credit.

The statutory language of the hydrogen PTC is straightforward: to qualify for the highest level of tax credit, hydrogen must be produced via a process with a lifecycle GHG emissions rate of less than 0.45 kg of CO₂e per kg of hydrogen. Today, electrolytic hydrogen needs the full value of the credit to approach cost competitiveness with SMR hydrogen, so its producers need to demonstrate a very low emissions rate. Electrolysis is a very electricity-intensive process, and emissions from electricity generation are the major contributor to its total lifecycle emissions rate. So the GHGs emitted from generating electricity that flows into the electrolyzer really matter.

Stakeholders and intervenors have proposed several approaches for calculating GHG emissions from relevant electricity generation. The most stringent of these approaches require temporal and regional matching and additionality provisions. In this approach, for electricity to qualify as zero-emitting, every kilowatt-hour (kWh) of electricity going into an electrolyzer must be matched with a kWh of electricity generated from a new, zero-emitting generator sited in the same region as the electrolyzer on an hourly basis. This provides the highest degree of assurance that the electricity demand from the electrolyzer isn’t causing increased GHG emissions in the power sector, thereby yielding the cleanest possible hydrogen.  Other approaches vary aspects of this formula, including matching kWhs on an annual basis instead of an hourly basis, not requiring the zero-emitting resource to be new, and not requiring its relative colocation with the electrolyzer.

Requiring a high degree of stringency across regional, temporal, and additionality variables on day one comes at a cost. The industrial end uses we’ve highlighted as the current market for green hydrogen need a relatively constant supply of hydrogen. This can be achieved by firming cheap wind or solar power with battery storage or other zero-emitting forms of electricity generation, allowing for steadier production from the electrolyzer. Energy system optimization models project minimal cost impacts over time as the system plans for and equilibrates to this demand. But today, firmed clean electricity contracts come at a cost premium—for example, a 38% increase in price for a solar power purchase agreement (PPA) paired with battery storage compared to a traditional solar PPA (Figure 2).

Since the cost of electricity is the single most significant factor in the cost of producing electrolytic hydrogen, these cost premiums can quickly push the total cost of production above the cost of SMR hydrogen, even with the full $3/kg tax credit in place. The cost increase from switching from a standalone solar PPA to a solar-plus-storage PPA increases the total subsidized cost of hydrogen production from $0.93-$2.98/kg to $1.49-$3.65/kg.[2] SMR hydrogen today is produced at a cost of around $1-$1.50/kg, depending on the price of natural gas, so the additional cost premium makes the economics of green hydrogen tough to pencil even at the low end of our cost ranges.

Firming with a four- or even eight-hour battery also doesn’t improve the regularity of electricity output enough to create a stream of hydrogen useful for industrial applications. Hydrogen producers or consumers can construct large storage facilities to hold hydrogen until needed, but the cost of that storage equipment, which is dependent on the storage type and context of the individual site, scales with their size and again adds to the total cost of hydrogen.

Beyond the hydrogen production cost implications, hourly tracking of the emissions attributes of electricity is still relatively new in the US. There have been promising developments in this regard among major energy attribute certificate (EAC) tracking platforms: the M-RETS platform, which tracks voluntary EACs in several parts of the country, developed hourly tracking tools in 2019, while PJM GATS, used to track compliance EACs in the PJM electricity market region, is expected to release the ability to do so this year. Still, there is currently no nationwide, common platform for tracking hourly EACs in the US. This makes consistent hourly clean electricity matching for early-stage green hydrogen production projects challenging, if not impossible.

Sizing the potential emissions impact

On the other hand, relaxing the hourly matching to an annual requirement will increase emissions from the power sector in the near term. To simplify slightly, if electrolyzers are running at relatively steady capacity factors, that demand is increasing generation from some fossil-fired generators when the renewable resource contracted via a PPA is not generating. As we highlight above, green hydrogen can’t contribute to meaningful decarbonization if it’s not actually low-emitting.

To assess the potential tradeoffs between hourly and annual matching, it can be helpful to consider the scale of emissions that could occur in the less restrictive annual matching scenario. As mentioned above, US electrolyzer capacity is starting from a very low level today. Even with the IRA and Infrastructure Investment and Jobs Act (IIJA), it will take time to scale up. If electrolyzer capacity grows 50% faster than utility-scale solar capacity did in its best 10-year period, installed electrolyzer capacity could reach 21 GW in 2030, producing just under 3 MMT of hydrogen—somewhere around 30% of total hydrogen demand today (Figure 3). The additional electricity used for electrolysis would represent about a 4% increase in total electricity use that year.

Under annual averaging, we estimate that electricity generation to fuel these electrolyzers could increase total greenhouse gas emissions from hydrogen production by 34-58 MMT in 2030 above today’s 100 MMT per year level—a roughly 1% increase in economy-wide GHG emissions—and a cumulative 56-97 MMT increase in emissions from 2023 through 2030.[3] For context on this figure, the Department of Energy finds that if it can scale, clean hydrogen can reduce total US greenhouse gas emissions by 660 MMT in 2050.

These figures are a conservative upper bound on the impact of annual averaging as they rely on high hourly emissions rates and assume no improvement in grid carbon intensity over time. The grid is already on course to be substantially cleaner than it is today—we estimate that the IRA can drive the total share of clean generation from 43% today to 60-81% by 2030.

Though temporal matching is perhaps the most hotly-debated design element, the other elements matter quite a bit as well. Our emissions estimates increase 73 MMT in 2030 if there were no additionality requirement and to 63-100 MMT if the hydrogen was only produced in parts of the country with the highest-emitting power grids. Finally, our estimates assume electrolytic hydrogen serves demand currently supplied by SMR-produced hydrogen. If all of this hydrogen went instead to new end uses and there was no reduction in SMR production, our emissions estimates increase to 60-85 MMT in 2030.[4]

Additional actions that drive grid decarbonization can mitigate some of this near-term tick-up in emissions. Just as a cleaner grid reduces the lifecycle emissions impact of other new electrified technologies like electric vehicles and heat pumps, it will do the same for electrolytic hydrogen production relative to the grid of today, especially to the extent that the cleaner grid includes higher capacity factor, zero-emitting sources of generation. Large-scale deployment of utility-scale batteries and increased transmission can also help make more zero-emitting power available in more parts of the country at more times. Beyond the increases in generation projected to materialize thanks to the IRA, policies including EPA power plant regulations and work to address transmission bottlenecks, siting and permitting issues for renewables, interconnection queue backlogs, and supply chain constraints can help secure progress toward a cleaner grid and drive it further.

How could we maximize deployment and minimize emissions? An example from Europe

The US isn’t the only place wrestling with what constitutes clean hydrogen. The European Commission recently set out its rules for what counts as green hydrogen, proposing a phased approach, and it’s instructive for a couple of reasons. First, the EU is another large energy consumer grappling with how to achieve its climate goals. Second, their requirements apply to any hydrogen imported to the continent as well, meaning US hydrogen producers would have to meet them if they want to consider the EU as an export market.

