The Inflation Reduction Act: far from over, just getting started

What happened

Since President Biden signed the IRA into law in August 2022, there has been considerable anticipation for a boom in the cleantech industry. However, the reality is that the effects of such significant legislation take time to manifest in the market. The processes involved in detailing how and where the incentives and tax credits apply for developing new technologies, reshoring supply chains, and scaling up production, are not instantaneous.

Now, 20 months after the IRA's endorsement the early impacts of this landmark policy are finally showing. As we navigate the initial stages of implementation and with elections approaching, it is a crucial moment to assess the progress made and to outline our expectations for the future of the clean technology sector.

Impact on our Investment Case

IRA at a glance

As a reminder, the IRA represents a monumental commitment by the U.S. to combat climate change and promote sustainable energy. This landmark legislation commits an unprecedented estimated $369bn (potentially even more) towards energy security and climate change initiatives, making it the largest investment in these areas in U.S. history.

Beyond the substantial amount committed, what makes the IRA unique is its financial framework, which is structured around a mix of tax credits, grants, and loans aimed at catalyzing and accelerating the adoption of clean technologies. One of the most significant features of the IRA is its expansive use of tax credits, which are designed to be straightforward for businesses and consumers to claim, enhancing the act's accessibility and impact. The IRA specifically targets a range of technologies across the clean energy economy, and levers both the supply and demand sides.

On the supply side, it includes substantial support for domestic manufacturing of clean technologies through manufacturing tax credits. This is aimed at bolstering U.S. competitiveness in global markets and reducing dependency on foreign supply chains for critical materials, especially those used in solar panels and batteries.

On the demand side, the IRA incentivizes consumers and businesses to adopt clean energy solutions through a series of direct incentives. These include expanded tax credits for purchasing electric vehicles (EVs), installing residential solar systems, making energy-efficient home improvements, and scaling up utility-scale solar and wind projects through improved Investment Tax Credits (ITC) and Production Tax Credits (PTC).

Tracking progress

Throughout 2023, the discussion around the IRA was dominated by the anticipation of detailed guidance from the Treasury. As a substantial legislative package, the IRA's fine details critically affect both investment decisions and project rollouts, particularly concerning tax credits for domestically produced technologies. These details are vital for both manufacturers considering U.S. facility expansions and consumers looking at clean technology options.

Stakeholders were particularly keen on specifics regarding enhanced tax credits for U.S.-made technologies and criteria defining sufficient U.S. manufacturing to qualify for these incentives. Additionally, complexities arose around technologies from countries labeled as Foreign Entities of Concern, such as China, exemplified by Ford and CATL proposed licensing agreement to produce battery technology in the U.S. This deal has sparked scrutiny due to concerns about the integration of Chinese technology into American manufacturing landscapes and potential implications for U.S. economic security. Lawmakers are particularly cautious, questioning the extent to which U.S. tax credits could inadvertently benefit Chinese firms and increase dependency on foreign technology. 

While the Treasury has recently issued guidance on several aspects, including incentives for low and medium-income households (known as 'adders'), qualifications for EV credits, and the transferability of these credits, uncertainty remains around domestic content requirements. The initial guidelines have begun to specify what qualifies as 'U.S.-made.' These stipulate that a rising percentage of the direct costs of clean technology products must be sourced from U.S. production, starting from 40% in 2023 and increasing to 55% by post-2026 

The partial and phased guidance, released over the year, has led to project delays as developers await further specifics to gauge the feasibility of investing in more costly U.S.-sourced materials. The industry remains optimistic yet cautious, hoping for more comprehensive updates soon, particularly as part of the Treasury's anticipated "Phase III" guidance expected in the first half of 2024.

Europe's flawed response

Europe's answer to the IRA, the Green Deal Industrial Plan (GDIP), was unveiled in February 2023 to boost the E.U.'s industrial policy and counterbalance the impact of IRA on European competitiveness. The GDIP aims to enhance the development, manufacturing, and installation of net-zero products in Europe over the next decade.

However, unlike the IRA's straightforward, tax credit-based incentives that support both the production and deployment of clean technologies, the GDIP primarily fosters emerging technologies through "Innovation Funds" and uses a more regulatory approach by taxing emissions. This approach adds layers of complexity and provides limited support for mature renewable technologies like photovoltaics and wind. The disparity in regulations and tax regimes across E.U. member states further complicates the implementation of the GDIP, contrasting with the unified and direct incentives under the IRA.

These complexities and the lack of direct production incentives have led some European cleantech firms, such as Nel and FREYR Battery, to expand operations to the U.S., attracted by the substantial and direct support mechanisms provided by the IRA. Nel  is expanding its electrolyzer manufacturing in Connecticut, and FREYR Battery is building a $2.5 billion battery plant in Atlanta.

