Final Analysis of Tax Reform Shows Substantial Boost to Utilities’ Rate Base Growth: By 2019, Rate Base Will Be 6 to 10% Higher at LNT, XEL, AGR, and PCG

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Eric Selmon Hugh Wynne

Office: +1-646-843-7200 Office: +1-917-999-8556

Email: eselmon@ssrllc.com Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

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January 16, 2018

Final Analysis of Tax Reform Shows Substantial Boost to Utilities’ Rate Base Growth:

By 2019, Rate Base Will Be 6 to 10% Higher at LNT, XEL, AGR, and PCG

The Tax Cuts and Jobs Act of 2017 will materially reduce the tax deductions enjoyed by the regulated utility industry and as a result will decrease utilities’ annual provision for deferred income taxes. As deferred tax liabilities are offset against property, plant and equipment in the calculation of regulated rate base, the impact of the law will be to increase the aggregate electric rate base of the publicly traded U.S. electric utilities by an estimated 4.1% by 2019, relative to what it would have been under the prior tax code, and by an estimated 5.2% by 2022. The regulated utilities with the largest planned capital expenditures will enjoy the greatest benefit: we calculate that electric rate base will be 6.0% higher at PCG, 7.2% higher at XEL and 10.0% higher at LNT in 2019 than it would have been under the prior tax code. Among the hybrid utilities, we estimate that 2019 rate base will be 5.0% higher at NEE, 5.1% higher at ETR and 6.3% higher at AGR. (See Exhibits 6 through 8.)

While at certain utilities, lower tax deductions will be reflected in higher cash taxes, and thus reduced cash flow, we calculate that the large majority of the publicly traded U.S. utilities will be able to offset the loss of tax deductions with the new law’s lower tax rate, the use of net operating loss carryforwards, and renewable energy tax credits. At regulated utilities, moreover, the increase in rate base from lower deferred taxes implies increased borrowing capacity, as utilities maintain the ratios of debt to rate base mandated by their regulators. For a minority of utilities, tax reform will imply a sufficiently large increase in cash taxes as to materially affect cash flow. We expect this impact to be limited, however: we estimate that 11 investor-owned utilities will be so affected, and at only one will the decrease in cash flow through 2019 exceed 1.5% of market capitalization. (See Exhibits 9 and 10.)

Given the substantial impact of tax reform on rate base, we have updated our estimates of medium term rate base growth for each of the publicly traded electric utilities, taking into account managements’ fourth quarter updates of their capital expenditures plans. We now expect aggregate electric rate base among the publicly traded U.S. utilities to grow at a 7.2% compound annual rate over the years 2018-2021, up from our prior estimate of 6.6% (see our note from October 10, 2017, How Would the GOP Tax Plan Impact Rate Base Growth?). In Exhibit 3, we have ranked the regulated electric utilities on their forecast rate base growth as well as their 2019 PE multiples. Regulated electric utilities trading at or below the industry average PE multiple, but whose 2018-2021 rate base growth ranks in the top quintile among their peers, include AEP, EIX and PCG. Utilities trading above the industry average PE, but whose 2018-2021 rate base growth ranks in the bottom two quintiles among their peers, include ALE, HE, IDA and POR.

