Governments are increasingly using their tax systems to steer companies toward more responsible energy usage, using two primary tools: penalties on behavior seen as having a negative effect and tax incentives to encourage climate-friendly investment.

By Gerri Chanel

According to Josephine Bush, EMEIA Tax Leader for Ernst & Young’s Climate Change and Sustainability Services, ”While some governments have focused on penalizing negative actions, others have focused more on incentives to encourage investment in green areas, including green energy, green buildings – really all things green – and some governments use both. And recent years have seen a significant increase in these incentives.”

In 2009, approximately US$430 billion in climate change stimulus funding was made available globally, much of it in the form of incentives such as tax credits and grants. While projections of future funding over the next several years have dipped, staggering amounts of benefits are still expected to be available.

Save, switch or offset

Broadly speaking, green incentives are intended to support more sustainable behaviors in three main categories: save, switch and offset.

“Save” refers to incentives to improve energy efficiency in buildings, vehicles, machinery and other infrastructure; reduce the carbon intensity of the supply chain; design and manufacture low-carbon products and re-engineer manufacturing processes to reduce the consumption of natural resources.

“Switch” incentives encourage companies to move to low-carbon, low- emission energy sources, including alternative and renewable energy.

“Offset” breaks, offered in certain countries with carbon pricing schemes, allow companies reducing emissions to sell those reductions, as credits, to companies unable to meet targets.

The government toolbox

“There is a diversity of approach in how governments provide incentives for sustainable spending,” says Bush. “The main categories are accelerated and enhanced depreciation, tax credits and other tax breaks, plus tax holidays and non-tax grants that are administered by tax authorities. But each country’s approach to incentives within these categories is unique.”

In some cases, sustainability projects can qualify for both tax breaks and non-tax grants and incentives. Moreover, some countries offer flexibility, enabling companies to select from among several grant and tax incentive options for which they can qualify, even if they do not pay taxes.

For example, the US provides tax credits linked to renewable energy generation and capital expenditure on renewable assets. However, there is flexibility for companies to receive a tax grant instead of a tax credit. The UK also builds flexibility by allowing companies effectively to “sell” R&D allowances and other tax credits back to the tax authority.

With respect to the broad variety of tax incentives for R&D, Frank Buffone, Head of Ernst & Young’s R&D Tax Services in the UK, points out that, “the definition of R&D for these incentives is often much wider than the traditional scientific and engineering idea of R&D that people tend to have in mind.”

And, the tax breaks don’t just apply to income tax. Some countries offer significantly reduced property taxes on energy-efficient buildings and other qualified property, reduced indirect taxes on certain goods and services, reduced capital gains taxes on the disposal of certain assets and lower taxes on cleaner fuel.

Tax holidays – temporary reductions or elimination of a tax – are often not targeted at climate change issues in particular. Rather, they are typically more focused on economic activities and job creation.

For example, in India, there are currently tax holidays for businesses that are set up to generate power. However, the tax holiday is available whether the power is generated from coal or from small-scale, environmentally desirable hydroelectric power.

Many countries offer non-tax grants and other incentives; these are often, but not always, administered by tax offices. Some of these incentives include soft loans for greenfield developments, often augmented by complementary international financing, designed to encourage inward investment and the growth of certain local activities.

Other incentives tend to be administered by regulatory bodies, such as a country’s energy or transportation agencies. These are most commonly government-funded grants, bond issues and low-interest loans that support research and investment in targeted activities.

Unlocking the value of sustainable investment

Bush emphasizes the importance of awareness of green incentives as companies develop their sustainability agendas.

“It is essential to have visibility within the company about these incentives,” she says, “so that the information feeds into the wider decision-making process of the business in all operational areas where those decisions are being made; whether it’s supply chain, product development, innovation, new markets or new manufacturing sites. Green taxes and green incentives will have some kind of footprint within each of those decisions.”

To provide that visibility, “there needs to be a really good integration or link between the tax department and the sustainability group, so that the tax function knows what is going on and then can think about how to help fund investments through green incentives,” points out Buffone.

With sustainability taking an ever-higher priority on the corporate agenda, taking advantage of related tax breaks and other incentives is the key to unlocking the full value of sustainability spend. And, in today’s tough economic climate, unlocking that value is more than just an opportunity, it is essential.