Tax Reform and Rate Base Growth: Which Utilities Benefit Most?

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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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December 4, 2017

Tax Reform and Rate Base Growth:

Which Utilities Benefit Most?

The tax reform bills passed by the House and Senate would 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. In this note, we identify those regulated utilities likely to benefit most and least from the changes proposed by the two bills. In a future note, we will analyze the impact of the two bills on the renewable energy industry.

Portfolio Manager’s Summary

  • Exhibit 2 lists those provisions of the House and Senate tax reform bills that will most affect the outlook for individual utility stocks, summarizes their implications, and identifies those utilities most likely to be positively and negatively affected.
  • Among the most important implications of the two bills for regulated utilities are:
  • Materially more rapid rate base growth in 2018-2019 for certain utilities, particularly LNT, XEL, AGR and PCG, if they maintain their current capex plans. We expect 2019 rate base at these companies to be 5.0% to 6.6% higher than it would have been under the current tax code, if the House bill becomes law, and 4.4% to 6.1% higher if the Senate bill becomes law (see Exhibit 4)
  • The positive impact of tax reform begins to reverse for certain utilities thereafter, for reasons related to the accounting for deferred taxes, but we expect rate base growth at LNT and XEL to continue to improve through 2022, rising by 6.1% to 6.9% relative to our current forecast under the House bill and by 5.6% to 6.4% under the Senate bill (see Exhibit 5).
  • The utilities whose rate base growth is expected to benefit least from tax reform are POR, SCG and AVA, where we expect rate base to be ~1% higher in 2019 and 2022 v. the status quo.
  • Potentially higher equity funding needs at certain utilities, particularly HE, ES, and AEP, where we estimate that tax reform will increase equity funding requirements by 1.0% to 1.6% of market capitalization over 2018-2019, relative to these companies’ equity needs under the current tax code. Most utilities, however, will be able to offset any increase in their tax liabilities with the carry forward of NOLs and tax credits from investments in renewable energy (see Exhibits 8 and 9).
  • Slower rates of increase in electricity rates and customer bills, particularly at WR, SO, NEE and PNW, where we expect the average annual rate of increase in average system rates and average residential bills to be reduced by 0.7% to 0.9% p.a. over 2017-2021, relative to our estimates under the current tax code (see Exhibits 10 through 13).
  • Among the most important implications of the two bills for utilities’ unregulated businesses are:
  • The Senate bill’s more stringent limits on the tax deductibility of interest expense, which could curtail the deductibility of interest at certain companies with significant competitive operations or portfolios of renewable investments, potentially including D, ETR, EXC, FE, NEE, PEG, and SO.
  • Provisions in the Senate bill potentially limiting utilities’ ability to apply the production tax credit for renewable energy against their tax liabilities beyond the fourth year of operation of renewable energy projects, which could dramatically reduce after-tax earnings on existing and planned wind investments at regulated utilities, including AEP, CMS, LNT, POR and XEL, as well as on the unregulated wind investments of AGR, ALE, DUK, NEE and SO.

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

Source: SSR analysis

Details

Summary

Exhibit 2 lists those provisions of the House and Senate tax reform bills that will most affect the outlook for individual utility stocks, summarizes their implications, and identifies those utilities most likely to be positively and negatively affected. Most importantly, the tax reform bills passed by the House and Senate would 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. In this note, we identify those regulated utilities likely to benefit most and least from the changes proposed by the two bills. In a future note, we will analyze the impact of the two bills on the renewable energy industry.

The tax reform bills passed by House and Senate contain provisions that will materially accelerate growth in rate base at U.S. regulated electric utilities over 2018-2019. Based on the disclosed capex plans of the publicly traded, regulated utilities in the United States, we estimate that the provisions of the House bill would increase the aggregate electric rate base of these utilities by 3.4% by 2019, compared to what it would have been under the current tax code; the Senate bill would add 3.0%, by our estimate, to electric rate base by 2019.

