Chapter Five - FINANCE AND
TAX
5.0 INTRODUCTION
While the concept of competition in the electric utility industry is
not new, the prospect of increased competition at the retail level has
placed additional pressure on utility financing for most electric
utilities in the United States. Investor-owned utilities have responded to
this new pressure by implementation of many strategies such as mergers,
acquisitions, reorganizations, development of new products and services
and a myriad of cost-reduction techniques. Consumer-owned utilities,
including public power and cooperatives, will not be exempt from these
competitive pressures as increased competition will require cost
reductions and the possible need to offer other products and services to
remain competitive with investor-owned utilities and other emerging
competitors such as power marketers, brokers and independent power
producers.
While much industry attention has been focused on merger and
acquisition activity of several investor-owned utilities, some public
power utilities are forming alliances to share resources and mutual aid to
capture some of the same benefits. Financially well-positioned electric
utilities, such as many of those in Nebraska, must consider proactive
steps to protect consumer-owned assets, debt holders, revenue streams and
obligations to customer-owners and state/local government. An
understanding of a utility’s financial and tax environment is a
necessary element in preparing for possible structural changes resulting
from retail competition. Chapter 5 considers the financial and tax related
issues of sources of capital, indebtedness, bond resolutions, credit
ratings and revenue transfers for consumer-owned utilities in Nebraska. It
provides analysis and comparisons to national averages for background
purposes.
5.1 SOURCE OF CAPITAL AND INDEBTEDNESS
The electric utility industry is a very capital intensive industry. It
is estimated that approximately 10 percent of capital investment in the
United States is dedicated to the generation and delivery of electricity.
Nebraska utilities have large investments in generation, transmission and
distribution and other support facilities and equipment. The following
table indicates the investment in plant type for reporting Nebraska
electric utilities.1
Table 5-1: NEBRASKA PLANT INVESTMENT
1995 |
PLANT TYPE |
GROSS INVESTMENT |
DEPRECIATED
INVESTMENT |
Generation |
$2,829,207,000 |
$1,640,537,000 |
Transmission |
798,525,000 |
456,969,000 |
Distribution |
1,508,620,000 |
1,020,991,000 |
General Plant |
454,391,000 |
265,852,000 |
TOTAL |
$5,590,743,000 |
$3,384,349,000 |
In addition to the above, another $157,580,000 in plant was reported
but not classified by function, plus $432,283,000 in
Construction-Work-In-Progress for a total of $6,180,606,000 investment in
plant. The revenue from retail electric sales was $1. 10 billion.2
This is a plant to revenue ratio of 5.62. In other words, Nebraska’s
electric utilities had a fixed plant investment of $5.62 for every $1.00
of revenue in 1995. Using the net electric plant (depreciated) value of
$3.8 billion of electric utility investment in Nebraska, the
plant-to-revenue ratio is 3.45.
The traditional sources of capital for electric utilities are stock
(common and preferred), bonds and revenues. All of these capital sources
are available to investor-owned utilities. Such is not the case with
Nebraska’s consumer-owned electric utilities.
Nebraska’s consumer-owned electric utilities only have two sources of
capital available - revenues and borrowed funds - and cannot use stock as
a source of capital. When a consumer-owned electric utility is formed, the
only ways to fund the utility are to have the customer-owners provide all
the required funds on the front end, or for the system to borrow funds for
the creation and amortize this debt over the expected useful life of the
facilities financed. Once the utility is up and operating, customer equity
starts to accrue and can be reinvested in the system. Customer equity is
created to the extent the utility has funds from revenues remaining after
paying the costs of operation and maintenance, taxes, debt service and
other costs of the system. This equity is then reinvested in the system in
the form of new facilities or reconstruction of electric facilities to
serve their customer-owners.
However, because of the capital intensive nature of the electric
industry and the long lives of electrical equipment, the internally
generated funds are normally not adequate to satisfy all of the capital
needs. Nor would it be prudent to look to internally generated funds alone
for capital since it would impose too great a financial burden on current
consumers to finance facilities that would be used by many consumers for
long periods of time in the future. Although it is important that there be
customer equity in the electric system, because of the large amount of
investment required and the long life expectancy of the facilities,
borrowing funds to provide part of the necessary capital is the best
solution. Using borrowed capital provides a way to balance the costs with
the benefits to be derived by the electric system by amortizing (repaying)
the debt over a period of time that is representative of the expected
lives of the facilities constructed. Debt service costs are included in
consumer cost of service.
