MUNICIPAL UTILITIES are arguing with the US Treasury over whether a scheme to prepay for gas under long-term purchase contracts works.

The utilities borrow the money for the prepayments in the tax-exempt bond market. They then protect against a drop in gas prices by entering into a separate hedge or swap transaction. The IRS is wondering whether this is not impermissible “arbitrage.” Arbitrage bonds do not qualify for tax exemptions. An arbitrage bond is a bond that someone uses to borrow at low rates in the tax exempt market in order to put the money into a higher-yielding investment. The American Public Gas Association sent the US Treasury a policy memo recently arguing that the scheme does not run afoul of arbitrage rules.

If it works, the idea probably warrants looking again at an idea independent power companies planning to supply power to municipal utilities explored in the early 1990’s. The idea was to have the municipal utility borrow to prepay for capacity under a long-term contract. The independent power company would then use this capacity payment as a form of tax-exempt financing.