Among the regulated utilities, we expect LNT, XEL, AGR and PCG to realize materially more rapid rate base growth in 2018-2019 under the House and Senate tax reform bills than they would have under the current tax code if they maintain their current capex plans. At these companies, we expect 2019 rate base to be 5.0% to 6.6% higher than it would have been under the current tax code, if the House bill becomes law, and 4.4% to 6.1% higher if the Senate bill becomes law (see Exhibit 5).

The positive impact of tax reform begins to reverse for certain utilities thereafter, for reasons related to the accounting for deferred taxes, but we expect rate base growth at LNT and XEL to continue to improve, with rate base rising by a cumulative 6.1% to 6.9% through 2022 relative to our current forecast under the House bill and by 5.6% to 6.4% under the Senate bill (see Exhibit 5).

The utilities whose rate base growth is expected to benefit least from tax reform are POR, SCG and AVA, where we expect rate base to be ~1% higher in 2019 and 2022 v. the status quo.

Exhibit 2: Key Provisions of the House and Senate Tax Bills Affecting the Power Industry

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Source: House Ways and Means Committee, Senate Committee on Finance, SNL analysis and estimates

Higher rate base growth due to lower deferred taxes comes at the cost of higher cash taxes and thus higher equity funding needs at certain utilities. Most affected over 2018-2019, we estimate, will be HE, ES, and AEP, where we calculate that tax reform will increase equity funding requirements by 1.0% to 1.6% of market capitalization, relative to these companies’ equity funding needs under the current tax code. Across the industry, however, this turns out to be a limited problem; the majority of utilities have enough accumulated NOLs, and tax credits from renewable energy investments, to offset the higher tax liabilities resulting from the increase in their taxable income due to the elimination of bonus depreciation. (See Exhibits 8 and 9).

While more rapid growth in 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. Despite the acceleration of rate base growth, therefore, we expect the pace of increases in electricity rates and customer bills to slow. 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 0.7% to 0.9% p.a. over 2017-2021, relative to our estimates under the current tax code (see Exhibits 10 through 13).

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

The provisions of the House and Senate bills 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 20%. Under the current tax code, businesses are allowed to write-off 40% of the value of qualified property, including electric utility plant and equipment, that enters service in 2018, and to write off 30% of the value of qualified property entering service in 2019. Bonus depreciation is scheduled to expire, under the current tax code, in 2020. By contrast, both the House and Senate bills would allow full expensing (100% bonus depreciation) of plant and equipment entering service between September 27, 2017 and January 1, 2023. Critically, however, both bills modify the definition of qualified property to exclude regulated utility plant,[2] thereby preventing regulated utilities from taking advantage of bonus depreciation going forward.

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 under the House and Senate tax reform bills thus promises to remove this headwind, speeding rate base growth relative to what it would have been under the current tax code, which allowed bonus depreciation of 40% in 2018 and 30% in 2019.

We illustrate how bonus depreciation contributes to the very rapid build-up of deferred taxes in Exhibit 3. A utility placing new electric plant in service in 2017 would, under the current tax code, (i) expense in 2017 50% of the utility plant placed in service in that year by applying bonus depreciation, and (ii) expense, at a minimum, 3.75% of the remaining 50% 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 52% of the value of new plant placed in service (50% by applying bonus depreciation plus 3.75% of the remaining 50% by applying MACRS to the balance) would reduce the utility’s tax liability by ~18% of the value of the asset (52% 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 be 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 ~17.5% of the value of the asset (18% less 0.5%) – would be added to the utility’s deferred tax liability. As a result, the utility would be allowed to add only 81% of the value of the asset (100% – 17.5% – 1.45%) to its regulated rate base.

Exhibit 3: 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 50% bonus depreciation, 20 year MACRS and book depreciation over 35 years.

