How Will the Trump and GOP Tax Plans Impact Rate Base Growth? The Opportunity and Risk Facing Utility Investors

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Eric Selmon

Office: +1-646-843-7200

Email: eselmon@ssrllc.com

Hugh Wynne

Office: +1-917-999-8556

Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

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November 29, 2016

How Will the Trump and GOP Tax Plans Impact Rate Base Growth?

The Opportunity and Risk Facing Utility Investors

Both President-elect Trump and the House Republican leadership have presented proposals for the comprehensive reform of U.S. corporate taxation. In this note we explore the implications of these proposals for the growth of utilities’ rate base – the invested capital on which they are allowed to earn a regulated return. Utility regulators calculate rate base by subtracting from utilities’ net PP&E their net deferred tax liability. Key elements of the competing tax plans, including dramatic cuts in the corporate tax rate and the expensing of capital expenditures for tax purposes, would have a radical impact on the rate at which utilities accumulate deferred tax liabilities and thus on their rate base growth. Under the Trump tax plan, the growth of rate base and regulated earnings would likely accelerate, but cash flow would fall; under the House plan, rate base growth slows but cash flow would slightly improve.

Portfolio Manager’s Summary

  • The keystone of both the Trump and House GOP plans is a radical reduction in the corporate tax rate, from 35% currently to 20% under the House plan and to 15% under the Trump plan. Any cut in the corporate tax rate will not benefit the earnings of regulated utilities over the long term, as utilities will only keep the increased earnings until they are called in by regulators to adjust rates, or the growth in their operating expenses so erodes earnings as to force them to file a rate case. Because it is impossible to know at this point which utilities are likely to be called in by regulators, or when, we cannot identify which regulated utilities will experience a greater temporary benefit. By contrast, utilities with large, profitable competitive businesses, such D, EXC, NEE and PEG, should see a permanent improvement in the after-tax earnings of these operations.
  • The proposed changes to the tax code would affect the growth in rate base of the regulated utilities, however, and with it the expected growth in utilities’ regulated earnings. Specifically, lower corporate tax rates would reduce the value of tax deductions such as bonus depreciation. This would slow the accumulation by utilities of deferred tax liabilities, which are offset against net PP&E in the calculation of rate base – thus accelerating rate base growth.
  • Today, with 50% bonus depreciation, MACRS and a 35% tax rate, the deferred tax liability triggered by the entry into service of new utility plant is ~17% of the value of the plant placed in service. For every dollar of capital expenditure, therefore, the corresponding increase in rate base is only 83 cents. By contrast, if the corporate tax rate were cut to 15%, the first year increase in deferred tax liability would be only 7% of the value of plant placed in service, allowing each dollar of capex to contribute 93 cents to rate base. The rate base impact of each capex dollar spent would thus rise by 12%.
  • The positive impact of lower tax rates on rate base growth would be offset in the House GOP plan by a provision requiring the expensing of capital expenditures. On utilities’ financial statements, however, investments in plant would still be capitalized and depreciated over their useful life, and the provision for income taxes would therefore remain unchanged. The expensing of capex for tax purposes would thus increase utilities’ deferred tax liabilities, slowing rate base growth.
  • If the House tax plan were adopted, cutting the corporate tax rate to 20% but requiring the expensing of capital expenditures, we calculate that growth in aggregate rate base over 2015-2020 could decelerate to 6.3% p.a. from 6.6% under the current tax code (see Exhibit 1).
  • In this scenario, we calculate that the companies whose rate base growth would decelerate most would be DTE, EE, ETR, NWE, PPL, SCG, and SO (see Exhibits 6 and 7).
  • Utilities whose rate base growth would decelerate least are CNP, ED, ES, EXC, FE, OGE and PEG.
  • Under the Trump tax plan, by contrast, companies would be allowed the option to expense capex; if they chose to do so, they would forego the deductibility of corporate interest expense. This option would be unattractive for regulated utilities, as the expensing of capex would slow rate base growth, and for their ratepayers, whose rates would rise due to the loss of the tax deduction for interest expense. For utilities that do not chose not to expense capex, the 15% tax rate in the Trump plan would materially reduce deferred taxes and accelerate rate base growth.
  • We calculate that growth in aggregate electric rate base over 2015-2020 could accelerate from 6.6% p.a. under the current tax code to 7.2%, if the corporate tax rate were cut to 20%, and to 7.5% if cut to 15%, as proposed in the Trump plan (see Exhibit 1).
  • We calculate that the companies that would see the largest increase in rate base growth, were tax rates to be cut to 15%-20%, would be AGR, EIX, ETR, EXC, LNT, PCG and PEG.
  • Absent the expensing of capex, we expect all U.S. regulated utilities to enjoy more rapid growth in rate base as a result of a cut in the corporate tax rate. Those utilities expected to benefit least, however, are ALE, EE, GXP, IDA, OGE, POR and WR (Exhibits 6 and 7).
  • The proposed changes in tax rates and the deductibility of capex will not only affect utilities’ deferred tax liabilities and thus the pace of growth in rate base; they will also have a material impact on utilities’ after-tax cash flow and thus on their capital needs.