On the question of temporal matching of clean electricity to hydrogen production, the European model starts with monthly matching, noting that more granular matching “is hampered in the short term by technological barriers to measure hourly matching, the challenging implications for electrolyzer designs, as well as the lack of hydrogen infrastructure enabling storage and transportation of renewable hydrogen to end users in need of constant hydrogen supply.”

Each of these challenges also rings true in the US context, particularly the technological barriers to hourly matching. As we’ve mentioned, there is currently no national hourly generation tracking system, and it’s unclear when one will be in place. Hydrogen projects will likely have difficulty securing financing if developers need to meet an hourly matching requirement with no common framework for compliance.

Given the patchwork nature of US electricity markets, monthly matching is likely even a stretch for the foreseeable future. Notably, the EU has a common power market, while the US market is highly segmented. Europe focuses on achieving hourly matching by 2030, providing a good model for a medium-term transition. ​​Europe’s approach also includes a review clause for the more granular matching in 2028, examining the impacts of the increased stringency on hydrogen production costs.

The EU approach also requires regional matching and that the electricity used for hydrogen production be relatively newly constructed (i.e., in operation within the last three years before the hydrogen production starts) with limited exceptions for regions that already have very clean grids. The rules also include a “transitional phase,” allowing installations in operation before 2028 to get an exemption from the additionality rules through 2037.

A path forward

Electrolyzers are a key technological solution to reducing the emissions of existing industrial processes that use natural gas-based hydrogen. Over time, they can increasingly play a role in other applications as well. To reap the potential benefits of green hydrogen, the US needs to develop an industry to build and install electrolyzers—something unlikely to happen if restrictive regulations constrain near-term electrolyzer deployment.

Global electrolyzer manufacturing capacity is expected to grow substantially over the coming years, and the US risks missing a key clean energy manufacturing opportunity absent supportive policies and robust domestic demand. Electrolyzer costs will reduce as global manufacturing capacity increases, and nothing is forcing US hydrogen developers to buy US-made electrolyzers. Still, domestic deployment can help further drive costs down the learning curve. Achieving steep capital cost reductions requires meaningful electrolyzer deployment above and beyond what is already in the pipeline—and the US can help fill that gap.

Another challenge of restrictive regulations on electrolytic hydrogen production is the risk of lock-in of blue hydrogen as the leading technology producing clean hydrogen. SMRs with carbon capture can already claim the $85/ton section 45Q tax credit, and developers and financiers already have some experience working with that policy. There is no lifecycle accounting requirement under 45Q if the CO₂ is permanently stored underground, and the measurement of emissions abatement is more straightforward—a ton of CO₂ captured results in a payout, hard stop. Especially if there aren’t policies driving new hydrogen demand, much of the current demand for hydrogen could be saturated with blue hydrogen—useful for near-term emissions reductions but not for decreasing dependence on fossil fuels or hydrogen playing a major role in long-term decarbonization.

Providing a runway for more restrictive limitations on what hydrogen qualifies for 45V, including more granular temporal and regional matching over time similar to what the EU is considering, can point developers in the right direction while giving them important experience installing electrolyzers today and developing a domestic industry.

At the same time, policymakers can’t ignore the long-term emissions risk that can accompany a boom in electrolyzer deployment. To construct emissions guardrails, the IRS can establish target dates for ratcheting up the certainty on key implementation details like a transition to more temporally granular matching. Such phase-in approaches give the hydrogen and power industries the signposts they need to develop the tracking tools, calculation approaches, contract language, and other key elements to assure green hydrogen contributes to decarbonization.

In the meantime, IRS can focus on implementing the (relatively) easy stuff based on existing frameworks and regulations:

1. Regional matching of clean electricity generation and hydrogen production, such as by balancing authority reported on form EIA-861, ensuring clean electrons are delivered into the same market as the electrolyzer.
2. Annual matching of clean electricity generation and electricity used in hydrogen production using existing tracking systems.
3. Simple additionality requirements like establishing an in-service date for new generating facilities to count as additional.

Finding a transition pathway that gets deployment going and minimizes emissions while phasing in a high bar for GHG performance over time represents a compromise and could be the best way forward.

[1] These summaries are not full lifecycle assessments of the greenhouse gas emissions associated with each production pathway.

[2] Cost ranges represent low, central, and high assumptions of the capital cost of electrolyzers. We assume batteries in a solar-plus-storage setting cannot charge from the grid.

[3] The low and high end of the ranges represent securing a PPA with wind and solar facility, respectively. We assume all electricity incremental to what’s available on an hourly basis via these PPAs emits at the eGRID 2021 nonbaseload emissions rate, which likely overstates emissions, as we discuss below.

[4] These outcomes appear relatively unlikely. An additionality requirement is easy to implement, as discussed below, and most regions of the country with existing hydrogen demand have average or cleaner-than-average electricity. As discussed above, a lack of new demand for hydrogen in this period means green hydrogen is largely or entirely substituting for SMR hydrogen. Note that these estimates are for each component individually and aren’t necessarily additive.

This nonpartisan, independent research was conducted with support from Breakthrough Energy. The results presented in this report reflect the views of the authors and not necessarily those of the supporting organization.

As China’s economy enters a period of prolonged slowing, regulators will be tackling difficult reforms that may have significant impacts on the financing of decarbonization. In a new workstream, Rhodium Group will be providing regular updates and analysis on the state of China’s green financing, domestically and abroad.

At the moment all eyes are on China’s leadership as President Xi Jinping and his newly appointed Politburo host the “Two Sessions.” In this inaugural note, we dive into some key takeaways on the state of China’s green financing, including China’s 2022 climate performance, the political representation of climate change and clean technology, and how the People’s Bank of China (PBoC) continues to support decarbonization investment.

China falling behind on energy intensity targets, sets none for 2023

On March 5, outgoing premier Li Keqiang delivered the Government Work Report (GWR) at the National People’s Congress. It reported that on performance over the past five years (2018-2022), China’s GDP grew at an annual average rate of 5.2% while the energy intensity of GDP decreased 8.1%, and carbon dioxide (CO₂) intensity of GDP fell by 14.1%. This assumes at face value China’s reported 2022 performance of a 0.1% year-on-year (y/y) decrease in energy intensity and a 0.8% y/y decrease in CO₂ intensity of GDP, with GDP growth at 3% y/y. There remain some questions about the accuracy of reported energy consumption data for 2022.

The accuracy of energy and emissions data is important in assessing China’s performance against its own near-term and long-term climate targets. China had previously set a target of a 13.5% reduction in the energy intensity of GDP and an 18% reduction in energy sector CO₂ intensity for the 14th five-year plan period (2021-25). This is aligned with its longer-term goal of achieving over 65% emissions intensity of GDP by 2030 from a 2005 baseline. Energy intensity improvements in China have stagnated since 2020 (Figure 1).