At the end of 1995, Nebraska’s electric utilities had outstanding
debt of $3.18 billion.3 State statutes provide the
authorization for districts and municipals to incur debt to establish
consumer-owned electric systems in Nebraska, pledging revenues and income
from the systems to provide security for and provide repayment of the
principal and interest on the debt. The specific bond resolutions of the
systems include additional requirements on the issuance and repayment of
debt by the systems. The bulk of the borrowed capital utilized by
Nebraska’s consumer-owned electric utilities is acquired by issuing
tax-exempt revenue notes and bonds in the national municipal credit
markets. In addition, Nebraska’s rural electric systems have used funds
borrowed from Rural Utilities Service (RUS) and National Rural Utilities
Cooperative Finance Corporation (CFC). At the same time, these utilities
had consumer equity (proprietary capital; reinvested earnings) of $2.17
billion.4 This equates to a debt/equity ratio of approximately
59/41. Chart 5-1 below illustrates the capitalization for Nebraska
electric systems and Chart 5-2 shows the debt-to-equity ratios, The higher
debt-to-equity for the three largest individuals systems reflects the
dominant generating role of those utilities.
Chart 5-1
Source: LR 455 Survey
Chart 5-2
Source: LR 455 Survey
Debt service for the year 1996 on the outstanding debt at year-end 1995
was $272.1 million. The average interest cost on outstanding debt varies
by system and ranges from 4.44 percent to 6.13 percent. The average
interest rate on all outstanding debt for all systems at the end of 1995
was approximately 4.94 percent. The higher debt levels of NPPD, OPPD and
LES are indicative of their investment in generating plants and
transmission facilities. NPPD’s debt reflects its investment to serve
systems at wholesale. Conversely, the high levels of equity for municipal
and rural systems correspond to the debt assumed by the larger public
power districts to serve them. Minimum debt service coverage formulas are
defined in the debt resolutions of the various entities. Simply stated,
debt service coverage indicates the ability of a utility to pay principal
and interest on their outstanding debt from operating revenues. If debt
service coverage is less than one, it indicates that the utility is not
able to service its debt as required by the debt resolution. Debt service
coverage for 1995 reported by the Nebraska utilities ranged from 1. 1 to
5.0, with the bulk of the coverage ratios in the 1.6 to 2.0 range. These
ratios are an indication of the financial strength of Nebraska’s
electric utilities.
The 1986 Tax Reform Act ("Act") imposed new restrictions on
the use of tax-exempt debt proceeds.5 Proposed regulations for
the Act were issued in 1994, but have not yet been finalized. The biggest
concerns are the limitations that were placed on the use of "output
facilities" (e.g., power stations and high voltage transmission
facilities) that were financed with tax-exempt debt. The Act imposed
"private use" limitations of 10 percent or $15 million,
whichever is less, on use of tax-exempt financed output facilities. Output
facilities that are debt free or that were financed with taxable debt are
unrestricted. This severely restricts consumer-owned utilities with
tax-exempt financed output facilities selling power and energy to other
utilities that are not tax-exempt. This limits the ability to sell off
surplus power and energy from a new facility in the early years of
operations (prior to the time the consumer-owned utility’s load grows to
use up the new power supply) and can also pose a financial hardship if an
owning utility’s load does not grow as projected or a loss of existing
load occurs. All of these situations could either leave a consumer-owned
utility with excess power and energy it could not market due to tax
restrictions, while still having to pay debt service on the debt that was
issued to construct the facility, or a possible loss of its tax-exempt
status if it marketed such excess to investor-owned utilities, power
brokers, etc.
The loss of tax-exempt status poses serious problems for both the debt
issuer and the investor. The debt issuance includes a covenant that the
issuer will maintain the tax-exempt status of the debt. The investor
relies on that covenant and takes a lower-than-market interest rate with
the expectation that income will be non-taxable. The investor does not
assume, nor is there compensation for, the risk that the income will
become taxable. If the income did become taxable, the investor would have
recourse against the debt issuer for loss of the tax exemption. For the
debt issuer, there would be a range of retroactive and future impacts from
this change. These include: possible compensation to investors affected by
the loss of tax exemption, higher borrowing costs and a diminished ability
to issue future debt.