 

    • If the House tax plan is adopted, and utilities are required to expense capex, rate base growth will slow but the industry’s cumulative cash flow over 2017-2020 will improve, we estimate, by an amount equivalent to 1.5% of the industry’s current market capitalization.
    • If, as under the Trump plan, utilities are not required to expense capex, but their tax rates are cut, utilities’ tax savings from bonus depreciation and other deductions will fall. As a result, we estimate that the industry’s cumulative cash flow over 2017-2020 would deteriorate by an amount equivalent to 4.4% of the industry’s market capitalization if the tax rate were cut to 15%, as proposed in the Trump plan, and by 3.3% if the tax rate were cut to 20%. (See Exhibits 8 and 9).
  • In conclusion, we calculate that:
    • If the corporate tax rate were cut to 15%, as proposed in the Trump plan, growth in aggregate electric rate base over 2015-2020 would accelerate from 6.6% p.a. under the current tax code to 7.5% (see Exhibit 1); but the loss in value of utilities’ ample tax deductions would cause their cumulative cash flow over 2017-2020 to fall by 4.4% of current market capitalization.
    • If the House tax plan were adopted, cutting the corporate tax rate to 20% but requiring the expensing of capital expenditures, growth in aggregate rate base over 2015-2020 would decelerate to 6.3% p.a. from 6.6% under the current tax code; but the industry’s cumulative cash flow over 2017-2020 would rise by 1.5% of current market capitalization(see Exhibit 8).

Exhibit 1: Estimated Growth in Aggregate Electric Rate Base Growth Over 2015-2020 Under Alternative Tax Regimes

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Source: FERC Form 1, company reports, SNL, SSR analysi

Exhibit 2: Heat Map: Preferences Among Utilities, IPPs and Clean Technology Companies

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Source: FERC Form 1, company reports, SNL, SSR analysis

Details

Tax Normalization and the Impact of Deferred Taxes on Rate Base Growth

The rate base of a regulated utility is the invested capital on which it is allowed to earn a regulated return. Utilities are allowed to earn a return on their rate base roughly equivalent to the weighted average cost of the debt and equity capital used to fund their investment in property, plant and equipment. Because a utility’s deferred tax liability largely represents income taxes expensed but not yet paid, and thus does not represent an outlay of capital, regulated utilities are not allowed to earn a return on the portion of their net PP&E that is funded by their deferred tax liability. As a result, rate base is generally calculated as the value of a utility’s net property, plant and equipment less the utility’s deferred tax liability. [1]

