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Issues & Policy - State Restructuring

February 25, 2000


TO: Advisory Committee
Washington Representatives

FROM: Joe Nipper

SUBJECT: Response to CRS Report on Tax-Exempt Bonds and Restructuring

In accordance with the memorandum I sent to you earlier in the week, attached is a more detailed analysis and response to the recent CRS report titled Electricity Restructuring and Tax-Exempt Bonds: Economic Analysis of Legislative Proposals.

If you have questions or comments, please call me at 202-467-2931 or Scott DeFife at 202-467-2985.


Response to CRS Report - Electricity Restructuring and Tax-Exempt Bonds: Economic Analysis of Legislative Proposals

February 24, 2000

Late in January 2000, the Congressional Research Service (CRS) issued a report titled "Electricity Restructuring and Tax-Exempt Bonds: Economic Analysis of Legislative Proposals." The report is aimed at providing a review of the economic differences between S. 386/H.R. 721, the Bond Fairness and Protection Act (Gorton/Hayworth), S. 1048, the Administration’s proposal for the private use problem, and H.R. 1253, the English bill supported by the Edison Electric Institute, in order to address the role of tax-exempt financing by public power systems in a "competitive electricity network." The report correctly identifies problems confronting public power systems with the current "private use" law, but the continued use of some faulty economic assumptions and a lack of information of the current state of the electricity industry and restructured markets creates some serious flaws in the recommendations for future action.

Report Bolsters Certain APPA Positions

The CRS Report details the relationship of current federal tax law to the problems that face public power entities as they confront the changing marketplace and must decide whether to enter into competition. This review actually bolsters the arguments that APPA has been making to Members of Congress in hopes of getting Congress to act to resolve the matter. These points include:

  • The report supports APPA’s contention that it would be economically damaging to force all of the existing outstanding tax-exempt bonds to be called and replace with taxable bonds. The report also substantiates the reality of the potential to cause these outstanding bonds to become retroactively taxable if public power entities are forced to take actions that violate the private use test. These points support the goal of the Bond Fairness and Protection Act, which is to allow public power systems with tax-exempt financed facilities to "exempt" these facilities from the private use limitations in exchange for giving up the right to issue tax exempt debt for new generation.
  • The report correctly points out that private sector monopolies must be regulated because of their historical "tendency to sell too little output at higher than optimal prices."
  • The report acknowledges that the advantages of low-cost electricity "can be lost if competitors with high-cost electricity also own the transmission lines (and) price transmission services in a noncompetitive fashion."
  • The report acknowledges that the English bill, H.R. 1253, includes a problematic section that "has nothing to do with tax-exempt bonds," -- the extension of federal income tax to certain public power income. However, the report indicates that such an action raises "major legal questions" and "a host of practical problems." The report supports increased taxes from an economic viewpoint, even though increasing taxes only serves to increase the cost of a commodity, which most people, economists included, believe runs counter to the goals of deregulation.

Key Fundamental Economic Assumptions Flawed

CRS has had a long-standing bias against the use of tax-exempt debt for municipal enterprises such as the provision of electricity. In this respect, the report does not present an objective analysis of the alternatives introduced for addressing the "private use" problem, but one slanted by the inherent predisposition against tax-exempt financing. This has been evident in CRS writings for over a decade, during which time it has even referred to local government’s fundamental, constitutional right to self-governance free of federal taxation as "socialist." Nevertheless, CRS reports tend to be viewed as credible and unbiased on Capitol Hill.

The primary problem with this analysis lies at the foundation. It is based from a "purist" economic perspective that "public production" of electricity is not required to serve all consumers, because "in general, the private market can provide the correct amount of energy." (emphasis added) In previous analyses, CRS has used the fact that IOUs serve 75 percent of the market as proof of the private sector’s ability to correctly serve public needs. If that were actually the case, then private, for-profit companies would have served all consumers with the commodity from the beginning. We know that this historically has not been true because private companies were unwilling to serve certain areas (and have admitted so) because it was not profitable and did not make economic sense. CRS argues that "universal service is now a reality," ending the need for any government activity in this area. This ignores the fact that states passing restructuring laws include "universal service" requirements out of the well-founded fear that residential consumers are likely to be left behind in a deregulated environment. These new requirements may not be sufficient to guarantee universal service. Public power grew to fill these needs in the electricity industry over 100 years ago. The legitimate use of tax-exempt financing is a long-standing matter of fiscal federalism with roots in the constitution, and among the many aspects of the issue that CRS usually neglects to add to its analysis.

