National Conference of State Legislatures

Tax Implications of Electric Industry Restructuring
A Series by the NCSL Partnership on State and Local Taxation of the Electric Industry

Overview of Effects of the Changing Electric Industry on State and Local Taxes

12 Page Document

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.

December 1997
By
Matthew H. Brown and
Kelly Hill

Contents

Introduction

Why Are States Considering Competition among Electricity Generators?

Possible Federal Action
Changes in Technology, a Market Glut of Power and Decreasing Fuel Prices
Utility Restructuring and Taxes.

Utility Restructuring and Taxes

Purpose of these Reports

Federal Actions that Affect the Electricity Market

Electric Industry Composition

Types of Taxes Assessed by States and Localities on Various Electricity Producers

How to Determine if Electric Industry Taxation is an Issue in Your State

Compare Your State to Others in Your Region
Examine the Effect of Tax Policy on Competition
Examine the Effect of Restructuring on State and Local Tax Revenues.
Other Concerns

Overview of State Tax Policy and Electric Industry Restructuring Policy

The Relationship between Taxes and Electric Industry Restructuring

The Effect of Competition on Tax Revenues

The Effect of Tax Policy on Competition

Tax Policy Considerations

Tax Revenue Neutrality
Neutrality of Effect on Various Taxpayer Classes
Competitive Neutrality
Tax Policy to Meet Larger Societal Goals
Tax Policy as an Economic Development Tool

Notes

Introduction

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.

Why Are States Considering Competition among Electricity Generators?

Possible Federal Action

At least six proposals are circulating in the U.S. Congress that would require states to allow competition among electricity providers. Some of these proposals include a grandfather clause that allows states that have already begun competition to continue with their own plans. This is not guaranteed, however, especially if the federal proposal differs significantly from the state plan. Some federal legislation would mandate states to allow competition, but would give states the authority to design many elements of their competition plan on their own, as long as the state plans meet federal guidelines.

Changes in Technology, a Market Glut of Power and Decreasing Fuel Prices

Many states' new approaches to regulating the industry are in response to changes in the business of generating electricity. New technologies have decreased the cost of generating electricity, and steadily decreasing natural gas prices1 have further reduced the cost of generating electricity with natural gas turbines. In addition, many new power plants began operation in the late 1980s, creating far more generating capacity than needed. This oversupply of electricity pushed the spot market, short-term price of electricity to historic lows. It now is possible to obtain power from this spot market or these new power plants at a price lower than many utilities are selling it for at retail. Some electricity consumers have argued that the current system of regulated monopolies should be eliminated. Advocates for competition argue that a system of price regulation-in which each utility is allowed a geographically-defined service territory and can pass its approved costs to customers-is not as efficient as an electric market in which customers can shop for their electricity provider. By 1998 the system that regulated these monopolies will have begun a fundamental change from state regulation of prices to market-based regulation of prices; at least 2.5 million Americans will have the opportunity to choose their electricity supplier.

This transformation is affecting the market for generating electricity, but is having relatively little effect on the physical system of delivering power to customers through transmission and distribution wires. The wires system that delivers electricity to customers is likely to continue to operate as a price-regulated monopoly, at least in the immediate future. Consequently, the effort to restructure the electric market focuses on bringing competition to the generation segment of the industry.2

Utility Restructuring and Taxes

A little-noticed aspect of the early stages of electric industry transformation has been its effect on state and local taxes. Many state legislatures are now beginning to focus on:

The effect of restructuring on state and local tax revenues, and

The effect of tax policy on competition.

States are approaching the issue in different ways:

Pennsylvania and New Jersey have made changes to their electric industry tax system in an attempt to make it more compatible with a competitive electric industry.

Nevada and Oklahoma have asked their state revenue departments to study the issue and report to them, even as they make the transition to competition.

State legislatures in Minnesota, Arizona and New Mexico have delayed the transition from regulation to competition in part because they want to understand the effect of electric industry restructuring on taxes, and the effect of taxes on competition.

Purpose of These Reports

The objective of this series of brief documents is to help state policymakers understand the potential effect of the changes in the electric industry on state and local tax revenues, the effect of state and local tax policy on competition and the policy options available to them.

Armed with these documents, states that choose to restructure their electric industry may be able to do so with a better understanding of the implications of that reform on their tax policy. Any effects of the tax structure on competition or potential effects of competition on tax revenues should be the result of the states' informed choices instead of inadvertent consequences of uninformed choices.