The American Public Power Association (APPA) and the Large Public Power
Council (LPPC) have been lobbying to remove the 10 percent and $15 million
private use limitations. Although there appears to be some sympathy in
Congress, there has not been any substantive movement at the Treasury or
in Congress to ease the private use limitations.
The issue of the use of tax-exempt financed facilities was further
complicated by the Energy Policy Act of 1992 which requires that utilities
open up their transmission systems for wholesale electricity transactions.
So where the Tax Act imposes restrictions on the private use of tax-exempt
financed transmission facilities, the Energy Policy Act mandates that
these facilities be made available to all users. This conflict needs to be
resolved on the federal level.
Although not a part of the "private use" issue discussed
above, rural electric cooperatives are required to conform to a tax
regulation known as the 85/15 rule. If at least 85 percent of an electric
cooperative’s income is collected from its members, the utility is
exempt from federal income tax. If the 85 percent limit is not met, the
cooperative will lose their tax exemption for a period of time. The 85/15
rule poses a problem for off-system sales and RUS borrowers who are
seeking to buy out of their RUS loans because of the current treatment of
the loan discount as non-member income by the Internal Revenue Service.
This forces the RUS borrower to phase out RUS loans over several years,
thereby increasing the risks of the buyout. The National Rural Electric
Cooperative Association is supporting federal legislation that would
exclude the discount from non-member income.
5.2 BOND RESOLUTIONS
Bond or debt resolutions approved by the governing boards of
Nebraska’s electric utilities outline the conditions under which debt
can be issued. They specify how debt proceeds are to be used, how the
principal and interest on the debt is to be paid, the length of the loan,
debt service coverage to be provided, rate covenants, control and disposal
of the facilities financed, minimum levels of expenditures that must be
made to upgrade/maintain the system, as well as other provisions to
protect the interests of the lender (bond holder). A debt resolution is
best characterized as a loan agreement such as most businesses have with a
lending institution. The lender wants assurance that the loan will be
repaid, and therefore, require a certain revenue stream to ensure
repayment, want to ensure that the assets financed are not disposed of or
control transferred without the lender’s approval and that the assets
are properly maintained so that the assets continue to produce revenues.
Some bond resolutions contain cross-obligation provisions. These are
most common when a group of utilities form a joint action agency to
perform a common function such as providing power supply for the group of
utilities. This provision obligates the remaining utilities for the
obligations of any utility of the joint action agency that drops out or is
unable to meet their obligations under the joint action agreement.
Debt resolutions also specify compliance with applicable tax laws,
especially as they relate to issues that ensure that the debt will retain
the same tax status throughout the life of the debt as when it was issued.
In 1994, the Securities and Exchange Commission (SEC) adopted an
amendment to Rule 15c2-12 under the Securities Exchange Act of 1934, which
for the first time effectively mandated ongoing disclosure obligations for
issuers of municipal securities. Since the SEC lacks direct jurisdiction
to require that governmental issuers file disclosure statements, the SEC,
by the amendment, imposed additional requirements on brokers and dealers
to make certain determinations about a municipal debt issuer before
purchasing or selling securities of that issuer. This SEC requirement
provides additional protection for an investor by requiring that
up-to-date information on the debt issuer is readily available to the
investment community.
This results in most municipal debt issuers making additional
disclosure in their debt offering documents, making current reports of
Material Events, and filing information annually with Nationally
Recognized Municipal Securities Information Repositories and state
repositories, if they exist.
5.3 CREDIT RATINGS/COMPETITIVE ASSESSMENTS
There are three credit rating firms ("rating agencies") that
determine the credit worthiness of most municipal debt that is issued.
These firms are Standard & Poor’s Rating Group (Standard & Poors),
Moody’s Investor Services (Moody’s) and Fitch Investor Services
(Fitch). The ratings assigned by the rating agencies impact the interest
rate an issuer must pay, as well as the marketability of the debt in both
primary and secondary markets.
