New Tax Subsidies for Energy Projects
Energy projects in the United States qualify potentially for an array of new tax subsidies under a massive new energy bill that runs 1,724 pages.
President Bush signed the bill into law on August 8. Congress estimated that the tax subsidies will be worth $14.6 billion over the next 10 years.
The biggest beneficiaries are developers of renewable energy projects like wind farms and power plants that run on biomass, landfill gas or geothermal energy. Approximately 19% of the tax benefits under the bill will go to renewables. Electric cooperatives, municipal utilities and Indian tribes that are not normally in a position to use tax subsidies will also benefit. They will be allowed to finance new equipment they install to generate electricity from renewables using interest-free bonds that pay the holders of the bonds tax credits in place of interest.
There are also new tax benefits for projects that make use of coal — for example, that turn coal into a liquid fuel for motor vehicles or gasify coal or use advanced processes to generate electricity. An example of an advanced process is an integrated gasification combined-cycle power plant. Companies that mine coal from reserves on Indian reservations will be given tax credits of $1.50 to $2 a ton.
The bill provides tax subsidies for power lines and pipes and related equipment needed to transmit electricity equipment or distribute natural gas. Electric transmission assets and gas distribution lines can be depreciated more rapidly in the future. The tax savings from the faster depreciation will pay roughly 3¢ per dollar of capital cost of such equipment.
Power companies that lost money in 2003, 2004 or 2005 — at least for tax purposes — will be allowed to use the losses in one of the years to get back any federal income taxes the companies paid up to five years in the past. There is a condition. The refunded taxes must be used to pay either for new transmission equipment or air or water pollution control devices. The transmission equipment might include an “intertie” or a substation upgrade to connect a new power plant to the grid.
Utilities will have to recalculate amounts they collect in the future as “tax grossups” on electric and gas interties. When an independent power company connects a new power plant to the grid, the utility that owns the grid usually requires it to reimburse the utility for the cost of the “intertie” — the radial line, circuit breakers and other substation improvements needed to connect the plant to the grid — as well as for any improvements to the grid itself to accommodate the additional electricity. Utilities sometimes insist that the independent power supplier pay not only these costs but also a “tax grossup” to compensate the utility if it has to report the value of the intertie and grid improvements as income. Because utilities will be able to depreciate transmission assets more rapidly in the future, the amount of any tax grossup should decrease to reflect the benefit the utility will receive from this faster depreciation.
The bill gives operating subsidies — in the form of “production tax credits” — to owners of new nuclear power plants.
It allows faster writeoffs of air pollution control equipment installed at power plants that burn coal.
It gives a windfall to owners of some existing coke batteries at steel mills. Anyone producing coke or coke gas in existing coke ovens built between 1980 and 1992 or after June 1998 will be allowed to claim up to $4.38 million a year in tax credits per coke battery. The credits can be claimed for four years. They can also be claimed on the output from new coke ovens installed through 2009.
Tax subsidies can be a mixed blessing. Foreign companies trying to develop projects in the United States and smaller US developers are usually not in a position to use them since both lack a US tax base. They must find ways to “monetize” the tax benefits in order to compete effectively against larger companies that can use them. Private equity funds looking to invest in the energy sector are often inefficient users of tax benefits and, as a consequence, they may have a harder time bidding against traditional institutional equity investors on projects that receive heavy tax subsidies.
The bill extends a deadline for completing wind farms and other renewable energy projects to qualify for “production tax credits.” The tax credits are currently as much as 1.9¢ a kilowatt hour on the output. The deadline for completing projects to qualify had been December this year. Developers now have another two years through December 2007.
This is expected to give a significant boost to the US wind market. Production tax credits on wind farms are worth roughly 35% of the capital cost of a typical project. That is the present value of the tax savings from claiming such credits.
Production tax credits are given to the owners of certain kinds of power plants as a reward for generating electricity from renewable fuels.
Seven types of projects qualify potentially for such credits after the new energy bill. They are: wind farms, power plants that are fueled by biomass, geothermal energy, landfill gas or municipal solid waste, small turbines of less than five megawatts in size that produce electricity in irrigation canals or ditches, and new turbines installed at existing dams. “Biomass” is organic material like wood, rice hulls or manure.
Solar projects had qualified, but the deadline for them was not extended. They continue to qualify if put into service by year end in 2005.
How long the tax credits run and the amount depends on the type of project and when it is first put into service.