Unsurprisingly, China has reduced the importance of energy intensity in measuring climate performance. The GWR has set a target of around 5% growth in GDP for 2023, but like 2022, set no energy intensity reduction target. “Continuing the transition to green development” remains one of the top eight priorities for Beijing in 2023, but without energy intensity targets, local governments may not necessarily prioritize reducing energy consumption and carbon emissions as they try to stimulate economic growth. For instance, historically during major political meetings like the “Two Sessions,” local regulators would take steps to control heavy industry, traffic, and other sources of air pollution in order to ensure blue skies in Beijing. However, this year, the “Two Sessions” were marked by a noticeable return of bad air quality.

Clean tech representation at “Two Sessions” rises as internet companies fall

The annual “Two Sessions,” currently taking place, is when both the National People’s Congress (NPC) and the Chinese People’s Political Consultative Conference (CPPCC) hold meetings at the same time. This year’s Two Sessions is also the first of the new five-year term of the Chinese Communist Party (CCP), meaning there is a new group of delegates for the NPC and CPPCC. The NPC is the CCP’s legislative body, and the CPPCC is an advisory body. Both have members drawn from various sectors of Chinese society, including government officials, social organizations, ethnic minority groups, and private individuals like academics, business executives, and celebrities.

Notably, for the first time in 30 years, the CPPCC has added a new working group on “Energy and Resources” (环境资源界). It is one of 34 working groups and one of the largest groups with 85 members. About 20% of the members are from energy and chemical companies, mostly power generation, oil and gas, and mining state-owned enterprises (SOEs). This group does not include delegates from clean tech companies in the private sector, who are represented elsewhere.

Another notable difference this year is the relative prominence of representation in the NPC and CPPCC of clean tech industries versus internet platform companies. In the last NPC and CPPCC term (2018–2023), many notable internet platform company executives were appointed as delegates, including Pony Ma (Tencent), Li Yanhong (Baidu), Liu Qiangdong (JD Group) and Wang Xiaochuan (Sohu). Notably fewer corporate leaders from China’s largest internet platform companies were appointed delegates in this term.

In contrast, we count at least 27 delegates representing private companies in the clean tech and energy industries, up from 21 in 2018. Significant ones include Li Liangbin, president of Ganfeng Lithium, and  Zhong Baoshen, president of LONGi Group, both members of the NPC, and Li Shufu, founder of Geely Auto and Zeng Yuqun, founder of CATL, both members of the CPPCC.

For the Party, appointing private-sector executives to the NPC and CPPCC signals openness to support private enterprises and a recognition of their importance to China’s economy. The increasing share of delegates from clean tech companies implies more political importance attached to green industries and supply chains in China’s overall industrial policy design. However, at a time when private Chinese clean tech companies are under scrutiny for their connections to the CCP, their growing political representation in government also weighs on external perceptions of their independence.

Key economic leadership reappointed, PBOC extends decarbonization lending support for another year

In a surprising announcement, Finance Minister Liu Kun and PBOC Governor Yi Gang were both reappointed, even though they are not currently members or alternate members of the CCP’s Central Committee, a break from tradition that has only happened once before, with the reappointment of ex-PBOC governor Zhou Xiaochuan in 2013. The reappointment of these key officials signals a need for continuity in economic policy, navigating a gradual exit from financial stresses worsened by three years of pandemic policy.

For the green transition,  currently Beijing’s plan is to keep in place monetary tools through the central bank (PBOC) that encourages investment in decarbonization. The PBOC has 15 structural monetary tools in place dedicated to providing discounted lending to strategic segments, including agriculture, innovation, logistics, pension, carbon reduction, clean coal, and small private businesses. Introduced in November 2021, the carbon emission reduction facility (CERF) and the clean coal special re-lending (CCSR) were specifically designed to incentivize investment in four green industries: renewables, environmental protection and energy conservation, low-carbon technologies, and clean coal.[1] The CERF does not have a hard quota, while the CCSR has a total quota of RMB 300 billion (initial quota of RMB 200 billion). In January, the PBOC extended the CERF to 2024 and the CCSR to 2023.

The CERF was limited to 21 state-owned national banks when it was introduced in November 2021. The PBOC has since expanded the list to include smaller local banks and some foreign banks, including Deutsche Bank and Société Générale. We calculated that as of Q3 2022, China’s six largest state-owned commercial banks[2] received at least 85% of CERF funds. The CCSR lending facility continues to be limited to state-owned national banks only.

The Chinese government admitted that many companies face challenges in clean coal utilization. Coal power companies have been losing money due to high fuel costs. Thus, market demand for the CCSR funds has been lukewarm compared to the CERF. As of year-end 2022, eligible clean coal projects received loans totaling RMB 82 billion, only 27% of the full quota (Figure 2). Given the facility uptake rate, the RMB 300 billion quota is unlikely to be exhausted before the lending facility expires at the end of 2023.

On the other hand, RMB 310 billion of CERF loans have been deployed as of the end of 2022. Our survey of Q3 2022 reports from the six largest state-owned commercial banks revealed that renewable energy projects accounted for over 95 percent of their portion of CERF lending, totaling RMB 337 billion. China’s renewable energy market has seen record growth over the last two years. China added 223GW of new wind and solar generation capacity since 2020, although notably nearly half of this capacity was commissioned before the CERF was established. Assuming most of the lending facility was used to finance new projects and not refinance existing projects, this indicates significantly more growth in China’s renewable power is to come.

The PBOC provides 60% of the loan principal to financial institutions for qualified CERF projects and 100% for the CCSR projects at an interest rate of 1.75%. Finance institutions then reloan to companies at roughly the loan prime rate of the same term. The average borrowing rate of CERF recipients from the six commercial banks was 4% as of Q3 2022, just 0.3 percentage points lower than the weighted average interest rate of all new loans issued, according to the PBOC’s data. But the average interest rate for small and medium-sized (SME) companies’ new borrowing is 5.35% nationally as of H1 2022. The CERF could be much more attractive for SME businesses; however, the majority of renewable energy developments are by SOEs, so it remains to be seen if the CERF mechanism has actually reduced borrowing costs for green energy projects or opened more support for SMEs and private companies.

Overall commercial banks’ disclosure of CCSR loan details is nonexistent, and their disclosure of CERF loans remains inadequate to determine their efficacy. For CERF loans, the PBOC initially required banks to disclose project details and third-party-verified emission reduction benefits. However, currently, the major commercial banks only disclose quarterly aggregated data on the number of projects, total loan amount, average interest rates, and emission reductions at the aggregate (rather than project) level without evidence of third-party verification. While CERF’s interest rates seem attractive, without more transparent and granular data, it’s hard to determine if the CERF and CCSR mechanisms have truly opened doors for SMEs and private companies to access lower cost borrowing for green projects.

[1] “Clean coal” refers to technologies that lower emission from coal-fired power generation, coal chemicals, coal-fired furnaces, civilian coal use, coalbed methane use, and coal waste utilization per the National Energy Administration http://www.nea.gov.cn/2017-10/13/c_136677423.htm

[2] The six banks are Bank of China, Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China, Bank of Communications, Postal Savings Bank of China

If you are interested in learning more about China’s green financing and climate policy, please email CERC@rhg.com. 