Portfolio Manager’s Summary

  • By curtailing the tax deductions enjoyed by the regulated utility industry, and decreasing the tax savings generated by those that remain, the Tax Cuts and Jobs Act of 2017 will materially reduce utilities’ annual provision for deferred income taxes. As deferred tax liabilities are offset against property, plant and equipment in the calculation of regulated rate base, the impact of the law will be to raise the aggregate electric rate base of the publicly traded U.S. utilities by an estimated 4.1% by 2019, relative to what it would have been under the prior tax code, and by an estimated 5.2% by 2022.
  • The Tax Cuts and Jobs Act of 2017 will reduce both the amount and the value of the tax deductions available to regulated utilities, reflecting:
    • The prohibition on regulated utilities making use of the bonus depreciation deduction on all capital investments placed into service after September 27, 2017, investments which, under the prior tax code, would have been eligible for bonus depreciation at a 50% rate in 2017, 40% in 2018 and 30% in 2019; and
    • The reduction in the corporate tax rate from 35% to 21% as of January 1, 2018, which will decrease by 40% the tax savings resulting from those tax deductions that remain available to utilities, including the repair deduction, which permits immediate expensing of certain transmission and distribution capex, as well as accelerated depreciation under MACRS.
  • The elimination of bonus depreciation for regulated utilities is the single most important factor accelerating rate base growth through 2019.
    • Under the prior tax code, a regulated utility placing an asset into service in 2018 could expense 40% of it immediately and apply accelerated depreciation to the remainder. As explained below (see How Tax Reform Will Slow the Accumulation of Deferred Tax Liabilities and Raise Rate Base Growth), this would have resulted in a deferred tax liability equivalent to ~16% of the value of the asset.
    • By contrast, in the absence of bonus depreciation, and at the new lower tax rate of 21%, the deferred tax liability faced by the utility would be only 2% of the value of the asset.
    • As deferred taxes are offset against PP&E in the calculation of rate base, under the prior code only ~84% of the value of the asset would have added to rate base; under the Tax Cuts and Jobs Act, the contribution to rate base rises to 98% of the value of the asset.
  • The tax savings from those deductions that utilities may still take, such as the repair deduction and accelerated depreciation, are worth 40% less at today’s 21% tax rate than the prior 35%. The reduction in the value of these deductions contributes to higher rate base growth among the regulated utilities in 2020 and beyond when, under the prior tax code, bonus depreciation would no longer have been available.
  • Thus, under the new tax code, a utility’s capital expenditure program will give rise to much lower deferred taxes than under the old tax code. The larger the utility’s capital expenditures, the larger this reduction in deferred taxes will be, and the bigger the boost to its rate base growth.
  • Because bonus depreciation was only available under the prior tax code through 2019, the bulk of the benefit to rate base will be felt this year and next, and will be largest for those utilities whose planned capex over this period was largest relative to rate base.
    • Based on their announced capex plans, we expect the largest boost to rate base to be enjoyed by LNT (whose 2019 rate base will now be 10.0% higher than under the prior tax code); XEL (7.2% higher); AGR (6.3% higher); PCG (6.0%); ETR (5.1%); NEE (5.0%); and EIX (5.0%). (See Exhibits 6 through 8.)
    • Benefiting least will be utilities whose planned capital expenditures imply the slowest pace of rate base growth, as well as those that had already opted not to use bonus depreciation, and therefore will see no change. These include POR (whose 2019 rate base will be only 1.2% higher than under the prior tax code); SCG (1.3%); AVA (1.4%); GXP (2.0 %); IDA (2.4 %); OGE (2.5%); WR (2.7%); EE (2.7%) and SO (2.8 %).
  • While at certain utilities, lower tax deductions will be reflected in higher cash taxes and reduced cash flow, we calculate that the large majority of the publicly traded U.S. utilities will be able to offset the loss of tax deductions with the new law’s lower tax rate, the application of net operating loss carryforwards, and renewable energy tax credits.
    • At regulated utilities, higher rate base from lower deferred taxes implies increased borrowing capacity, as utilities maintain their regulatory ratios of debt to rate base.
    • For a minority of utilities, tax reform will imply a sufficiently large increase in cash taxes as to as to materially affect cash flow. We expect this impact to be limited, however: we estimate that 11 publicly traded utilities will be so affected, and at only one will the decrease in cash flow through 2019 exceed 1.5% of market capitalization. (See Exhibits 9 and 10.)
    • Most adversely affected over 2018-2019 will be HE, ETR, AEP, and ES, where we calculate tax reform will decrease cash flows by 1.4%-1.6% of market capitalization. To maintain their existing capex and rate base growth targets, these utilities could issue equity or increase holdco debt; alternatively, they could defer previously planned capex to future years.
  • While higher rate base will be reflected in an increase in utilities’ revenue requirements, this will be more than offset by the reduction in utilities’ tax rates, the benefit of which will be passed through to ratepayers. We estimate that over 2016-2021, the compound annual rate of increase in average system electricity rates and average residential bills will be about 0.3% p.a. lower, given tax reform, than it would have been under the previous tax code.
    • Benefiting most, we calculate, will be WR, SO, NEE and PNW, where we expect the rate of increase in average system rates and average residential bills to be lower by 0.5% to 0.7% p.a. over 2016-2021, relative to our estimates under the previous tax code. Benefiting least, we expect, will be NWE, EIX, PCG, ED, EXC, SCG, CMS and IDA (see Exhibits 11 through 14).
  • In light of the new law, we have updated our estimates of medium term rate base growth for each of the publicly traded electric utilities, taking into managements’ fourth quarter updates of their capital expenditures plans. We now expect aggregate electric rate base among the publicly traded U.S. utilities to grow at a 7.2% compound annual rate over the years 2018-2021, up from our prior estimate of 6.6% (see our note from October 10, 2017, How Would the GOP Tax Plan Impact Rate Base Growth?). In Exhibit 3, we have ranked the publicly traded electric utilities on their forecast rate base growth as well as their 2019 PE multiples.
  • Regulated electric utilities trading at or below the industry average PE multiple, but whose 2018-2021 rate base growth ranks in the top quintile among their peers, include AEP, EIX and PCG.
  • Utilities trading above the industry average PE, but whose 2018-2021 rate base growth ranks in the bottom two quintiles among their peers, include ALE, HE, IDA and POR.