In 1981, to ensure that the benefit of federal tax incentives for investment were enjoyed and acted upon by regulated utilities, Congress modified the federal tax code to require the use of tax normalization rather than flow through accounting by regulated utilities. Flow through accounting recognizes immediately the reduction in income taxes resulting from fiscal incentives to investment, such as accelerated depreciation or the investment tax credit; as utilities are regulated on a cost of service basis, this reduction in income tax expense would be flowed through to ratepayers in the year in which it occurs. Tax normalization, by contrast, avoids this outcome by stipulating that utility rates “normalize” the benefit of such tax incentives by spreading them out over the useful life of the asset to which they apply. Thus, normalization accounting requires that, in calculating their taxable income and income tax expense for regulatory purposes, utilities depreciate their property, plant and equipment over its useful life and without regard to any provisions of federal tax law allowing the accelerated depreciation of these assets. The result is that during the early years of an asset’s life, a utility’s regulatory accounting, on which cost of service rates are calculated, will show lower depreciation expense and higher taxable income and income tax expense than will appear on the utility’s tax books. The recovery of these costs in rates implies that customers are charged more to defray income tax expense than they would have had flow through accounting been used. In later years, however, the situation reverses; the utility’s tax books, on which accelerated depreciation has been applied, will show the asset to be fully depreciated, while for regulatory accounting purposes depreciation expense will continue to be recorded until the end of the asset’s useful life. As a result, the utility’s regulatory accounts will show higher depreciation expense, and lower taxable income and income tax expense, than will its tax books. During this phase of the asset’s life, customers are charged less to defray the utility’s income tax expense than they would have been had flow through accounting been applied.

To track the difference between the income tax expense recorded on a utility’s regulatory books and the cash taxes actually paid by the utility, normalization accounting, like GAAP, requires the utility to book a deferred tax liability. In the early years of an asset’s life, the utility will record as a liability on its balance sheet the difference between the income tax expense recorded for regulatory purposes and the cash taxes the utility actually pays. In the later years of an asset’s life, when cash taxes fall below book taxes, this liability will be reduced each year by the amount that book taxes exceed cash taxes. Thus, by the end of an asset’s useful life, the deferred tax liability is reduced to zero.Under the current tax code, a dollar added to property, plant and equipment can generate substantial write-offs for tax purposes that are not recognized on utilities’ financial statements, resulting in large deferred tax liabilities. The most important of these tax write-offs is bonus depreciation, which permits 50% of additions to utility plant to be expensed immediately rather than capitalized and depreciated in future years.[2] In recent years, the IRS has also allowed even more rapid expensing of maintenance capital expenditures. IRS regulations adopted in final form 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 maintenance capex.Also significant is accelerated depreciation for tax purposes. The current system of depreciation for tax purposes in the United States (known as Modified Accelerated Cost Recovery System or 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.

Exhibit 3 illustrates how the difference between book and tax depreciation drives the accumulation of a deferred tax liability. In the chart, book depreciation is represented by the red columns, tax depreciation by the blue columns and the deferred tax liability by the green columns. All three are presented as a percentage of the value of new plant placed in service. Assuming 50% bonus depreciation and accelerated depreciation per MACRS, ~52% of the value of plant placed in service is written off for tax purposes in year one; GAAP depreciation, by contrast, is less than 3%. Assuming a 35% tax rate, this 49% difference in recognized depreciation expense leads to a year one deferred tax liability of approximately 17% (35% x 49%) of the value of the new plant placed in service. (See the green columns in Exhibit 3 as well as the penultimate line of Exhibit 4.) Because deferred taxes are an offset to property, plant and equipment in the calculation of rate base, for every dollar of capital expenditure the corresponding increase in rate base is only 83 cents. By contrast, if the corporate tax rate were cut to 15%, the first year increase in deferred tax liability would be equivalent to only 7% of the value of plant placed in service (again, see Exhibit 4, allowing each dollar of capex to contribute 93 cents to rate base. The rate base impact of each capex dollar spent would thus rise from 83 to 93 cents, an increase of 12%.

