The following post was written by research groups within our Energy offering, including Regulatory Research Associates, or RRA. For further information on the full reports, please request a call.
For the first time in 30 years, the administration is spearheading sweeping tax reform that includes a significant reduction in corporate rates. The U.S. House of Representatives passed tax reform legislation, and the U.S. Senate is taking up similar legislation this week. While the bills vary on some specific issues, both bills call for a significant reduction in the corporate income tax rate to 20% from 35% currently. With the administration hoping to sign comprehensive tax reform legislation before the end of the year, Regulatory Research Associates, an offering of S&P Global Market Intelligence, analyzes potential impacts to our covered electric and gas utility universe.
Most regulated utilities and potentially unregulated power generators appear (based on language in the House bill) to be exempt from certain legislative provisions calling for the elimination of the deductibility of net interest expense and the immediate expensing of the most recent five years of capital investment. Absent the exemptions, both provisions could have significantly impacted the heavily indebted, capital-intensive utility/power sector.
The reduction in the income tax rate to 20% will benefit merchant power operators, but they are unlikely to realize a windfall for shareholders in our view. Due to highly competitive wholesale power markets, lower wholesale power prices are the most likely outcome as merchant generators fight for market share. On the regulated side of the fence, utilities will almost certainly be required to pass along savings from new tax guidelines through state regulatory proceedings.
An anticipated advantage for regulated utilities, however, is that a lower tax rate will slow the build-up of accumulated deferred income tax liabilities, or ADIT — representing unpaid future federal taxes resulting from aggressive depreciation of capital investments — as the benefit of accelerated/bonus depreciation (tax shield) is reduced. This in turn will likely help utilities grow rate bases faster than under the current tax code because rate bases in most states are calculated after deducting ADIT. Thus, reducing the value of ADIT as an offset to rate base could, all else being equal, result in higher rate base values in most jurisdictions. However, any earnings boost from this rate base acceleration is likely to be muted due to the significant possibility of regulatory claw-back.
All other things held constant, rate base is expected to accelerate faster for those regulated utilities whose ADIT represents a higher percentage of rate base. (See below for a list ranking utility holding company by consolidated ADIT as a percentage of net property plant and equipment, which represents the companies' regulated assets but is not exactly equivalent to rate base.)
Based on our analysis of deferred income tax liabilities, those RRA-covered utility holding companies that are likely to realize stronger growth in rate base from a reduction in the corporate income tax rate include CenterPoint Energy Inc., Public Service Enterprise Group Inc., IDACORP Inc., OGE Energy Corp., and MGE Energy Inc. (See full table below.)
How would state regulatory commissions account for the excess deferred tax liability created as ADIT established under the 35% rate are paid off at the new 20% rate? We believe it is plausible that regulators could require utilities to set up a regulatory liability reflecting the excess deferred tax liability and require them to flow this back to ratepayers in some manner over time. This method would be consistent with what was done by states the last time the federal corporate income tax rate was significantly reduced through the Tax Reform Act of 1986.
Following passage of the Tax Reform Act of 1986, states took somewhat different approaches to passing through savings onto ratepayers. For example, Alabama included adjustment provisions/tax riders in tariffs allowing customer rates to reflect income tax rate changes. Georgia regulators required utilities to track the estimated annual effect on their revenue requirements resulting solely from the reduction in tax expense and place that amount in a deferred account. Indiana asked utilities to voluntarily file for rate reductions reflecting lower tax rates, or be subject to an investigation and hearing as to why rates should not be reduced.
The latest proposed tax rate changes are already being addressed in rate proceedings, namely in multiyear cases. Under a multifaceted rate and solar settlement, the Florida Public Service Commission on November 6 authorized Tampa Electric to change rates outside of a rate freeze to address the potential impacts associated with any tax reform that may occur through 2021. Connecticut regulators in a December 2016 decision for United Illuminating stated they would reopen the proceeding if income tax rates change in the near future. Florida regulators adopted more detailed language as part of a much broader settlement with Duke Energy Florida, or DEF, in 2016. Regulators stipulated that if tax reform enacted during the settlement term results in a decrease in base revenue requirements, DEF would retain 40% of any impact each year, up to $50 million pre-tax, to accelerate the depreciation of a coal plant, and flow back the remaining impact to customers through a one-time base rate decrease.
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