Exhibit 1: Heat Map: Preferences Among Utilities, IPP and Clean Technology

Source: SSR analysis

Details

Summary

The Tax Cuts and Jobs Act of 2017 will have a material and highly differentiated impact on the rate base growth and cash flow of the regulated electric utilities, as well as on the future trajectory of their customer rates and bills, although the effects are generally positive across the industry. In this note, we identify those regulated utilities likely to benefit most and least from the changes proposed by the two bills.

Exhibit 2 lists those provisions of the law that will most affect the outlook for individual utility stocks, summarizes their implications, and identifies those utilities that benefit most and least. Among the most important are two provisions that will reduce both the amount and the value of the tax deductions available to regulated utilities. The first of these is a prohibition on regulated utilities making use of the bonus depreciation deduction for all equipment that is placed in service after September 27, 2017. By contrast, under the prior tax code, bonus depreciation had been available to regulated utilities at a 50% rate in 2017, 40% in 2018 and 30% in 2019. The second is a cut in the corporate tax rate from 35% to 21% as of January 1, 2018, which will decrease by 40% the tax savings resulting from the tax deductions that remain available to utilities, including the repair deduction, which permits immediate expensing of certain transmission and distribution capex, as well as accelerated depreciation under MACRS.

Exhibit 2: Key Provisions of the Tax Cuts and Jobs Act of 2017 Affecting the Power Industry

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Source: The Tax Cuts and Jobs Act of 2017, SSR analysis and estimates

The single most important factor accelerating rate base growth through 2019 is the elimination of bonus depreciation for regulated utilities for all capex placed into service after September 27, 2017. Under the prior tax code, a regulated utility placing an asset into service in 2018 could expense 40% of it immediately and apply accelerated depreciation to the remainder. As explained below (see How Tax Reform Will Slow the Accumulation of Deferred Tax Liabilities and Raise Rate Base Growth), this would have resulted in a deferred tax liability equivalent to ~14.3% of the value of the asset. By contrast, in the absence of bonus depreciation, and at the new lower tax rate of 21%, the deferred tax liability faced by the utility would be only 2% of the value of the asset. Because deferred taxes are offset against PP&E in the calculation of rate base, under the prior code only ~84% of the value of the asset would have added to rate base; under the Tax Cuts and Jobs Act, the contribution to rate base rises to 98% of the value of the asset.

Moreover, the tax savings from those deductions that utilities may still take, such as the repair deduction and accelerated depreciation, are worth 40% less at today’s 21% tax rate than the prior 35%. The reduction in the value of these deductions contributes to higher rate base growth among the regulated utilities in 2020 and beyond when, under the prior tax code, bonus depreciation would no longer have been available.

Under the new tax code, therefore, a utility’s capital expenditure program will give rise to much lower deferred taxes than under the old tax code. The larger the utility’s capital expenditures, the larger this reduction in deferred taxes will be, and the bigger the boost to its rate base growth.

Because bonus depreciation was only available under the prior tax code through 2019, the bulk of the benefit to rate base will be felt this year and next, and will be largest for those utilities whose planned capital expenditures over this period were largest relative to rate base.

Based on their announced capex plans, we expect the largest boost to rate base to be enjoyed by LNT (whose 2019 rate base will now be 10.0% higher than under the prior tax code); XEL (7.2% higher); AGR (6.3% higher); PCG (6.0%); ETR (5.1%); NEE (5.0%); and EIX (5.0%). (See Exhibits 6 through 8.) Benefiting least will be those utilities whose planned capital expenditures imply the slowest pace of rate base growth, and those utilities that had already opted to not use bonus depreciation. These include: POR (whose 2019 rate base will be only 1.2% higher than under the prior tax code); SCG (1.3%); AVA (1.4%); GXP (2.0 %); IDA (2.4 %); OGE (2.5%); WR (2.7%); EE (2.7%) and SO (2.8 %).

While at certain utilities, lower tax deductions will be reflected in higher cash taxes and reduced cash flow, we calculate that the large majority of the publicly traded U.S. utilities will be able to offset the loss of tax deductions with the new law’s lower tax rate, the application of net operating loss carryforwards, and renewable energy tax credits. At regulated utilities, moreover, the increase in rate base from lower deferred taxes implies increased borrowing capacity, as utilities maintain their regulatory ratios of debt to rate base.