The tax credits are 1.9¢ a kilowatt hour on output from wind farms and power plants that run on “closed-loop” biomass, geothermal energy and sunlight. They are half that amount on other projects. These are the amounts for electricity produced during calendar year 2005. The credits are adjusted each year for inflation. “Closed-loop” biomass is matter from plants that are grown exclusively for use as fuel in power plants. Congress had in mind crops grown at so-called electricity farms.
The credits run for 10 years on wind farms and power plants that burn closed-loop biomass. The 10 years start when the plant is first put into service. Other projects qualified previously for only five years of credits. The energy bill extends the period to 10 years for all projects. However, the extra time applies only to new projects put into service after August 8 when President Bush signed the bill.
Developers of ocean energy projects had hoped to persuade Congress to let them claim production tax credits, but they were unsuccessful.
However, Congress did allow tax credits to be claimed for the first time on electricity from hydroelectric projects. Tax credits can be claimed on the “incremental output” from such projects, meaning the increase in output due to “efficiency improvements or additions to capacity” after August 8, 2005. Congress said that “efficiency improvements” are not “operational changes,” suggesting that the owner of an existing hydroelectric facility probably must install new equipment to be able to claim credits, even if he or she can increase output without any new equipment. However, the bill is unclear. Anyone installing new turbines at a dam that was not used previously to produce electricity must show that there will not be “any enlargement of the diversion structure, or construction or enlargement of a bypass channel, or the impoundment or any withholding of any additional water from the natural stream channel” as a consequence of using the dam to generate electricity.
Although Congress failed to extend the deadline for solar projects, it gave the solar industry a 30% “investment tax credit” instead. That’s a tax credit for 30% of the cost of equipment used at solar installations, but only for solar equipment put into service during calendar years 2006 and 2007. The entire tax credit is claimed in the year the project is put into service. (Solar projects completed after 2007 will qualify for a 10% investment tax credit.)
Congress cleared up some confusion that it created last October when it voted to let owners of existing power plants that burn biomass claim five years worth of production tax credits on the electricity they produce. The tax credits started to run in January this year. The confusion was that it looked like the five years might be counted from October 23, 2004, so that no one would actually get a full five years of tax credits. The energy bill makes clear that the five years are measured from January 1, 2005.
Congress also tried to address an issue that affects landfill gas projects, but did so poorly.
Decomposing garbage at landfills produces methane gas. The gas is trapped in collection systems. There are two tax credits that encourage the use of landfill gas. One is a “section 29 credit” of $1.13 an mmBtu that rewards anyone who traps and sells landfill gas to a third party. The other tax credit is the production tax credit given to anyone who uses landfill gas to generate electricity. Congress did not want projects to double up on these credits. However, a provision it wrote last October to do this was poorly drafted.
Congress tried in the energy bill to clear up the confusion, but still left one big question unanswered. The US tax code now bars anyone using landfill gas to generate electricity from claiming production tax credits if the gas comes from a “facility” on whose output section 29 credits were allowed at any time in the past. Landfills are filled with garbage one section at a time. At many landfills, the gas might come from a newer section from which section 29 credits were never claimed on gas because the wells used to draw the gas from the ground were not put into service in time to qualify for section 29 credits. (Wells had to be in operation by June 1998 to qualify.) However, the gas passes through a central blower that is also used for older wells that draw gas that qualified for section 29 tax credits. An electricity generator who uses gas from the newer section should probably qualify for production tax credits, but this may require a private letter ruling from the Internal Revenue Service to confirm.
Production tax credits are subject to a “haircut” if the project benefited from government grants, tax-exempt financing, “subsidized energy financing” or other credits. However, only government subsidies or credits that help pay the capital cost of a project are a problem. Thus, for example, state tax credits that are calculated on output — so that they are essentially operating subsidies — are not a problem. Also, the Internal Revenue Service has taken a liberal view in private rulings about what is considered a grant. Money might not be considered a grant if there is a possibility that it might have to be repaid. The maximum haircut is 50%.
Production tax credits are hard for individuals, S corporations and “closely-held” C corporations to use. A “closely-held” corporation is one in which five or fewer individuals own more than half the stock.
Congress tried to give something equivalent to production tax credits to electric cooperatives, municipal utilities, state and local governments, US territories and possessions and Indian tribes planning wind farms and other renewable energy projects. (Examples of US territories and possessions are Guam, Puerto Rico and the US Virgin Islands.)
However, early calculations suggest such entities would do better to let an institutional investor own such a project and merely buy the electricity with an option to acquire the project after 10 years. An institutional investor could claim accelerated depreciation and production tax credits in the meantime and share the benefits indirectly by charging a reduced price for electricity.
The energy bill would let electric cooperatives, municipal utilities, state and local governments, US possessions and Indian tribes issue “clean renewable energy bonds” to finance any project that would qualify, in private hands, for production tax credits.