Source: IRS and SSR analysis

Under the House bill, by contrast, the utility would be prohibited from applying bonus depreciation would thus 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 20% under the House bill, the utility would be required to increase its deferred tax liability by only 0.46% of the value of the asset (2.3% x 20%). Over 98% (100% – 0.46% – 1.45%) of the value of the asset could thus be added to rate base.

In addition to eliminating bonus depreciation for utilities, both the House and Senate tax bills would cut the corporate tax rate from 35% to 20%. 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 depreciation 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. Neither the House nor Senate bills 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 20%, they materially reduce 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 current tax code, the corresponding tax savings would be equivalent to 35% of the value of the asset (the current tax rate of 35% multiplied by 100% of the value of the asset), while at the 20% corporate tax rate proposed by the House and Senate bills the tax savings would be only 20% of the value of the asset. Assuming a 35-year useful life for the asset, the depreciation rate for book purposes would be 1.45% if placed in service at mid-year and the corresponding reduction in the utility’s book provision for income taxes would be 0.5% at 35% tax rate and 0.3% at a 20% tax rate. In this example, then, the utility would be required to post a deferred tax liability equivalent to 34.5% of the value of the asset given the current corporate tax rate of 35% (35% less 0.5%) but only 19.7% of the value of the asset if the tax rate is cut to 20% (20% less 0.3%). The deferred tax liability triggered by the asset placed in service is thus reduced by 15% of the value of the asset (34.5% less 19.7%), and the proportion of the asset’s value that can be added to rate base is increased from 65% to 80%.

Importantly, however, the House and Senate tax bills differ in the timing of the reduction in the corporate tax rate from 35% to 20%, with the House version bringing new, lower tax rate into effect in 2018 and the Senate version in 2019. The implication is that utilities will accumulate higher deferred tax liabilities in 2018 under the Senate bill than the House bill, resulting in a slower pace of rate base growth under the Senate bill.

Finally, we note that for many utilities, the benefit to rate base of the House and Senate bills diminishes over time and in some cases begins to reverse. Under the House and Senate bills, the elimination of bonus depreciation in 2018 and 2019 (when under the current tax code bonus depreciation would have been 40% and 30%, respectively) materially reduces utilities’ deferred taxes in those years, accelerating rate base growth. Under the current tax code, however, bonus depreciation expires in 2020; the elimination of bonus depreciation by the House and Senate tax bills thus conveys no benefit to rate base growth 2020 on.

By the early 2020s, moreover, the annual rate of change in deferred tax liabilities begins to increase at certain utilities under the House and Senate bills when compared to the current tax code. This reflects the fact that, under the House and Senate bills, 100% of utility plant placed in service during 2018-2019 is subject to accelerated depreciation under MACRS; under the current tax code, by contrast, MACRS would apply to only 60% of the plant placed in service in 2018 and 70% in 2019. This is important because, absent bonus depreciation, under accelerated depreciation schemes such as MACRS, tax depreciation exceeds book depreciation in each year until the asset is fully depreciated for tax purposes. Because utilities enjoy higher tax depreciation than book depreciation over this period, reducing their cash tax liability relative to their book provision for income tax, they must in each year book an increase in their deferred tax liability (please see Exhibit 4 below for an illustration of this). Initially, this effect is offset by the lower corporate tax rate prevailing under the House and Senate bills. By 2021, however, utilities generally face a larger annual dollar increase in their deferred tax liabilities than they would under the current tax code. As a result, from 2021 on, the benefit to rate base growth of tax reform is gradually reduced.

