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National Conference of State Legislatures National Conference of State Legislatures
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
Payments in Lieu of Taxes (PILOTS)
Electric Industry Composition
Investor Owned Utilities (IOUs)
Rural Electric Cooperatives
Public Power Systems
Federal Electric Utilities
Independent Power Producers
Power Marketers
A Definition of Payments in Lieu of Taxes
Who Pays Pilots?
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
Payments in Lieu of Taxes and Electric Industry Reform: A Hypothetical Example
Payments in Lieu of Taxes after Restructuring
Options for State and Local Policymakers
State Policymaker Options
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 are 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 direct effects of electric industry restructuring on payments in lieu of taxes (PILOTs). If restructuring fulfills the promise of lower rates and greater economic activity, it will lead to economic growth, new investments and a larger tax base. These effects on PILOTs are difficult to quantify with a useful degree of accuracy and it is not the purpose of this paper to make assertions about the potential benefits of restructuring. This paper should be taken in that context.
PILOTs are used by many local governments to raise revenue for the general fund and to obtain services for the municipality. Utility restructuring presents two main issues related to PILOTs:
The effect of competition on PILOTs, and
The effect of PILOTs on effective competition.
Although PILOTS have been decided at the local level, state policymakers may want to consider the following points as they determine how PILOTs fit into a restructured system:
The way local governments assess PILOTs will affect the competitiveness of different electricity retailers.
Public power systems may see a decrease in electricity sales, but could still be required by local governments to provide local governments with PILOTs equal to those before restructuring.
Changes in state taxation could impose new taxes on electricity providers without taking account of their current level of payments and contributions to local governments. Therefore, legislators should be aware of PILOTs and the role they play in local government operations.
The effect changes in the PILOT system will have on local tax administration and collection efforts.
The potential of overlapping new taxes in a restructured electric system with PILOTs already in place.
State legislators cannot eliminate PILOTs, but may be able to limit them.
Electric Industry Composition |
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Investor-Owned Utilities (IOUs). IOUs are taxable-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 to serve the end user. |
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Rural Electric Cooperatives. Rural electric cooperatives are owned by their customers. 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&T's 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. |
A payment in lieu of tax or transfer to the local government's general fund is a cash payment or services provided at no charge by an electric utility to its local government. In the case of public power systems, the utility is a part of local government; it is not subject to local property taxes. Instead, the local government establishes an annual payment or transfer in lieu of tax revenues based upon the public power system's general revenues. There may be a formula for computing the payment, or it may be an amount negotiated each year. Some jurisdictions differentiate between payments that are computed by formula or set by contract (payments in lieu of taxes), and payments that are determined on an annual basis (transfers to the general fund), but typically these two terms are used interchangeably.
Various services also may be provided to municipal governments as PILOTs. Examples of these services include free street lighting, holiday lights, traffic control lighting, highway lighting, electricity for local government facilities, use of utility employees and unbilled services for special events. In some cases, the monetary value of these services is worth as much as several million dollars annually.
PILOTs are, to a large extent, paid by public power systems. However, other electricity providers also may pay them, including investor owned utilities, rural electric cooperatives and federal electric utilities.
Public power systems, predominantly municipal utilities, are extensions of state and local governments that operate on a not-for-profit basis. As such, public power systems generally are not subject to federal or state income taxes or local property taxes within the municipal boundaries. Historically, it has been sound public policy that one level of government does not tax another level of government in recognition of the legitimate purposes and services provided by each. For one level of government to mandate a tax on another would result in a shifting of taxpayer money and essentially would impose a tax on self service.
Public power systems provide a dividend to the owner-customers (residents of the municipality) in the form of a payment to the general fund (PILOT), reduced rates, or a combination of the two.
Federal Actions Affecting the Electricity Market |
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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. |
The following example illustrates how utilities and others in the electric industry pay PILOTs and how those payments could be affected by electric industry restructuring. The example is a useful tool for explaining the topic. Questions for state policymakers are interspersed with the example. The answers to these questions will help policymakers determine how to address this issue in their individual states. Any solutions described in the example should be considered only as illustrative and not as recommendations for policy actions.
Example A
City Power, a public power system (municipally owned) operates in State A's capital city. City Power has been responsible for providing electricity to the municipality since 1898. Two other utilities are located in State A-Rural Power, a rural electric cooperative, and Amalgamated Electric, an investor owned electric corporation. City Power, Rural Power and Amalgamated Electric all own power plants that are located in State A.
Amalgamated Electric and Rural Power pay property taxes. Amalgamated also pays federal and state income taxes. City Power is exempt from income taxes, but it provides the municipal government with several payments in lieu of taxes (PILOTs). City Power PILOTs include:
A $6 million payment to the municipal government's general fund.
Street lighting (valued at $750,000 annually).
Unbilled services for special events, such as holiday lighting (valued at $100,000 annually).