These are bonds on which no interest has to be paid. The bondholders receive tax credits instead.
Congress directed the IRS to calculate the minimum tax credit that would have to be offered to the bondholders to get them to forego interest. The IRS is also supposed to set the maximum term on the bonds. The term is supposed to be the number of years that would set the present value of the principal repayments on the bonds equal to one half the principal amount originally borrowed. The US Treasury Department already does these calculations for “qualified zone academy zone bonds” and updates the figures on a daily basis on its website. Qualified zone academy bonds are bonds issued to finance improvements at public schools in low-income areas or that draw at least 35% of their students from low-income groups. The credit rate and term in early August were 5.3% and 16 years.
The bonds must require level principal repayments over the term.
Each bondholder must report the tax credits it receives in place of interest as income.
Only $800 million in total in clean renewable energy bonds can be issued for all projects. All bonds must be issued in 2006 and 2007. The IRS will allocate the bond authority among interested projects if there is more interest in the bonds than there is capacity. It must reserve at least $300 million of the bond authority for electric cooperatives.
There are three separate tax subsidies in the bill to encourage the use of coal.
First, the bill allows an investment tax credit to be claimed on new IGCC (integrated gasification combined-cycle) power plants, but the credit can be claimed only on part of the plant — the equipment that is “necessary for the gasification of coal, including any coal handling and gas separation equipment.” The credit is 20% of the cost of such equipment.
There is a 15% investment tax credit for other power projects that use “advanced” technologies to generate electricity from coal. In such projects, the credit can be claimed on the entire project. The project can be a new power plant or a retrofit or repowering of an existing plant. To be considered an “advanced” technology, the project must have a design net heat rate of 8,350 Btus/kWh with 40% efficiency of energy conversion. (A majority of the energy in fuel is lost as the fuel is converted into electricity.) The plant must also be designed to meet certain pollution standards, including 99% removal of sulfur dioxide and 90% removal of mercury. The energy bill describes a series of assumptions that should be made in calculating the heat rate.
The tax credit can be claimed on progress payments to the construction contractor each year while a project is under construction, or the owner can wait to claim the full credit in the year the project is put into service. The IRS will have to certify that a project qualifies. The fuel must be at least 75% coal. The plant must have a nameplate capacity of at least 400 megawatts. No more than $1.3 billion in total tax credits can be taken under the program; the IRS will have to allocate the credits among competing applicants. Congress envisioned that there would be two rounds of awards. There would be a first round within the next three years and then a second round in 2011 if the IRS receives too few applications to use up the full credits in the first round or credits have gone unused because projects for which awards were made go unbuilt. The IRS is supposed to set aside $800 million for IGCC projects and $500 million for other types of advanced clean coal projects.
Second, the energy bill allows a separate investment tax credit for gasification projects, but only in the following industries: chemicals, fertilizers, glass, steel, petroleum residues, forest products and agriculture.
The material being gasified can be any “solid or liquid product from coal, petroleum residue, biomass, or other materials which are recovered for their energy or feedstock value.” The equipment must turn the material into a “synthesis gas” composed primarily of carbon monoxide and hydrogen. The gas must be used as gas or for “subsequent chemical or physical conversion.” Thus, it appears the credit can be claimed on equipment used in the Fischer-Tropsch process to make fuel for motor vehicles from coal.
The credit cannot be claimed on gas collection equipment at a landfill. “Biomass” is defined more narrowly than in the past. It includes only agricultural or plant waste, byproducts from wood or paper mill operations, and forest trimmings.
Anyone hoping to claim a tax credit for a gasification project must have his or her project certified by the IRS. Total credits for all projects are limited to $350 million. No more than $130 million in credits can be allocated to a single project. Certificates will be issued during a 10-year period that runs from October 1, 2005 through September 30, 2015.
Projects that benefit from these new investment credits will get less tax depreciation. The “tax basis” is reduced by half the amount of “energy credits,” but Congress did not use that label for these new credits. Therefore, it appears in this case that the basis is reduced by 100% of the credit.
Projects that benefit from tax-exempt bonds or “subsidized energy financing” will suffer a reduction in the tax credits they can claim.
Third, the energy bill lets anyone who produces coal from reserves on Indian lands claim tax credits on the coal sold to third parties. The credits can be claimed on seven years of output.
The credits can be claimed on coal from existing mines as well as from new mines opened through 2008. The credits are $1.50 a ton on coal sold in 2006 through 2009 and $2 a ton thereafter. Both the $1.50 and $2 figures will be adjusted for inflation. The first adjustment will apply to 2007 coal and reflect inflation during 2006. The coal reserves had to be owned by an Indian tribe or held in trust by the US government for the benefit of a tribe on June 14, 2005.