Types of Taxes Assessed by States and Localities on Various Electricity Producers

How to Determine if Electric Industry Taxation Is an Issue in Your State

Just as every state's electric industry is different, so, too, is every state's system of taxing the electric industry. As a consequence, tax policy will require a great deal of scrutiny in some states, somewhat less attention in other states and only minor adjustments in the rest. State policymakers may find it helpful to review the following questions to determine the importance of tax concerns to the electric industry restructuring debate.

Compare Your State to Others in Your Region

New technologies and other pressures are rapidly changing the business of generating electricity. All states and the U.S. Congress are considering the merits of reforming the electric industry. How is your state considering retail competition?

How far have other states in your region moved toward allowing competition among electricity generators and providers?

How do taxes in your state compare to those of other states in your region? Might taxes be a factor in convincing electricity generators or electricity providers to locate inside or outside your state?

The competitive electric industry will be characterized by new types of providers selling electricity from both within and outside your state. Are electric utilities in your state taxed or assessed at a different rate from other in-state electricity providers or other manufacturing businesses?

Are effective tax rates for utilities higher than those for other businesses?

Competition also may result in out-of-state providers entering the market in your state. Are out-of-state electricity providers taxed differently from in-state providers? If so, how similar are the tax burdens?

Does your state tax law adequately address nexus, which is your ability to tax companies or transactions that may be located outside your state?

Does your state adequately address interstate electricity sales?

How will the restructuring of the electric industry affect tax payments from all types of electricity providers (power marketers, public power systems, rural electric cooperatives, investor owned utilities) in your state?

Examine the Effect of Restructuring on State and Local Tax Revenues

How much of your state and local revenues are derived from electric utilities?

Have you considered the possibility of increased fluctuations in your tax revenues as a result of industry restructuring? Is your tax and revenue department or ways and means committee aware of this possibility?

Are there power plants in your state that may lose value in a competitive electric market? Are there power plants or other electric utility resources that may become more valuable in a competitive electric industry?

In some states, property tax revenue will decrease as a result of the lower value of power plants in a competitive electric industry. In some states property tax revenue also may increase. To what extent do the taxing jurisdictions in your state depend on property taxes to fund their activities?

Are your local governments' franchise fees based on gross receipts? Does your state levy a gross receipts tax on utilities?

Does your state or do local governments in your state have bonding and borrowing limitations that are based on a predicted tax revenue stream or a specified percentage of assessed valuation?

If your goal is tax revenue neutrality after restructuring your electric industry, what are the candidate taxes to replace your current tax revenues, and who (homeowners, businesses, etc.) will pay them?

How much do state and local governments now pay in electricity bills, how much might they expect to save as a result of restructuring, and could those savings offset any tax revenue losses?

Are there jurisdictions in which power plants make up a large share of the property tax base?

Other Concerns

Does your state use electric rates to finance social policies and goals such as energy efficiency, renewable energy and low-income assistance programs?

Because of the possible shift from monopoly to competition in many states, the way that states tax electricity generators and electricity providers may gradually begin to have more in common with the way that they tax other businesses that are not run as monopolies. Considerations that have heretofore been less paramount in electric industry taxation-such as comparative tax burdens on competing energy industries or the burden of taxes on households, commercial businesses or industry-will become increasingly important as the electric industry continues this transformation.

Overview of State Tax Policy and Electric Industry Restructuring Policy

When state legislatures created regulations and agencies to govern the electric industry in the first part of this century, their goal was to shape an industry that would provide reliable electricity at a reasonable price. As figure 5 shows, the industry that formed around these state- and later federal-laws grew to serve 98 percent of the American public through four types of electricity providers.

When state legislatures wrote these laws, they concluded that the electric industry-the nation's most capital-intensive industry-was a natural monopoly that was closely entwined with the public interest. As a result most states gave each retail seller of electricity a service territory in which it could sell electricity without competition. In exchange for receiving this monopoly, the retail sellers agreed that the state could regulate many aspects of their business. This regulation applied in almost every state to investor owned utilities. In varying degrees in different states, rural electric cooperatives and public power systems are regulated at the local or state level.

In general, the states moved quickly to regulate the investor owned utilities' electricity prices through cost of service regulation. One objective of this action was to regulate the prices of these monopoly providers of electricity.

