Comments on §141 Related to Output Facilities

Section of Taxation
Committee Comment: Tax Exempt Financing

COMMENTS ON REGULATIONS UNDER SECTION 141
OF THE CODE AS THEY RELATE TO OUTPUT FACILITIES

MEASUREMENT OF PRIVATE USE OF GENERATION

We applaud the return to the bright line test of nameplate capacity, because a test which can be applied with certainty is essential where the limitations on private use are as restrictive as they are in the case of output facilities. We believe, however, that the provisions of the Temporary Regulations relating to facilities with a limited source of supply and measuring use with respect to reserved capacity are inconsistent with this approach, as well as unwise and unnecessary, as discussed below.

Facilities Acquired or Constructed Primarily for Use by Private Business Users

We think the return to the 30 percent standard is appropriate for purposes of determining when a basis other than nameplate should be used to measure the output of a facility.¹⁸

This provision specifies that reasonable expectations on the "issue date" control the determination. The issue date refers to "the issue date of the bonds that finance the unit." Thus, where subsequent experience differs from expectations, issue date expectations can be relied on, and a deviation from expectations would not affect the test because it would not be a deliberate act. The Temporary Regulations are ambiguous, however, as to whether the expectations must be retested in the event of a second issue for the same project, a refunding, or a subsequent financing of improvements. If, as seems likely, "bonds that finance the unit" includes second issues and refunding or improvement bonds, it appears that a retest would be required. We do not believe such a retest should be necessary. See "Time for Applying Tests—Effect of Involuntary Changes."

The title of this provision, "Facilities Acquired or Constructed Primarily for Use by Business Users," is largely unrelated to the substance of the provision.

Facilities with a Limited Source of Supply

This provision appears to cover the same subject covered by the 30 percent rule discussed immediately above, except that there is no limitation to the application of the rule. Theoretically the rule would apply if an operator of a gas fired turbine knew that its output would occasionally be briefly constrained by limits on the supply of gas in periods of peak demand. We think the rule should be limited to cases where it is obvious that the output will be constrained and see no reason to use a different approach than that applied in the 30 percent rule. Thus, we would eliminate this rule as redundant.¹⁹

This rule also raises questions as to when it should be applied. It provides that, if a limited source of supply constrains the output of a facility, the number of units to be produced must be determined by "reasonably taking into account" those constraints, but the rule does not specify when. For example, the output of a hydro-electric facility "must be determined by reference to the reasonably expected" flow of water through the facility. Presumably the pertinent expectations are those at the time of the financing, although the reference could be to the time any contract for sale is entered into. That would add undesirable complexity since expectations would likely change year to year, so that contracts entered into in different years could have different available output.

If a contract is entered into and subsequently the supply of water is less than reasonably anticipated, the contract could turn out to have exceeded the permissible amount of actual capacity. Presumably, however, that would not be by reason of an intentional act of the issuer. Nonetheless, in the event of a refunding, it could be apparent that, on the basis of actual events, the contract was going to involve too large a sale. We suggest the expectation at the date of issue as to the amount of output should not have to be retested. See "Time for Applying Tests—Effect of Involuntary Changes."

Reserved Capacity Rule

The Temporary Regulations provide that, if an output contract results in private business use under this section, "the amount of private business use generally is the capacity that must be reserved for the non-governmental person under prudent reliability standards." The rule appears to be a "back door" repeal of the relevance of nameplate. The rule can apply in various different types of situations. The first is illustrated by the example of a peaking unit where 100 percent of the capacity must be reserved to provide 10 percent of the available output based on nameplate. In this context, the rule appears to serve the same function as the 30 percent rule.

