California Fallout: New Tax Incentives Possible For Project Developers

California Fallout: New Tax Incentives Possible For Project Developers

April 01, 2001

Senate Republicans are pressing for a long laundry list of new tax incentives to promote construction of additional power plants.

The proposals are in a bill that the chairman of the Senate Energy Committee, Frank Murkowski (R.-Alaska), and the Senate Republican leader, Trent Lott (R.-Mississippi), introduced at the end of February. Murkowski and Lott also sit on the Senate tax-writing committee. Many of the proposals also have support from Senate Democrats.

Ironically, the bill could slow down some new power plant construction in cases where projects might qualify for tax relief by delaying completion until after the new tax benefits take effect. Most provisions in the bill apply only to projects that are placed in service after the new provisions are enacted.

The odds of the proposals becoming law are hard to assess. The new energy secretary, Spencer Abraham, said in a speech in late March that the Bush administration opposes tax incentives for energy producers. The administration has favored a free-market approach to the power shortages in California. However, nature Anchorabhors a vacuum, and the clamor from Republicans in Congress for the administration to do something is growing louder. Abraham said a Bush energy task force would issue policy recommendations by early April.

Another complicating factor is the business lobby has agreed not to push business tax relief this year in order to give President Bush a chance to put his $1.6 trillion tax relief package through Congress. That package is full of tax relief for individuals. (The only business tax provision in it is a proposal to make a tax credit for spending on research and development permanent.)

Congressional staffers say the fate of the tax proposals in the Murkowski bill will turn on whether Congress passes an energy policy bill. If so, then there will probably be a tax component to that legislation. Energy policy legislation has remained bottled up in committee for the past several years because of lack of consensus about whether to move forward with federal deregulation. However, high gas prices, electricity shortages on the West Coast, and cutbacks in oil production by OPEC may finally spur Congress to act, especially if the president ends up calling on Congress to enact a new national energy policy.

The Murkowski bill would speed up depreciation of most new power plants, create new tax credits for cogeneration facilities and for coal-fired power plants that retrofit with new technologies, and extend a so-called section 29 tax credit for tapping gas from coal seams, tight sands and landfills and for making synthetic fuels from coal — to flag just a few of its provisions.

Depreciation

The bill would allow most power plants to be depreciated over seven years using the 200% declining-balance method. Most power plants are depreciated today over 15 or 20 years using the 150% declining-balance method.

The change is worth a lot of money. For each dollar invested in a power plant today, the tax savings from depreciation over 20 years are worth about 15 cents. However, with 7-year depreciation, the tax savings for each dollar invested would almost double to 27 cents.

The bill would only apply to power plants whose output is primarily for sale. Thus, a manufacturing company would be unable to claim the faster depreciation on power plants that it owns to supply its own electricity. Such power plants would remain depreciated over 15 years. This could have the effect of encouraging paper mills, aluminum smelters, food processors and other heavy users of steam and electricity to rely on independent power producers for electricity.

Only projects placed in service after the enactment date qualify for the faster depreciation. This is a strong incentive to wait to place any new projects in service until after the proposal clears Congress. (The Murkowski bill would not stop someone from selling an existing power plant and leasing it back in order to get a new in-service date. However, Congress usually adds “anti-churning” rules to prevent this sort of transaction.)

The bill — as drafted — would slow down depreciation for small power plants that use biomass. They are depreciated currently over five years. It would not affect other power plants — like solar and windpower projects — that qualify currently for five-year depreciation.

It would let power plants that are financed with tax-exempt debt be depreciated on a straight-line basis over 10 years. Most power plants financed with tax-exempt debt today must be written off over 22 or 28 years.

Cogeneration Facilities

The Murkowski bill would allow a 10% energy tax credit to be claimed on any “combined heat and power system.” A 10% credit means 10% of the cost of the project could be claimed as a credit against federal income tax liability.

In order to qualify for the credit, a power plant would have to produce two useful forms of energy. Mechanical shaft power can count as one. At least 20% of the total useful energy output would have to be in the form of steam or other thermal energy and at least 20% would have to be electricity or mechanical shaft power. The project would have to have an energy efficiency of at least 70% at normal operating rates (60% for smaller power plants of up to 50 megawatts). The energy efficiency is the energy content of the output compared to the energy content of the fuel that went into the power plant.

The credit could only be claimed on projects that go into service after it is enacted. “Enacted” means the measure has passed both houses of Congress and been signed into law by the president. This would not be before next autumn at the earliest. The credit could only be claimed on investment after that date. Thus, for example, if the credit is enacted on October 30, it could be claimed on a cogeneration facility that is put into service in December, but only on the portion of the construction cost that is spent after October 30.

