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National Conference of State Legislatures National Conference of State Legislatures
Franchise Fees in the Changing U.S. Electric Industry
December 1997
By Matthew H. Brown and Kelly Hill
The National Conference of State Legislatures' Partnership on State and Local Taxation of the Electric Industry was formed in 1997 as a forum for those with various roles in restructuring the electric industry. The partners include key state legislators, experienced state legislative staff and sponsors of NCSL's Foundation for State Legislatures who chose to participate in this project.
Contents
Introduction
Electric Industry Composition
Investor Owned Utilities (IOUs)
Rural Electric Cooperatives
Public Power Systems
Federal Electric Utilities
Independent Power Producers
Power Marketers
Franchise Fees
A Definition of Franchise Fees
Who Pays Franchise Fees
Franchise Fees and Electric Industry Reform: Some Hypothetical Examples
Franchise Fees Before Restructuring--Example A
Franchise Fees After Restructuring--Example B
Federal Actions Affecting the Electricity Market
The Public Utility Regulatory Policies Act of 1978 (PURPA)
The Energy Policy Act of 1992 (EPACT)
Private Use Restrictions
Nexus
Options for State and Local Policymakers
As with the telecommunications, natural gas and airline industries, the electric utility industry is in the midst of a fundamental transformation. Indeed, one no longer can accurately characterize it as solely the utility industry. Wholesale competition is robust today, with dozens of sellers of electricity as a result of the Public Utility Regulatory Policies Act of 1978, the Energy Policy Act of 1992 and the actions of the Federal Energy Regulatory Commission in orders 888 and 889. As shown in figure 1, retail customers in at least a dozen states will be able to choose their electricity providers as the result of legislation or comprehensive regulatory packages enacted in those states. It is not only utilities that now is selling electricity. Electric companies that operated in the retail electricity sales business as state-regulated monopolies for more than 50 years will face competition not only from each other, but also from other companies that previously sold no retail electricity.
The effect of electric industry restructuring on state and local taxes should be part of these policy debates because electric industry restructuring may cause a shift in expected revenues and thereby affect state and local budget planning. In a restructured electric market, policymakers may need to revise the state’s tax system to more fully reflect the economic activity being taxed.
This paper deals with the direct effects of electric industry restructuring on franchise fee revenues. If restructuring fulfills the promise of providing lower electricity rates and greater economic activity, it may potentially lead to economic growth, new investments and a larger tax base. The effects of such growth and investment on the franchise fee are difficult to quantify with a useful degree of accuracy. This paper should be taken in that context.
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Investor-Owned Utilities (IOUs). IOUs are available corporations owned by shareholders. The rates that investor-owned utilities charge for electric service are regulated on a cost-of-service basis by federal or state and local regulatory agencies. Most, if not all, IOUs currently are vertically integrated, i.e., in the past they owned the generation, transmission and distribution assets required serving the end user. |
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Rural Electric Cooperatives. Their customers own rural electric cooperatives. As not-for-profits they do not own generation property. Rates charged by rural electric cooperatives are subject to regulation in some jurisdictions. Although most rural electric cooperatives are exempt from federal and state income taxes, they pay all other types of state and local taxes. Rural electric cooperatives are not vertically integrated, but may own generation property through generation and transmission (G&Ts) organizations. G&Ts are cooperative organizations that own power plants, generate electricity and transmit it at wholesale prices to distribution cooperatives, which are members of the G&T and provide distribution services to deliver power to end users. The formation of G&Ts allowed member systems to gain the benefits of sharing larger, more economical power plants while retaining the advantages of local ownership, control and operation. Distribution systems generally are bound to their G&Ts by an all-requirements contract, under which the distribution system agrees to purchase—and the G&T agrees to provide—all the distribution co-op’s power needs. The distribution system agrees to pay rates sufficient to cover all the G&Ts cost. |
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Public Power Systems. Public power systems, which are predominantly municipal utilities, are extensions of state and local governments. As such, they are generally not subject to federal or state income taxes. Depending on state laws, public power systems may pay sales taxes or gross receipts taxes. These organizations also may provide payments in lieu of taxes (transfers to the general fund and contributions of services to state and local governments). Public power systems can join to form joint action agencies; these consist of two or more electric utilities (usually municipally owned) that have agreed to join under enabling state legislation to carry out a common purpose—usually the provision of bulk power supply, transmission and energy-related services. This arrangement allows the utilities to operate as separate entities. |
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Federal Electric Utilities. Most of the electricity produced by these entities is sold for resale. These utilities generally are exempt from federal, state and local taxes. Bonneville Power Administration is an example of a federal electric utility. |
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Independent Power Producers. These producers include exempt wholesale generators (EWGs) and other nonutility generators. Independent power producers are subject to federal, state and local taxes, but the rates assessed may be different than those for other power producers. |
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Power Marketers. Power marketers negotiate electricity sales between the power producer and consumer. Power marketers are not defined as utilities, and therefore may be subject only to taxes levied on businesses and business transactions in the state. |
Franchise fees are implemented as part of a service agreement usually executed between local governments and a utility company. Local governments require utility companies to execute service agreements to ensure service to all customers in a geographic area. Electric industry restructuring presents two main issues related to franchise fees:
• The effect of competition on franchise fee revenues, and
• The effect of franchise fees on effective competition.