Exhibit 3: The Difference Between GAAP and Tax Depreciation and the Associated Deferred Tax Liability (Assumes MACRS and 50% Bonus Depreciation)

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Source: IRS and SSR analysis

Exhibit 4: Year One Difference Between Tax and GAAP Depreciation and Consequent Increase in Deferred Tax Liability, Assuming MACRS and Various Levels of Bonus Depreciation (Expressed as a % of New Plant in Service)

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Source: IRS and SSR analysis

Key Provisions of the Trump and House GOP Tax Plans

The key elements of the House GOP and Trump tax plans that would affect U.S. regulated utilities are summarized in Exhibit 5 below. Since the primary purpose of this note is to analyze how the rival plans will affect rate base growth among U.S. regulated utilities, we will focus on two elements of the proposed plans: (i) the reduction in the corporate tax rate and (ii), in the case of the House GOP plan, the expensing of capital expenditures in the year in which they are made.

The keystone of both plans is a radical reduction in the rate of corporate taxation, from 35% currently to 20% under the House GOP plan and to 15% under the Trump plan. The implication of such a sharp cut in corporate tax rates would be to materially slow the accumulation of deferred tax liabilities. This in turn would affect the growth of utilities’ rate base – the invested capital on which they are allowed to earn a regulated return. Utility regulators calculate rate base by subtracting from utilities’ net PP&E their net deferred tax liability. If the rate at which utilities accumulate deferred tax liabilities were to slow, rate base growth would accelerate, and with it the growth of regulated earnings.

As an example, consider a utility that is recognizing a higher level of depreciation for tax purposes than it does on its financial statements (reflecting, for example, the use of 50% bonus depreciation

for tax purposes and straight-line depreciation over the useful life of the asset for financial accounting purposes). Bonus depreciation would allow this utility to record a lower level of taxable income on its tax books, and hence a lower level income tax expense, than it would on its financial statements. In this case, the company defers a portion of its provision for income taxes for use in later years, when the mismatch between its book and cash taxes is expected to reverse (e.g., when depreciation of a particular asset is complete for tax purposes but on-going on the company’s financial statements). The amount of this deferred tax liability is equal, in this example, to the excess of tax depreciation over book depreciation multiplied by the company’s tax rate. At today’s 35% tax rate, every dollar by which tax depreciation exceeds book depreciation thus results in 35 cents of deferred tax liability. Under the Trump tax plan, which would cut the corporate tax rate to 15%, the deferral would fall to 15 cents. The rate at which the utility accumulates deferred taxes would thus slow markedly. As we will see below, the impact of this change on rate base growth is material.

Exhibit 5: Key Elements of the Trump and House GOP Tax Plans

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Source: The Speaker of the House of Representatives, “A Better Way: Our Vision for a Confident America,” June, 2016; www.donaldjtrump.com, “Tax Plan.”

Critically, however, the positive impact of lower tax rates on rate base growth would be offset in the House GOP plan by a provision requiring the expensing of capital expenditures. Expensing capital expenditures in full in the year in which they are made would materially reduce utilities’ taxable income and cash taxes. On utilities’ financial statements, however, investments in plant would still be capitalized and depreciated over their useful life, and the provision for income taxes would therefore remain unchanged. The portion of utilities’ provision for income taxes that would be deferred on their financial statements would therefore increase, accelerating the growth in the utility’s deferred tax liabilities. As these are an offset to rate base, the effect would be to slow rate base growth.

Under the Trump tax plan, companies would be allowed the option to expense capex; if they chose to do so, they would forego the deductibility of corporate interest expense. This option would be unattractive for regulated utilities, as the expensing of capex would slow rate base growth, and for their ratepayers, whose rates would rise due to the loss of the tax deduction for interest expense. As noted above, for utilities that do not chose not to expense capex, the 15% tax rate in the Trump plan would materially reduce deferred taxes and accelerate rate base growth.