Sign up to receive the China 30/60 newsletter

The passage of the Inflation Reduction Act (IRA) in the US has elicited two competing reactions from policymakers in Europe. European officials are relieved that with the passage of the IRA, the US has a credible pathway to meet its 2030 emission reduction target under the Paris Agreement, provided it is paired with federal climate regulations and additional state-level climate action. At the same time, many in Europe are concerned that incentives for US clean energy manufacturing investment in the IRA could harm European industrial competitiveness. In response, the European Commission has proposed a Green Deal Industrial Plan to further support clean energy manufacturing on the continent. This has generated headlines warning of a “subsidies arms race” between allies.

In this note, we unpack the IRA and what it means for European industry. We find that while the IRA includes meaningful new incentives for the US clean energy industry, the share of IRA spending that supports US manufacturing directly at the expense of European industry is considerably lower than recent reporting on the transatlantic clean energy rift might suggest. The primary driver from the IRA shaping the clean energy manufacturing landscape is likely to be the overall accelerated pace of clean energy deployment in the US. This will expand clean energy manufacturing in the US, but will also create opportunities for European companies and lower the cost of clean energy on both sides of the Atlantic.

Understanding the role of domestic content requirements in the IRA

Press reports generally describe the IRA as containing $369 billion of spending on climate mitigation and adaptation over ten years. This number is drawn from the Congressional Budget Office (CBO)’s “score” of the legislation. Some of the IRA’s investments come in the form of direct spending, like grants and agency appropriations, where the dollar amount is outlined in the legislative text. Other investments come in the form of tax credits, where the ultimate amount of federal investment depends on how much demand there is for the credits. Rhodium Group estimates that the ultimate amount of climate-related investment in the IRA will be somewhere between $355 and $552 billion between 2022 and 2031, based on a combination of CBO estimates and Rhodium Group energy system modeling. In this section, we break down where these investments are allocated and which programs have domestic content requirements attached.

Domestic manufacturing funding ($40.6 billion)

The IRA provides direct fiscal support for domestic clean energy manufacturing primarily through two provisions. The first is an extension and expansion of the existing section 48C tax credit that provides up to $10 billion over ten years to cover up to 30% of the cost of investing in new or retrofitted facilities to manufacture qualifying clean energy equipment. The CBO estimates that $6.3 billion of this amount will be utilized over the course of a decade. The second provision is a new production tax credit for manufacturing facilities that produce qualified clean energy equipment (section 45X). The CBO estimates that this provision will result in  $30.6 billion in federal investment over the course of a decade. There is an additional $3.7 billion in domestic manufacturing support in other parts of the IRA.

Clean vehicle tax credits with content/assembly requirements ($32-85 billion)

The IRA provision that has arguably elicited the most concern among US allies, including those in Europe, is the extension and modification of the federal tax credit for consumer purchase of electric vehicles and other qualifying clean vehicles (section 30D). To qualify for this credit when purchasing a new car, buyers must have an income below $150,000 (or below $300,000 for joint filers), and the vehicle they are purchasing must meet the following criteria:

1. Have an MSRP below $55,000 (or below $80,000 for a van, truck, or SUV)
2. Final assembly must have occurred in North America
3. At least 40% of the critical minerals (by value) used in the car (growing to 80% by 2027) must come from North America or a country with which the US has a free trade agreement, and none can come from a country deemed by the US government to be a “foreign entity of concern.” If these conditions are met, the consumer can claim a $3,750 credit.
4. At least 50% of the battery components (by value) used in the car (growing to 100% by 2029) must be manufactured and assembled in North America, and none can come from a “foreign entity of concern.” If these conditions are met, the consumer can claim a $3,750 credit.

If all requirements are met, the credit for each vehicle is $7,500. Rhodium estimates that the 30D consumer clean vehicle tax credit will result in between $32 billion and $85 billion in federal investment between 2022 and 2031.

Clean electricity tax credits with domestic content bonus ($73-177 billion)

The IRA extends and modifies the existing production tax credit (PTC) and investment tax credit (ITC) for wind, solar and other clean electricity generation in the United States. In Rhodium’s modeling, between now and 2030 these credits do more to reduce US greenhouse gas (GHG) emissions than anything else in the IRA. The ITC covers 30% of the cost of investing in new clean electricity production and the PTC provides a $26/MWh credit for all clean electricity production from new facilities. Project developers choose which credit they would like to receive.

Under the IRA, the ITC credits increase by 10 percentage points and PTC credits increase by 10% if the project satisfies two requirements:

1. All iron and steel used as construction materials in the project were produced in the United States.
2. At least 40% of the manufactured components of the project (growing to 55% in 2026) are mined, produced, or manufactured in the United States.

Rhodium Group estimates that the extended and modified ITC and PTC will result in between $73 and $177 billion in federal investment in clean electricity generation between 2022 and 2031.

Other GHG reduction funding ($211-251 billion)

Beyond the clean vehicles and clean electricity tax credits discussed above, the IRA includes another $211 to $251 billion in federal investment in GHG reduction activities in the US. None of this funding has domestic content or manufacturing requirements attached to it within the IRA (though existing Buy America provisions may apply to some programs).

Domestic climate adaptation funding ($7.6 billion)

The IRA also includes $7.6 billion in funding for domestic climate adaptation between 2022 and 2031. These programs do not include any domestic content or manufacturing requirements (though existing Buy America provisions may apply to some programs).

Key factors in gauging the impact on European industry

In assessing the impact of the IRA on the competitiveness of European clean energy, there are several factors worth keeping in mind:

1. Direct subsidies to domestic manufacturing are a small share of the IRA total

Based on Rhodium Group analysis, direct fiscal support to the manufacture of clean energy technology within the United States accounts for only 7-11% of total funding in the IRA. The vast majority of the funding is to accelerate adoption of clean electricity, vehicles, fuels, energy efficiency solutions and carbon capture and removal within the US in order to get the country closer to meeting its 2030 climate target under the Paris Agreement.

2. There are no import restrictions in the IRA and most funding has no content requirements

The IRA does not prevent the importation of clean energy technology from any country. The domestic content requirements (in the case of the clean vehicle tax credit) and bonuses (in the case of the clean electricity tax credits) provide an incentive to purchase domestically manufactured cars and clean electricity technologies over imported vehicles or equipment if the value of the credit or bonus is greater than the cost premium for domestic content. But if it isn’t, then the consumer or project developer can and likely will purchase imported vehicles or equipment. In addition, between 48% and 60% of all funding in the IRA does not include new domestic content requirements.

3. Clean electricity bonus credits likely won’t matter much for Europe

The largest portion of IRA funding with some form of domestic content requirement, the clean electricity credits, likely won’t matter much for Europe. First, using domestic content only raises the value of the tax credit by 10% (and the tax credit itself only covers part of the cost of the project), so there is only a modest incentive to do so. Second, for those project developers that do seek to qualify for the 10% bonus credit, doing so is unlikely to have a significant impact on European equipment suppliers. Wind and solar construction accounts for a small share of overall US steel demand, so using domestically-produced construction steel likely won’t change aggregate US-EU steel trade in any meaningful way.