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State policymakers may want to consider the following issues as they determine how franchise fees fit into a restructured system: |
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· Which local governments assess franchise fees? |
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· The competitive position of incumbent utilities. |
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· Status and disposition of in-state power plants. |
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· How out-of-state electricity providers and power marketers fit into the local franchise fee assessment. |
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· The effect changes in the franchise fee system will have on state and local tax administration and collection efforts. |
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· Where changes in the tax are necessary, it may require state legislation, because many state statutes enable local governments to collect franchise fees. |
A Definition of Franchise Fees
Franchise fees are implemented as part of a service agreement executed between local governments and a utility company. These service agreements are executed to ensure service to all customers in a territory. Service agreements outline the terms under which utility companies provide service to customers in a specific territory. These fees are intended to reimburse local governments for use of public rights-of-way and other public services. Franchise fees work much like a gross receipts tax. Specifically, a franchise fee typically is calculated on a percentage of the revenues derived from sales of electricity to customers in that territory. A franchise fee generally is imposed in lieu of licenses or permits that would otherwise be required.
In a restructured system, it is likely that local governments will no longer have only one electricity provider in their jurisdiction. Therefore, they may need to reconsider their franchise fee system to account for the multiple providers and may work with the state to achieve revenue neutrality in tax revenues.
Although there is variation among the states, franchise fees can be paid by investor owned utilities (IOUs), rural electric cooperatives and public power systems. When possible, franchise fees then are passed to the customer as a cost of doing business.
Franchise Fees and Electric Industry Reform: Some Hypothetical Examples
The following examples illustrate how utilities and others in the electric industry pay franchise fees and how those payments could be affected by electric industry restructuring (as shown in figure 1). The examples are a useful tool for explaining the topic. Questions for state policymakers are interspersed with the examples. The answers to these questions will help policymakers determine how to address this issue in their individual states. Any solutions described in the examples should be considered only as illustrative and not as recommendations for policy actions.
Franchise Fees Before Restructuring—Example A
Residents of the city of Metro, centrally located in State B, have purchased power from First National Power (a state-regulated, investor owned utility) for more than 25 years. As a condition of the service agreement between the city and the utility, First National Power pays Metro a franchise fee based on the percentage of revenues First National Power derives from customers in the city. The franchise fee has averaged about $1 million annually. Revenue from the franchise fee is placed in Metro’s general fund.
Franchise Fees After Restructuring—Example B
State B recently enacted legislation that opened the electric industry in the state to competition. As a result, many out-of-state electricity providers began vying for business throughout the state. In Metro this meant that many consumers decided to purchase power from providers other than First National Power. For example, Amalgamated Electric, an investor owned utility in State A, offered a lower electric rate to residents in State B, and as a result, gained a 10 percent market share in the state. Amalgamated now supplies power to 20 percent of the Metro residents. Power marketers also have entered the electricity supply market in State B. One power marketer in particular—Marketer Inc.—has gained a 5 percent market share in the state. Marketer Inc. negotiates electricity sales between power producers and consumers. Marketer Inc.’s offices are located in State B, outside the city limits of Metro. Ten percent of Metro’s residents have agreements to purchase electricity through Marketer Inc. Therefore, in the Metro market, First National has lost 30 percent of its revenue base from electricity generation.
The loss in customer base for First National Power has caused a decline in the amount of First National franchise fee payments to Metro. Metro is examining its franchise fee structure to determine if there are other means by which it recovers this deficit. Metro does not have nexus to collect a franchise fee from Marketer Inc. and Amalgamated because the companies do not have a physical presence in the city.