Implications of the Trump and House GOP Tax Plans for Rate Base Growth

Based upon the updated capital expenditure plans disclosed by utility management teams in the fourth quarter to date, we calculate that U.S. regulated utilities can achieve 6.6% compound annual growth in aggregate electric rate base over 2015-2020. This represents a material acceleration from the 6.1% CAGR in rate base realized over 2010-2015 and our prior forecast of 6.2% annual growth over 2015-2020. Our estimate of each utility’s growth in electric rate base, given the current tax code, is presented in Exhibit 6.

We calculate that growth in aggregate electric rate base over 2015-2020 could accelerate from 6.6% p.a. under the current tax code to 7.2% if the corporate tax rate were cut to 20%, and to 7.5% if the corporate tax rate were cut to 15% (see Exhibit 1). We calculate that the companies that would see the largest increase in rate base growth, were tax rates to be cut to 15%-20%, would be AGR, EIX, ETR, EXC, LNT, PCG and PEG (see Exhibit 7).

Absent the expensing of capex, we expect all U.S. regulated utilities to enjoy more rapid growth in rate base as a result of a cut in the corporate tax rate. Those utilities expected to benefit least, however, are ALE, EE, GXP, IDA, OGE, POR and WR (see Exhibit 7).

The companies that will benefit most from a reduction in tax rates are those whose capital expenditure budgets are largest relative to rate base. These companies will generate the largest amount of bonus depreciation relative to rate base, resulting in the accumulation of the largest deferred tax liabilities relative to rate base. At lower tax rates, the reduction in deferred taxes enjoyed by these companies is also largest relative to rate base, and thus adds most to rate base growth. Conversely, the companies that will benefit least from a reduction in tax rates are those whose capital expenditures are smallest relative to rate base.

Regardless of the scale of their capex budgets, transmission and distribution utilities also tend to benefit more from a reduction in tax rates than do vertically integrated utilities, a substantial portion of whose assets comprise generation plant. This reflects the fact that the repair deduction allowed by the IRS is drafted in such a way that it is more easily applicable to transmission and distribution networks than to power plants. As a result, maintenance capex on T&D assets is more likely to be expensed in the year in which it is incurred that maintenance capex on generation assets. For any given level of maintenance expense, therefore, the taxable income and cash taxes paid by a T&D utility will tend to lower than those of a vertically integrated utility, causing the former to post higher deferred tax liabilities. If the corporate tax rate is cut, T&D utilities will enjoy a greater benefit as this drag on rate base growth is reduced.

The positive impact of lower tax rates on rate base growth would be offset in the House GOP plan by a provision requiring the expensing of capital expenditures, materially reducing utilities’ cash taxes. On utilities’ financial statements, however, investments in plant would still be capitalized and depreciated over their useful life, and the provision for income taxes would therefore remain unchanged. The expensing of capex for tax purposes would thus increase utilities’ deferred tax liabilities, slowing rate base growth.

If the House tax plan were adopted, cutting the corporate tax rate to 20% but requiring the expensing of capital expenditures, we calculate that growth in aggregate rate base over 2015-2020 could decelerate to 6.3% p.a. from 6.6% under the current tax code (see Exhibit 6). In this scenario, we calculate that the companies whose rate base growth would decelerate most would be DTE, EE, ETR, NWE, PPL, SCG, and SO. Utilities whose rate base growth would decelerate least are CNP, ED, ES, EXC, FE, OGE and PEG. (See Exhibit 7).

Importantly, we anticipate that any reduction in the corporate tax rate would have no impact on utilities’ existing rate base. A reduction in the corporate tax rate will force companies to recalculate the value of deferred tax liabilities; as tax rates fall, the excess of future cash taxes over book taxes will fall as well, and must be reflected in a reduction in the deferred tax liability on utility’s books. A nonregulated company generally would recognize the reduction in its deferred tax liability as income, which in turn would increase retained earnings and owners’ equity. A utility subject to cost of service regulation would enjoy no such windfall; rather, its regulators would require it to refund the excess deferred taxes to ratepayers.[3] To document this obligation to return the excess deferred taxes to ratepayers, the utility would record a regulatory liability. Like the deferred tax liability that it replaces, this regulatory liability would be an offset to rate base, thus leaving utilities’ existing rate base unchanged.

