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Issue Brief

Existing "Private Use" Tax Laws Inhibit State and Federal Electricity Competition

January 2000

Summary: Twenty-three states have now adopted deregulation legislation. Many other states will follow in the near future. These new laws, and the retail competition they seek to promote, have created a serious problem for communities served by public power systems that have issued tax-exempt debt to finance their local electric utility infrastructure. As these community owned electric utilities take steps to conform their operations to these new state policies, they are immediately confronted with the nearly insurmountable obstacle of federal tax code private use restrictions. In most cases, implementation of state restructuring plans - and even Federal Energy Regulatory Commission (FERC) policies designed to provide open transmission access for competitive wholesale markets - will jeopardize the financial standing of these public power communities and harm millions of bondholders across the U.S. Specifically, if community owned utilities participate in competitive markets and violate private use restrictions, their outstanding tax-exempt bonds could become retroactively taxable to the date of issuance. Collectively, public power has approximately $75 billion in outstanding tax-exempt bonds.

The Private Use Problem Clearly Defined: Under current federal tax law, electric utilities owned and operated by units of state and local government ("community owned utilities") issue tax-exempt bonds to finance their capital investments. These bonds are subject to the private use rules in the federal tax code designed to prevent private parties from benefiting from lower-cost tax-exempt financing. These private use rules impose two significant restrictions on community owned utilities with tax-exempt financed transmission and generation facilities:

  1. The private use rules severely limit the ability of community owned electric systems from selling power (from tax-exempt financed generation facilities) to individual customers on negotiated terms; and
  2. The rules severely restrict the use of community owned utilities’ transmission facilities by private business, including investor owned utilities and power marketers, and could prevent the transfer of control of these facilities to third party, independent grid management organizations.

Both problems discourage community owned utilities from embracing electricity restructuring and form a barrier to open and efficient electricity markets at both the wholesale and retail level. These problems, and the need for flexibility from the private use restrictions, make it impossible for community owned utilities to compete, even for their own existing customers, or open up their transmission and distribution facilities to third parties.

Financial Implications are Severe: If community owned utilities permit too much "private use," bondholders will retroactively lose the tax-exempt status of their investments and the utilities will be forced to redeem some or all of the bonds. Hundreds of communities nationwide will have to reimburse bondholders for their losses in addition to suffering increased financing costs for both existing facilities and future borrowings.

Legislation Advanced: The Bond Fairness and Protection Act (BFPA), S. 386/H.R. 721. The BFPA is bi partisan, compromise legislation introduced in the first session of the 106th Congress by Senators Slade Gorton (R-WA) and Bob Kerrey (D-NE) and Representatives J.D. Hayworth (R-AZ) and Bob Matsui (D-CA). The BFPA would preserve local decision making about how to use tax-exempt bonding authority. It would allow each community owned electric system to "elect" to obtain relief from private use limits, but only if it also elects to forego the right to issue tax-exempt bonds for new generation facilities in the future. The bill essentially provides each community two choices:

1. Lift the private use test on outstanding bonds (i.e. grandfather existing bonds), but only if the utility agrees to never again issue tax-exempt bonds to build new generation facilities, or

2. If no private use relief is needed, the utility can continue to issue tax-exempt debt under a clarified version of the existing private use rules.

The bill’s clarifications of the private use definition allow common sense activities envisioned by federal and state deregulation plans such as: providing open access transmission in compliance with FERC Order 888 or state laws; joining an Independent System Operator, Regional Transmission Organizations (RTO) or power exchange; or providing open retail access over the distribution system.

If enacted, this legislation will accomplish two objectives: a) permanently clarify existing tax laws and regulations regarding the private use rules so that they will work in a new competitive marketplace, and b) provide encouragement for public power utilities to open their transmission or distribution systems, thereby providing choice to more consumers. Moreover, the purpose of the Bond Fairness and Protection Act is to prevent existing tax-exempt bonds from becoming retroactively taxable and keeping rates low, not to permit or encourage community owned utilities to sell power into distant markets, aggressively pick off large industrial customers from the private sector or build the country’s national transmission network.