The primary focus of the rating agencies in evaluating the credit
worthiness of a debt issuer is on financial, legal and economic aspects.
The ability to repay the debt, the provisions of the debt resolution, the
legal status of the issuer and the specific and general economic
conditions in the service area of the debt issuer are all taken into
consideration.
To ensure a credit rating higher that would be assigned on the
issuer’s credentials alone, some utilities purchase an insurance policy
that guarantees payment of principal and interest on the debt in the event
the issuer does not make the payments as scheduled. This type of insurance
is available through firms such as Municipal Bond Insurance Association (MBIA),
Federal Guarantee Insurance Corporation (FGIC) and American Municipal Bond
Assurance Corporation (AMBAC). Some of the outstanding utility debt in
Nebraska is insured. Insuring an issue guarantees that the debt issue will
be rated in the highest category.
Standard & Poor’s and Fitch also do competitive (business
position) assessments of their larger municipal electric utility
customers. These competitive assessments were started after the passage of
the 1992 Energy Policy Act. In addition to the financial, legal and
economic considerations that are part of a rating on a debt issue, these
rating agencies examine other key factors to determine whether utilities
have the ability to compete in a rapidly evolving electric industry with
wholesale and retail competition. Standard & Poor’s focuses on
Management, Operations, Competition Position and Markets, along with the
traditional credit-worthiness considerations when making a competitive
assessment. Standard & Poor’s uses a scale of 1 to 5, with 1 being
the strongest. Standard & Poor’s has assigned a 1 to LES, a 2 to
OPPD and a 3 to NPPD and Tri-State. Fitch also uses a scale from 1 to 5
with 1 being the most competitive. Fitch has assigned a competitive index
of 2.13 to LES and 2.75 to Tri-State.6 All of these assessments
indicate that the Nebraska utilities reviewed have good competitive
characteristics,
Investors in municipal bonds and notes issued by Nebraska utilities
rely on the credit ratings and competitive assessments published by the
credit rating firms. There is no guarantee that these ratings or
assessments will not change over time. The advent of competition could
have positive or negative implications for the Nebraska systems. This
would change the risk for the holder of the debt. The most negative
consequence would be a default on principal and interest payments.
The larger electric systems in Nebraska have their debt rated on an
ongoing basis. This debt includes revenue bonds, revenue notes and
commercial paper. The current ratings on Nebraska’s electric utility
debt indicate an overall strong financial condition. There have not been
my major changes in the ratings over the last several years and there are
no major rating changes contemplated in the near future.
5.4 REVENUE TRANSFERS
When a governmental unit (municipal or public power district) operates
an enterprise business such as an electric utility, state and local
governments utilize various alternate means to obtain tax replacement
funds from these non-taxable entities. For example, after Consumers Public
Power District was formed in 1939, the Enabling Act was amended to provide
for payment in lieu of taxes to be made by any district acquiring property
which had previously been taxed.
The alternate means used to collect these tax replacement funds in
Nebraska consist of the following:
- Payments in Lieu-of-Taxes
- Gross Revenue Tax
- General Fund Transfers
- Free/Subsidized Electrical or Other Services
All electric utilities operating in Nebraska make payments to the state
or local governments in one or several of the forms shown above. Payments
in lieu-of-taxes and gross revenue tax are set by state statute, whereas
general fund transfers and free/subsidized services policies are set at
the local level. In addition to the types of payments shown above, rural
cooperatives also pay property taxes.
Some municipalities lease their local distribution systems to public
power districts and electric cooperatives. NPPD, Loup, Norris and certain
Nebraska G&T and Tri-State members lease municipal distribution
systems. Although these lease payments do not constitute a tax equivalent,
they are similar to franchise fees. These lease payments represent a major
expense to the leasing public power system and a major benefit to the
municipalities that lease out their local distribution systems.
