The New Hydrogen Rules Risk Opening the Door to Methane Offsets

In late December, the Treasury Department proposed draft regulations to implement the Inflation Reduction Act’s generous hydrogen production tax credit. Under Section 45V of the tax code, eligible projects must show that their life cycle greenhouse gas emissions fall below exacting benchmarks. Treasury’s final rules will determine how hydrogen projects are allowed to calculate their emissions and direct the flow of tens of billions of tax dollars — or more.

Most of the discussion that followed focused on the draft rule’s proposed guardrails for green hydrogen, which is produced from water using clean electricity. The climate policy community in particular largely approved of Treasury’s approach, in part because it lays the groundwork for hourly emissions accounting in the electricity sector — essentially, making sure that clean energy is being made and used in real time, a foundational shift needed for deep decarbonization.

But when it comes to producing hydrogen from methane — which is how nearly all hydrogen is made today — Treasury’s draft was incomplete. In place of a concrete proposal, the draft regulations raised detailed technical questions about what should be allowed in the final rule. Among these was the suggestion that hydrogen production from fossil fuels might qualify for tax credits by using methane offsets. This, quite simply, would undermine the tax credit’s entire purpose.

If the final regulations authorize methane offsets, then the 45V tax credit could end up subsidizing fossil fuel projects, stifling the nascent green hydrogen industry and locking in emissions-intensive infrastructure for decades to come. Just as concerning, authorizing offsets for the hydrogen production tax credit would also pave the way for similar treatment in the upcoming implementation of technology-neutral clean energy production ( Section 45Y) and investment tax credits (Section 48E).

To understand how offsets could affect the strategic outlook for the hydrogen industry, we looked at how the Treasury Department calculates the life cycle emissions of hydrogen production from natural gas, which is essentially just methane. Treasury’s draft regulations propose to use a bespoke life cycle analysis model to determine whether hydrogen projects qualify for the tax credit, and if so, what level of support they will receive.

This model has several important features: It accounts for CO2 emitted in the process of producing hydrogen from methane, which is straightforward, as well as methane emissions from upstream gas production, processing, and pipeline transportation, which is not. (Unfortunately, it doesn’t include impacts from hydrogen, which itself is an indirect greenhouse gas that contributes to global warming.)

The model’s treatment of methane emissions is particularly important. Although the academic literature suggests a national average above 2% and finds impacts above 9% in some cases, the model assumes that gas supply chains emit only 0.9% of the methane they deliver. Differences in methane emissions matter a lot, even when they look small. That’s because methane traps about 30 times as much heat as CO2 over a 100-year period, so its calculated CO2-equivalence is that much larger.

As a result, Treasury’s proposed approach undercounts the true climate impacts of hydrogen production, particularly hydrogen made from methane. Even so, fossil hydrogen production faces a narrow path to qualifying for the tax credit. For example, a fossil hydrogen project would have to capture more than 70% of its CO2 emissions and buy enough clean electricity to power all its operations — either directly as energy or indirectly as energy credits — even to qualify for the lower tiers of the tax credit. And even though projects’ actual methane emissions are likely to be undercounted, the model’s assumptions are enough to disqualify fossil projects from the highest tax credit tier, which is substantially more lucrative than any of the others.

Because of the difficulty of achieving high CO2 capture rates, some analysts have argued that fossil hydrogen projects will instead wind up applying for tax credits under Section 45Q of the IRA, which provides incentives for sequestering CO2 underground without the hydrogen tax credit’s exacting emissions standards.

But a fossil hydrogen project can claim totally different outcomes if it’s allowed to buy environmental certificates that claim to avoid methane emissions in the first place, a.k.a. methane offsets. The logic goes like this: If someone else was going to emit methane to the atmosphere, but agrees instead to capture and inject it into a gas pipeline network, then a hydrogen producer can buy a certificate from that other methane producer representing that same captured gas and potentially treat their own fossil gas as negative emissions.

For example, consider a large dairy that sends cow manure to uncovered manure lagoons, which produce significant methane emissions. Suppose the dairy installs a methane capture system and sells credits to a hydrogen producer, which then claims to have avoided the dairy’s methane emissions — even if these emissions could be avoided in other ways, like alternative manure management or flaring. Because methane is considered almost 30 times more impactful than CO2 over a 100-year period, the CO2-equivalence of avoiding methane emissions is larger than the project’s direct CO2 emissions, and therefore the resulting hydrogen production process gets a negative carbon intensity score.

If your head is spinning at this point, welcome to the world of offsets. Outcomes depend on counterfactual scenarios that can’t be measured or observed, burning fossil fuels can supposedly reduce pollution, and even the verb tenses are hard to parse.

Vertigo aside, the practical implications of methane offsets for the hydrogen production tax credit are enormous. Without methane offsets, fossil hydrogen projects couldn’t benefit much from the hydrogen tax credit; even with strict carbon capture and storage pollution controls, they can't meet the life cycle requirements for the top tier and would likely prefer to claim a smaller carbon storage tax credit instead. But if projects can use methane offsets, they can easily reduce their calculated emissions to qualify for the top tier of the hydrogen production tax credit.

This would also mean these fossil projects could undercut truly clean hydrogen projects. Green hydrogen projects that comply with the draft guardrails will have to invest in novel electrolyzer technologies and new clean power sources. The top tier of the tax credit provides enough money to make clean hydrogen projects competitive, but methane offsets are a lot less expensive than electrolyzers. If fossil producers can qualify with cheap offsets, they can pocket the difference and outcompete clean producers who have to invest in costly infrastructure.

We set out to estimate the amount of methane offsetting needed to qualify fossil projects for the top production tax credit tier. You can review our calculations here; for the carbon intensity of putatively negative emissions feedstocks, we used a conservative estimate that is about half the level of what other researchers use.

Remarkably, a fossil hydrogen project without carbon capture could qualify for the top production tax credit by offsetting just 25% of its fuel use. And a fossil hydrogen project that abates 90% of its CO2 emissions could earn the top tier of the tax credit if it bought offsets for just 4% of its fuel use.

So far a lot of the discussion about negative carbon intensity scores has focused on methane captured from livestock manure, but Treasury’s draft regulations also make reference to the possibility of capturing “fugitive emissions,” which could include methane emitted from the oil and gas sector or even from coal mines. If methane offsets are made eligible across a wide range of fugitive emissions, the hydrogen tax credit — which was designed as a generous incentive to promote innovation in new technologies — could end up subsidizing incumbent emitters.

Treasury’s hydrogen regulations will also set an important precedent for how offsets are treated in other government policies. The last set of tax credits in the IRA, a pair of technology-neutral investment and production tax credits for clean electricity generation, are under development this year. It’s great news that soon the U.S. federal government will support a full range of clean technologies, not just solar and wind — but not if those policies encourage higher-emitting activities that claim to be clean through the use of offsets. There are a few existing markets for methane offsets already, and certain segments of the economy — particularly the dairy industry — are hungry for more.

At the end of the day, the Biden administration faces a similar set of issues when it comes to producing hydrogen from methane that it did with clean hydrogen produced from electricity and water. If the tax credits encourage green hydrogen projects in places where it is difficult to supply cheap and clean electricity, then those projects risk becoming stranded assets when the tax credits expire. Similarly, if the tax credits encourage hydrogen production from chemical feedstocks and methane offsets, they will prop up fossil fuel infrastructure that could keep operating long after the requirement to buy offsets expires.

For all the complexity, though, one thing is clear: We won’t get a true green hydrogen industry if the Treasury Department decides to subsidize methane offsets — which, when you put it like that, doesn’t make much sense in the first place.