How the US Inflation Reduction Act will impact the economy

The Inflation Reduction Act (IRA) is widely recognized as a compelling nudge from the US government to private sector and investors to decarbonize hard-to-abate sectors. It clears the path for many climate financiers and investors to move companies towards net zero. But can its incentive-based policies work in the context of a looming recession, spiking inflation, and oil shortage?

Between the IRA and the Infrastructure Investment and Jobs Act, which was adopted in late 2021, the US government has committed to $479 billion in new climate and energy spending across the board. This will materially change the economics of industrial decarbonization. These investments are focused on four key areas: carbon-free energy, manufacturing, transportation, and clean technology.

Large corporate buyers of heavy industry materials and transportation are keen to benefit from the various provisions that will drive industrial decarbonization. A variety of tax credit schemes amounting to $35 billion have been set up to spur investment in breakthrough clean technologies such as hydrogen, direct air capture, and sustainable aviation fuels. According to a report by Boston Consulting Group, these incentives have levelled the cost competitiveness of traditional hydrogen production with green hydrogen (renewable energy with water electrolysis) and blue hydrogen (fossil-derived hydrogen with carbon capture). With these incentives, clean energy sources such as green and blue hydrogen will be even cheaper than traditional hydrogen by 2030.

In the transportation sector, US government will give up to $7,500 for the new purchase of a passenger electric vehicle and up to $400 for a used electric vehicle. This brings up the purchase price parity between electric vehicles and vehicles with internal combustion engines by 5 years. The IRA mandates sourcing battery minerals from the United States or a country with free-trade agreement, which disqualifies vehicles manufactured by China and Russia.

Investment in clean technologies makes a positive impact across the value chain. These incentives are likely to accelerate the deployment of hydrogen in the shipping sector; carbon capture, utilization, and storage in the steel and cement sectors; and direct air capture, which can be applied across several industrial processes at point source.

The impact on inflation

The Inflation Reduction Act is a forward-looking, incentive-based policy that will spur investments into clean energy technologies, and increase the demand for clean energy sources, by 2030. But will it succeed in reining in inflation? There is no simple answer. Conservative think-tanks such as the Heritage Foundation believe that the IRA will increase the prices that Americans pay for energy, as an increase in demand of clean energy sources will increase the price of those products. This is especially true in the context of growing demand for energy.

On the other hand, investment in clean energy products will also create new jobs in the energy sector, thus increasing the supply of clean technology and bringing prices down. A research report by University of Massachusetts predicts that “over a 10-year period, the IRA will generate an average of about 912,000 jobs per year through combined annual public and private investments at $98 billion.”

Some politicians on the left have criticized the IRA for funding the construction of a natural gas pipeline. If it were possible to create a fully renewable grid now, there would be no doubt that the IRA would immediately be massively deflationary. However, we know that the energy sources necessary to replace fossil fuels are not available immediately, and the IRA does not deter the government from investing in fossil fuel today to bring the energy prices down. On the contrary, it requires the Department of the Interior to offer 2 million acres of onshore and 60 million acres of offshore annual oil and gas lease sales. It also reinstates the lease sales in Gulf of Mexico and Cook Inlet in Alaska for oil and gas exploration. These provisions are a notable divergence from the climate goals, but will have a deflationary impact in the short- to medium-term.

Looking to the long-term

In the short term, the US government and investment banks will remain invested in assets that may have higher emissions. But in the medium- to long-term, the impact of the IRA is likely to be deflationary. This is because the IRA is not promoting divestments from fossil-fuel, but rather encouraging investment in clean technologies. Private and institutional investors will put their long-term capital into cleaner energy sources. New start-ups and corporate investments will generate new jobs.

In the meantime, companies, governments, and civil society need to continue to reduce their carbon emissions at source, and not just through carbon offsets. The IRA creates an opportunity for entire supply-chain decarbonization, even if it doesn’t seek to eliminate the use of fossil fuel. With COP27 starting on November 6th at Sharm-el-Sheikh, governments and companies will come forward with more ambitious commitments. They do so in the face of uncertain economic times, so companies and governments will need to focus both on the near-term strategies to manage the looming recession, and also long-term investment in a cleaner planet.