Cost of service regulation allows utilities to recover the costs of their reasonable and prudent investments in power plants, power lines, offices and equipment. The system also allows them to pass their approved expenses-like personnel or state and local taxes-to their ratepayers. In addition to recovering their costs, utilities also could earn a reasonable profit on certain investments-power plants or power lines, for example. These investments collectively make up what is known as the utilities' rate base. State regulatory commissions decide what is a reasonable profit and what are reasonable investments. In this cost of service regulatory system, a power company might build a power plant for $100 million and recover $5 million each year for 20 years plus a return of 11 percent. The utilities' ratepayers pay for this power plant, the utilities' other reasonable costs, plus the reasonable rate of return.

Utility commissions can disallow some expenditures from the rate base if they appear too high or unnecessary. Major investments-like electric power plants-undergo the most scrutiny, and sometimes are only partially allowed into the rate base. The cost of service approach has not been sufficient to prevent significant disparities in rates among electric utilities even within the same state. These disparities have arisen because of management decisions by individual utilities, because of different timing of the need for new power plants among utilities, because of state and federal regulatory decisions, and for various other reasons.

Other expenditures receive less scrutiny in some states, and utility commissions have long allowed them to be passed to customers as a matter of course, with the understanding that the utilities have little control over these expenses. Utility taxes are an example of this type of expense. In this respect, utilities are different from other business taxpayers, which attempt to pass tax expenses to their customers, but have less opportunity to pass those expenses on to their customers. Utilities became tax collectors for the state, rather than taxpayers, because they have almost always had the legal right to pass their tax expenses to their customers. Utilities became an attractive means through which state legislatures could quietly raise revenues. These taxes that utilities essentially collected for the state became known as hidden taxes.

With the exception of the sales tax, most taxes that states or other governmental units levy on electric utilities are included as part of the electric rate, assumed to be simply part of the cost of generating, transmitting and distributing power. The utilities have been a politically convenient means through which to levy taxes. For their part, while many electric utilities fight these taxes in the legislature, they know that they will be able to pass their tax expenses to their captive retail customers and that they face no competition from other electricity retailers with a different tax burden.

As a result of this situation, utilities have become a surrogate tax collector for the government in many states. To the extent that these taxes are passed to customers in their electric rates, it is the ratepayers who have borne this burden some parts of the country; taxes have become a significant proportion of utility rates. In a market where utilities have little or no competition, these organizations have become an important source of cash for state and local governments.

Investor owned utilities, rural electric cooperatives and public power systems each are affected by this tax burden, but each to a different extent and each by different taxes. Rural electric cooperatives and investor owned utilities pay many of the same taxes, although sometimes at different rates from one another. Public power systems pay some traditional taxes, but more often make payments in lieu of taxes, or payments to the local government of which they are a part. The rate at which public power systems pay these taxes and the method that is used to determine them vary significantly from one political subdivision and state to another. Like the investor owned utilities, both rural electric cooperatives and public power systems have become a source of revenue for state governments and their political subdivisions.

Utilities in some states have spent little time or energy fighting these taxes, while in other states the utilities have vigorously opposed them. If, as in some states, electric rates are capped (held by legislation or regulation below a certain level) the utility may not be able to pass the tax costs to customers. Utilities are becoming increasingly sensitive to their taxes in a restructured, competitive environment because their state and local tax burden is large. For example:

At Consolidated Edison in New York City, 21 percent of the price of each kilowatt-hour (kWh) charged to consumers consists of state and local taxes.

At Chicago's Commonwealth Edison, 15 percent of the per kWh electricity price charged to consumers consists of state and local taxes.

Industrial customers of Wichita-based Kansas Gas and Electric pay a 26 percent state and local tax load per kWh.

The Relationship between Taxes and Electric Industry Restructuring

The relationship between state and local governments and the utility monopoly may have to change now that utilities in many states no longer will have state sanctioned monopolies. Investor owned utilities, rural electric cooperatives and public power systems-both in-state and out-of-state-may change their structure to compete in the generation of electricity with each other as well as with a new type of competitor called a power marketer. Power marketers will buy electricity from any company that is willing to sell it, and then will resell the power to its own customers. These power marketers may own no power plants, have little other tangible property and may operate from an office in a state that has no income tax. In many states, all these competitors will be taxed differently and, in some cases, may be taxed at rates lower than the utilities.