For a minority of utilities, tax reform will imply a sufficiently large increase in cash taxes as to materially affect cash flow. We expect this impact to be limited, however: we estimate that 11 investor-owned utilities will be so affected, and at only one will the decrease in cash flow through 2019 exceed 1.5% of market capitalization. Most affected over 2018-2019, we estimate, will be HE, ETR, AEP, and ES, where we calculate that tax reform will decrease cash flow by 1.4% to 1.6% of market capitalization. (See Exhibits 9 and 10.) To maintain their existing capex and rate base growth targets, these utilities could issue equity or increase holdco debt; alternatively, they could defer previously planned capex to future years.

Unlike most companies, regulated utilities will not benefit directly from the reduction in corporate tax rate from 35% to 21%. For the regulated utilities, whose rates are set on a cost-of-service basis, any decrease in income tax expense must eventually be passed through to ratepayers. We are seeing many states taking action to ensure that, if savings are not being returned immediately, they are being tracked from the beginning of 2018 so they can be refunded at a later date. As these savings are passed through to ratepayers, they will alleviate pressure on rates and bills, potentially allowing for increased capex and rate base expansion and, ultimately, earnings growth. In this sense, lower tax rates may provide a further mild stimulus to the growth of rate base and regulated earnings.

We estimate that over 2016-2021, the compound annual rate of increase in average system electricity rates and average residential bills will be about 0.3% p.a. lower, given tax reform, than it would have been under the prior tax code. Benefiting most, we calculate, will be WR, SO, NEE and PNW, where we expect the rate of increase in average system rates and average residential bills to be lower by 0.5% to 0.7% p.a. over 2017-2021, relative to our estimates under the prior tax code. Benefiting least, we expect, will be NWE, EIX, PCG, ED, EXC, SCG, CMS and IDA (see Exhibits 11 through 14).

In light of the new tax law, we have updated our estimates of medium term rate base growth for each of the publicly traded electric utilities, taking into account managements’ fourth quarter updates of their capital expenditures plans. We now expect aggregate electric rate base among the publicly traded U.S. utilities to grow at a 7.2% compound annual rate over the years 2018-2021, up from our prior estimate of 6.6% (see our note from October 10, 2017, How Would the GOP Tax Plan Impact Rate Base Growth?).

In Exhibit 3, we have ranked the publicly traded electric utilities on their forecast rate base growth as well as their 2019 PE multiples. Regulated electric utilities trading at or below the industry average PE multiple, but whose 2018-2021 rate base growth ranks in the top quintile among their peers, include AEP, EIX and PCG. Utilities trading above the industry average PE, but whose 2018-2021 rate base growth ranks in the bottom two quintiles among their peers, include ALE, HE, IDA and POR.

Exhibit 3: PE Multiples Compared to Historical and Forecast Growth in Electric Rate Base

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Source: Company reports, including FERC Form 1 and SEC 10Q filings, SNL, SSR analysis and estimates

How Tax Reform Will Slow the Accumulation of Deferred Tax Liabilities and Raise Rate Base Growth

The provisions of the Tax Cuts and Jobs Act that most affect the rate of growth in electric rate base are those that (i) disallow the use bonus depreciation[1] by regulated utilities and (ii) reduce the corporate tax rate from 35% to 21%. Under the prior tax code, businesses were allowed to write-off 50% of the value of qualified property, including electric utility plant and equipment, that enters service in 2017, 40% of the value of qualified property, including electric utility plant and equipment, that enters service in 2018, and 30% of the value of qualified property entering service in 2019. Bonus depreciation was scheduled to expire, under the old tax code, in 2020. By contrast, the Tax Cuts and Jobs Act allows full expensing (100% bonus depreciation) of qualified property, plant and equipment entering service between September 27, 2017 and January 1, 2023. Critically, however, the new law modifies the definition of qualified property to exclude regulated utility plant,[2] thereby preventing regulated utilities from taking advantage of bonus depreciation on all capital investments placed into service after September 27, 2017.

Bonus depreciation at a rate of at least 50% has been in effect since January 1, 2008. Given the scale of their annual capital expenditures, the ability to write off a material portion of new utility plant in service has for the last decade created a large annual tax deduction for the regulated utilities. As a result, utilities’ taxable income has averaged well below their book earnings before tax, and their cash tax liabilities well below their book provision for income taxes. On average across the industry, this has been reflected for the last decade in large annual increases in utilities’ deferred tax liabilities.[3] Because net deferred tax liabilities are offset against utility plant in service in the calculation of rate base by regulators, the annual accumulation of these deferred tax liabilities has materially slowed utilities’ rate base growth. The elimination of bonus depreciation by the Tax Cuts and Jobs Act will remove this headwind, speeding rate base growth relative to what it would have been under the previous tax code, which allowed bonus depreciation of 50% in 2017, 40% in 2018 and 30% in 2019.

