President Donald Trump on Dec. 22 signed a $1.5 trillion Republican tax overhaul bill, putting into law what the president has called “one of the great Christmas gifts."
But for utilities and the electric power sector overall the tax cuts are a mixed bag.
Utilities, like other corporate entities, will enjoy a lower, 21% tax rate, a reduction of 14 percentage points from the previous 35% rate. For many corporations, a lower tax rate means more cash flow and higher earnings. That prospect has already boosted stock prices for many companies, but utility stocks have not seen the same boost as stocks in other sectors.
Chief among the reasons is that utility stocks often trade more like bonds, falling when interest rates are rising, as they are expected to do in 2018. But regulated utilities are also less likely than companies in other industries to see the benefit of tax cuts flow directly to their bottom lines.
“For regulated utilities, most of the tax cut will accrete to ratepayers,” Paul Patterson, an analyst at Glenrock Associates, told Utility Dive.
Taxes are part of the cost-of-service calculation that utilities make in presenting a rate case. So lower taxes often translate into lower rates for customers.
For utilities in many states, the rate changes are already in motion. In Massachusetts, Attorney General Maura Healey on Dec. 20 asked the state’s Department of Public Utilities to reverse a recent rate hike for utility Eversource, citing the prospect of the utility’s lower tax bill.
The Kansas Corporation Commission has requested an investigation into the savings utilities could realize from the tax cuts and how those benefits might be passed on to customers. Minnesota Power is also looking at lowering its rates because of the tax cuts. In Montana, regulators on Dec. 27 voted to require utilities to account for financial impacts of the tax bill and resulting benefit as a deferred liability payable to consumers. Regulators took similar action in Michigan, and more states are expected to follow suit.
Over recent years, many utilities have been increasing their investment in capital projects. For those utilities, “the tax cuts could be an opportunity for them to mitigate potential rate hikes,” Patterson said.
The real benefit for utilities, however, is not the tax cut itself, but is more likely to be an exemption they won in the tax bill. The new law puts limits on the amount of interest a corporation can deduct to lower its tax bill. The limit is set at 30% of EBITDA (earnings before interest, taxes, deductions and amortization) and then drops to a more restrictive measure of 30% of EBIT (leaving out the deductions and amortization). Utilities, however, have a 100% exemption.
“It is a significant change,” James Wickett, a partner with Hogan Lovells, told Utility Dive.
The argument for the exemption is that the utility business is one of the most capital intensive industries. Limiting the amount of interest that can be deducted could put a damper on capital investments.
On balance, even though utilities will not be able to use bonus depreciation, the ability to deduct interest payments will likely drive higher capital expenditures relative to the former tax law, Wickett said. That is because utilities’ cost of capital relative to other debt financed industries should be lower.
The tradeoff for utilities was that they were exempted from the limit on interest rate deductions, but they gave up bonus depreciation. That puts utilities back on the modified accelerated cost recovery system, or MACRS. But Wickett said that's a small loss for the sector. Bonus depreciation was never very popular at regulated utilities because it lowers rate base, he said. So, its lack could boost ratebase for utilities.
Munis, IPPs face uncertainty
For other sector players, the devil remains in the unresolved details of the tax bill. And the details of the interest rate deduction are that it applies to regulated utilities. “Regulated” appears to be defined broadly in the legislation to include utilities regulated by state and federal agencies and even at the last minute was broadened to include electric cooperatives.
It is unclear, however, if that definition includes independent power producers (IPPs) such as Calpine or the merchant arm of a utility company with regulated subsidiaries. Those entities often sell power into competitive markets that are regulated by the Federal Energy Regulatory Commission.
One reading of law is that the exemption does apply to those entities because the markets they sell into are subject to FERC jurisdiction.
“IPPs tried for the same trade [interest rate exemption for bonus depreciation], but they didn’t get it,” said Keith Martin, co-head of U.S. projects for law firm Norton Rose Fulbright. The language in the law, “established or approved” has been interpreted in other instances to mean a rate of return, Martin said, and that is not how competitive markets operate.
There are also other nuances of the law that are going to have to be worked out, such as how the interest rate exemption applies to utility holding companies. Many regulated utility operations are owned by holding companies and it is unclear if the interest of debt held at the parent company will be eligible for the interest rate exemption. It may require a ruling from the Internal Revenue Service to decide that question.
Another detail of the tax package is the new treatment of prepaid contracts. Those contracts have often been used by entities that sell power or gas to electric cooperative and municipal utilities. The buyer prepays for part of the commodity, but the seller reports the income over the time the goods are delivered. The new law puts an end to that practice. That is a relatively small market, Martin said, but it was also a mechanism that became common among companies selling rooftop solar systems under lease agreements.
One of the higher profile provisions of the tax bill for the renewable energy industry was the Base Erosion Anti-abuse Tax (BEAT) that was slipped into the Senate version at the last minute.
The provision aimed to ensure that corporations would not be able to use cross-border payments to lower their tax bill, but in also lowered the value of the production tax credits and investment tax credits that are used to finance wind and solar project.
The provision threatened to put as much as $12 billion of renewable energy deals at risk, but before the final bill was passed, the BEAT provision was amended. Instead of excluding the use of the PTC and ITC to lower tax liability, the final bill allows those credits to be used to offset up to 80% of the BEAT tax.
The BEAT tax still has the potential to claw back 20% of tax credits that investors claim between 2018 and 2025, but it is far less severe than the original proposal.
The result is that banks that are affected by the provision could propose investing smaller amounts, as tax equity investors not give full value to any credits that might be clawed back. But only a small part of the banking world is affected by this, says Martin, “so the tax equity market should continue to function.”
But wait there’s more
Several items were not included in the tax overhaul bill, leaving them later consideration. Among them are the so-called orphan technologies such as fuel cells, geothermal generation, biomass and combined heat and power plants.
There has been talk of including those technologies in a tax extender bill that could be introduced in the new year.
On Dec. 20, Senate Finance Committee Chairman Orrin Hatch (R-UT) released a tax extenders bill. The items in the bill include a tax credit for short-line railroad maintenance, faster depreciation for motorsports tracks, a credit that helps StarKist Co.’s tuna cannery in American Samoa and a variety of breaks for renewable energy, including an extension of the nuclear PTC.
The nuclear PTC is worth about $800 million and would essentially be available to one company, Southern Co. The extension of the nuclear PTC was an issue at the recent Georgia Public Service Commission meeting that approved the continuation of the troubled nuclear project, including a “personal appeal” from PSC Chairman Stan Wise for Congress to pass the extension.
Whether Congress will have the appetite for another tax package in 2018 remains to be seen. The Senate gets back to business on Jan. 2, but the House is still out until the next week. Before the holidays, Sen. Lisa Murkowski (R-AK), chair of the Senate Energy Committee, told Utility Dive she received an indication from GOP leadership that there is a "very clear desire to resolve the extenders,"
"Don't panic," she said. "There is a path forward for all of that."
Despite the uncertainty and elements left out of the bill, observers say the tax law, on the whole, is a positive for the power sector.
“I think the industry is pretty happy,” Wickett said.