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 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 both the House and Senate tax bills, 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 20%, 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, 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 their 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, and to return the tax benefits to the future ratepayers that will still be paying for the assets that were placed into service.) Historically, utilities have calculated their provision for income taxes at the 35% rate, and passed the cost along to ratepayers, yet have deferred a large portion of these annual provisions for future years; if this tax rate is now reduced to 20%, the full amount of these deferred taxes will never be paid. Regulators will therefore require utilities to return these historical over-collections to ratepayers. 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. Finally, both the House and Senate tax bills would require 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

The tax reform bills passed by House and Senate contain provisions that will materially accelerate growth in rate base at U.S. regulated electric utilities over 2018-2019. We estimate that the provisions of the House bill would increase the aggregate electric rate base of the investor owned utilities by 3.4% by 2019, compared to what it would have been under the current tax code; the Senate bill would add 3.0%, by our estimate, to electric rate base by 2019.

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 base case forecast of the rate of growth in electric rate base by utility is predicated upon the provisions of the current tax code (see our note of September 6thRising Growth and Falling Beta: Electric Utility Rate Bases Show Accelerating Growth Through 2021.) We have also prepared forecasts of rate base growth by utility assuming the provisions of the House and Senate bills become law. We have compared our estimates of future rate base in these two forecasts to our base case to estimate the impact of the two bills on rate base growth.

Exhibit 5 presents our estimated increase in rate base under the House and Senate tax bills relative to our estimate of rate base under the current tax code. We present these results for two time periods, 2018-2019 and the five-year period 2018-2022. Finally, we have ranked the utilities into quintiles based on their estimated increase in rate base as a result of the House and Senate tax bills.

To facilitate the identification of those utilities likely to benefit most and those likely to benefit least from tax reforms, we have averaged our estimates of the rate base impact of the House and Senate bills and presented the results in Exhibits 6 and 7, 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 6, which presents the results of our analysis for the period 2018-2019, LNT, XEL, AGR, and PCG stand out as enjoying the largest estimated increases in rate base, ranging from 4.7% to 6.3% over this two year period. By contrast, POR, SCG and AVA appear to benefit least, with estimated increases in rate base of 1.0% or less. In Exhibit 7 we present the results of our analysis for the five year period 2018-2022. As can be seen there, POR, SCG and AVA again appear to benefit least, while LNT and XEL, we estimate, will continue to see the largest cumulative increases in rate base (5.8% to 6.7%).

Exhibit 5: Impact of House & Senate Tax Reform Bills on Total Electric Rate Base (Difference with Current Tax Code in 2019 and 2022)

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

Exhibit 6: Average Estimated Impact of House & Senate Tax Reform Bills on 2019 Electric Rate Base (Difference to Current Tax Code in 2019)

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

Exhibit 7: Average Estimated Impact of House & Senate Tax Reform Bills on 2022 Electric Rate Base (Difference to Current Tax Code in 2022)

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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

It is important to bear in mind that the increase in utilities’ electric rate base discussed in the prior section is attributable to an increase in utilities’ cash taxes, and that this increase in cash taxes implies a commensurate reduction in cash from operations. Utilities can offset this erosion in cash flow by borrowing against the increase in their rate base, up to allowed ratio of debt to rate base set by their regulators; any increase in rate base above this level, however, must be funded with equity.

Interestingly, our analysis suggests that, over 2018-2019, the carry-forward of past net operating losses, and tax credits from investments in renewable generation, will allow most utilities to offset the higher tax liabilities resulting from the increase in their taxable income due to the elimination of bonus depreciation. As a result, we estimate that only a handful of utilities will likely face an increase in their equity funding requirement over this period.

We present below our estimate of the potential erosion in utilities’ cash flow that may result from the House and Senate tax bills. 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 House or Senate bills, 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 8 and 9, two of the utilities that may face a decrease in cash flow are SCG and AVA, which we have also identified as two of the utilities whose rate base growth is least likely to benefit from tax reform. We note that, rather than issue equity to meet this funding shortfall, 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 8: Estimated Decrease in 2018-2019 Cash Flow Under House Tax Reform Bill Compared to Current 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 9: Estimated Decrease in 2018-2019 Cash Flow Under Senate Tax Reform Bill Compared to Current Tax Code, Expressed as a Percentage of Market Capitalization

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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 20%. 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 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 tax reform is expected to be mildly positive: we estimate that over 2017-2022, the compound annual rate of increase in average system electricity rates and average residential bills will be about 0.4% p.a. lower, given tax reform, than it would be under the current tax code (see Exhibits 10 and 11). As illustrated in Exhibits 12 and 13, however, the estimated impact on average system rates and average residential bills varies widely within 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 0.7% to 0.9% p.a. over 2017-2021, relative to our estimates under the current tax code. Benefiting least, we expect, will be NWE, EIX, ED, PCG and EXC.