The Effect of Competition on Tax Revenues

Some states may find that their tax revenues will decrease if they use a tax code that originally was set up to deal with regulated monopolies to now tax a competitive electric marketplace. Several organizations have posited figures by which tax revenues could fall. These estimates will vary depending upon the methodology used to make the estimates and upon who makes them, but it appears clear that some states will lose some revenue if they move to competition without also changing their tax system. Other states may actually see an increase in tax revenues as a result of competition. Just how much revenue each state loses or gains will depend a great deal upon how the state tax system currently is set up and what changes it makes to accommodate electric industry competition.

Some electricity taxes are based on the gross receipts of the electricity sellers. If the price of electricity falls, so also will the receipts of the electric companies. California, for instance, predicts that restructuring will reduce the price of electricity by 20 percent. Rhode Island has suggested that it will save 10 percent, and others have estimated similar savings. If utility revenues do fall by 10 percent to 20 percent, the gross receipts tax revenues will decrease by the same amount unless the consumption of electricity rises enough to compensate for the decrease in price, or unless governments save enough money on their own electric bills to make up for the tax revenue loss.

A few states may find that the tax revenues shift, so that those who are accustomed to receiving the revenues¾often school districts, parks or local governments¾may no longer receive the revenue. In other words the revenues from some taxes¾such as property taxes and franchise fees and taxes¾that dedicate their receipts to distinct geographic areas or distinct purposes could decrease, while the revenues from other taxes with revenues directed to the states' general fund could increase. This means that some states may have to examine ways to reallocate revenues from a few taxes to compensate for decreasing revenues from others.

The Effect of Tax Policy on Competition

In a business in which the largest consumers of electricity might choose their electric company based on a quarter-cent difference in price, the tax burden on competing electricity providers will affect just how effective competition is at eliminating the most inefficient electricity suppliers.

Electricity prices may differ because of varying tax burdens among sellers. As a result, the tax structure may make it difficult to determine the effectiveness of competition

Most states will need to determine how to reform their tax policy to align it with competitive electric markets. This reform will require careful thought and negotiation. Some states may find it useful to define the goal of the tax policy changes according to the following suggestions.

Tax Policy Considerations

Tax Revenue Neutrality

Without changes to the tax code, some states will lose or gain tax revenues when the industry moves from monopoly to competition. Meeting a goal of tax revenue neutrality would guarantee that the state or local governments do not see a decline or increase in their tax revenues as a result of competition.

Neutrality of Effect on Various Taxpayer Classes

New taxes will affect taxpayers differently. Meeting a goal of neutrality of effect on the various taxpayer classes would guarantee that homeowners, industrial companies and commercial companies of all income levels will at least be no worse off under competition than they were under the monopoly system and that the change in tax burden will not fall disproportionately on any one class of taxpayers. Some suggest that states should focus on the hidden taxes.

Competitive Neutrality

One general principle of a quality revenue system is that taxes should be neutral in their effect upon behavior. Taxes should not affect a consumer's choice between two products or the choice of one production technique over another. Competition in the electric industry will mean that companies and organizations now may have a choice of buying from a range of electricity providers that may be located in state or out of state. Meeting a goal of competitive neutrality would mean that tax policy would not affect the consumer's choice by affecting the price. In other words, the goal would be that tax policy not determine which type of producer wins market share.

Tax Policy to Meet Larger Societal Goals

States use tax incentives to promote environmental or other social goals. A tax policy designed to meet larger societal goals would attempt to guarantee that, for instance, some renewable energy resources receive a tax break to encourage fuel diversity in the state.

Tax Policy as an Economic Development Tool

States use tax policy to bring jobs to the state and to increase the tax base. A tax policy designed to encourage economic development goals might, for instance, encourage power plants to locate in the state. Tax policy, electricity prices and other factors can combine to form a good or bad economic development climate for all businesses in a state.

State tax policy goals probably will be a combination of these goals. Indeed, it is unlikely that states will be able to meet any of these goals with precision or perfection. The objective of this NCSL Partnership is to give states guidance to make informed decisions without unexpected tax consequences, and to allow competitive electric markets to operate efficiently, with tax policy not the determinant of the market's efficiency.

Notes

1. The price of natural gas has generally been declining; some seasonal price increases do occur, however, as happened during the winter of 1996.

For convenience, many talk of deregulating the generation component of electric sales. Actually, generation, the sale of power and many power-related services are being unbundled and deregulated. There may be power marketers that do not generate power and there will be many generators who do not sell their power at retail.