Specialized equipment and personnel to assist other municipal departments (valued at $250,000 annually).
City Power pays property and gross receipts taxes as part of the cost of the electricity it purchases under wholesale agreements with the state joint action agency and Amalgamated Electric.
Questions for state policymakers:
Who pays PILOTS in your state?
What percentage of electricity providers pay PILOTS?
With passage of State A's new legislation allowing competition among electricity providers, City Power, Amalgamated Electric and Rural Power are competing with each other and with other power providers that have entered the market. The other providers now include First National Power, an investor owned utility located in State B, and Marketer Inc., a power marketer. Power marketers purchase power from the power producer and sell it to the customer.
In a restructured electricity market, public power providers may see their sales increase, decrease or remain relatively stable. Each scenario could have a different implication for PILOTs, depending on how they are calculated. If sales remain stable, municipal jurisdictions could continue to impose PILOTs similar to those currently in place. However, potential changes in public power market share should be considered by state and local policymakers. In particular, a loss in market share could result in a decrease of revenues to local government if the PILOT is calculated as a percent of gross electric revenue. If the PILOT is calculated as a percent of net assets, the payment to the city may remain constant, but the financial viability of the utility may be affected. If the utility then needs to raise rates, it may continue to lose market share. PILOTs also may be assessed in a flat amount. In this case, the utility may lose market share, but it would not be evident in the PILOT. In this situation, a utility would still need to try to recoup its losses, and may raise its rates.
Before State A's restructuring initiatives, City Power began building a power plant. The new plant came online in 1997. With the increased generation capacity, City Power no longer needed a wholesale contract with Amalgamated Electric. In fact, it became a wholesale electricity provider to Municipal Electric, a public power company in State B. City Power lost 17 percent of its competitive electricity market share to other power providers, but increased its customer base by attracting retail customers outside its service territory. In the cases where City Power did not have transmission and distribution capacity, it was able to use the transmission and distribution facilities of other electricity providers. As a result, City Power increased its gross revenue by 2 percent.
When the annual agreement between the municipality and City Power was up for review, the city council determined that the PILOTs should be increased. Rather than increasing City Power's cash payment, the city council required them to provide energy for traffic control (valued at $45,000).
The restructuring efforts in State B had a different effect on Municipal Power's ability to provide PILOTs. State B is a home rule state. Broadly defined, home rule allows for local self-government. Local governments, unlike states, have only derivative powers and constitutional and legislative provisions for home rule are enacted for the purpose of giving authority to counties and municipalities over certain matters. In State B, the municipal home rule powers are constitutionally based. The state constitution also limits the sales that Municipal Power can make outside city or village limits to a percentage of their total load. Therefore, not withstanding a revision in State B's constitution, while Municipal Power will continue to have home rule authority, it also will continue to be limited in the power sales it can make in a restructured electric industry.
As retail customer choice becomes widespread in State B and nationwide, Municipal Power finds that a number of its customers inside city limits that are part of national chains come to city council and announce their desire to purchase power from Marketer Inc., which has secured arrangements for the national accounts. As a result, during the first year of restructuring, Municipal Power's market share decreases by 12 percent. They are stepping up customer retention and economic development efforts, but plan to ask city council to reduce their PILOTs based on sales figures.
Questions for state policymakers:
What are the values of Payments in Lieu of Taxes to local governments in your state?
Does your state have any jurisdiction over limiting or setting PILOTS?
These hypothetical examples illustrate some of the issues state policymakers need to examine during discussions of the effects of electric industry restructuring on state and local taxation. If there are PILOTs in your state, some of the following options may be useful to consider.
States may have the authority to limit PILOTs. The question of how to ensure a continued revenue stream to local government without unduly draining revenues from its public power system is an issue that by necessity must be decided at the local, rather than the state level. However, in some instances state legislators do have the ability to limit PILOTs, and should take into account PILOTs and other contributions made by electricity providers to their local governments when considering any changes to the current tax system.
Impose a state tax on all electric energy use in the state. Proposals have been made in some states (such as Minnesota) to eliminate a portion of the property tax that currently is paid by investor owned utilities. This could be replaced by a per kilowatt-hour tax paid by all utilities. The revenues would be collected by the state and redistributed to local governments on a revenue-neutral basis. However, this has raised concerns that customers of electric providers who pay PILOTs would be required to pay a new tax without receiving any of the benefits.
Include all PILOTs in distribution wheeling component. This option would still require the local public power utility to make the payments or provide the services, but it would be collected from all retail customers or other providers using the distribution system.
Replace PILOTs with a local franchise fee payable by all providers. While PILOTs are only between different segments of local government, franchise fees could apply to all electricity providers. This fee could be structured as a rate per commodity delivered.
Question for state policymakers:
Are public power providers in your state limited in their ability to make electricity sales outside municipal limits?