Senate Bill 257 passed on a 38-11 vote and faces one more round of Senate voting before it can move to the House.
The measure would allow upgrades to increase dam capacity to generate the same renewable energy credits as investments in wind or other renewables. Companies can buy these credits to meet renewable use requirements mandated by law.
Sponsored by a Democrat, the measure split that party's vote, with 11 voting for the change and 12 against it.
"This is an expanding market, and we need to be competitive in that market," said Sen. Jim Keane of Butte, the bill's sponsor.
A 2005 law requires Montana power companies to buy some of their energy from renewable sources. They can also meet the requirement by buying credits that represent others' investments in renewables.
As stricter renewable standards are set by states, trade in such credits is expected to surge.
Opponents of the bill, however, argue that including hydroelectric energy upgrades in the renewables list will undermine the value of Montana's tradable credits, and erode incentives to develop renewable energy in the state.
"Our concern with this bill is that changing the renewable energy standard could have a chilling effect on all economic development in Montana," said Jason O'Neill, spokesman for Democratic Gov. Brian Schweitzer.
In particular, O'Neill said, the 2005 law was intended to jump-start the development of new renewable projects in the state.
Since the change applies retroactively, capacity increases that PPL Montana already made to the Kerr Dam southwest of Polson will generate credits if the bill passes. The bill would also allow companies to receive credits before the upgrades have actually produced any energy.
"It's going to flood the market with these credits, and there will be no need for NorthWestern Energy to go anywhere else to meet their renewable energy requirements," said Anne Hedges, spokeswoman for the Montana Environmental Information Council.
But proponents say increases in energy generation at hydroelectric dams should be rewarded as a way to increase supplies without requiring new projects.
"It's fair treatment for the investment they made, and it encourages them to do more of that type of activity," said Sen. Jerry Black, the Republican chairman of the Senate Energy and Telecommunications Committee.