This aspect of the rule would also apparently reverse the result of PLR 8327090 (Apr. 8, 1983). There, the private purchaser was to take 37 1/2 percent of actual output but not more than 25 percent of nameplate. The ruling confirmed that power actually taken divided by nameplate, rather than 37 1/2 percent of actual output, was the standard for purposes of the Subparagraph 5 Regulations. Under the Temporary Regulations, it appears an issuer would be required to determine the amount of capacity that would have to be reserved to deliver 25 percent of nameplate, which would be some number other than either 25 or 37 1/2. There is no guidance other than prudent utility practice (on which opinions may differ) for determining how this should be done. It is not a standard which provides the requisite precision for measuring private use under a law that imposes very strict and precise restrictions on such use.

A second application of the rule arises where an MOU sells a specified amount of capacity and energy and is required by regulatory authorities or an entity such as a power pool to maintain reserves in a multiple of that amount. For example, an MOU selling 10 megawatts ("MW") would be required in some states to maintain reserves equal to one hundred fifteen percent of the amount sold, or 11.5 MW. (On the other hand, an MOU selling 10 MW from a specific facility if produced would only have to reserve the 10 MW.)

The additional 1.5 MW reserve requirement above has nothing to do with the output of a particular facility. It need not even be from any facility owned by the MOU if the MOU has contractual rights to such capacity. Moreover, the reserve requirement would be subject to change over time. If the Temporary Regulations are intended to apply to this situation, the regulations would have to address when the requirement is to be determined: when original bonds are issued, when a particular contract is signed, or when bonds are refunded. Further, there may be additional complexities because the same reserve may serve different purchasers at different times where the purchasers have different daily or seasonal peak loads. See "Time for Applying Tests—Effect of Involuntary Changes."

The rule may also apply in another and different way. Increasingly, utilities are engaging in sales of energy or capacity that are "financially firm."²⁰ These transactions are desirable for utilities in part because they do not require that any capacity be reserved. If the touchstone of private use is reserved capacity, these "financially firm" transactions should not be treated as private use. The Temporary Regulations are currently unclear on this point because they provide only that reserved capacity "generally" is the measure of private use. If reserved capacity is indeed the touchstone of private use, the term "generally" should be removed.

Additionally, we think the requirement that reserved capacity be put into the numerator but not the denominator will often result in an overstatement of private use.

On balance, there is a tremendous amount of mischief and complexity in the Temporary Regulations approach to measurement of private use of generation. Whether or not it is conceptually better than the prior regulations, it will add problems entirely out of proportion to the benefit. The regulations should return to prior law.

In any event, this provision should be excluded from any requirement that the Temporary Regulations be elected in whole.

Time for Applying Tests—Effect of Involuntary Changes

A number of provisions in the Temporary Regulations raise questions as to when a particular test is to be applied and whether there are subsequent events that necessitate reapplication of the test. These include the facts and circumstances approach to requirements contracts, the determination of the actual output of a facility, the determination as to the effect of constraints in supply, and the determination of the amount of reserves that must be allocated to a contract. Generally, we have been critical of these rules in part because of uncertainty in their application generally. If the rules are retained, however, a determination needs to be made as to the occasion(s) on which they are to be applied.

Obviously these rules should be applied at the time of the initial financing of a project.²¹ If the issuer is required to reapply the tests to subsequent financings or refinancings with respect to the project, the only new facts taken into account should be those that arise from deliberate acts of the issuer; changes in facts over which the issues has no control, such as an increase in the stability of a requirements purchaser customer base, a change in energy available to a plant, or a deviation from the reasonably determined actual output should be ignored. We have considered whether involuntary revisions to original facts should be taken into account as to any refundings that extend maturity or increase the amount of the borrowing (advance refundings), but think that the 120 percent limit on maturity, together with the fact that output facility bonds are generally revenue bonds and must be repaid during the economic life of the project, are sufficient limitations on maturities, and that the Congressional limitations on the number of tax-exempt advance refundings are a sufficient restraint on such refundings.

