by Roger Feldman -- Bingham, Dana and Gould, P.C.
Most private power players, other than those involved with renewable and waste fuels have not been required to focus on the tax exempt finance dynamics which tilt the competitive financeability of projects and therefore collaterally impact the competitive power market in ways having little to do with energy policy. By contrast, public power proponents, rooted in their tax exemption, have been much more sensitive to the extent to which deregulation and the introduction of competition may affect their hold on traditional markets. The increased amount of public outsourcing of services and efforts to securitize the resulting cash flow as a basis to facilitate project development has sharpened the interest of power privateers in the rules governing the public market. "Privatization" in the form of finance of long term outsourcing has become increasingly popular in many utility service fields.
The overall issue recently achieved some public attention with the publication by the IRS of guidance on the governmental issuance of debt for "output facilities" and to nongovernmental persons engaged in the "local furnishing" of power or gas utilizing tax exempt debt. Stated very broadly and in non-technical terms, the IRS Rules (TD 8757, 26 CFR Part 1) are intended to advise when the issuance of bonds by a governmental body to finance governmentally owned facilities producing fungible commodities like electric power-- "output facilities"-- are taxable, because of the involvement in the overall transaction of private parties. That can occur when the sales from that facility to (or uses of that transmission system by) a private party are such the "benefits and burdens" of the facility are transferred to a private party. This can occur even if ownership is not transferred to the private party, where the private use of output is on a different basis than it is for the general public and/or where long term private payment for a portion of the output is more or less certain. In other words, if the tests are "met", the bonds are taxable.
The IRS (naturally) wants to restrict the uses of tax exempt debt, i.e. see the tests "met". "Take or pay" or "take" contracts have been deemed to meet the test since 1994, with resultant bars to use of tax exempt finance. In the new Rules, certain types of "requirements contracts" by a private party to take all or part of its requirements from a government financed facility are exempted, but only when and to the extent it is not substantially certain that all output available under a contract will be taken. For example, a retail requirements contract will not meet the benefits and burden standard, so that government bonds are tax exempt, unless substantial private termination payments are built into the contract. Note, however, that the benefits and burdens test is also deemed met by any output contract in which private purchase obligations effectively are pledged as part of the security for the bonds issued to finance the facility.
The output facility rules are complex regulations which apply as well, under separate carefully crafted provisions, to transmission facilities; power swapping and pooling; and excess generation capacity resulting from the creation by deregulation of excess capacity at a facility. Public power has hailed the rules as a "welcome relief," i.e. California munis will be able to join the State ISO without jeopardizing their tax exempt debt. But they do not appear to have been developed with a view to facilitating the kinds of creative transactions which may be necessary to save whole segments of public power through restructuring to make feasible optimum utilization of plants and transmission in a competitive environment; or to accommodate the full scope of types of transactions in which power marketers can engage. Puzzling out the complexities of this seemingly straightforward and deregulation-accommodating rule should therefore be one of the requirements for future development activities which private power must either "take or pay."
ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years. In particular, he has analyzed and executed a wide variety and substantial value of project financings. He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration. He is a graduate of Brown University, Yale Law School and Harvard Business School.