Distributed Generation

The same 10% energy credit could be claimed on “distributed power property.” The bill defines this as two kinds of equipment: a generator with a rated capacity of more than one kilowatt that produces electricity primarily for use in an office building or apartment complex or equipment with a rated capacity of more than 500 kilowatts that generates electricity primarily for use in the taxpayer’s own factory.

Coal

The bill would reward owners of existing coal-fired power plants who take steps to reduce air pollution at such plants or retrofit using new generating technologies. New coal plants would also qualify for tax breaks. The power plant would have to be in the United States.

This set of proposals may be a hard sell in Congress because of their sheer complexity.

First, Murkowski proposes a 10% investment tax credit for anyone adding pollution control equipment to an existing coal-fired power plant to control one or more pollutants “regulated under title I of the Clean Air Act.” Such pollutants include nitrogen oxide, ash and other “particulate matter,” sulfur dioxide, volatile organic compounds and mercury. The pollution control would have to be a “system of continuous emission control.” Credits could only be claimed on up to $100 million in spending per “generating unit.” The bill includes language that is supposed to allow taxpayers with too little tax appetite to use the credits to transfer them to another company via a sale-leaseback. However, the language is not drafted properly.

Next, Murkowski proposes a new tax credit of 0.34¢ a kilowatt hour for generating electricity at an existing coal-fired power plant that has been retrofitted with a “clean coal technology.” Tax credits could be claimed on the electricity generated for the 10 years after the retrofit. The amount of the credit would be adjusted each year for inflation.

There is a long set of conditions before something qualifies as a “clean coal technology.” The bill gives the following examples: advanced pulverized coal or atmospheric fluidized bed combustion, pressurized fluidized bed combustion, and integrated gasification combined cycle. However, it says that whatever is used must have a design heat rate of at least 500 Btus per kWh below that of the existing power plant before the retrofit. In addition, the design heat rate must be 9,000 Btus or less per kWh when using coal with an energy content of more than 8,000 Btus per pound. The credit would only apply to retrofits that are completed after the enactment date. It could not be transferred to a lessor in a leasing transaction.

Third, Murkowski proposes a 10% investment credit for retrofitting or replacing an existing coal-fired power plant with an “advanced clean coal technology.” This credit is poorly drafted and will be hard for anyone to claim. The bill places a limit on the number of megawatts worth of different technologies that can qualify for the credit. For example, credits could only be claimed on up to 2,000 megawatts of integrated gasification combined cycle technology. The Department of Energy would run a “competitive solicitation” to choose who qualifies. The existing plant would have to have used “conventional technology” before it is retrofit or replaced. There is a detailed definition in the bill of what qualifies as conventional. The bill has language intended to allow the credit to be transferred to a lessor in a lease financing, but it does not work.

Fourth, Murkowski proposes a separate tax credit tied to the amount of output from facilities that use “advanced clean coal technology.” Credits could be claimed on the output whether it takes the form of electricity or “fuels or chemicals.” Credits could be claimed on output for 10 years after the facility goes into service. The amount of the credit varies. It is anywhere from 0.3¢ to 0.95¢ for each kilowatt hour of electricity generated or for each 3,413 Btus of fuels or chemicals produced, depending on the design of the facility.

Section 29 Credits

The bill would breathe new life into the section 29 tax credit.

This is a tax credit of $1.035 an mmBtu for looking in unusual places for fuel. The credit was enacted in 1980 soon after the Arab oil embargo. The idea was to reduce demand for imported oil and gas from the Middle East by inducing Americans to tap such underused domestic fuels as landfill gas and gas from tight sands, coal seams and Devonian shale, and to figure out ways to make synthetic fuels from coal.

The credit goes to the person producing the fuel. He must sell it to an unrelated party.

The deadline for placing projects in service to qualify for section 29 tax credits has already passed. Projects to produce gas from tight sands, coal seams and Devonian shale had to be in service by 1992. Landfill gas and coal synfuel projects had to be in service by June 1998.

The Murkowski bill would reopen the window for placing projects in service. The window would be reopened for a period from date of enactment through 2010. Credits could be claimed on any new projects put in service during this new window period through 2012. However, the amount of the credit would phase out starting in 2009. For example, credits in 2009 would be only $0.897 an mmBtu compared with $1.035 an mmBtu today. (The tax credit is adjusted each year for inflation. This 2009 figure does not take into account inflation adjustments.) Credits in 2012 would be only $0.276.

The bill would also extend tax credits through 2012 for projects that are already in service. However, this may have been inadvertent.

The bill would add heavy oil to the list of eligible fuels. Anyone producing heavy oil would qualify for tax credits without the need to sell the output, as long as the heavy oil is “not consumed in the immediate vicinity of the wellhead.”