COMMENTS REGARDING $15,000,000 LIMITATION

Nonqualified Amount

The Temporary Regulations base the application of the $15,000,000 limitation on the "nonqualified amount"²² but do not define "nonqualified amount." The 1994 Proposed Regulations provided that the nonqualified amount is to be determined by reference to "sale proceeds," thus making clear that investment earnings need not be taken into account. The Temporary Regulations refer to "sale proceeds" for purposes of the payment test but simply to "proceeds" for purposes of the use test. Under section 1.141-1, the term "proceeds" includes investment earnings during the project period. It is inappropriate to use a different base for the two tests. As a practical matter, it would be impossible to apply the rule to include investment earnings on old issues at this stage. We believe the references should be consistent and to "sale proceeds."

Definition of "Project"

Multiple Units. The Temporary Regulations provide that, where multiple generating units are constructed at the same site, such units are not part of the same project only if one unit is reasonably expected, on the date of each issue that finances the project, to be placed in service more than three years before the other unit.²³ We believe it should be sufficient if the units are placed in service more than a year apart.

The Temporary Regulations provide that, where a multiple unit station is under construction, all costs of common facilities that are incurred before the earlier of the issue date of bonds that finance the second unit and the commencement of construction of the second unit are allocated to the first unit. This provision may be circular, since when the bonds are issued or construction commences may depend on which costs are allocated to the second unit. Moreover, the Temporary Regulations require a precision that is not necessary. A requirement that an allocation be reasonable should be sufficient. The regulations could clarify that an allocation of costs to the second unit generally is not reasonable if the decision has not been made to construct the second unit.

The Temporary Regulations provide that a peaking unit and a baseload unit generally are not part of the same project. The regulations should be clarified to state that this is the case even though the two units are located in the same place and placed in service less than three years (or one year if our prior suggestion is adopted) apart.

Improvements. The Temporary Regulations provide than an improvement that is not part of the original design is not part of the same project if commenced more than three years after the original project was placed in service and if the bonds issued to finance²⁴ that improvement are issued more than three years after the original project was placed in service. The regulations should clarify whether there is any substantive requirement intended by the use of the term "improvement," (as opposed to a term such as "addition") and if so what it is. We suggest it is enough that the item was not a part of the original design. We also believe the requirement that the issuance of the bonds as well as the commencement of the project be 3 years after the in-service date of the facility is unnecessarily redundant.

Replacements. With respect to replacement property, the Temporary Regulations require that the bonds issued to finance the replaced property have a weighted average maturity that is not greater than 120 percent of the reasonably expected economic life of the property being financed. It is highly unusual to allocate bonds that finance a large generating unit to specific assets. Because level debt service financings have low principal amortization in the early years, it may be difficult to allocate specific bonds to specific replaced items. We think the requirements for repairs that relate to the unexpected nature of the repairs serve the same purpose, and that the requirement with respect to the weighted average maturity of the bonds should relate to the facility as a whole.

COMMENTS REGARDING ALLOCATION OF OUTPUT TO FACILITIES AND PORTIONS THEREOF

While Temporary Regulation section 1.141-7T(g) contain rules for determining whether output sold under an output contract is allocated to a particular facility or to the entire system of the seller of that output, additional clarification is needed in several respects.

System Allocations

Allocation to Particular Units. Under the section 1.141-7T(g) rules, certain sales of output may be allocated to the system of the seller. It is not clear whether such sales must be allocated pro-rata to all units within the system or may still be allocated to particular units. Thus, where a seller has multiple units within its entire system, some of which are bond financed and some of which are not, the regulations should be clarified to permit the seller to allocate the sales to particular non-bond financed facilities within its system. This would be consistent with longstanding practice as well as with the example in Temporary Regulation section 1.141-8T(c). The possible implication in section 1.141-7T(g) that a "system allocation" requires a pro-rata allocation to all units within the system should be eliminated. Allocations to particular units should be permitted so long as the particular "nexus" rules contained in the Temporary Regulations (e.g., physical or operational factors) would not otherwise preclude an allocation to a particular equity-financed facility.