Exhibit 10: Estimated Impact of House and Senate Tax Reform Bills on the Increase in Utilities’ Average System Electricity Rates over 2017-2022

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

Exhibit 11: Estimated Impact of House and Senate Tax Reform Bills on the Increase in Utilities’ Average Residential Electricity Bills over 2017-2022

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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 House and Senate Tax Reform Bills on the Annual Average Increase in Utilities’ Average System Electricity Rates over 2017-2021

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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 House and Senate Tax Reform Bills on the Average Annual Increase in Utilities’ Average Residential Electricity Bills over 2017-2022

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

The Impact of Provisions from the Senate Bill

The bill which passed the Senate on Friday night included a couple of provisions that could have a significant negative impact on utilities with large unregulated operations or with large existing or planned investments in wind power. The impact of these two provisions is discussed below.

  • Limitations on the deductibility of interest expense

The first provision is the limitation on the deductibility of interest expense for non-utility businesses. The House bill also includes this provision, but the Senate bill includes a more restrictive definition of the adjusted pre-tax income that is used to define the limitation. Whereas both bills limit the deduction of interest to 30% of adjusted pre-tax income, the House bill includes depreciation and amortization in its definition of pre-tax income, making it essentially equivalent to EBITDA, but the Senate bill does not, making it essentially equivalent to EBIT. While we do not believe that the House bill would have a significant impact on the any of the companies our regulated electric utility or hybrid utility universes, the Senate bill could limit the deductibility of interest and thus could adversely affect earnings and cash flow at utilities with large unregulated operations, such as D, ETR, EXC, FE (until its unregulated generation subsidiary enters bankruptcy), NEE, PEG, and SO. While excess (non-deductible) interest expense may be deferred for future use, after-tax cash flow in the current year is reduced and, if a company does not believe it will be able to use the deductions fully in the future, it must apply a higher tax rate to reflect the lost deductions.

  • Retention of the corporate minimum tax

The second provision of the Senate bill is the retention of the corporate alternative minimum tax, or AMT. The corporate AMT was slated to be repealed in the original version of the Senate bill, as it is in the House bill. However, the repeal was removed just before passage of the Senate bill. The corporate AMT is a provision to ensure that companies pay a minimum level of tax. It requires companies to calculate their taxes twice, once using the regular tax framework and a second time under the corporate AMT framework, which applies a minimum 20% tax rate and imposes some restrictions on use of credits and other tax benefits. Companies are then required to pay taxes based on the higher of the two tax calculations. As the both the regular corporate tax rate and the AMT rate are now 20%, and the use of credits and tax benefits allowed under the AMT calculation is less generous than in the regular tax framework, the Senate bill’s failure to eliminate the AMT implies that many companies will find themselves paying the alternative minimum tax.

Importantly, the corporate AMT limits the use of PTCs generated by renewable energy projects to the first four years of the project’s life, resulting in a loss of the value of the PTCs for the remaining six years that they would be available under the regular tax framework. This provision could dramatically after-tax earnings on existing and planned wind investments at a number of regulated utilities, including AEP, CMS, LNT, POR and XEL, as well as on the unregulated wind investments of AGR, ALE, DUK, NEE and SO. However, there has already been a very strong reaction across several industries against the retention of the corporate AMT in the Senate bill, so there is a high probability this provision is deleted or modified in conference committee.

©2017, 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. Both bills exclude 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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