President Trump's tax reform proposal to prove favorable for customers; ratemaking model could be significantly impacted

This article first appeared in Utility Dive.

One of President Trump’s campaign promises is tax reform. On the corporate side, proposed reforms have focused primarily on a reduction of the maximum corporate tax rate from 35% to 15%. However, in an interview with The Wall Street Journal on June 19, House Ways and Means Committee Chairman Kevin Brady also discusses changes in deductions for investments and interest. These changes will have far-reaching effects for utilities, regulators and customers. For investor-owned utilities (IOUs) and their customers, the overall impact of tax reform will likely be favorable and noticeable, but not shared equally among IOUs and their customers.

Impact of Corporate Tax Rate Reduction
The current tax reform proposals broadly cut statutory corporate tax rates. To understand how these tax rate changes are likely to impact customers and shareholders, a review of the impact of the last major tax reform bill is instructive.

The Tax Reform Act of 1986 (TRA of 1986) resulted in the reduction in the top end corporate federal income tax rate to 34% from 46%. For a utility’s customers, the benefits from a reduction in federal corporate income tax rates were direct and took the form of reduced rates for utility services. Depending on the state, the benefits occurred “immediately” or were reflected in the next rate case.

For example, in Kentucky, the PSC stated in its Order in Case No. 9781 (December 11, 1986) that it did not view retaining savings from tax reform as a proper way for a utility to improve its earnings and subsequently ordered a total statewide utility revenue reduction exceeding $75 million. In New York, the PSC used a different tactic, ordering that incremental tax savings or expenses generated between January 1, 1987 and the date of a utility’s next-following general rate case would be deferred. The Commission indicated that the use of a deferred accounting mechanism had the advantage of preserving interim tax benefits for ratepayers without disturbing existing cash flow and interest coverage targets or producing undesirable fluctuations in base rates.

In our opinion, history is likely to repeat itself, with state commissions probably taking different approaches (that is, deferral vs single issue) to address the change in tax rates. A review of gas and electric utility rate case filings over the past 10 years suggests that many utilities are now in a pattern of routine rate cases. Most gas and electric utilities have had rate cases within the past two or three years. This includes a number of utilities who had previously avoided rate cases for a number of years. For those few companies whose strategies have been to avoid rate cases, tax rate changes may bring that strategy to an unavoidable end.

Of course, the utility world has seen significant structural changes since 1986. Electric utilities were generally vertically integrated in 1986, but this is no longer the case as a result of subsequent industry restructuring and deregulation. From a regulatory perspective, many utilities are now under one or more alternative ratemaking mechanisms, which provide for the recovery of “between rate case” capital expenditures while limiting earnings within bands.

For state regulated retail utility customers, the benefit from reduced tax rates should be fairly direct as revenue requirements will ultimately be reduced to reflect the change in tax expense. This assumes that benefits from accumulated deferred income taxes will be normalized similar to the TRA of 1986.

For unregulated generation companies (Gencos), the lack of details in the current tax reform proposals make estimating the net impact difficult. While the Gencos will benefit from the tax rate reduction, these benefits will potentially be offset to some degree by changes in depreciation rules and renewable investment tax credits (ITCs) and production tax credits (PTCs). For transmission owners regulated by FERC with formula rate structures, retail customers could see an almost immediate benefit as tax benefits are passed on.

Impact of Changes in Tax Preference Related to Investments
The discussion of another significant aspect of tax reform as it relates to utility and energy companies has heretofore largely been restrained. In a Wall Street Journal interview with House Ways and Means Committee Chairman Kevin Brady appearing in the June 19, 2017 print version of the WSJ, Chairman Brady discusses a change in the tax preference associated with investments. Rather than give that preference to the source of funds, borrowing, the preference would be given to the use of funds, business investments.

This means that interest expense will no longer be deductible for federal tax purposes while investments will be immediately and fully deductible.

For companies such as utilities with current balance sheets comprised on long-lived assets and corresponding liabilities to fund these investments, coupled with uncertainty around changes in ratemaking practices driven by these tax reforms, the financial picture becomes very muddy. For an industry that has thrived on being risk averse, the world may suddenly become a scary place.

Without substantial financial and rate modeling and serious conversations with regulators, the impact on utilities, investors and customers is unclear.

The Impact on Utility Shareholders Will Likely Vary
Also of interest are the consequences of indirect impacts and whether there will be winners and losers among U.S. investor-owned electric and gas utilities.

For states offering deferred accounting mechanisms similar to New York post TRA of 1986, utilities will likely benefit in the short term from improved cash flows associated with the reduction in tax rates. However, these benefits may be offset by the timing associated with the revenue requirements now built on the deductibility of interest expense for federal tax purposes. Longer term, winners and losers may depend on how quickly utilities and their regulators sort through the tax preference issues.

For the unregulated players in the energy marketplace such as generation and transmission owners, the changes in tax preferences will likely be mixed depending on the treatment of interest deductibility associated with legacy investments and regulatory mechanisms in place to provide for near real-term recoveries of changes in costs.

While it’s somewhat unclear, owners of actual and planned fleets comprised of larger than average portfolios of renewable resources may be negatively affected by the loss of federal tax incentives. This will impact earnings long-term.

Those utilities located in states with high state and local income tax rates will see less of a relative impact on rates than those utilities located in lower tax rate states. The value of the deductibility of state and local taxes for purposes of calculating federal income tax expense diminishes as federal tax rates are reduced. This gives those states with lower tax rates a competitive advantage.

And the competitive advantage of low-cost utilities will become even stronger, especially when coupled with abundant, firm supply. Manufacturing firms looking to build new or expand existing production facilities are influenced by low-cost and reliable energy. This is especially true in industries in which energy is a significant component of overall product cost. Of course, these decisions are also influenced by transportation and skilled workforce requirements, among others.

For those investor-owned utilities (IOUs) in regions where they compete with public power entities, the public power pricing advantage related to the payment of income taxes will be significantly reduced. This will apply pressure to those agencies to pursue productivity and efficiency opportunities to minimize load loss to the IOUs.

Derek HasBrouck, Joel Jeanson and Pranav Shanbhag are energy and utility experts at PA Consulting Group.

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