Broad and Diverse Support for the Legislation: Support for the BFPA has grown considerably. In the Senate, S. 386 has 32 co-sponsors, seven of which are members of the Senate Finance Committee -- Senators Jeffords (R-VT); Thompson (R-TN); Grassley (R-IA); Moynihan (D-NY); Hatch (R-UT); Robb (R-VA); and Kerrey (D-NE). The companion House legislation (H.R. 721) has 110 co-sponsors, ten of which sit on the House Ways and Means Committee: Representatives Hayworth (R-AZ), Matsui (D-CA), Houghton (R-NY); Herger (R-CA); R. Lewis (R-KY); McDermott (D-WA); J. Lewis (D-GA); Neal (D-MA); McNulty (D-NY); and Tanner (D-TN). In addition, the House Energy and Power Subcommittee included provisions of H.R. 721 in its large comprehensive electricity restructuring legislation, H.R. 2944, The Electricity Competition and Reliability Act, approved on October 27th 1999. H.R. #2944 may advance further in the second session of the 106th Congress.

In addition to the wide-ranging Congressional support, a number other entities have publicly endorsed S. 386/H.R. 721. They include seniors organizations, environmental groups, investor owned utilities, state and local organizations, as well as individual companies such as Alcoa, Praxair, and Enron Corporation, to name a few. Lastly, over 1,026 local elected officials throughout the country have endorsed the bill with several hundred personally active in lobbying their members’ of Congress.

Legislative Status: During the first session of the 106th Congress, the tax writing committees considered comprehensive tax-reduction legislation, however, the Bond Fairness and Protection Act was not included in this package. Members of the House Ways and Means Committee expressed concern over moving H.R. 721 prior to consideration of federal electricity restructuring legislation. In the Senate, concern was raised over the controversial nature of the legislation, and the need for a legislative hearing on all tax-related restructuring issues. Moreover, strong opposition by the investor owned utility community continued in both chambers.

On the other hand, a separate tax concern advanced on behalf of the investor owned utilities, to deal with the current tax impact of contributions to nuclear decommissioning funds, was included in this year’s comprehensive tax-reduction bill. The tax bill subsequently was vetoed by the President, over other issues.

Late in the session (October 19th), the Senate Finance Long-Term Growth, Debt and Deficit Reduction Subcommittee held a hearing on all tax-related electricity restructuring issues including, but not limited to, the BFPA. Members of the subcommittee heard testimony on the investor owned utilities nuclear decommissioning tax problem, the rural electric cooperatives’ "85/15" rule concerning their federal income tax-exemption, and public power’s private use conflict -- all of these are a direct result of state and federal restructuring initiatives. Through this hearing, the Senate Finance Committee has now established a formal record upon which it can proceed to act on these issues at the appropriate time.

The provisions of the BFPA were also largely included (along with provisions addressing the IOU and coop tax transition issues) in H.R. 2944, the electricity restructuring bill approved last October by the House Energy and Power Subcommittee. While H.R. 2944 or some other electricity restructuring bill could be a vehicle for enactment of the BFPA, it is uncertain at this time whether Congress will be able to enact restructuring legislation this year.

More likely is the enactment this session of tax legislation that could include the BFPA. At this time it appears that the tax writing committees may try to move as many as three separate tax packages starting early in the session. APPA will work vigorously with those committees and supporters of the BFPA to seek its inclusion and enactment.

Conclusion: A fully competitive retail electricity market will include a variety of electrical suppliers, many of which are for-profit, taxable entities and others like public power systems, that are not for-profit state and local agencies. Each type of market participant (private utilities, electric cooperatives and community-owned electric providers) faces barriers to participate in competitive markets. Municipal financing concerns are barriers that must be addressed as part of a balanced approach to a fair and open marketplace.

The Bond Fairness and Protection Act (S. 386/H.R. 721) is a legislative solution that makes political and economic sense. This legislation, along with the private utilities nuclear decommissioning tax problems and the cooperatives 85/15 rule, should be packaged together and enacted by the 106th Congress.

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