We illustrate how bonus depreciation contributes to the very rapid build-up of deferred taxes in Exhibit 4. A utility placing new electric plant in service in 2018 would have, under the previous tax code, (i) expensed in 2018 40% of the utility plant placed in service in that year by applying bonus depreciation, and (ii) expensed, at a minimum, 3.75% of the remaining 60% of the value of the asset under the Modified Accelerated Cost Recovery System (MACRS) required by the IRS for the calculation of tax depreciation.[4] At a 35% tax rate, the utility’s ability to expense some 42% of the value of new plant placed in service (40% by applying bonus depreciation plus 3.75% of the remaining 60% by applying MACRS to the balance) would have reduced the utility’s tax liability by 14.8% of the value of the asset (42% x 35%) in 2017. In preparing its GAAP financial statements, by contrast, the utility might depreciate the asset over 35 years, taking an annual depreciation charge of only 2.9% and only half of that (1.45%), if we assume assets are placed into service ratably over the course of the year. On its GAAP financial statements, therefore, the utility would have been allowed to reduce its book provision for income taxes by just 0.5% (1.45% x 35%) of the value of the asset. The difference between the utility’s book provision for income taxes and its cash taxes due – equivalent, in this example to 14.3% of the value of the asset (14.8% less 0.5%) – would have been added to the utility’s deferred tax liability. As a result, the utility would have been allowed to add only 84.3% of the value of the asset (100% – 14.3% – 1.45%) to its regulated rate base.

Exhibit 4: The Difference Between Book and Tax Depreciation and the Consequent Build-Up and Reversal of the Deferred Tax Liability Associated with a Utility Asset (1)

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1. Assumes 40% bonus depreciation, 20 year MACRS and book depreciation over 35 years.

Source: IRS and SSR analysis

By contrast, a utility prohibited from applying bonus depreciation by the Tax Cuts and Jobs Act would expense only 3.75% of the asset in the year it was placed in service, corresponding to the first year MACRS depreciation charge. In this example, the MACRS depreciation rate of 3.75% and the book depreciation rate of 1.45% in the first year imply that the difference between tax and book depreciation is only 2.3% of the value of the asset placed in service. Given the reduction in the corporate tax rate to 21%, the utility would be required to increase its deferred tax liability by only 0.48% of the value of the asset (2.3% x 21%). Over 98% (100% – 0.48% – 1.45%) of the value of the asset could thus be added to rate base.

In addition to eliminating bonus depreciation for utilities, the Tax Cuts and Jobs Act cuts the corporate tax rate from 35% to 21% as of January 1, 2018. This has the effect of reducing the tax savings, and thus the accumulation of deferred tax liabilities, triggered by other deductions allowed under the tax code. A principal example is the repairs deduction: IRS regulations adopted in 2013 allow businesses to deduct, rather than capitalize, the cost of repairs to property used in carrying on their business. As a result of the new rules, utilities are now able to expense for tax purposes, rather than capitalize and depreciate, a substantial portion of their annual capex (we estimate, based on utilities’ financial disclosures, that approximately 25% of the capital expenditures for transmission and distribution assets qualify for immediate expensing under the repair deduction). A second significant deduction is accelerated depreciation for tax purposes. MACRS allows wind and solar power plants to be fully depreciated over five years, nuclear power plants and combustion turbine generators to be depreciated over 15 years, and transmission and distribution assets, as well as steam turbine generators and combined cycle gas turbine plants, to be depreciated over 20 years. By contrast, these assets would generally be depreciated over 20 to 40 years for financial accounting purposes, with the average GAAP depreciation rate among U.S. regulated utilities (2.9%) corresponding to a 34-year depreciation schedule. The Tax Cuts and Jobs Act does not modify the provisions of the existing tax code with respect to the repairs deduction or MACRS; however, by cutting the tax rate from 35% to 21%, it materially reduces the value of these deductions, and thus the amount of deferred taxes to which they give rise. By way of example, a utility able to claim the repair deduction for maintenance capex on its transmission network generates a tax deduction equal to 100% of the value of the asset placed in service; under the previous tax code, the corresponding tax savings would have been equivalent to 35% of the value of the asset (the previous tax rate of 35% multiplied by 100% of the value of the asset), while at the new 21% corporate tax rate the tax savings will be only 21% of the value of the asset. Assuming a 35-year useful life for the asset, the depreciation rate for book purposes in the first year would be 1.45% if the asset were placed in service at mid-year. The corresponding reduction in the utility’s book provision for income taxes would be 0.5% at 35% tax rate (1.45% x 35%) and 0.3% at a 21% tax rate (1.45% x 21%). In this example, then, the utility would have been required to post a deferred tax liability equivalent to 34.5% of the value of the asset given the previous corporate tax rate of 35% (35% less 0.5%) but only 20.7% of the value of the asset when the tax rate is cut to 21% (21% less 0.3%). The deferred tax liability triggered by the asset placed in service is thus reduced by 13.8% of the value of the asset (34.5% less 20.7%), and the proportion of the asset’s value that can be added to rate base is increased from 65% to 79%.