While the Green Deal Industrial Plan (GDIP) shares similar decarbonization and reshoring goals with the IRA, its complex implementation and varying requirements across E.U. member states pose challenges. This complexity underscores the need for the E.U. to simplify its approach to better support and retain green industries. As these policies evolve, they will be crucial in determining each region's success. Currently, the U.S., with its straightforward IRA policies, appears to be leading in the cleantech race, a perspective that is reflected in our current portfolio.

What a Republican return could mean?

Even if a Republican administration returns to power, we believe a complete repeal of the IRA is highly unlikely. The IRA enjoys bipartisan support for key themes like energy independence and reshoring, resonating across political lines, especially since many of the jobs it creates are in Republican strongholds. This broad base of support lends robustness to the IRA's core elements against a total reversal.

A Republican administration might refine some aspects of the IRA, especially around the specifics of tax credits. Potential changes could include tightening restrictions on collaborations with countries of concern, like China, and tweaking some demand-side supports, while likely leaving manufacturing incentives intact. Adjustments might also target specific incentives within the IRA for emerging technologies not yet widely deployed, aiming to align the IRA's benefits more closely with Republican policy priorities.

In our Sustainable Future strategy, we focus on solid Chinese companies that are market and/or technology leaders that do not rely on the U.S. market to maintain their growth. This approach aligns with our anticipation of increased scrutiny and potential restrictions on Chinese firms under a Republican administration.

It’s also worth noting that during Trump’s presidency, renewable deployment actually accelerated compared to the Obama era, demonstrating that Republican governance does not inherently hinder progress in renewable energy initiatives.

The most immediate impact of a Republican victory could be on investor sentiment, swayed by campaign rhetoric. However, the fundamental aspects of the IRA related to job creation and energy security are expected to endure. While the IRA’s implementation or focus might see adjustments, the core incentives supporting the clean technology and energy sectors are likely to persist. This belief is based on the bipartisan nature of the IRA’s main benefits, the complexity of a full legislative repeal, and historical precedents that illustrate the advancement of renewable energy under various political administrations.

Spotting Opportunities

As the specifics of the IRA become clearer, we are starting to see substantial impacts on companies’ financials, indicating the initial phases of IRA benefits materializing within the clean technology sector. Companies like First Solar and Enphase are forefront examples of how recent clarifications on tax credits are being leveraged to enhance business operations and financial results.

Indeed, First Solar, a pioneer in U.S. solar modules manufacturing, has recently entered into two deals to sell up to $700mn worth of tax credits (compared to its 2023 revenues of $3.3bn). This move came shortly after the U.S. Treasury and IRS defined the incentives available to domestic renewable energy equipment manufacturers.

Similarly, Enphase, a leader in microinverter technology, reported a substantial $25.8mn in Section 45X manufacturing tax credits in its latest quarterly results, directly boosting its gross margin to 48.5% (from 41.8% without the IRA benefits).

These instances underscore that the benefits from the IRA’s manufacturing tax credits are just beginning to influence corporate finances. We expect even more positive outcomes with anticipated ongoing adjustments and further clarifications, especially regarding domestic manufacturing bonuses. Companies are currently reshaping their supply chains in response to the IRA, indicating that the full impact of this legislation will unfold gradually.

Moreover, beyond the solar industry, substantial opportunities exist for firms engaged in the grid infrastructure sector, like MYR Group, which specializes in electrical infrastructure construction. The bipartisan support for grid modernization ensures that such companies are well-positioned to benefit from federal funding and policy backing. These efforts are vital for enhancing the reliability and capacity of the nation’s power systems, facilitating a broader shift towards a cleaner energy landscape.

Our Takeaway

We believe that the impact of the IRA is just beginning to materialize. It's only been one or two quarters since we've started to see the tangible dollar contributions of the IRA benefits to the financial performance of companies. As the final details of the IRA continue to be clarified over the upcoming months, the uncertainty surrounding the legislation will diminish, enabling many renewable projects that were previously delayed to resume. Additionally, supply chains are actively adapting to the new conditions, and we expect there will be clear winners emerging from these adjustments.

Given these developments, we assess that the market has not yet fully priced in the extensive impact of the IRA. This underestimation presents a strategic opportunity, which is why we have recently decided to increase our exposure to U.S. companies that are well-positioned to capitalize on the impending U.S. cleantech boom. Our allocation to these entities has increased from roughly 30% to 40% of our Sustainable Future strategy, reflecting our confidence in the robust growth potential fueled by the IRA.