The bill gives electric utilities more time to shed all or part of their transmission grids. One obstacle to doing this has been that the utilities face potentially large tax bills if they have little unrecovered “tax basis” in the grids. In such situations, virtually all the compensation they receive is taxable.
Congress voted last October to let any utility that sells transmission lines or related equipment spread the income taxes on its gain over eight years. The utility must reinvest the sales proceeds in other electric or gas utility property or another power or gas company.
The legislation last October set a deadline of December 2006 for utilities to shed their grids to take advantage of the spread.
The energy bill would allow another year through 2007. The grid must be sold to an “independent transmission company.” An independent transmission company can be an ISO (independent system operator), RTO (regional transmission organization) or other independent transmission provider approved by the Federal Energy Regulatory Commission, or any company that is not a “market participant” as FERC defines that term and whose own transmission facilities are put under operational control of an ISO or RTO before 2007.
The bill also lets power companies depreciate their transmission lines and related equipment over 15 years using the 150% declining-balance method. Such equipment is depreciated over 20 years currently. The change applies to new equipment put into service after April 11, 2005. The utility cannot have been under binding contract to acquire the equipment on or before April 11 or have started construction of the equipment before that date in cases where the utility is building the transmission line itself. The tax savings from the faster depreciation are worth about 3¢ per dollar of capital cost.
Most independent power plants involve a transmission line to connect to the utility grid. The part the independent power company owns would benefit from the faster depreciation. Transmission can be an especially significant cost for wind farms.
Some power companies will be given cash by the US government to pay for new transmission equipment and air and water pollution control devices.
Any power company that had tax losses in 2003, 2004 or 2005 can elect to use the losses in one of the years to get a refund of any federal income taxes the company paid within the five years before the loss year.
The election must be made between 2006 and 2008.
The company must spend the money on electric transmission assets or pollution control. It can only elect to carry back losses equal to 20% of the amount it spent on such property the year before the election is made.
The money can be used on interconnecting a new power plant to the grid, but only on the part of the intertie that the independent power company will own. Congress said it will consider the tax refund as properly spent only if the refund is invested in property that the taxpayer will own.
The United States allows the cost of pollution control devices installed at older power plants that were in operation before 1976 to be “amortized” — or deducted — on a straight-line basis over five years.
The energy bill eliminates the requirement that a plant must have been in operation before 1976, but only for equipment installed to control air pollution at coal-fired power plants. The bill allows the cost of such equipment installed at post-1975 power plants to be amortized over seven years.
It will be interesting to see how many power companies take advantage of the provision. Some power companies already depreciate such equipment over seven years using the 200% declining-balance method. Congress estimated that the provision will be worth $1.147 billion to US power companies over the next 10 years. It applies to air pollution equipment acquired after April 11, 2005 (or built by the power company itself and completed after April 11, 2005).
The state where the power plant is located must certify that the equipment is required to comply with state law.
The power company must also get a certificate from US environmental authorities that the equipment complies with federal environmental regulations. The tax code bars the US from certifying any equipment “to the extent” the costs will be recovered through sale of ash or other byproducts.
Section 29 Credits
Congress renumbered section 29 of the US tax code. It is now section 45K. Documents in future section 29 tax credit deals should reflect this.
The energy bill gives a windfall to owners of some existing coke batteries at steel mills.
Steel production requires a fuel that, when burned, produces very high temperatures. Coke comes close to pure carbon and is produced by heating pulverized coal in a coke oven. The process also produces coke gas.
Companies that produce “synthetic fuel” from coal are allowed currently to claim section 29 tax credits of $1.13 an mmBtu on their output. The synthetic fuel must be sold to a third party. The equipment used to produce the fuel must have been put in service between 1993 and June 1998. The tax credits can be claimed on the synthetic fuel produced through 2007.
Coke and coke gas qualify as synthetic fuels.
The bill allows four years of additional tax credits to be claimed on coke and coke gas produced at facilities that were put into service during two “window periods.” The first runs from 1980 through 1992. (Coke batteries put into service during the first window period used to qualify for section 29 credits, but the credits have expired.) The second window period runs from July 1998 through 2009. The additional tax credits will be at a reduced rate: 51.7¢ an mmBtu. The credit amount will be adjusted for inflation, starting with inflation during 2005. The bill limits the total credits that can be claimed on output from a single “facility” to $4.38 million a year (before inflation adjustments). A “facility” is a coke battery with multiple ovens. Credits on output from existing coke batteries can be claimed for four years starting in January 2006.