Example 3 of Section 1.141-7T(h) Should Be Clarified. In this example, contracts entered into in 1999 with four investor-owned utilities ("IOUs") under which the IOUs purchase all of the output of existing facilities are allocated to the municipal utility’s entire generating system, including a new facility funded with bonds in 2004 and to be constructed thereafter. As part of the financing plan for the new bonds, a fifth IOU agrees to take or pay for 15% of the output of the facility but to pay amounts equal to less than 10% of debt service. The balance of the output of the new facility will be available for sale as required, but initially it is not anticipated that there will be any need for that power. The example states that the balance of the debt service will be paid initially from revenues derived from the contracts with the four systems for sale of power produced by the old facilities. The example concludes that the output contracts with all the private utilities are allocated to the MOU’s entire generating system, citing section 1.141-7T(g)(1) and (2), but without specifying a reason.

Apparently the reason for the conclusion was that the contracts entered into in 1999 were a part of the common plan of financing for the new facility. This is unclear from the example, however, since the contracts were only for the output for the existing facilities, and there is no indication that they were entered into in contemplation of the financing five years in the future. Because the example does not connect the contracts to the financing, it has been read as standing for some kind of vague proposition that sales can never be safely allocated to specific facilities (such as equity financed facilities). The example should be clarified to indicate that the basis for the conclusion that the contracts should be allocated to the entire facilities is their connection to the future financing; if that is not the basis, the basis should be explained.

COMMENTS REGARDING TRANSMISSION FACILITIES

Transmission Facilities

Section 1.141-7T(b)(6) of the Temporary Regulations defines transmission facilities as follows:

Transmission facilities are facilities for the transmission or distribution of output. Transmission facilities include facilities necessary to provide ancillary services required to be offered as part of an open access transmission tariff under rules promulgated by FERC under Section 205 and 206 of the Federal Power Act.... Thus, if a facility also serves another function (for example, the facility provides for operating reserves for transmission and also provides generation), an allocable portion of the facility is treated as a transmission facility.

Thus, transmission is defined to include distribution, as well as facilities used to provide ancillary services, such as generation facilities used to provide voltage control and spinning reserves.

It should be noted that the inclusion of distribution facilities in the definition of "Transmission Facilities" does not mean they are used the same way or have the same private use as true transmission facilities. With some exceptions, the industry distinguishes between transmission and distribution: distribution involving lines generally carrying electricity at 69 kw or less. The lines are functionally different in that, once power enters the distribution system, it generally is not stepped back up to a higher voltage and used elsewhere.

The inclusion of facilities for ancillary services in the definition of transmission facilities is helpful, but only in so far as it sweeps into the grandfathering rules for open access all of the facilities providing ancillary services that might be used in open access, thereby eliminating a lot of questions that might otherwise bedevil facilities financed with existing bonds. Outside of the grandfathering context, however, the treatment of facilities providing ancillary services as transmission facilities creates so many questions that we doubt it is worthwhile.

Under the Federal Power Act, ancillary services include:

Scheduling power, which includes general control centers and computer systems needed to control the flow of electricity through the wires.
Voltage control, which is provided by generating facilities to maintain the voltage on certain lines to permit usable power to flow on such lines.
Non-spinning and spinning reserves, both of which are provided by generation facilities to assure that if outages occur on scheduled power facilities that alternative sources of power are quickly available to avoid user outages.
Black start reserves, which are generating reserves which do not require electric energy to provide power to restart in the case of widespread power outages.

In a vertically integrated industry, ancillary services are part of the services needed to deliver power. Very little separate attention is paid to their cost because it becomes a calculated component of a charge for transmission only when transmission services are sold separately. In an open access environment, such as under an open transmission tariff under FERC Order 888 or where an independent system operator controls transmission, ancillary services are sold to the "grid" and the cost of such services becomes a component of the overall cost for transmission within a particular area.

