CUB Supports Utility Tax Law Reform

“Phantom taxes”, built into utility rates, are controversial. The problem arises because some utilities are not “stand-alone companies” and file taxes as part of the larger affiliated group. Rather than pay taxes to the government, these utilities pay “taxes” to their parent companies, which, after working internal company magic, have in some cases been able to retain the “tax payment” as an increase to earnings instead of paying it to the government. Thus the taxes, which are built into utility rates, can become “Phantom taxes” existing only on paper and not paid in reality. This phenomenon was previously discussed in relation to Enron and in relation to ScottishPower. We will refer to these as the Enron Problem and the Scottish Power Problem:

The Enron Problem:

Enron used to own Portland General Electric. Enron took an entrepreneurial approach to taxes, and attempted to avoid paying them. This meant that customers paid hundreds of millions of dollars in “taxes” to PGE, which parent company Enron then eliminated by washing through the larger company and paying little or no taxes to both the state and federal government. Enron then pocketed the taxes as additional profits.

The ScottishPower Problem:

ScottishPower used to own PacifiCorp. ScottishPower created a holding company, PacifiCorp Holding Inc. (PHI), to be the immediate corporate parent to PacifiCorp. ScottishPower loaned PHI much of the money it used to purchase PacifiCorp. PHI then incurred $160 million annually in interest payments for this debt. That $160 million interest payment was tax deductible. This meant that the tax payment PacifiCorp collected from its customers, to pay state and federal taxes, largely disappeared when applied as an offset against the parent company’s tax deductible interest payment. PacifiCorp’s customers paid the taxes but the state and federal governments did not receive the money. (see blog: July 11, 2006 PUC Upholds Rate Reduction in PacifiCorp Reconsideration).

SB 408

While CUB believed the PUC had authority to address the issue of phantom taxation without legislation, the Staff of the PUC opposed all proposals to adjust the taxes that customers pay in order to address this problem. Legislation seemed the only route to fix the problem and several legislative fixes were proposed.

The legislative fight in 2005 was difficult. All of the Oregon utilities fought the legislation. CUB, with other customer organizations, led the fight to pass SB 408. Ultimately, we prevailed and SB 408 passed. Under that legislation, for any given year, the PUC is required to true up the difference between taxes paid by customers and taxes the utility (or its parent company) pays to the government. If there is an imbalance and customers paid too much, then there is a refund. If customers paid too little, then there is a surcharge.

While the true-up process sounds easy, compare the taxes that are in rates to the taxes that end up with the Government, implementing the law has proven difficult.

Taxes in Rates.

When utility rates are set, we forecast the cost of providing utility service and the volume of demand that customers will place on the system for a particular year (called a test year). These forecasts always turn out to be wrong either because of weather, changing economic conditions which affect the demand for electricity and natural gas, or other unanticipated events. There are countless variables that are forecast, and all we can be sure of is that our forecast will be wrong. When we look back on a year of actual operations, SB 408 first requires us to determine the amount of taxes in rates. But since the actual year we are looking at may be 2 or 3 years after a utility test year, and has different costs, different demand, and even a somewhat different set of customers, we had to come up with a methodology to decide what was the level of taxes in rates. In the end we decided to convert the rate case figure to a ratio, so the amount that customers pay in taxes varies with the amount of revenues received by the utility.

Accelerated Depreciation.

One of the more difficult issues to deal with is accelerated depreciation. Under federal tax rules, businesses are able to take advantage of accelerated depreciation. As part of efforts to stimulate the economy during the current recession, businesses have been given the opportunity to achieve bonus depreciation, allowing them to depreciate a new investment in one or two years. However, under IRS rules, utilities cannot pass through the benefits of accelerated depreciation to customers. This creates a timing difference, where a utility can depreciate an asset for tax purposes in one or two years, but for ratemaking purposes the depreciation happens over the life of the asset. For SB 408 purposes this means that in order to determine the amount of tax that the utility should have paid we have to take the amount of taxes paid by the utility and adjust that number to remove the benefits of accelerated depreciation and to convert the number to traditional depreciation schedules.

Consolidated Tax Filing.

When a utility is part of a large parent owned conglomerate that does a consolidated tax filing that can include dozens or even hundreds of affiliates, what methodology should be used to determine the share of the consolidated tax filing that represents the share the utility should pay in Oregon and to the federal government? This is a difficult issue. There is no single right answer.

