In his article, "Why Taxes Don't Distort Emissions Trading" (Dec. 1, 1994, p. 37), Michael Thomas suggests that utilities should flow through the proceeds of emission allowance sales to ratepayers in the year of sale. His idea is that utilities can eliminate any net effect on current income taxes by matching the increased revenue (emissions sales proceeds) against a revenue decrease (lower rates charged to customers). Slam dunk. End of story. Unfortunately, it's not so simple. The Thomas "wash" theory disregards ratemaking realities and the legislative intent of the Clean Air Act Amendments of 1990 (CAAA). It ignores the practicalities of allowance trading and fails to take account of the corrective tax legislation proposed by Allegheny Power System and the Chicago Board of Trade, and endorsed last year by the National Association of Regulatory Utility Commissioners.
The truth is that the federal tax system seriously interferes with the intended operation of the emission allowance market.
The CAAA created a unique system of transferable sulfur dioxide (SO2) "emission allowances." The legislative history shows clearly that Congress designed these allowances to facilitate over- and undercontrol strategies at those electric generating units forced to begin curtailing their SO2 emissions on January 1, 1995, (Phase 1) and January 1, 2000 (Phase 2). Some generating facilities can curtail their SO2 emissions much more economically than others, whether by fuel-switching, scrubbing, or otherwise. That premise found support in the many economic studies circulated in the Congress during the legislative debate. At those plants where emissions can be more economically curtailed, the theory was that owners could "overcontrol" emissions and sell their extra allowances to plants that found emissions reductions more expensive. The economic benefit presumably would be shared equitably between the two owners. As the CAAA worked its way through Congress, proponents of this market-based approach predicted dramatic savings from interutility transfers. None of the economic studies that flooded Congress at the time showed any income tax effect whatsoever; yet most of the hypothetical "trades" they projected would be negated by the huge tax bite now facing prospective sellers.
Emission allowances carry a vintage by year of first permissible use, but are otherwise basically equal in the hands of their owners. They originate from two principal sources. The so-called "Table A" allowances issue from the government to the owners of the 110 units listed in Table A of the CAAA. The other 3.5 million "extension and bonus allowances" go only to those plants that install "qualifying technology" (em that is, scrubbers. In both cases, the Internal Revenue Service (IRS) assigns a zero tax basis to the allowances in the hands of the original owners. Hence, all sale proceeds are fully taxable and subject to a substantial capital gains tax. Internal uses, including stockpiling of emissions allowances, do not trigger taxation. This fact favors internal use.
Some authors, and certainly the IRS, have likened the Table A allowances to a gift or grant by the government. Unfortunately, this perception has obscured the actual effect of the CAAA.
Prior to the start of Phase 1 on January 1, 1995, owners of affected facilities were free to emit SO2, subject to any other applicable federal, state, and local laws and regulations. After that date the permissible level of such emissions was effectively halved; emissions must be matched on an annual basis by presenting allowance certificates to the Environmental Protection Agency. During Phase 1, affected facilities receive an allowance quota approximating half of their baseline emissions. So it is quite in line with normal tax policy to characterize the Table A allowances not as a gift, but as partial compensation for a "taking" of property by the government.
Utilities can earn extension and bonus allowances by installing scrubbers, but this strategy calls for a significant upfront investment. Of course, as with any other type of capital expenditure, the taxpayer can depreciate the investment over a period of years. But since the installed scrubbers literally create the extra extension and bonus allowances, proper tax policy should allow taxpayers to match any revenues from sales of extension or bonus allowances against the associated installation costs. Current tax treatment puts the utility in an untenable position if it wants to sell these extra allowances soon after receiving them. That utility will incur a large capital gain tax, yet must wait many years to fully depreciate the entire installation cost.
Immediate flow-through also raises questions of intergenerational equity. For either type of allowance, immediate flow-through would cut rates only for the year of sale, while future ratepayers would still incur costs. Immediate flow-through would also create a serious "rate shock" during the second year, when rates would climb back up.
Allegheny Power System and the Chicago Board of Trade have advocated, and the National Association of Regulatory Utility Commissioners has endorsed, legislation to correct this problem. Together we propose to allow selling utilities the option of deferring taxation by applying allowance sale proceeds to reduce the tax basis of the capital investment incurred to reduce SO2 emissions. This proposal would lower the depreciation expense (and, hence, increase income taxes) in each subsequent year over the useful life of the asset. The proposal does not eliminate taxation. It merely defers it. To prevent utilities from "gaming" the system, the gain that qualifies for deferral would be offset by any amounts the taxpayer expends to purchase allowances within two years of the sale.
These arguments should override any tax rule that might otherwise dictate recognition of income when property is converted to cash. The proposal would help achieve the objectives of the CAAA, removing most tax considerations from the decision to use or sell allocated allowances. By writing down the basis of pollution control equipment over time, the proposal would defer tax on the sale transaction and make tax policy more consistent between the "sell" and "use" strategies.
Moreover, our proposal would also even out the year-to-year flow-through of allowance sales proceeds to ratepayers. Flowing through all allowance proceeds to ratepayers in the year of sale risks potentially wild swings in utility bills. No reason exists to think that allowance sales will come in roughly equal amounts over time. In fact, the public record reveals an episodic pattern of allowance sales.
Virtually all Phase 1 compliance activities are now complete. Nevertheless, any tax anomaly in allowance trading should be corrected so that Phase 2 compliance planning can proceed on a rational basis. If our proposal is implemented, the tax code will no longer penalize utilities that pursue an overcontrol strategy. Owners of affected facilities will then turn increasingly to the allowance market to comply with the Clean Air Act.
The author has been an active participant in Clean Air Act legislative and regulatory issues. He is the chief financial officer of Allegheny Power System, Inc., whose subsidiaries (Monongahela Power Company, The Potomac Edison Company and West Penn Power Company) are among the utilities most affected by the Clean Air Act Amendments of 1990. He also serves as chairman of the Allowance Pooling Group, comprised of the utilities who held the 3.5 million extension and bonus allowances enacted by the Act.
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