The truest resource price of electricity is the price that is closest to the cost of production, but CRS ignores certain economic facts when advancing the theory that investor-owned utilities charge a price that "presumably" better reflects the true resource costs of electricity than public power. CRS overlooks the fact that any profit gained by a regulated rate of return that is built into the rate structure of the private company is designed to reward investors, not provide the basic commodity of electricity at the lowest possible price. The report also suggests that the cost of income tax on profit is somehow a base element of the cost of the commodity, and incorrectly asserts that the primary reason for public power’s cost differential with IOUs is tax subsidies, rather than non-profit operational savings. The analysis implies that the consumer, when deciding whether to turn on the lights or run the microwave, is most influenced by the price of electricity rather than the need to use it. Based on this assumption, CRS argues that when public power passes on the lower cost of electricity to its consumers that it gained through the use of tax-exempt financing, that it "induce(s)" consumers to inefficiently "consume more electricity than they otherwise would" if the price (including a profit) were higher.

Reality of the Transmission System Ignored

The flaws of this "pure competition" philosophy are most problematic when applied to the reality of a highly regulated sector of the industry, and the key to the differences in the legislative remedies –transmission. CRS argues that continuing the use of tax-exempt financing for new transmission services could lead to "inefficient production decisions," and "overconsumption of transmission services." Transmission services are likely to become more regulated than they are now, not competitive like generation. Extending FERC jurisdiction, promoting RTOs and regional transmission planning and siting boards will all increase the regulation over transmission that already exists at the state and local level with zoning, rights-of-way, and environmental compliance requirements.

CRS does not seem to understand the current reality of the transmission grid. If the use of tax-exempt financing drove transmission production decisions, it should be doing so now, yet public power owns less than 10 percent of the existing transmission, and constantly experiences transmission constraint problems. As we know, there are many other factors considered in whether or not, and where, to site transmission facilities. Unfortunately, the flaws in the economic review of the appropriateness of allowing continued use of tax-exempt debt for future transmission facilities underlies the analysis of legislative remedies and thus produce flawed recommendations.

Among those analysts and lawmakers that have spent the most time studying the present state of the industry, the capacity, ability to access, and reliability of the transmission system are the issues viewed to be most important. CRS assumes from an economic perspective that "low-cost" generation can easily supplant the need for "high-cost" transmission. While developments in distributed generation hold some promise for siting smaller-scale, efficient generation, this assumption misses the logistical and engineering realities of the existing transmission grid. The market and reliability needs for additional investments in transmission are readily apparent, and Congress should take every possible step to ensure the adequacy of the nation’s transmission system. Making it more costly to build new transmission facilities works against this objective.

Other Information Left out of the CRS Analysis

A tremendous amount of relevant information was left out of this analysis when looking at the big picture of the tax consequences of electricity restructuring. Examples of such information are:

  • Investor-owned utilities have a combined total of approximately $30 billion in outstanding tax-exempt debt (as of 1996), mostly from the use of tax exempt debt for pollution control efforts (an exemption for IOUs that ended in 1994).
  • Some IOUs qualify as "two-county" issuers and have several billion dollars of outstanding tax-exempt debt.
  • Roughly 80 percent of the price difference between public power rates and IOU rates come from characteristics of public ownership, including non-profit operational savings. About 16 percent of the cost differential can be attributed to the use of tax-exempt debt, and the remaining is attributed to access to preferred access to PMA power in rural areas.
  • Two activities associated with restructuring, the end of rate regulation and the divestiture or transfer of assets, are providing circumstances for opportunistic utilities to inappropriately increase shareholder returns at the expense of consumers. According to a 1999 study for APPA by MSB Energy Associates’ on Major Tax Subsides to Investor-owned Electric Utilities and the Cost to the U.S. Treasury, IOU's have over $56.7 billion in accumulated deferred income tax (ADIT) reserves. They also have several billions of dollars in excess deferred income taxes (EDIT) resulting from a 1986 decrease in the corporate tax rate and Unamortized Investment Tax Credits (UTIC) not yet returned to ratepayers. Notwithstanding that the deferred excess taxes were collected from ratepayers, some IOUs have begun to argue that earnings on ADIT reserves should go to shareholders. In addition, IOUs are claiming that entire EDIT and UTIC balances should be transferred to shareholders upon deregulation even though they are over-collected taxes that will never be paid to the IRS. As a result, some stranded cost recovery and asset disposition proceedings prompted by state retail competition programs have included decisions regarding the treatment of deferred taxes that are adverse to the interests of consumers.


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