Exhibit 6: Forecast Growth in Electric Rate Base Under Current Tax and Various Tax Reform Scenarios

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Source: FERC Form 1, company reports, SNL, SSR analysis

Exhibit 7: Change in Rate Base Growth (2015-2020 CAGR) Under Various Tax Scenarios

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  1. Quintile 1 = largest increases, Quintile 5 = smallest increases

Source: FERC Form 1, company reports, SNL, SSR analysis

We note that if a utility’s expense from accelerated depreciation exceeds their taxable income and they are generating net operating losses (NOLs) for tax purposes, the IRS has ruled that the NOLs must be recognized by regulators as regulatory assets and included in rate base. Therefore, utilities that are in such a situation would see their rate base grow a bit faster than we forecast. However, at this time it is difficult to estimate which utilities will be in such a situation so we have not included this in our forecasts.

Regulated Utilities and the Possible Loss of the Tax Deduction for Interest

Under the Trump tax plan, firms engaged in manufacturing in the U.S. may elect to expense capital investment; if they do so, however, they lose the deductibility of corporate interest expense. The House GOP tax plan does not offer corporate taxpayers an option: it would require capital expenditures to be expensed immediately, and would eliminate the deductibility of interest on all future loans. With interest on new loans no longer tax deductible, the gradual amortization of existing debt would result over time in the phase out the deductibility of interest for U.S. corporations.

For heavily leveraged U.S. utilities, a tax system that disallows the deductibility of interest expense (either immediately, as the Trump tax plan would seem to do, or over time, as the House tax plan proposes) would have a material impact on utility rates. On average, U.S. utility regulators permit utilities to fund ~50% of their investment in rate base with equity; the remainder is usually funded with debt. The average rate of interest on the outstanding debt of U.S. electric utilities is approximately 4.5%. Thus, as a numerical example, a utility with a rate base of $1 billion would fund $500 million of it with debt, on which it would incur $22.5 million of annual interest expense. At today’s corporate tax rate of 35%, the deductibility of this interest expense reduces the utility’s income tax expense, and thus the revenue it is required to recover from ratepayers, by $8 million annually.

In return for giving up this deduction, utilities would be allowed to expense their capital expenditures in the year in which they are incurred. Today, with 50% bonus depreciation, half of capex is expensed immediately and the remainder is expensed as depreciation over the life of the asset. Given IRS rules requiring tax normalization, utilities are not allowed to pass through to ratepayers the year one tax savings from 50% bonus depreciation or 100% expensing of capex; rather, for purposes of setting their customer rates, utilities must calculate their taxable incomes and income tax expense based on depreciating their plant in service over its useful life. As explained above, this mismatch between regulatory and tax accounting gives rises to an increase in utilities’ deferred tax liability when a new asset is placed in service. Because this deferred tax liability largely represents income taxes expensed but not yet paid, and thus does not represent an outlay of capital, regulated utilities are not allowed to earn a return on the portion of their net PP&E that is funded by their deferred tax liability. Thus, the benefit to ratepayers of allowing 100% expensing of capex would be to increase utilities’ deferred tax liabilities and reduce the portion of rate base on which utilities are allowed to earn a return.

