Giving Utilities Credit When Tax Credit Is Due
Federal tax credits creates winners. Tax credits can boost utility earnings. Government is not using tax credits to pick losers. Tax credits can be helpful for taxpayers and consumers. Government has limited influence over utilities’ investments. It cannot force investor-owned utilities to build new wind turbines, solar farms, nuclear power or clean coal. However, it can offer incentives and hope utilities will be motivated to build new projects. One powerful incentive is the federal tax credit. For qualifying assets, the federal government allows investor-owned utilities to claim a credit on their income tax. That credit is determined by the asset’s type, condition and age. Federal tax credits come in two flavors. One is an investment tax credit (ITC). The other is a production tax credit (PTC). Normally, assets cannot qualify for both credits at the same time. Tax-exempt utilities, such as municipals and cooperatives, cannot use either. The ITC is a one-time credit offered for new capacity. The amount is a percentage of capital expended. It can only be claimed for qualified equipment after the new facility is fully constructed and only after it produces commercial power (source: 26 USC § 48 ). The federal government assumes no development risk and it assumes no construction risk. Except for initial production, the ITC is not designed to reward investors for energy production. The PTC is an annual credit offered for new energy production. The amount is based on energy produced (source: 26 USC § 45 ). To earn PTCs, utilities not only assume all development and construction risks, they also assume all production risks. If the facility’s production is anemic and underproduces, owners are penalized with reduced PTCs. In some cases, PTC payments may be reduced further if the asset earns above threshold revenues. In addition, PTC payments are limited to the first few years of the asset’s operating life. Unlike ITCs, PTCs are generally indifferent towards the utility’s capital cost. Most existing assets do not qualify for either credit. Wind power plants operating more than ten years do not qualify for tax credits. Solar power plants operating more than five years do not qualify. In addition, there are clawback provisions for assets that change ownership within prescribed periods. The government’s intent is to stimulate new investments. They use tax credits to help utilities reduce their capital expenditures, help small businesses with project financing and help owners reduce operating risks. They also use credits to help investors attract permanent financing. During the recent recession, the government used tax credits to create a temporary incentive that was intended to stimulate large, small and tax-exempt businesses. It was called 1603 and it referred to Section 1603 of American Recovery and Reinvestment Act of 2009 ( Public Law 111-5 ). For a short time, Congress allowed power plants that normally qualified for ITCs or PTCs to earn cash payments in lieu of tax credits. According to a recent US Treasury report , § 1603 performed as intended. It stimulated approximately 99,000 new energy projects with a combined capacity of 31,700 megawatts valued at approximately $84.5 billion (or $2.66 million per megawatt). Notwithstanding, special interests mischaracterize tax credits. Some claim tax credits are a federal giveaway program. Some claim the federal government uses tax credits as a means to pick winners over losers. Some also claim that tax credits intentionally hurt their businesses and help their competitors. There is a thread of truth in most of these claims. However, there are some distortions. Tax credits can be profitable for federal, state and local governments. First, the federal government allows all taxpaying businesses to deduct a number of ordinary expenses, including interest, taxes, depreciation and amortization. In addition to those deductions, qualifying assets may also earn ITCs. However, if a taxpayer earns an ITC, it must reduce their depreciable basis by one-half the value of the ITC. When the reduced depreciation is combined with the credit, the ITC’s net cost to the federal government is zero. In fact, it is less than zero. Second, the Modified Accelerated Cost Recovery System (MACRS) assigns a five-year useful life to solar, wind, geothermal and other property. For solar, wind and geothermal assets, there are no fuel costs. After five years, owners have no depreciation expenses. With no fuel costs or depreciation expense, utilities may find their asset generating revenues at the maximum federal income tax bracket for the remaining life of that asset (typically 15 to 20 more years). Consequently, the federal government can expect to receive at least some of their tax credit money returned. In some cases, as in ITC-earning utility-grade solar, they can expect to see all of it returned. Federal tax credits also produce new local, state and payroll taxes. If utilities had done nothing and not built new assets, state and local governments would earn no new taxes. With new assets appearing, state and local government have a new tax base that cost them nothing. Consequently, federal tax credits benefit state and local governments directly. When those benefits are added, the returns on federal investments become positive. There is more. Tax credits produce other economic benefits, some tangible and others intangible. Some tangible benefits include reduced energy costs, reduced taxes and increased economic development. Intangible benefits include improve system reliability, increased energy independence and improved energy security. Adding direct and indirect benefits and improving the federal, state and local tax base, tax credits appear to represent a solid investment. Another distortion is the argument that the federal government uses tax credits to pick winners over losers. It is true government is picking winners. However, their picks are not what some critics would have us believe. To illustrate the point, look at Exelon (NYSE: