Power Asset Taxes

7.30.03
Mark Pomykacz, Managing Partner, Federal Appraisal & Consulting LLC

UTILITY COMPANIES ARE CURRENTLY SUFFERING A DOUBLE BODY BLOW. They are currently suffering a dramatic industry-wide decline. And in many areas of the country, they are suffering through the negative effects of deregulation. However, while these conditions certainly have a negative impact on power asset values, the effects can be mitigated by acting to reduce property taxes. The tax manager who is knowledgeable of recent industry and assessment events and their implications can find a silver lining in property tax management. Given that property taxes are often the third largest operating expense, (behind fuel and payroll), the proper manage of property taxes can substantially improve net income and thus preserve company value.

Currently, four factors are impacting utility assessments in dramatic ways; the recent dramatic industry-wide decline, deregulation is negatively effecting utility’s income, deregulation mandates the income approach, and structured leases may serve as the basis of assessment.Assessors are for-warned. State-level law makers and regulators, in their enthusiasm to deregulate for the benefit of state-wide consumers, forgot to warn local taxing jurisdictions that their local budgets would be negatively impacted. Deregulation was designed to reduce the cost to utility consumers and thus income to utility companies. An axiom of appraisal mandates that if income declines, value declines. Since property taxes are based on values, logically and actually, deregulation is lowering property tax assessments, taxes and local budgets. Note that the deregulation impact is a one-time event, lasting the first several years after deregulation, and resulting in a new permanently lower value for the deregulated assets. Given the size of contribution of power assets to the tax rolls and given the dramatic industry decline, assessors should take special steps to plan for a major loss in municipal income for the next several years, until the industry recovers.

Active Tax Managers will carry the day. Jurisdictions are being taken by surprise when utilities successfully argue to dramatically reduce their taxes, due to deregulation and the industry decline. Industry-specific market details, such as electricity deregulation, are out side the daily experience of many assessors. Assessors are rarely given the resources to cover such industry-specific events. Additionally, the power industry is currently in a different phase of the economic cycle than the general economy and the real estate industry. Real estate has been doing better than the general economy, while the electricity power industry is truly in a bad state. Real Estate has being doing rather well in many markets. Unless property tax managers act to provide the power industry-specific information, assessors sometimes assume the industry is on par with the general economy or with real estate. Unlike income taxes, where the taxpayer estimates what their taxes should be, and the IRS reacts if the IRS believes the taxes are too low, property tax managers are fundamentally reactive. For property taxes, the jurisdictions decide what the owners should pay, and the owner reacts. This arrangement is to the disadvantage to the passive tax manager, given that the power industry is out of phase and going through a very rough period. The opportunity to lower property taxes will only last for several years, as of course, the industry will recover eventually and the initial impact of deregulation will pass.

The Income Approach for deregulation. Another major surprise for both the inexperienced assessor and tax manager is the switch in appraisal methodology necessitated by deregulation. In the old regulated market days, the cost approach was king. In deregulated markets, the income approach rules. Under regulation, if the utility built it, the consumer will pay, (based on the cost and the permitted return on the cost). In a deregulated market, there are no guarantees of recapture of costs. Investors, thus, look to the quantity and quality of the cash flow (an income analysis, with normal market considerations of risk and return). This presents a host of assessment management issues, including appraisal, engineering, legal, and corporate management. Old school power engineering consultants will not be up to the task of estimating assessed value via an income analysis. While most traditional real estate mortgage appraisers will not have the engineering experience needed for electricity power facilities. Given that local assessment laws are often specialized for power facilities, experienced legal advice may be needed to negotiate and litigate the transition to appraisals for deregulation. Recent legal precedents confirm this valuation methodology. Additional precedents may be required to sustain the methodology and obtain the proper tax assessment under deregulation. The fundamental argument in favor of the switch from a cost basis of assessment to an income basis is that deregulation is at its heart, the establishment of competitive markets. In competitive markets, the cost to build periodically diverges from the income-based value as the market cycles through periods of growth and decline. In periods of decline, the income approach indicates a lower value than the cost approach (calculated before external obsolescence). Yet, since in deregulated markets, investors will not pay more for an asset than the value based on its cash flow, the cost approach value exceeds the market value in a declining market.

The Wild Card, Structured Leases The assessment law in some jurisdictions permits the appraisal of real property based on the leases in place. There are a number of usability criterion, but the most important are that the lease be at market levels and between unrelated parties. Over the last decade, many power assets have become subject to leases created through structured finance arrangements. By their nature, no structured lease is intrinsically disqualified from being the basis of assessment, in jurisdiction permit appraisals based on leases in place. Many structured leases can pass all of the usability criterion. Some structured leases would yield higher assessments, others, lower assessments.

Copyright 2003 CyberTech, Inc.

Readers Comments

Date Comment
George Kamburoff 8.5.03 This is well-written and timely, and the author makes a good exposition of the issues. He misses an important point, however. Taxes are the price we pay for civilization. That load must be borne by the wealthy as well as the workers.Do we really want to keep finding ways for millionaires and businesses to dodge their fair share of the taxes that pay for our (and their) police, fire, and social services?If we continue this madness, Leona Helmsly will be proven right when she explained conservative tax policy as: “Only little people pay taxes”
Jack Sprat 8.13.03 Mark has a point in theory, but in actual practice many power companies may find themselves paying higher rather than lower real estate taxes.For may years utilities paid taxes on outdated power plant property values. They often argued with local jurisdictions about the low values of their generating plants and often used their depreciated plant values to convince tax assessors that the actual market values of their plants was miserably low.Recently those utilities sold their plants to independent power producers for the fair market values based on the plants’ projected earnings which was often many times greater than the plants’ depreciated or book values.It’s hard to argue with a local tax assessor that a plant you just paid $10 million for is really only worth $3 million which was the previous tax assessment value. Fair market value is fair market value and the Utilities made a bundle selling plants, which the ratepayers had paid much of the depreciation on, for market value.

That was one of the lies of deregulation– that the rates would go down. How can rates go down when the ratepayers start paying the carrying charges on the fair market value of the generating plants instead of the depreciated value which is all the utilities were allowed to charge in their approved regulated rate bases?

With new full market prices for power plants come full market taxes.

If the taxing jurisdictions really understood how to compute the fair market value of power plants, based on their income potential, the taxes on power plants would go up almost across the board nationally.

The new independent power producers had better hope the tax assessors don’t find out just how far out of wack their taxes are and hire the expertise to do fair market value computations for the generating plants in their jurisdictions.