We can calculate the extent of this benefit using the numerical example begun above. Let us assume that our utility has net property, plant and equipment of $1 billion, that its portfolio of assets has an average useful life is 30 years; and that the average age of its assets is 15 years, so that the assets are 50% depreciated. Under these assumptions, net PP&E of $1 billion corresponds to gross PP&E of $2 billion and annual depreciation expense of approximately $60 million. If our utility, as is typical of U.S. electric utilities today, is expanding its rate base of $1 billion at ~6% p.a., it must invest some $120 million annually to do so, $60 million to offset depreciation expense and $60 million in growth capex. Under a tax code that would allow these capital expenditures to be 100% expensed in the year in which they are made, up from 50% bonus depreciation today, our utility would enjoy an incremental tax deduction of $60 million (50% of $120 million, reflecting the difference between 50% and 100% expensing of its annual capex). Given a corporate tax rate of 20%, this would give rise to incremental deferred taxes of some $12 million, on which the utility would not be allowed to earn a return. The weighted average cost of capital to U.S. utilities for rate making purposes, assuming no tax deduction for interest, can be estimated at 8.5%; the savings to ratepayers from this increase in deferred taxes would thus be only $1 million annually (8.5% x $12 million). By comparison, we calculated the lost benefit to rate payers from the non-deductibility of interest at some $8 million annually. The net cost to rate payers of the new tax regime would be ~$7 million annually, equivalent to 0.7% of rate base.

Under the House GOP plan the deductibility of interest expense would be phased out over time, as utilities gradually take on new loans (on which interest is not deductible) and repay old ones (on which it is). Given the long average life of utility debt, it is likely that under the House plan the phase out of the deductibility of interest would require a decade or more, materially mitigating its effect on rate payers. Nonetheless, the cost would be recoverable by regulated utilities and its impact on customer rates could be large enough as to cause concern among regulators and rate payer advocates, likely increasing opposition to utilities’ requests for rate relief until it is phased in.

The Trump tax plan allows, but does not require, utilities to expense capital expenditures and forgo the tax deduction of interest. Given the option, we would expect utility managements to opt not to do so in the interest of keeping utility rates as low as possible.

The Impact of Tax Reform on Utility Cash Flow

The proposed changes in corporate tax rates and the deductibility of capital expenditures will not only affect utilities’ deferred tax liabilities and thus the pace of growth in rate base; they will also have a material impact on utilities after-tax cash flow and thus on their capital needs.

For companies as capital intensive as electric utilities, where capital expenditures can be twice the size of pre-tax income, the impact of tax reforms on cash flow is a function primarily of the interplay of tax rates and the deductibility of capital expenditures. Under the current tax code, with 50% bonus depreciation and a 35% corporate tax rate, utilities can deduct half of their annual capex and reduce their taxes by 35% of this amount. The net tax reduction is equivalent to ~17.5% of a utility’s capital expenditures for the year. If 50% bonus depreciation is maintained but the corporate tax rate is cut to 20%, the net tax reduction is reduced to 10% of capex per year; at a 15% tax rate, it falls to 7.5%. The impact of lower tax rates on utility cash flow is therefore often negative.

If utilities are allowed to expense capex in full, however, there may be cash flow benefit; the combination of full deductibility of capex and a 20% tax rate, as set out in the House GOP plan, would increase utilities’ tax deduction to 20% of capex from ~17.5% today. A combination of full deductibility of capex and a 15% tax rate would still affect utility cash flows adversely, reducing the annual tax benefit from capital expenditures from 17.5% of capex today to 15%.

In Exhibit 8, we have estimated for each of the publicly traded, regulated electric utilities in the U.S. what the cumulative impact on cash flow will be over 2017-2020 of various combinations of tax rates and the deductibility of capex, both in dollar terms and as a percentage of current market capitalization. In Exhibit 9, we provide a quintile ranking of the same companies, under the same combinations of tax rates and deductibility of investment, based upon the ratio of (i) cumulative change in cash flow over 2017-2020 to (ii) current market capitalization. As can be seen there, the utilities whose cash flow would be least adversely affected from a reduction in tax rates alone are ALE, CNP, D, GXP, IDA, NEE and WEC. Those whose cash flow would be most adversely affected by a cut in tax rates are AEP, EIX, ETR, EXC, FE, LNT and PNM.