Most US wind projects likely already meet the requirement that 40% of all manufactured inputs to a wind farm be produced domestically. This requirement is more difficult for solar given a) the relatively high share of total manufactured product costs in a utility-scale solar project attributable to PV modules, and b) the relatively high import share of solar PV modules in the US. But as most US solar PV imports come from Asia, not Europe, to the extent to which the 10% bonus credit changes sourcing decisions, it will impact US-Asian trade more than US-Europe trade.

4. The clean vehicles credit will likely be more distortive, but doesn’t apply to all of the market

Compared to the clean electricity tax credits, the clean vehicles tax credit will likely have a more significant impact on US-EU trade and investment flows. The domestic content requirements are more stringent (100% final assembly in North America, and the EU does not get the free trade agreement exception for battery components) and the $7,500 credit is a larger share of the cost of a new electric vehicle than the clean electricity bonus credit is relative to the cost of a new wind or solar farm. It’s no wonder then that this specific provision of the IRA has attracted the most ire from European policymakers.

One important caveat is that the 30D credit will likely only apply to a portion of clean vehicles sold in the US. The income and MSRP limits mean that many EV buyers won’t qualify for the credit. In addition, the IRA also includes a new tax credit (section 45W) for the purchase of commercial clean vehicles, which does not include any domestic content or assembly requirements. For cars and light trucks, the credit is the lesser of a) $7,500 and b) the incremental cost of the vehicle relative to a gasoline or diesel-powered alternative. In December of last year, the Treasury Department indicated that companies that purchase electric vehicles to lease to consumers would qualify for this credit. About one-fifth of all new cars are leased instead of purchased in the US. It’s unclear how much leasing under 45W will be a substitute for purchasing under 30D, but at the margin it provides a pathway for some EVs manufactured in Europe to receive credits in the US.

5. European companies can qualify for domestic content-tied credits

None of the tax credits in the IRA (with or without domestic content requirements or bonuses) exclude European companies from participating. The accelerated deployment of clean technologies in the US through the IRA may present significant opportunities to invest in, and export to the US. In fact, European companies are already some of the most active wind and solar project developers in the US and can take advantage of clean electricity bonus credits just like US developers if they meet the domestic content requirements. Likewise, customers of European automakers can claim the 30D tax credit if the car they are buying meets the domestic content requirements of that credit. European companies can also qualify for the 48C and 45X tax credits for qualifying clean energy equipment manufacturing facilities they set up in the US (provided either they or a co-investor have US tax liabilities against which they can claim the credits). Rather than a threat to competitiveness, the IRA could be an additional source of innovation and deployment funding for European clean tech manufacturers looking to demonstrate their technology or expand production capacities, complementing the various support instruments already available in Europe (e.g. Innovation Fund, Horizon Europe, and REPowerEU).

6. Accelerated deployment in the US will lower the cost of clean energy in Europe

Much of the press coverage of the US-EU clean energy rift suggests that clean energy investment is a zero-sum game—and that now that the US is a more attractive investment destination post-IRA, that will necessarily come at the expense of investment in Europe. But the much larger competition is investment in clean energy vs. fossil fuels, not just in the US but around the world. IRA-incentivized investments in clean energy deployment in the US will help drive down the green premium for those technologies in a way that makes them more competitive vis-à-vis fossil fuels around the world. When Europe led the way in funding solar deployment in the 1990s and 2000s, the resulting reduction in solar costs led to more solar deployment in the US, not less. We could see the same dynamic occur as a result of US funding for today’s emerging climate technologies like clean hydrogen, sustainable aviation fuels, long-duration storage, and carbon dioxide removal. In addition, the speed at which the tax credits in the IRA are likely to make it to market is shining a spotlight on the relatively bureaucratic nature of some European clean energy funding vehicles and prompting calls for streamlining. This kind of peer competition can accelerate clean energy deployment on both sides of the Atlantic.

Conclusions

Of the $355 to $552 billion in climate mitigation and adaption spending over 10 years included in the IRA, only a fraction of that (7-11%) directly subsidizes domestic clean energy equipment manufacturing (Figure 2). The rest is funding for the deployment of clean energy and adaptation solutions to reduce GHG emissions and make the country more resilient. Some of this comes in the form of tax credits that include bonuses or requirements for domestic content (at levels that vary by provision). In our estimation, only 9-15% of total IRA funding is for the subset of these tax credits where the domestic bonuses or requirements themselves could have a meaningful impact on US-EU clean energy trade and investment.

None of this is to say that the IRA won’t have a significant impact on the global clean energy competitiveness landscape and transatlantic clean energy trade in particular. Accelerating the pace of clean energy deployment in the US along the lines projected to occur under the IRA will necessarily drive the expansion of existing clean energy manufacturing in the US as well as the development of new industries—just as clean energy deployment policy has done in Europe and Asia. This will create new investment and export opportunities for allies in Europe as well as new sources of competition both at home and in third markets, ultimately driving down the costs of technologies crucial to the energy system transition. The direct subsidies for manufacturing and domestic content requirements/bonuses attached to some of the IRA’s tax credits will undoubtedly shape the nature of this competition, but the primary driver will likely be the overall accelerated pace of clean energy deployment in the US resulting from the IRA.

This nonpartisan, independent research was conducted with support from the William and Flora Hewlett Foundation. The results presented in this report reflect the views of the authors and not necessarily those of the supporting organization.

In February 2022, the White House Council on Environmental Quality (CEQ) released the beta version of their Climate and Economic Justice Screening Tool (CEJST), which identifies environmentally and socioeconomically disadvantaged communities eligible for federal resources under the Justice40 initiative. Notably, the tool did not explicitly consider race and ethnic demographics when determining if a community qualifies for the Justice40 initiative. Using 2019 census data, previous Rhodium analysis of the beta tool found that over 50% of Hispanic/Latino, Black, and American Indian/Alaska Native individuals reside in census tracts considered disadvantaged under the screening tool criteria.

On November 22, 2022, the final version (V1.0) of the CEJST was released. This version includes several new environmental and socioeconomic criteria which could establish eligibility for the Justice40 initiative. In this note, we update our analysis to include the criteria in the final version of the tool, and find that the number of communities eligible for benefits under the Justice40 initiative has increased overall. Further, we show that the final criteria dataset highlights the increased burden of compounding environmental, health, and socioeconomic barriers on Black, Hispanic/Latino and American Indian/Alaska Native communities. These communities make up 30% of the US population and 49% of the population of communities eligible for the Justice40 program, but they make up 60% of the population exceeding at least five threshold screening criteria in the tool and 71% of the population exceeding 10+ screening criteria.