Exhibit 5: The Difference Between Book and Tax Depreciation and the Consequent Build-Up and Reversal of the Deferred Tax Liability Associated with a Utility Asset Assuming No Bonus Depreciation and Accelerate Depreciation of the Asset Under MACRS

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Source: IRS and SSR analysis

The Treatment of Excess Deferred Taxes

A significant provision of the Tax Cuts and Jobs Act, which does not affect rate base growth, deals with utilities’ treatment of excess deferred taxes. The deferred tax liability on a corporation’s balance sheet is a provision for taxes deferred, or due in future: it reflects the fact that cash taxes tend to run below book taxes during the early years of an asset’s life, due to accelerated depreciation for tax purpose, but that this relationship will reverse when the asset is fully depreciated for tax purposes but not for book purposes; at that point, cash taxes will exceed book taxes and the deferred tax liability is reversed as “deferred” taxes are finally paid in cash. The reduction in the corporate tax rate from 35% to 21%, however, will reduce the amount of deferred taxes ultimately paid. Corporations in competitive industries will reflect this by reducing their deferred tax liabilities accordingly, and offset this reduction in their liabilities by increasing owners’ equity.

Regulated utilities, however, cannot adopt this treatment. Under IRS rules, referred to as “tax normalization,” utility regulators are required to allow utilities to calculate their provision for income taxes on their financial statements based on book depreciation schedules, and to recover this book provision for income taxes from their ratepayers, even if it exceeds the utility’s cash taxes due. The purpose of this requirement is to prevent utility regulators from forcing utilities to pass through to ratepayers the benefit of tax incentives for investment, such as bonus or accelerated depreciation, thereby eliminating the incentive to investment that these provisions were meant to create. In addition, tax normalization ensures that the tax benefits of these incentives are not enjoyed disproportionately by current ratepayers, at the expense of future ratepayers that will still be paying for the assets long after they were placed into service.

Thus, utilities have historically calculated their provision for income taxes at the 35% rate and passed the cost along to ratepayers. A large portion of these annual provisions for income tax were deferred to future years, and accumulated on utilities’ balance sheets as a deferred income tax liabilities. If the tax rate is now reduced to 21%, however, the full amount of these deferred taxes will never be paid. Regulators will therefore require utilities to return to ratepayers the taxes they have collected at the old, higher rate. Consequently, when faced with a reduction in the tax rate, regulated utilities reduce their deferred tax liabilities but offset this by the creation of a new regulatory liability to reflect the obligation to return to ratepayers the taxes recovered from them at the old rate. The new regulatory liability is treated by regulators as an offset to property, plant and equipment in the calculation of rate base, just as the deferred tax liability that it replaces had been previously. The reduction in the corporate tax rate will thus change the classification of utilities’ balance sheet liabilities but will not materially affect the calculation of their rate base. The Tax Cuts and Jobs Act requires utilities to amortize these new regulatory liabilities on the same schedule that the utilities would have reversed the deferred tax liabilities that they replace.

The Impact of Tax Reform on Individual Utilities’ Rate Base Growth

In light of the new tax law, we have updated our estimates of medium term rate base growth for each of the publicly traded electric utilities, taking into account managements’ fourth quarter updates of their capital expenditures plans. We now expect aggregate electric rate base among the publicly traded U.S. utilities to grow at a 7.2% compound annual rate over the years 2018-2021.

To estimate the growth in electric rate base by utility we have relied upon:

(i) the announced capital expenditure plans of the publicly traded U.S. regulated electric utilities, which we have used to forecast the growth over the next five years in gross utility plant;

(ii) the rates of depreciation applied by these utilities to each class of utility asset (generation, transmission and distribution); and

(iii) our estimates of the annual increases in the net deferred tax liabilities of each of the regulated utilities over time, resulting from the interplay of their capital expenditure plans and the provisions of the tax code that permit accelerated recovery of capital investment, including bonus depreciation, accelerated depreciation and the repair deduction.

Our prior forecast of the rate of growth in electric rate base by utility was predicated upon the provisions of the previous tax code (for our most recent forecast of growth for 2018-21, see our note from October 10, 2017, How Would the GOP Tax Plan Impact Rate Base Growth?). To assess the impact of the Tax Cuts and Jobs Act on rate base growth, we first updated our prior forecast to reflect managements’ fourth quarter revisions to each company’s capex guidance. We then compared that updated forecast, based upon the provisions of the prior tax code, to our current forecast of future rate base growth based upon the provisions of the Tax Cuts and Jobs Act.