The problem as set forth above is similar to asking, ”What is Oregon’s share of the federal budget?” Do you divide the federal budget by the number of citizens of each state, or by income, since income taxes are how most federal revenue is generated? Or do you try to identify the cost of all the services provided with federal dollars on Oregon’s behalf? Or do you try to identify all the revenue that comes from Oregon residents and businesses?  For utility taxes, the PUC chose to use a method that begins with the total taxes of the consolidated company and attributes them to each corporate affiliate based on three factors (sales, property and payroll). This is similar to how large consolidated companies allocate other corporate overhead costs such as accounting, insurance, management and Board of Directors costs.

Double Whammy.

Finally, we had the problem of what has been called “the double whammy.” When a utility has higher costs than we forecast, lower revenues than we forecast or a combination of the two, it is going to have lower profits than forecast. Lower profits also means lower taxes. Under the true up provision of SB 408, a utility that has a bad year and earns less than its rate of return has to refund tax payments to its customers, thus making its already bad year worse. But, when a utility has lower costs than forecast, greater revenues or a combination of both, it also has higher profits than forecast and should pay higher taxes than forecast. Under SB 408, this utility gets to surcharge its customers for its higher taxes, making its good year even better.

After SB 408 passed, it took a year to put in place rules to deal with these difficult issues. CUB ultimately believed that the resolution of these issues reached by the PUC was reasonable. CUB further believed that the resolution would lead to a reduction in the overpayment of taxes by customers. In July 2006, CUB blogged on the topic CUB Praises PUC Tax Reform Ruling:

The Public Utility Commission today released its Interim Order regarding implementation of the new utility tax law, SB 408. CUB Executive Director Bob Jenks had this to say about the ruling: “The PUC found a simple and elegant compromise to solve a serious problem in ratemaking. We expect that customers will see lower rates as a result”.

The Actual History of Tax True Ups.

We have now had several years of tax true ups and it is time to look back and evaluate whether the bill has had the desired effect of reducing customer tax overpayments.

However, like everything else about SB 408, it is not clear whether the bill had the desired effect and actually lowered customer payments. If we look simply at the sum total of refunds and surcharges, the results for customers were actually negative – customers have continued to pay more than CUB thinks they should. That is, customers have paid about $21 million more in surcharges than they have received in refunds. There is, however, a mitigating factor that can be added to the mix and that is that right after SB 408 passed, CUB, who had been in the middle of challenging the “ScottishPower Problem” in a ratecase, obtained a ruling from the PUC - which cited SB 408 as the reason for the adjustment it was offering - and adjusted PacifiCorp’s rates down by $26 million. If you factor this into the SB 408 equation, and count this as a result for customers, then customers do come out ahead by about $5 million. We note that even though PacifiCorp asked the Commission to reconsider that order, on the grounds that SB 408 while passed was not yet in effect, the PUC responded by keeping the adjustment and saying that they would have implemented the adjustment with or without SB 408 based simply on the evidence that CUB had presented. So, whether SB 408 reduced rates, or increased rates, all depends on whether you attribute that $26 million rate reduction to SB 408 or not.

One other thing you find when you evaluate SB 408 is that the results of SB 408 really vary by utility. On the gas side, customers of NW Natural are being hit with a surcharge every year, while customers of Avista are receiving refunds every year. In both cases, the surcharges and refunds are the results of the double-whammy and not the result of consolidated companies or affiliates.

On the electric side, Enron and ScottishPower are gone, replaced by an independent PGE and the enormous Berkshire Hathaway owned PacifiCorp. PGE customers have benefited from SB 408 refunds. PGE has had a series of higher costs caused by problems at its Boardman plant, the requirement to refund to customer dollars associated with the Trojan nuclear power plant, and broken equipment at its Pelton/Round Butte hydro facility. These issues have led to the company having lower earnings than forecast, and thus to them also having lower taxes. Under SB 408, PGE customers have received refunds. PacifiCorp, on the other hand, hit its customers mostly with surcharges.