Final updates to the Climate and Economic Justice Screening Tool

In this analysis, Rhodium Group combined the CEJST beta and V1.0 datasets in order to quantify the eligibility impacts of new criteria added for the final version of the tool. Developed by the White House Council on Environmental Quality, the CEJST identifies disadvantaged communities which have been historically burdened by climate change, pollution, and environmental hazards. The tool covers census tracts across all 50 US states, the District of Columbia, and the US territories. Data on climate, environmental, and socioeconomic indicators are combined with census data to identify which communities are disadvantaged. The CEJST is updated annually to reflect changes spurred by new public comments and the availability of new data.

In the beta version of the tool, released in February 2022, a community is identified as disadvantaged if: (1) it is within a census tract that meets at least one of the thresholds of the tool’s burden categories; or (2) it is within a census tract that is above the threshold for the socioeconomic indicators. Data on indicators mapping to eight different threshold categories are included in the initial version.[1] Not included are data on any demographic indicators such as race. The latest version (V1.o), however, does include data on race, ethnicity, and age from the 2019 American Community Survey for each census tract, as well as data on nine new indicators of climate, housing, legacy pollution, transportation, and wastewater risks.[2] Rhodium Group applied the same demographic data to the beta version of the CEJST in our earlier analysis.

Any census tract which meets these or the beta version criteria and are also low income[3] qualify for Justice40 resources. In addition, the screening criteria in V1.0 were updated to designate any census tracts within the boundaries of a federally recognized tribe and any middle income tracts surrounded by tracts designated as disadvantaged as disadvantaged as well, for a total of 11 new criteria. As a result of these changes, the number of individuals living in tracts designated as disadvantaged and qualifying as Justice40 communities increased across all demographic groups (Figure 1). The largest increase in eligibility was in American Indian and Alaskan Natives communities—an additional 11% of that population was identified as Justice40 communities under the new criteria.

In order to paint a more detailed picture of the varying impacts of the addition of new criteria in the updated CEJST, we calculated the demographic breakdowns of census tracts which meet the threshold for each new criteria. Hispanic/Latino and individuals of two or more races make up a larger fraction of the population of the set of census tracts exceeding a given criteria than their fraction of the total US population for nine of the new criteria; Black and African American and American Indian/Alaskan Native individuals do so for seven of the new categories; Asian individuals for two of the new categories; and White Non-Latino communities for one new category. Figure 2 shows each demographic group as a fraction of the total US population as well as each demographic group as a fraction of the population identified as disadvantaged for each of the 11 new threshold criteria.

Tracking compounding effects

Examining the average number of CEJST threshold criteria faced by individuals of different demographic groups reveals disparities in the number of threshold criteria exceeded. The final version of the CEJST includes 30 different environmental, health and infrastructure criteria paired with considerations for whether a community is also low-income or facing low educational attainment. Black or African American, American Indian and Alaska Natives, Hispanic/Latino and individuals of two or more races on average are exposed to more criteria burdens than the overall average for the population. The addition of new criteria in the final tool version increased the average count of burdens an individual is exposed to across all racial demographics; in the beta tool dataset, the average census tract weighted by population exceeds 1 threshold criteria, and in the V1.0 dataset the average tract exceeds 1.3 criteria. The increase was most pronounced for American Indian and Alaska Native communities.

The CEJST provides a binary output; a community is labeled as either disadvantaged or not based on whether it meets one of the tool criteria and is considered low-income. Under the CEJST V1.0 criteria dataset, 34% of the US population is living in census tracts labeled as disadvantaged. However, the criteria utilized in the tool lends insight into the burden of compounding environmental and socioeconomic effects across different communities. The communities which face multiple burdens make up a smaller portion of the population than those qualifying as Justice40 communities—only 11% of the US population meets five or more of the CEJST threshold criteria, and 1.4% meets 10 or more. However, the communities which face multiple environmental and socioeconomic burdens are disproportionately non-white compared to both the US population as a whole, and all those qualifying as Justice40 communities. Of the individuals living in communities which exceed 10 or more threshold criteria, 39% are Black or African American, 1.1% are American Indian or Alaska Native, and 24% are Hispanic/Latino, although these communities only make up 11%, 0.5% and 16% of the US population, respectively.

The CEJST is an important first step for identifying disadvantaged communities for targeted infrastructure funding. However, consideration of the burden of compounding effects lends insight towards identifying and uplifting historically underserved communities.

[1] The eight categories include: (1) climate change, (2) clean energy and efficiency, (3) clean transit, (4) affordable and sustainable housing, (5) reduction and remediation of legacy pollution, (6) health burdens, (7) critical clean water and wastewater infrastructure, and (8) training and workforce development.

[2] See Figure 2 for list of all new indicators added in CEJST version 1.0.

[3] “Low income” communities are defined as census tracts which are in the 65^th percentile or above for number of households with income less than twice the federal poverty level, excluding students enrolled in higher education.

The passage of the Inflation Reduction Act (IRA) kicked off a new phase of decarbonization in the US. This single largest action to date to reduce US greenhouse gas (GHG) emissions will accelerate climate progress in the US, but on its own, it won’t be enough to get the US on track to meet its 2030 climate target of reducing emissions by 50-52% below 2005 levels. Given that 2030 is only seven years away, actions taken in the next year or two will be highly consequential. But what can be done to make the most of the opportunities presented by the IRA? And what additional actions can further accelerate emission reductions and put the 2030 climate goal within reach? In this note, we provide a framework for prioritization and examples of possible actions. We find that, first and foremost, swift implementation of the IRA with a focus on maximizing clean energy deployment is key. On top of that, there are several policy opportunities that can help to close the gap to the 2030 target. When prioritizing new decarbonization opportunities, it’s important to focus actions on emissions sources where the IRA alone doesn’t deliver a lot of reductions but does incentivize clean technologies.

The IRA ushers in a whole new ballgame

The hundreds of billions of dollars in long-term incentives and tax credits contained in the IRA represent a step change in US climate action. Our in-depth assessment of the IRA found that the package cuts net GHG emissions to 32-42% below 2005 levels in 2030—a 7-10 percentage point gain compared to a world without it. The reduction range reflects uncertainty around future fossil fuel prices, clean technology costs, and economic growth (represented as our high, central, and low emissions scenarios). Uncertainty aside, it is clear that the IRA accelerates the pace of US decarbonization.

From 2005 through 2022, the US averaged annual net GHG reductions of 1%. Considering that there was no major federal climate legislation in that timeframe, and US GDP rose by 1.9% per year and population by 0.7% per year, it’s remarkable how much progress toward decarbonization the US achieved (Figure 1). The gains were the result of a variety of factors, including cheap natural gas and ever-cheaper renewables displacing coal in the electric power sector, increasing efficiency of vehicles and appliances, state clean energy policies, federal tax credits, and the continuation of a macroeconomic shift away from heavy manufacturing towards the less carbon-intensive service sector. Historical experience dispels the myth that decarbonization is not compatible with growth. It also suggests that faster decarbonization is possible with deliberate policy action in place.