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The Public Utility Regulatory Policies Act of 1978 (PURPA). PURPA was passed in response to the oil embargoes and natural gas shortages of the early 1970s, and was designed to encourage alternative generation sources. PURPA requires utilities to purchase power produced by small cogeneration or renewable energy facilities at contractual rates set out or approved by state utility commissions. |
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The Energy Policy Act of 1992 (EPACT). Proponents of competitive market mechanisms encouraged Congress to introduce competition into wholesale electric markets. EPACT encourages competition in several ways. It creates a new class of power company, the exempt wholesale generator, that can compete against electric utilities to supply electricity. In addition, owners of transmission lines will be required to let any electric generator use the lines at an approved and published price. In compliance with EPACT, the Federal Energy Regulatory Commission issued orders 888 and 889, which permitted utilities access to the transmission grid to enhance the sale and purchase of energy for resale. They do not apply to the retail or end-user customer. |
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Private Use Restrictions. The Tax Reform Act of 1986 (P.L. 86-272) directed the Internal Revenue Service to promulgate rules restricting the use of tax-free financing for private projects. As a result, public power providers who finance generation, transmission, or distribution may be unable to compete outside their service territory boundaries because of private use restrictions. |
Nexus is the minimum connection the taxing state must have with the corporation or the activity being taxed in order to collect taxes from that corporation or activity. To legally uphold its authority to impose a tax, a state’s interpretation of nexus cannot violate the Due Process Clause or the Commerce Clause of the U.S. Constitution. The concept of nexus was litigated in the 1992 case, Quill Corporation v. North Dakota, 504 U.S. 623 (1992), in the context of the mail-order catalog business. In that decision, the U.S. Supreme Court ruled that some kind of physical presence was necessary to support imposition of sales and use tax collection responsibility. Physical presence generally refers to having property or people in the state, either directly or through certain kinds of agency relationships.
Similar issues of jurisdiction are likely to arise in states that open their electric industry to competition. A state or local government may have jurisdiction to tax the company that resides within its borders, but not the business transactions that company performs with out-of-state companies or business transactions performed in it by an out-of-state company.
Because First National Power has been the sole electricity provider for much of State B, it has built a transmission and distribution infrastructure throughout the state. Amalgamated and Marketer Inc. have contracted with First National for use of its transmission and distribution capacity, including the distribution facility in Metro. The state regulatory commission regulates the fees First National Power charges to use its distribution system. The Federal Energy Regulatory Commission regulates the fees First National Power charges to use its transmission system. In other words, transmission and distribution remain regulated utility functions.
The loss in customer base for First National has caused an annual decline in the amount of First National’s franchise fee payment to Metro. In expectation of future declines in First National Power’s market share within the city, Metro must determine if there are other means by which it can recover this deficit. The city plans to change its service agreement with First National Power so that the franchise fee payment is assessed on the value of electricity distributed through First National’s Metro distribution facility rather than on the revenue derived from customer payments. The franchise fee will be assessed at $0.01 per each kilowatt hour of electricity passing through the facility. Metro’s city managers forecast that, under this new agreement, First National will pay $1 million annually. First National will likely pass this cost on to Amalgamated and Marketer Inc. in the form of increased charges for use of its distribution facility.
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Questions for State Policymakers: |
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· Do local governments in your state impose a franchise fee on utilities? |
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· How will local government revenues from franchise fees be affected by the changing electric industry? |
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· Can local governments recover any losses in franchise fees from out-of-state and out-of-jurisdiction electricity providers? |
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· Do local changes in franchise fee collection require changes in state statutes? |
Options for State and Local Policymakers
These hypothetical examples illustrate some of the issues state and local policymakers need to examine during their discussion of the effects of electric utility industry restructuring on state and local taxation. The following options have been considered by states that have implemented restructuring
• Limit the amount of franchise fees. Because franchise fees are assessed by local governments, state legislators cannot eliminate them. However, they can impose an upper limit on the amount of franchise fees. If states limit franchise fees, they may need to consider redistributing some state tax revenues to local governments to make up for local deficits.
• Assess an exit fee on customers that leave the electricity provider that pays the franchise fee. In an attempt to prevent the erosion of franchise fees paid by a utility to a municipal government, the California Legislature adopted legislation that allows a surcharge to be applied to natural gas and electricity suppliers that replaces, but does not increase, franchise fees that would have been collected before restructuring occured. The California Public Utilities Commission establishes the surcharge, which is collected by the utility through distribution billing.
• Impose the franchise fee on a different base. In the hypothetical example, Metro imposed the franchise fee on the value of the electricity distributed from the distribution facility because Metro did not have the nexus to tax power providers that are located outside its limits. The franchise fee also could be reconfigured so that taxes are levied on the distribution facility revenues. This design should be considered on a state-by-state basis.
• Eliminate the franchise fee and replace it with another form of taxation. If the franchise fee is eliminated, some local governments could see a considerable decline in the amount of their general treasury funds. Therefore, policymakers may consider imposing a state tax on electricity providers and distributing the revenues to local governments. Issues such as nexus should be considered when discussing how the state and local taxation system could be most effectively redesigned.