Exhibit 6 presents our estimated increase in rate base the Tax Cut and Jobs Act relative to our estimate of rate base under the previous tax code. We present these results for two time periods, 2017-2019 and the period 2017-2022. Finally, we have ranked the utilities into quintiles based on their estimated increase in rate base as a result of the Tax Cuts and Jobs Act.

Exhibit 6: Impact of Tax Cut and Jobs Act on Total Electric Rate Base

(Increase in Rate Base vs. Rate Base Under Prior Tax Code)

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Source: Company reports, including FERC Form 1 and SEC 10Q filings, SNL, SSR analysis and estimates

To facilitate the identification of those utilities likely to benefit most and those likely to benefit least from tax reforms, we presented the results in Exhibits 7 and 8, sorting the utilities from left to right based upon the degree to which their growth in rate base appears to accelerate as a result of tax reform. In Exhibit 7, which presents the results of our analysis for the period 2017-2019, LNT, XEL, AGR, and PCG stand out as enjoying the largest estimated increases in rate base, ranging from 6.0% to 10.0% over this two year period. By contrast, POR, SCG and AVA appear to benefit least, with estimated increases in rate base of 1.4% or less. In Exhibit 8 we present the results of our analysis for the five year period 2017-2022. As can be seen there, POR, SCG and GXP appear to benefit least, while LNT, XEL, AGR and PCG, we estimate, will continue to see the largest cumulative increases in rate base (7.5% to 10.8%).

Exhibit 7: Estimated Impact of Tax Cuts and Jobs Act on 2019 Electric Rate Base (Estimated Increase in 2019 Rate Base vs. 2019 Rate Base Under Prior Tax Code)

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Source: Company reports, including FERC Form 1 and SEC 10Q filings, SNL, SSR analysis and estimates

Exhibit 8: Estimated Impact of Tax Cuts and Jobs Act on 2022 Electric Rate Base (Estimated Increase in 2022 Rate Base vs. 2022 Rate Base Under Prior Tax Code)

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Source: Company reports, including FERC Form 1 and SEC 10Q filings, SNL, SSR analysis and estimates

Cash Flow Implications of Tax Reform

While at certain utilities, lower tax deductions will be reflected in higher cash taxes and reduced cash flow, we calculate that the large majority of the publicly traded U.S. utilities will be able to offset the loss of tax deductions with the new law’s lower tax rate, the application of net operating loss carryforwards, and renewable energy tax credits. At regulated utilities, the increase in rate base from lower deferred taxes implies increased borrowing capacity, as utilities maintain their regulatory ratios of debt to rate base. For a minority of utilities, tax reform will imply a sufficiently large increase in cash taxes as to reduce meaningfully cash flows, but we expect the impact to be limited.

We present below our estimate of the potential erosion in utilities’ cash flow that may result from the new tax law. We estimate this deterioration in cash flow as the sum of (i) any increase in a utility’s tax liability as a result of the provisions of the Tax Cuts and Jobs Act, offset by (ii) the use of federal NOLs and tax credits accumulated to the end of 2016, less (iii) any additional borrowing allowed the utility against the increase in rate base of its regulated utility subsidiaries. As can be seen in Exhibits 9 and 10, we estimate that 11 publicly-traded utilities will suffer a modest erosion in after-tax cash flows. Most affected over 2017-2019, will be HE, ETR, AEP, and ES, where we calculate tax reform will reduce cash flows by 1.4%-1.6% of market capitalization. We note that this estimate may overstate the impact of the new tax law due to the potential for the accumulation of additional NOLs and tax credits in 2017 before the law came into effect. To maintain their existing capex and rate base growth targets, these utilities could issue equity or increase holdco debt; alternatively, they could defer previously planned capex to future years.

Furthermore, rather than issue equity to offset this reduction in cash flow, utilities could instead choose to defer some of their current capex plans, maintaining their current pace of rate base growth in the medium term while adding the deferred capex to future years. Importantly, neither of the utilities whose rate base growth we expect to benefit most from tax reform – LNT and XEL – is expected to face the need to augment its equity funding.

Exhibit 9: Estimated Decrease in 2017-2019 Cash Flow Under Tax Cuts and Jobs Act

versus Prior Tax Code, Expressed as a Percentage of Market Capitalization (1)

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1. Decrease in cash flow is defined here as (i) any increase in cash taxes offset by (ii) the additional borrowing allowed against rate base of regulated utility subsidiaries.

Source: Company reports, including FERC Form 1 and SEC 10Q filings, SNL, SSR analysis and estimates

Exhibit 10: Estimated Decrease in 2017-2022 Cash Flow Under the Tax Cuts and Jobs Act versus Prior Tax Code, Expressed as a Percentage of Market Capitalization (1)

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1. Decrease in cash flow is defined here as (i) any increase in cash taxes offset by (ii) the additional borrowing allowed against rate base of regulated utility subsidiaries.