Companies that own other synfuel plants or landfill gas facilities were not given an extension on their tax credits — the credits run out after 2007 — but Congress made it easier to use section 29 credits to which such companies become entitled in the future.
The energy bill makes section 29 credits into a type of “general business credit.” This will let companies that have extra section 29 credits they cannot use carry them back one year or forward for 20 years until the companies are in a position to use the credits. Until now, credits were lost if they could not be used immediately (except where the reason a company cannot use them is because it is on the “alternative minimum tax”).
Section 29 credits were originally supposed to encourage Americans to look in unusual places for fuel. They were enacted in 1980 soon after the Arab oil embargo. The hope was that if US companies would produce more alternative fuels, then the United States would be less dependent on the Middle East for oil. The credits were given originally to anyone producing gas from biomass, tight sands, Devonian shale, geopressured brine and coal seams or synthetic fuel from coal.
Some producers of these alternative fuels were hoping for an extension in the tax credits. There was none. However, Congress may have given them another outlet.
The energy bill allows half the cost of any new “refinery” put into service during the period August 9, 2005 through 2011 — defined as equipment for turning oil or landfill gas, synfuel or other fuels that qualified previously for section 29 tax credits into a liquid fuel — to be deducted immediately. Any such equipment put into service after 2007 must be under binding contract by December 2007 to be built.
The bill lets gas utilities depreciate their distribution lines over 15 years using the 150% declining-balance method rather than the current 20 years. The change only applies to distribution lines put into service during the period April 12, 2005 through 2010.
Congress also clarified that “gathering lines” that bring gas from the field to a larger pipeline or processing plant can be depreciated over seven years. Gas pipeline companies had been fighting with the IRS over seven-year depreciation in court. Congress stepped in to settle things in favor of the pipeline companies.
More than 20 prepaid gas deals have been done where a gas supplier enters into a long-term contract to supply gas to a municipal utility. The utility pays in advance for the gas that it will receive over the contract term in exchange for a discount off the gas price. It borrows the funds to cover the prepayment in the tax-exempt bond market. The gas supplier gets access indirectly to money at tax-exempt borrowing rates.
These deals run afoul potentially of rules that bar a municipality from borrowing at tax-exempt rates and then reinvesting the proceeds in a commodity or other “investment-type property” that earns it a higher return than its cost to borrow. The discount off the gas price might be viewed as such an arbitrage profit.
Many independent power companies are looking at doing similar deals with electricity not only with municipal utilities, but also with electric cooperatives.
The IRS wrote exceptions from the arbitrage restrictions into its regulations for prepaid gas contracts in 2002 and for prepaid electricity contracts the next year.
The energy bill adopted a slightly different version of the exception for prepaid gas deals than is in the IRS regulations. It wrote it directly into the US tax code. The bill is silent about electricity, raising the question what to make of Congressional silence on electricity. A judge might read into the silence a suggestion that Congress intended a special rule for gas but not for electricity. On the other hand, the exception from the arbitrage rules for electricity remains in the IRS regulations. A Treasury official told Chadbourne that he believes there was no intention to rule out prepaid electricity deals.
The bill gives operating subsidies — in the form of “production tax credits”— to owners of new nuclear power plants.
The credits can only be claimed on the output from “advanced” nuclear power plants. These are plants that use a reactor design approved by the Nuclear Regulatory Commission for the first time after 1993. A “substantially similar design of comparable capacity” cannot have been approved earlier.
The credit is 1.8¢ a kilowatt hour. It runs for eight years after the nuclear plant is first put into service. Credits may be claimed only at new nuclear power plants built by 2020. There is a limit on the total number of projects that can qualify for credits of 6,000 megawatts. The IRS will allocate the megawatt capacity among projects that apply for credits. No more than $125 million in credits can be claimed on a single project for each 1,000 megawatts in capacity the project is allocated by the IRS. Thus, for example, if a project is allocated 1,500 megawatts in capacity, then it will be allowed to claim up to $200 million a year in tax credits.
Projects that benefit from government grants, tax-exempt financing, “subsidized energy financing” or other tax credits that are a function of project cost will suffer a “haircut” in production tax credits. The haircut will not be more than 50%.
Credits that a company cannot use because of insufficient tax capacity can be carried back one year and carried forward for 20 years. They can be used only against regular taxes and not alternative minimum taxes. The revenue estimators in Congress are guessing that it will be another eight years before the first new nuclear power plant will come on line. The final “conference report” on the energy bill shows no revenue loss from the tax credits before 2013.