As will be discussed below, the Temporary Regulations provide limited provisions for measuring the private use of transmission facilities. "Available Output" is defined as being determined on a reasonable basis, but there is no guidance as to how much of the available capacity is being used (unless it is to be found somewhere in the reserved capacity rule). Finally, there is little guidance as to how the private use, whatever it is, is to be allocated to particular facilities. As to the use of facilities which provide the ancillary services, there is no guidance at all beyond the definition of transmission which provides that transmission includes the "allocable portion" of facilities which provide ancillary services. How the "allocable portion" referred to in the Temporary Regulations is to be determined is far from apparent. If a private user is using some of the transmission facility pursuant to a transmission contract, it can be imagined that some part of the control center(s) (for scheduling services) is used, but how one allocates that use is not clear, other than perhaps as a percentage based on the total capacity of the entire T&D system. If the intent of the Temporary Regulations is that the use of the control center(s) is to be measured based on the private use of the entire T&D system, possibly on the basis of total megawatt hours, language or an example would be useful.

Measuring the private use of a generating facility that provides ancillary services is difficult. The nameplate rating on a generating facility indicates its total capacity and such capacity is the denominator in normal private use analysis. However, how the issuer adds the use created by a user of the transmission facility, because, for example, that generating facility also supplies spinning reserves or black start services is not at all clear. For example, many of the generating facilities in California will, in all likelihood, not be used for the delivery of power except during peak hours. However, the municipal utility may be paid by an ISO as a result of holding the facility as available to provide ancillary services. We think the simplest measure of use for these services may be to ignore nameplate concepts and focus on compensation for use. Often the payment for facilities held in reserve is equal only to the net operating cost of such facilities and does not include a capital component. In such case, presumably, private use should be considered to be zero and the regulations should so indicate. If the issuer receives a payment reflecting a portion of the capital cost of such facilities, perhaps the portion of the capital cost represented by the payment would be an appropriate measure. The problem with applying the traditional analysis is trying to compare apples and oranges, where a generating facility can both provide power based on its nameplate rating and also provide ancillary services.

In addition, the rule of section 1.141-3(g)(4)(iii) of the 1997 Final Regulations that simultaneous use of a facility causes the entire facility to be privately used cannot be applied. For example, if 100 percent of the ancillary services supplied by a generating facility are sold to an ISO (and such "use" is private use, see the discussion below), but produced power is sold to the MOU’s residential customers, the generating facility is clearly not 100 percent privately used. Even if a capital component is included in the charge for ancillary services, only a portion of the facility should be treated as privately used. The use of an allocation approach is essential. Although the Temporary Regulations imply such a result, the inclusion of an example seems appropriate. Because dollars generally are the only common denominator for measurement, the private use allocation should be based on the amount paid for capital as part of the ancillary service charge divided by the total capital charge for electricity.

Finally, the effect of excluding ancillary services provided by a generating capacity from the generation function needs to be reviewed. If treating a portion of generating capacity as involving a transmission function means that the available output of all generating properties used for that purpose must be recalculated for purposes of determining permissible sales of output other than for ancillary services going forward, substantial additional complexity would result not only from the recalculation process but from the unknowns involved in evaluating the amount of available output that is, in fact, devoted to ancillary services.

For the above reasons, we believe that while it is desirable to treat generating facilities providing ancillary services as part of transmission for purposes of the open access transition rules, such generating facilities should not be treated in whole or part as transmission facilities for any other purpose.

Transmission Contracts–Relationship of Firm Contracts to Requirement Contract Rules

Section 1.141-7T(c)(3)(ii) provides that firm transmission contracts are generally treated as take or take or pay contracts, so that such contracts generally give rise to private use. Because the Temporary Regulations provided that such contracts are take or take or pay contracts, they would seem to be excluded from the requirement contract rules. We believe the concepts involved regarding requirements contracts are as applicable to transmission as they are to generation, and that the same rules should apply to firm contracts for transmission of requirements as apply to generation of requirements. Otherwise a utility that could provide requirements service with its generating facilities might have no way to deliver the electricity.