EXC ). Exelon owns the nation’s largest fleet of commercial nuclear power plants. When originally built, every one of those plants received government guarantees. Those guarantees amounted to tens of billions of dollars, all of which have all been previously consumed. Notwithstanding, Exelon and their Washington-based lobbying group (Nuclear Energy Institute) are upset about PTCs. They have been aggressively lobbying the US Congress to kill the PTC for wind turbines. Their argument is found on Exelon’s website , which claims: “The federal wind energy production tax credit is a prime example of the negative consequences of subsidies through which the government picks energy technology winners and losers.” It is an incredible statement. It turns out; the nuclear power industry is also granted PTCs (source: 26 U.S. Code § 45J ). In fact, nuclear-PTCs are designed to look very much like wind-PTCs. While wind-PTCs are set to expire, nuclear-PTCs are available today and tomorrow. In fact, two utilities plan to use those credits to help them finance their new nuclear construction projects. Southern Company (NYSE: SO ) expects to earn $2 billion worth of nuclear-PTCs. They, and their non-profit partners, are building a two-unit new nuclear power plant in Georgia. Their expected investment is approximately $15 billion. Their first unit is expected to enter commercial operations in 2019. Their second unit is scheduled to enter service in 2020. After each unit begins to produce power, they will be eligible to earn approximately $125 million per year in tax credits for eight years. For both units, Southern can expect to book approximately $2 billion in nuclear-PTCs. SCANA (NYSE: SCG ) also expects to earn nuclear-PTCs. Like Southern, SCANA and their non-profit partner, are building new nuclear units in South Carolina. They are using the same technology, similar contractors, similar budgets and similar schedules as Southern. They also expect to earn $2 billion in nuclear-PTCs after their units enter commercial operations. Considering the $4 billion in nuclear-PTCs allocated for Southern and SCANA, Exelon’s complaint appears confused. On the one hand, we have the nuclear industry complaining about wind-PTCs; on the other hand, we have the very same industry planning to book $4 billion in nuclear-PTCs. At the same time, the nuclear industry is complaining about the government picking winners, it appears they want the government to pick winners. The difference is Exelon wants the government to pick their assets as the winner and, conveniently, they want their competitors’ assets to be designated as the loser. While it appears the federal government likes new nuclear, new solar, new wind and new geothermal, they must hate coal. It turns out; they don’t. Like new nuclear units, the coal industry gets to play in the tax credit game. Utilities building new coal-burning power plants qualify for tax credits (source: 26 U.S. Code § 48A ). Unlike nuclear-PTCs, new coal burners earn ITCs. For example, the government offers a 20 percent ITC for coal projects using integrated gasification combined cycle technology (IGCC) and a 15 percent ITC for other advanced projects. Like all other power producers, coal-burning assets must qualify their assets in order to claim their tax credits. It appears coal-ITCs offered enough incentive for Southern and several other utilities to build new coal facilities. Southern has been building a next-generation IGCC in Kemper County, Mississippi. Unfortunately, Southern took too long to finish their project. Those delays forced Southern to disqualify Kemper for ITC purposes under current tax rules. Consequently, Southern lost $133 million in tax credits . The lesson learned from Southern’s Kemper experience is to count your chickens after they hatch, not before. Specifically, tax credits are not earned until all construction work is completed and the plant is producing power. If a utility booked a tax credit before the project is completed, they could find that tax credit recalled and siezed. There are other lessons. It is true; the government is using tax credits to pick winners. Those winners include new investments in almost everything, including coal, nuclear, wind, solar and other power technologies. The government is not using tax credits to pick losers, but they are ignoring gas turbines and depreciated assets. Those older assets consumed all manner of government incentives years ago. In fact, some of those older assets received higher levels of state government assistance than and new solar, wind or efficiency projects could ever expect. Tax credits do not work everywhere. Most of the nation’s 3,000+ utilities are municipal and cooperative utilities, which are normally tax exempt. To provide broader incentives, the federal government created other tools, which include grants, loan guarantees and public-private partnerships. And yes, it is possible for utilities to simultaneously secure federal loan guarantees, a state guarantees and federal tax credits for a single asset. The federal government offers carrots to utilities. They also keep sticks in their back pocket. The Environmental Protection Agency, the Nuclear Regulatory Commission, the Federal Energy Regulatory Commission, the Securities and Exchange Commission and the Internal Revenue Service all limit utility investments and operations. For utility investors, consumers and those relying on nation’s infrastructure, a balance favoring carrots is needed. When looking at utility financial statements, consider the impact of tax credits and related depreciation schedules. Those incentives affect earnings, balance sheets and cash flows in positive ways. As we saw with Southern’s Kemper project, premature declarations can be clawed back. For shareholders, utilities’ strategic investments in targeted areas can be profitable. It can also be profitable for states, consumers and taxpayers. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Feel free to edit for clarity and readability. Constructive criticism is always appreciated