Chart 5-3
Source: LR 455 Survey
Nebraska’s consumer-owned electric utilities contributed $51.257
million, exclusive of sales and use tax payments, primarily to local
governments in 1995 as follows and as illustrated in Chart 5-3 above. The
dollar amounts for the individual categories:7
Payments in Lieu-of-Taxes (PILOT) ..... $ 9.957 million
Gross Revenue Tax .................................21.419 million
General Fund Transfers ........................... 1.893 million
Free/Subsidized Services ........................ 0.889 million
Distribution System Leases .................... 17.099 million
Total ..................................................... $51.257
million
Total retail electric energy revenues in Nebraska for 1995 were $1.102
billion. Comparing these revenues to the total transfer payments in 1995
totaling $51 .3 million produces an average tax equivalent rate for all
Nebraska systems of 4.7 percent.8 Because most of the revenues
of the REA/RUS systems come from rural areas, the gross revenue tax
(calculated as 5 percent of the gross revenue derived from retail sales of
electricity within incorporated cities and villages) produces a very small
amount of tax replacement revenue for local governments. Excluding the
REA/RUS systems, the average tax equivalent rate for Nebraska systems is
5.7 percent. This compares to the American Public Power Association (APPA)
median rate for all consumer-owned utilities of 5.8 percent and the APPA
median rate for the West North Central Region (which includes Nebraska) of
5.3 percent.9 The comparable median rate for private
investor-owned utility is 5.9 percent for 1994.10 This is
indicated in Chart 5-4 below.
Chart 5-4
Source: LR 455 Survey, EEI, APPA (See Chapter Notes
9,10).
There has been speculation that the relatively low electric rates
enjoyed by Nebraska consumers is primarily the result of a lower average
tax equivalent paid by the Nebraska systems. However, if all Nebraska
systems made transfer payments in 1995 equal in percent to the tax paid by
private investor-owned utilities as shown above (e.g., 5.9 percent), the
average impact on the cost of electricity in Nebraska would be minimal.
The difference between the investor-owned utility rate of 5.9 percent and
the Nebraska average rate of 4.7 percent when applied to the Nebraska
retail electric energy revenues in 1995 ($1.102 billion) is $13.761
million or 1.25 percent.11
5.5 SUMMARY AND EMERGING ISSUES
The elements of revenue transfer, sources of capital and indebtedness,
bond resolutions and credit ratings/competitive assessments are parameters
for use by financial analysts internal and external to a particular
utility organization. As noted above, Nebraska’s three largest utilities
that are carrying the bulk of the industry debt have been judged to have
good competitive characteristics. There is wide variance between the
diverse systems in debt service coverage and IRS restrictions, however,
and competitive pressure could have different impacts on individual
systems.
The following is a fist of financial and tax-related emerging issues
that wise from the prospect of competitive retail market conditions:
- Without a guaranteed customer base and guaranteed revenue stream how
would public power systems utilize revenue bonds to finance future
debt? Or will all future financing come from taxable debt or internal
funds? How will this affect operational capability and rates?
- Given the variance in the financial positions of the diverse systems
and IRS restrictions, what would be the range of impacts, or
significant individual impacts, of a competitive retail market?
- How will consumer-owned systems comply with FERC open access
requirements for transmission service, especially in light of
private-use restrictions that may apply to transmission facilities?
- How will private-use restrictions and the 85/15 role impact
consumer-owned system participation in ISOs containing investor,
consumer and privately owned utilities and organizations?
- What would be the impacts of consumer-owned systems using taxable
debt for participation in competitive, non-traditional energy
services, telecommunications and other business growth areas within
and outside currently assigned service areas?
- What would be the most beneficial process for stranded cost recovery
treatment for consumer-owned utility assets and debt in the transition
to a retail competition environment, if retail competition is to be
implemented?
- What would be the impact on revenue transfers of expanded FERC
jurisdiction into traditional state jurisdictional areas in regards to
rate setting and taxation?
- What would be the state and local tax implications as part of
stranded obligations and what mitigation processes might be used?
Chapter One - HISTORY
Chapter Two - STRUCTURE AND
GOVERNANCE
Chapter Three - STATUTORY AND
REGULATORY OVERSIGHT
Chapter Four - PLANNING AND
OPERATIONS
Chapter Five - FINANCE AND TAX
Chapter Six - DEREGULATION AND
RESTRUCTURING
Glossary
Chapter Notes
The Central Nebraska Public Power and
Irrigation District
415 Lincoln Street
P.O. Box 740
Holdrege, Nebraska 68949
Phone 308-995-8601 Fax 308-995-5705
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