Looking ahead to the rest of this decade, we find that the IRA will accelerate emission reductions to a level never previously experienced. Average emission reductions are on track for a pace of 2.7 to 4.6% per year across our emissions scenarios (Figure 2). That means that on average, every year moving forward will see decarbonization more than twice as fast as the pace since 2005 and as much as more than four times faster. We should expect nothing less from the biggest single action on climate change in US history. However, the US will need to move even faster to achieve the 2030 climate target of reducing emissions by 50-52% below 2005 levels, which would require an over 6% average annual reduction pace to keep the target within reach.

Where to start?

When considering additional actions in the US to meet the 2030 target, the first thing to do is make sure the IRA actually delivers what we estimate is possible, through swift and effective implementation. The vast majority of emission reductions from the IRA occur in the electric power sector (Figure 3). This means any IRA programs that drive electric power decarbonization need to be implemented quickly and robustly to get as much clean generation on the grid as fast as possible. The industrial and carbon removal sectors are also important sources of emission reductions. So where to start?

Speedy implementation

Staff at the Department of Agriculture, Department of Energy, Environmental Protection Agency, the Department of Treasury, and elsewhere across the federal bureaucracy are working hard to implement their congressional marching orders from the IRA. Speed is of the essence. The sooner project developers and manufacturers have clarity and certainty as to how new IRA programs and tax credits work, the sooner they can leverage private capital to accelerate clean energy deployment and cut emissions.

The most important center of activity from a decarbonization perspective is the Department of the Treasury, and in particular the Internal Revenue Service (IRS). The vast array of expanded and new tax credits within the IRA all fall within the IRS’s purview. One important feature of tax credits is that, for the most part, the amount of federal expenditure is driven solely by qualifying installation or use of clean energy technologies. Put another way, the more solar panels installed and electric vehicles (EVs) on the road, the higher the investment by the federal government with no upper limit. This sets tax credits apart from the rest of the IRA where direct spending on grant programs, loans and other mechanisms have specific caps set by Congress.

Across our three emissions scenarios, we find that through 2031, tax expenditures generally represent the majority of federal spending under the IRA. The final official score from the Congressional Budget Office and Joint Committee on Taxation said that the IRA clean energy and climate investments would cost $383 billion over ten years. Our corresponding estimate from our high emissions scenario is in the same ballpark at $355 billion, split roughly 50/50 between direct spending and tax expenditures. In our central and low emissions cases, total spending is higher than official estimates as we project tax credits drive more clean energy deployment, ending up with total spending of $459 billion and $552 billion respectively. Tax expenditures represent 60-67% of all spending in these scenarios. In other words, up to two-thirds of IRA investments are in the hands of the IRS. All of the implementation decisions this agency makes over the next few years from clean hydrogen to electric vehicles to battery production will have an outsized impact on the pace of decarbonization in the US in the 2020s and beyond.

Walking the tightrope

In implementing IRA provisions, the IRS will have to walk a fine line and balance many factors beyond decarbonization. International trade dynamics, supply chain security, labor relations and administrative practicalities are all in tension. One does not have to look far to find examples. The IRS recently indicated that it would interpret language in the IRA to allow leased vehicles to qualify for the commercial clean vehicle tax credit (45W) rather than the more restrictive clean vehicle credit (30D). Broader availability of tax credits for EVs accelerates deployment, all else being equal, in turn driving greater emission reductions. But this decision raised concerns about supply chain security from Senator Joe Manchin and at the same time is in line with requests from trading partners.

There are also concerns surrounding the implementation of emerging clean technology credits, such as the clean hydrogen credit. Deployment of emerging clean technologies starts from a very small base and, in general, initial projects are quite costly to build because of a lack of supply chains, experience, and scale. They are at the top of the learning curve and many have the potential to see dramatic cost reductions as deployment accelerates—similar to what we’ve seen for solar, wind and batteries over the past 15 years. As the IRS implements the IRA, it will have to balance the need to expand emission reduction opportunities over the long-term with near-term GHG implications. Overly strict, near-term rules that maximize the environmental integrity of the first wave of projects may stifle deployment and cost reductions from learning, as well as forfeit innovation. At the same time, failing to ensure that implementing regulations addresses outstanding climate and environmental concerns could lead to blowback from advocates and Congress, as well as unintended increases in emissions down the road. A phased-in approach that unleashes investment quickly while raising the environmental performance bar in a predictable manner over time could be one way forward.

These same challenges apply to direct spending programs under the IRA as well. For example, DOE is currently determining how to spend $5.8 billion on a new advanced industrial facility deployment program. The Office of Clean Energy Demonstrations is wrestling with whether to focus the money on deployment of commercial technologies across the sector or to go for big transformational investments in getting a few emerging clean technologies down the learning curve. New grant programs elsewhere at DOE, EPA and other agencies also face similar trade-offs. If these programs are going to maximize innovation and emission reductions, it will be important to avoid redundancy with other IRA provisions and make sure each investment leads to additional technology deployment.

The next wave of action

Even with speedy and successful implementation of the IRA, the US still has a long way to go to achieve its 2030 target of reducing emissions 50-52% below 2005 levels. Fortunately, there is no shortage of additional policy actions that executive branch agencies, states, the private sector, and the new Congress can take to further accelerate decarbonization and put that target within reach. A range of policies can fortify and amplify the gains made in the IRA, but a host more will be required to achieve additional reductions beyond the IRA.

There are a few strategies to consider in any push to achieve additional emission reductions above and beyond the IRA. These include:

• Overcome non-cost barriers to clean technology deployment. The IRA makes most clean technologies cheaper than fossil alternatives, but cost isn’t the only thing inhibiting rapid deployment. Siting, permitting, lack of information, principal-agent problems, workforce bottlenecks, supply chain constraints and other barriers all stand in the way of maximizing clean energy deployment. Overcoming any of these headwinds will increase the impact of the IRA and cut carbon pollution. We plan to take a closer look at these issues in a forthcoming research note.
• Target sectors that don’t see many IRA-driven reductions. Based on our analysis, we see only small decarbonization gains in the sectors of transportation, buildings, and agriculture & waste, making them prime targets for additional action.
• Target sources that aren’t affected much by the IRA. Our analysis finds that even the enhanced IRA tax credits generally don’t incent fossil fuel-fired power plants and large sources of fossil fuel combustion in industry to install carbon capture. New requirements to install such equipment could lead to additional reductions and IRA tax credits can reduce the cost of compliance. Emissions sources could see similar opportunities with other clean technologies.
• Target opportunities where IRA incentives lower the cost of action. Revamping state and federal energy efficiency and transportation programs to prioritize electrification should be easier with cost reductions from IRA incentives, driving more technology deployment beyond what the IRA alone can accomplish. There may be more opportunities in other sectors.

We modeled a range of policies in addition to a major congressional investment in our October 2021 report, Pathways to Paris: A Policy Assessment of the 2030 US Climate Target. Many of the actions we considered fit within one or more of the strategies listed above. We plan to revisit that analysis with fresh eyes later this spring.

