A Tax Cut For Utilities May Not Be As Attractive As It Looks
by Bob Shively, Enerdynamics President and Lead Facilitator
If you are a business, what could be better than having your federal corporate income tax cut from 35% to 21%? Think of all the extra profits you can either invest in new business endeavors or return to shareholders in dividends! Except, if you are an investor-owned utility (IOU), it doesn’t quite work that way. Read on to see why the recent federal tax cut may not be beneficial, and may even be harmful, for utilities.
First, let’s consider the role of taxes in revenues and earnings for utilities. Rates charged to customers are based on an annual revenue requirement that is approved by the commission in a rate proceeding. The revenue requirement contains a line item to recover the cost of forecast income taxes:
But it is important to remember that what is included in rates is forecast income taxes not actual taxes paid (since that isn’t known until after the fact). Utilities can often benefit from the timing difference between taxes included in rates and taxes actually paid to the IRS.
A key factor in timing of tax payments is that utilities often normalize the tax flow in the revenue requirement. This means that ratemaking assumes that taxes paid on earnings are level across time. In reality, utilities have been able to make use of accelerated tax depreciation provisions (and in recent years even more accelerated “bonus depreciation”), which allowed them to delay paying taxes while going ahead and collecting tax-based revenues from ratepayers. The resulting tax implications look like this:
In the long run it all balances out, but in the short run utilities have significant deferred taxes accumulated on their books. Utilities like this because it boosts cash flow; regulators have allowed it because it keeps rates more stable.
So what happens if there is a major tax cut like the one that just occurred? Suddenly utilities:
- are collecting more money in rates than they should be since rates were set assuming at 35% tax rate, and
- have a large amount of deferred taxes that were collected assuming tax would be paid at 35%, but because these have been deferred, will now be paid at 21%.
Ratepayer advocates are calling for reduced rates immediately, and many states have already moved to open-rate proceedings to address the issue. It is easy to conclude that rates should be reduced quickly to account for the first item. But a bigger question is what should happen to the deferred tax amounts. These amounts are not small – one estimate recently suggested deferred taxes make up 15% of utilities’ balance sheets. Some parties believe these amounts too should be returned to consumers through even lower rates. Others argue that this pool of money could be used as a one-time opportunity to pay for desirable policy outcomes.
Ideas put forward include investments in grid modernization and/or clean power, or to buy down stranded costs on older power plants thus allowing them to be retired early without the sticky question of how the utility will be compensated. These issues will need to be considered in each state for distribution utilities and at FERC for transmission utilities and interstate pipelines. One way utilities could benefit from the tax cut is if their regulators allow them to use some of the deferred taxes to invest in capital assets. This would increase the utility ratebase and increase earnings. But otherwise, utilities will not gain any earning benefits.
Meanwhile, utilities may have cash flow issues. Reducing rates reduces revenue brought in the door. And returning deferred taxes earlier than originally assumed means utilities must come up with extra cash. So for many utilities revenues will go down at the same time cash requirements will go up. This will result in declining cash flow and a potential credit squeeze since a key factor in credit rating include the ratios of earnings to debt and cash flow to debt. Indeed, Moody’s lowered its outlook to negative on multiple utilities in January in response to the tax cut.
|Utilities With Moody’s Lowered Outlook as of January 2018
||Orange and Rockland
|Brooklyn Union Gas
||Piedmont Natural Gas
||Public Service of Oklahoma
|KeySpan Gas East
||Southwestern Public Service
|New Jersey Natural Gas
||South Jersey Gas
|Northwest Natural Gas
So what’s the potential result for utilities? Lower rates that makes customers happy but possible cash flow issues and increased borrowing costs. And no boost to earnings. Unless utilities can convince the regulators to allow them to invest some of the deferred taxes into capital assets that will earn a return over the life of the new assets, utilities may find themselves wishing the tax cut had never occurred.
Want to learn more about how ratemaking works, how it affects your company, and how ratemaking is changing? Enerdynamics has multiple learning opportunities. Classroom options include the basic How Your Utility Makes Money and the more advanced Utility Ratemaking and the Evolving Utility Business Model for Executives courses. Or learn online by taking Enerdynamics’ Revenue Requirement and Ratemaking course. Call us today at 866-765-5432 or email us for more information.
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