Effect on Mergers

A wonderful side effect of SB 408 has been the elimination of a tool that holding companies have used to purchase utilities. By prohibiting a holding company from using debt at its parent level to purchase a utility and hide a tax deduction from the utility’s customers, SB 408 takes away an important means by which utility purchases are financed. Because that tax deduction will be passed through to customers, purchasing an Oregon utility is not as lucrative as purchasing utilities in other states. None of the four utilities that are affected by SB 408 have changed hands since the law passed, even though there have been a large number of utility mergers around the country. (The change in ownership of PGE and PacifiCorp happened before SB 408 was law) CUB believes this is a huge and powerful – pun intended – benefit to SB 408.

A Tale of Two Utilities: NW Natural and PGE

NW Natural and PGE offer a good contrast. After Enron left town PGE became an independently owned utility. Now both NWN and PGE are independent utilities with the bulk of their operations dedicated to providing utility service in Oregon. Both have experienced the double whammy, but both have been nearly exclusively on one side of the double whammy – PGE paying refunds and NW Natural charging surcharges. While NW Natural has earned more than its allowed rate of return – CUB thinks it is over-earning – and has had to pay additional taxes as a result, it has, nevertheless been able to bill those excess taxes to customers, thus creating additional earnings for its shareholders. PGE, on the other hand, has earned less than its allowed rate of return, has paid less in taxes, and has still had to refund money to customers, further reducing its earnings. Five years ago, when we were developing the rules for SB 408, NW Natural’s stock price was $33.4/share. Today, its stock price has increased by about 33% to $47.39. Five years ago, PGE’s stock price was $28.5/share. Today it has declined 18% to $23.5/share.

Finally, we note that in order to deal with its under-earning, PGE has filed three rate cases during this period of time to increase its rates. NW Natural, on the other hand, has been able to avoid a rate case that could cut its rates. One poor consequence of SB 408 is that it actually has made it harder to reduce the rates of a utility like NW Natural that is over-earning. NW Natural’s customers pay too much. If a utility is chronically over-earning, it is a sign that rates are too high. Initiating a rate case to reduce rates is a tremendous amount of work. It requires the PUC staff to go in and audit the books of the company in order to prove that rates should be reduced. Because of the burden SB 408 puts on the PUC staff – from October through March, SB 408 true up proceedings for each of the energy utilities, dominates the workload – SB 408 is actually is making it harder for the PUC to do the necessary work to gain rate relief for NW Natural customers. So instead of a rate reduction, NW Natural customers continue to see annual surcharges. Sadly, it seems that justice is not to be had even with the advent of SB 408. Something has to be done.

Reforming SB 408

This brings us to the need to reform SB 408. Can we remove the burden of the annual true-up proceedings, while at the same time stopping the Enron and ScottishPower problems and preventing a new set of utility mergers? Repealing SB 408 and returning to the days when the PUC allowed utilities to charge customers hundreds of millions of dollars for taxes, regardless of whether the utility’s parent company actually paid taxes, is unacceptable. For all its flaws, SB 408 is preferable to what came before it. But from our experience with SB 408, we know we need a different fix. CUB, having learned from SB 408 thinks we now have the knowledge to design a new and improved system that is fair to customers while being simpler and eliminating surcharges associated with over-earning utilities. CUB believes this can be done if we require the following:

We get rid of the SB 408 requirement of an annual true up. Outside of SB 408, other utility costs are also subject to true-ups but not necessarily on an annual basis. If the SB 408 annual true up is repealed, we will still be able to true up taxes. But we can do it on a case-by-case basis, not as a legal requirement. This will reduce the burden of SB 408 and still allow us to true up taxes if another Enron shows up.

We provide clear direction in the law that the PUC must look at the corporate structure, and consider the actual tax payments that are made to government when determining customer rates. We believe the Commission could have done this before SB 408, and we advocated that in the ScottishPower/PacifiCorp rate case discussed above. However, because the PUC staff historically opposed such adjustment to utility taxes, any reform of SB 408 must contain mandatory language requiring the PUC to protect customers from overpaying utility taxes.

Explicit direction for the PUC to consider true ups and holding company equity when a utility merger is being considered. We want to send a message to holding companies that Oregon is not going to encourage you to purchase our utilities by giving you tax breaks to do so.

SB 967 is a bill that would accomplish all of these important items. It will create a regulatory structure that does not allow Enrons and ScottishPowers to turn tax payments made by customers into profits for themselves, while at the same time ending the practice of over-earning utilities placing additional costs onto customers.

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