Source: Company reports, including FERC Form 1 and SEC 10Q filings, SNL, SSR analysis and estimates

The Estimated Impact on Utilities’ Average Rates and Residential Bills

Unlike most companies, regulated utilities will not benefit directly from the reduction in corporate tax rate from 35% to 21%. For the regulated utilities, whose rates are set on a cost-of-service basis, any decrease in income tax expense is a benefit that must eventually be passed through to ratepayers.[5]

Utilities may benefit indirectly, however, insofar as a reduction in rate of increase in their average system rate or in their average customer bills alleviates pressure to restrain the growth in other costs that might drive up rates – including the increase in depreciation expense, interest expense and, critically, the allowed return on equity associated with rate base growth. In this sense, a slower rate of increase electricity rates and customer bills facilitates the realization of capital expenditures to drive future rate base growth.

Viewed from this perspective, the impact of lower tax rates is expected to be mildly positive: we estimate that over 2016-2021, the compound annual rate of increase in average system electricity rates and average residential bills will be about 0.3% p.a. lower, given tax reform, than it would have been under the previous tax code (see Exhibits 11 and 12). As illustrated in Exhibits 13 and 14, however, the estimated impact on average system rates and average residential bills varies widely across the industry. Benefiting most, we calculate, will be WR, SO, NEE and PNW, where we expect the increase in average system rates and average residential bills to be lower by 0.5% to 0.7% p.a. over 2016-2021, relative to our estimates under the previous tax code. Benefiting least, we expect, will be NWE, EIX, PCG, ED, EXC, SCG and CMS.

Exhibit 11: Estimated Impact of the Tax Cuts and Jobs Act on the Increase in Utilities’ Average System Electricity Rates over 2016-2021

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Source: Company reports, including FERC Form 1 and SEC 10Q filings, SNL, SSR analysis and estimates

Exhibit 12: Estimated Impact of the Tax Cuts and Jobs Act on the Increase in Utilities’ Average Residential Electricity Bills over 2016-2021

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Source: Company reports, including FERC Form 1 and SEC 10Q filings, SNL, SSR analysis and estimates

Exhibit 13: Estimated Impact of Tax Cuts and Jobs Act on the Annual Average Increase in Utilities’ Average System Electricity Rates over 2016-2021

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Source: Company reports, including FERC Form 1 and SEC 10Q filings, SNL, SSR analysis and estimates

Exhibit 14: Estimated Impact of the Tax Cuts and Jobs Act on the Average Annual Increase in Utilities’ Average Residential Electricity Bills over 2016-2021

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Source: Company reports, including FERC Form 1 and SEC 10Q filings, SNL, SSR analysis and estimates

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

  1. Full depreciation of all or part of qualified property in the year that it enters service. Qualified property eligible for bonus depreciation is tangible personal property with a recovery period of 20 years or less under the modified accelerated cost recovery system (MACRS), certain off-the-shelf computer software, water utility property, and qualified improvement property. To be eligible for bonus depreciation, the original use of the property must begin with the taxpayer. 
  2. The Tax Cuts and Jobs Act excludes from the definition of qualified property certain public utility property, i.e., property used predominantly in the trade or business of the furnishing or sale of (1) electrical energy, water, or sewage disposal services, (2) gas or steam through a local distribution system, or (3) transportation of gas or steam by pipeline, if the rates for such furnishing or sale, as the case may be, have been established or approved by a State or political subdivision thereof, by any agency or instrumentality of the United States, or by a public service or public utility commission or other similar body of any State or political subdivision thereof. 
  3. While utilities may opt-out of using bonus depreciation, regulators generally require them to elect to use bonus deprecation because of the beneficial impact on rates for customers. However, AVA and POR have in recent years opted out of bonus depreciation because they are receiving excess PTCs from wind projects and bonus depreciation would defer their use of those PTCs with no immediate impact on rates, thus hurting ratepayers over the long run. 
  4. Depending on the class of asset placed in service, the first year rate of depreciation under MACRS ranges from 20%, for certain wind, solar and geothermal energy projects, to 3.75% for steam turbine generators and electric utility distribution assets. 
  5. Depending on the regulatory situation of each utility, however, there may be a period of up to a few years when a utility is able to retain the benefit of the lower tax rate because it is (i) currently in an extended period of frozen or set rates under a settlement, (ii) it is currently under-earning and the tax savings do not result in overearning, or (iii) its regulators choose to wait until the utility opts to file a rate case, to recover the cost of new investments, before adjusting its allowed revenues to reflect the new tax rate. 
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