If, however, a reduction in tax rates is combined with full deductibility of capital expenditures, the relative ranking of the utilities changes. Given a combination of a 20% tax rate and 100% expensing of capital expenditures, as proposed in the House GOP plan, the utilities whose cumulative cash flow over 2017-2020 would benefit most, as a percentage of current market cap, are AEE, EE, ETR, GXP, PNW, SCG, and SO. The utilities whose cumulative cash flow would benefit least are AGR, CNP, ED, ES, EXC, OGE and PEG.

The ranking changes again if 100% expensing of capital expenditures is combined with a 15% corporate tax rate. In that case, the utilities whose cumulative cash flow over 2017-2020 would be least affected, as a percentage of current market cap, are DTE, EE, GXP, IDA, NWE, SCG and SO. The utilities whose cumulative cash flow would be most adversely affected are AEP, EIX, ES, ETR, EXC, FE and LNT.

Exhibit 8: Change in Cumulative Cash Flow (2017-2020) Under Various Tax Scenarios

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Source: FERC Form 1, company reports, SNL, SSR analysis

Exhibit 9: Quintile Ranking on Cumulative Cash Flow Change over 2017-2020

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Source: FERC Form 1, company reports, SNL, SSR analysis

Appendix 1: Forecast Growth of Electric Rate Base Given Current Tax Code

SSR Forecast of Rate Base Growth by Utility, Updated to Reflect Managements’ Q4 Disclosures of Utilities’ Capital Expenditures Plans Over 2016-2020

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  1. Quintile 1 = fastest growth, Quintile 5 = slowest growth

Source: FERC Form 1, company reports, SNL, SSR analysis

©2016, 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. Rate-regulated utilities are allowed to recover their prudently incurred cost of service in rates, including all costs to procure fuel and purchased power, operation and maintenance expense, depreciation expense, income and other taxes, and a fair return on rate base. Rate base represents the capital invested by a rate-regulated utility monopoly in the supply of a public service (e.g., electricity or gas) and in the U.S. is roughly equivalent to the net depreciated historical value of the utility’s plant, property and equipment. Rate base may be funded by common and preferred equity, long term debt and net deferred tax liabilities. On the debt portion of rate base, utilities are generally allowed to earn a return equivalent to their embedded cost of long term debt. A similar approach is to taken the recovery of the cost of preferred equity. Because a utility’s deferred tax liability largely represents income taxes expensed but not yet paid, and thus does not represent an outlay of capital, regulated utilities are not allowed to earn a return on deferred taxes. As a result, rate base is generally calculated as the net depreciated historical cost of a utility’s property, plant and equipment net of the utility’s deferred tax liability. Finally, on the portion of rate base funded with equity (a proportion set by regulators at a level deemed adequate to sustain an investment grade rating on the utility’s long term debt, and referred to as the “equity ratio”) utilities are allowed to earn a fair return (the utility’s “allowed ROE”) as determined by regulators in periodic rate cases. Given this regulatory framework, it is common for investors to estimate future utility earnings as the product of rate base, the utility’s equity ratio and its allowed ROE.
  2. The rate of bonus depreciation will remain at 50% in 2017 before falling to 40% in 2018 and 30% in 2019. Under current tax law, bonus depreciation will cease altogether in 2020.
  3. Under normalization accounting, utilities do not pass through to ratepayers the tax benefits of accelerated depreciation during the early years of an asset’s life; rather, customer rates are calculated to recover the higher income tax expense recorded on the utility’s regulatory books, on which assets are depreciated over their useful life. In later years, when an asset is fully depreciated for tax purposes but continues to throw off depreciation expense for book purposes, the utility’s cash taxes will exceed the income tax expense calculated on its regulatory books. In these years, customer rates will fall below the level necessary to defray the utility’s cash taxes; in effect, the utility must return through these lower customer rates the cash it collected from its customers in excess of its cash tax liability during the early years of the assets life. If this future benefit to customers is reduced due to a reduction in the tax rate, a regulated utility cannot pocket the difference but must return any over-collection.
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