This next chapter is different

The IRA is such a consequential piece of legislation that it is worth taking a moment to recalibrate before pushing hard for policies from the same old playbook. Strategic prioritization of new policy actions that leverage the IRA and target emissions, bottlenecks, and barriers that the IRA doesn’t touch will be essential to accelerating decarbonization—not just for the sake of making progress in this decade, but also to expand the range of opportunities over the long-term. Given all the work ahead, it is also not the time to be considering major funding cuts to agencies and departments at the federal and state level where a lot of the action resides. Big federal legislative wins don’t come easy or often, especially in climate policy. Any progress beyond the IRA can cut emissions and expand the space for the next wave of policy action. It’s time to get to work.

The year 2022 was marked by the emergence of longer-term economic repercussions of the COVID-19 pandemic and an unexpected war in Eastern Europe that caused turmoil in energy markets. Despite efforts to continue stimulating the US economy in the wake of the pandemic, high inflation put a damper on economic growth, which was exacerbated by a spike in oil prices as a result of Russia’s invasion of Ukraine. Consequently, the US economy grew 1.9% in 2022, down from a 5.7% GDP increase in 2021.

Based on preliminary economic activity and energy data, Rhodium Group estimates that greenhouse gas (GHG) emissions in the US slightly increased in 2022, rising 1.3% compared to the previous year. While this is the second year in a row that emissions have increased, it nonetheless marks a change from 2021, when emissions rebounded faster than the economic growth rate. This reversal in 2022 was largely due to the substitution of coal with natural gas—a less carbon-intensive fuel—and a rise in renewable energy generation.

Economic and energy market turmoil in 2022

The year 2022 was characterized by economic challenges and uncertainty, with inflation emerging as a key source of concern for the US economy. The rising prices of goods and services, initially caused by the disruption of the COVID-19 pandemic on global supply chains, were further exacerbated by a spike in oil prices due to Russia’s invasion of Ukraine. Natural gas prices were also up in 2022 relative to 2021, owing to increased demand for gas from Europe due to reductions in Russian gas supply, as well as a colder-than-normal first quarter in the US. As actions to mitigate inflation were put in place, the outlook for US GDP growth dimmed considerably over the past year, with the consensus now forecasting a 1.9% increase in 2022.

Although we won’t have official GDP data for 2022 until September, preliminary activity data suggests that total greenhouse gas (GHG) emissions in the US slightly increased in 2022, rising 1.3% compared to the previous year (Figure 1). Even with the slight increase, this indicates that the GHG intensity of the US economy declined in 2022, a turnaround from the more carbon-intensive rebound experienced in 2021.

Over the past few years, the COVID-19 pandemic has shifted the underlying forces that shape the carbon intensity of the economy. In 2019, the downward trend in coal consumption helped to reduce GHG emissions, despite GDP growth. In 2020, the pandemic had a significant impact on the economy, causing GDP to decline by 5.9% and emissions to drop by 10.6% compared to 2019, the largest decrease in emissions since the 2008 recession. However, in 2021, GHG emissions rebounded faster than economic growth—GHG emissions rose by 6.5%, while GDP rose by 5.9%—primarily due to an increase in coal generation and a modest recovery in transport demand. By contrast, in 2022 GDP growth outpaced the increase in GHG emissions.

This reversal in 2022 was primarily driven by a drop in emissions from the electric power sector, mostly due to the displacement of coal by natural gas and an increase in renewable energy (Figure 2). Outside of the power sector, emissions increased slightly. The most significant increase was seen in direct emissions from buildings, which rose by 6% and was the only sector to rebound to pre-pandemic levels (Figure 3). This was largely due to increased energy consumption for heating in homes, as 2022 reported below-average winter temperatures.

Coal generation displaced by natural gas and renewables

In the electric power sector, which accounts for 28% of overall emissions in the US, emissions decreased by 1% in 2022. Coal generation in the US fell in 2022, returning to the downward trend that had been in place until last year’s modest increase. Based on monthly and daily generation data from EIA, we estimate that coal generation declined by 8% compared with the previous year, with several factors contributing to the drop (Figure 4). Among these was the retirement of coal-fired generators and disruptions to the railroads that deliver coal to power plants, which hindered power plants’ ability to replenish their coal stocks and led to a reduction in coal generation. The EIA also forecasted that these factors contributed to a 19% increase in the price of coal for the power sector relative to 2021. Given these conditions, we anticipate that coal’s contribution to electricity generation will continue its downward trend and reach 20% in 2022, a decrease from the 23% it represented in the previous year (Figure 5).

Natural gas and renewable energy sources compensated for the decline in coal-based power generation in 2022. Despite high Henry Hub prices (up  65% higher from 2021), gas consumption for electricity generation increased by 7%, largely due to its ability to meet peak demand during record-high summer temperatures. As a result, the share of natural gas in total electricity generation in the US rose slightly from 37% in 2021 to 39% in 2022.

Renewable energy generation also saw a significant increase, rising by 12% compared to the previous year. For the first time in over sixty years,[1]  renewables surpassed coal in the US generating 22% of total electric power, with coal dropping to only 20%.

Little change in transportation and industry

Emissions in the transportation and industrial sectors—the two highest-emitting sectors which together account for two-thirds of total US GHG emissions—rose slightly by 1.3% and 1.5%, respectively (Figures 2 and 3).

The changes in industrial and transportation sector emissions reflect the impact of inflationary uncertainty. Industrial production was affected by supply chain turmoil and rising oil prices, leading to higher production and shipping costs. This led to a limited increase in the manufacturing of goods, and emissions in the industrial sector remained mostly unchanged. Meanwhile, in the transportation sector, emissions remained relatively flat due to the impact of rising oil prices on demand. The slight emissions increase in this sector was driven mainly by the demand for jet fuel as air travel increased relative to 2021 (Figure 6). In the first quarter of 2022, fuel demand in the transportation sector, including gasoline, jet fuel, and diesel, rose slightly. However, once the cost of oil began to affect transportation fuel costs, demand remained below 2019 levels for the rest of the year.

Still off track for meeting the US target under the Paris Agreement

With the slight increase in emissions in 2022, the US continues to fall behind in its efforts to meet its target set under the Paris Agreement of reducing GHG emissions 50-52% below 2005 levels by 2030 (Figure 7). In 2022, emissions reached only 15.5% below 2005 levels. In order to meet the 2025 target of 26-28% below 2005 levels and get back on track for the 2030 Paris goal, the US needs to significantly increase its efforts.

The passage of the Inflation Reduction Act (IRA) by Congress is a significant turning point, and we may start to see its effects on emissions as early as this year if the government can fast-track implementation, with progress expected to accelerate by 2025. However, even with the IRA, more aggressive policies are needed to fully close the gap to 50-52% by 2030. In 2023, federal agencies can close this gap further by proposing aggressive regulations that drive down emissions. These actions, together with additional policies from leading states as well as action from private actors, can put the target within reach—but all parties must act quickly.

[1] Prior to the 1960s, hydropower exceeded coal generation.