Section 45 Credits

The bill would extend and greatly expand an existing tax credit for generating electricity from wind, “closed-loop biomass” and poultry waste.

The tax credit is currently 1.7¢ a kilowatt hour. The amount is adjusted each year for inflation. Projects must get into service by December 2001 to qualify. Tax credits may be claimed for 10 years after a facility is put into service. “Closed-loop biomass” refers to trees or crops grown exclusively for use as fuel in power plants. There are no closed-loop biomass projects currently in operation, according to the Internal Revenue Service. Poultry waste was added to the list of eligible fuels in 1999 at the urging of the then-chairman of the Senate Finance Committee, William Roth (R.-Delaware). Roth was defeated last November for reelection.

The Murkowski bill would expand the list of fuels that can be used to generate electricity to include biomass generally, municipal solid waste, geothermal steam or fluid, and landfill gas. Biomass facilities would have to burn at least 75% biomass to qualify; the rest could be another fuel, like coal.

Credits could also be claimed in the future on electricity produced at “incremental hydropower” facilities. “Incremental hydropower” means the extra output from adding capacity or increasing efficiency at existing hydroelectric facilities. Murkowski would also reward anyone producing electricity or steam at a cogeneration facility that “integrates the production of coke, direct reduced iron ore, iron, or steel,” but only to the extent the electricity or steam is produced using waste gas or heat from the mill.

The bill would extend the deadline through June 2011 for placing projects in service to qualify for section 45 tax credits. Credits would continue to run for 10 years after a project goes into service. (The deadline for placing steel cogeneration facilities in service would be December 2010.)

One problem with the current section 45 tax credit is it does not allow smaller developers with little tax appetite to get value for their credits by transferring them in a lease financing. The Murkowski bill would fix this problem. (The fix would be retroactive to 1994 for existing windpower projects.)

The bill has a number of peculiar features. Some are intended, and some may be drafting errors. First, it drops poultry waste from the list of eligible fuels. Second, the language that allows credits to be transferred in leasing transactions does not cover incremental hydropower projects. Third, a producer of landfill gas qualifies for tax credits even if he does not use the gas to generate electricity. The bill does not sort out who gets the tax credit in cases where another company uses the gas to generate electricity. Fourth, the bill would allow anyone already using at least 75% biomass as fuel at an existing power plant — or who switches to such a fuel at an existing power plant in the future — to claim credits for 10 years. Finally, it would retroactively negate a rule that tax credits cannot be claimed to the extent that a project benefited from tax-exempt bonds, other tax credits or government subsidies. However, it would only negate it for projects that went into service before 1997.

Senator Charles Grassley (R.-Iowa), the new chairman of the Senate Finance Committee, strongly supports extending section 45 credits for wind projects. Grassley introduced his own bill to do this in late March.

Interties

The bill would bar the Internal Revenue Service from taxing utilities on any “connection fees” the utilities receive from customers. This would solve a problem that some merchant power plant developers are facing. Some utilities are insisting that merchant plant developers pay not only the cost to connect their power plants to the grid, but also pay a “tax gross up” that can add another 25% to 70% to the cost. The provision would apply not only to electric interties, but also to gas, water and sewage connections. However, it would only apply to “transactions occurring” after the enactment date.

Other Provisions

The bill has a large number of other provisions.

It would settle a dispute between the gas pipeline companies and the IRS over whether the pipelines can depreciate gathering lines at gas fields over seven years rather than having to use the same 15-year depreciation that they use for the rest of their assets. The bill would allow 7-year depreciation not only for gathering lines, but also for all “the pipe, storage facilities, equipment, distribution infrastructure, and appurtenances used to deliver oil, natural gas, crude oil, or crude oil products.” The change would be prospective. However, taxpayers could elect this depreciation retroactively for gas gathering lines.

Local gas distribution companies would be allowed to “expense” — or write off immediately — the full cost of gas storage facilities.

The bill implements a compromise that has been worked out between the private power industry and municipal utilities over whether tax-exempt bonds that the municipal utilities used to finance their systems will be put in jeopardy if the municipal utilities expand to provide service outside city limits.

It would also shield utilities from adverse tax consequences if they transfer operating control or ownership of their transmission grids to RTO’s, or regional transmission organizations.

Finally, it would allow tax-exempt bonds to be used to finance projects that use bagasse — or the residue after the juice is extracted from sugar cane or sugar beets — to manufacture ethanol.

Outlook

Unless the Bush administration digs in firmly in its opposition to new tax incentives for energy producers — including for the oil and gas industry — some new tax incentives seem likely in the wake of the chaos in California. The Murkowski bill should be seen as the industry wish list. The lobbyists pushing for these items made one important cut for their proposals — with more cuts to follow.

by Keith Martin, in Washington