Thursday, January 7, 2016

#TBT: Financing Pollution Control

This post is part of an occasional series highlighting a project finance article or news item from the past. It is often interesting and thought provoking to look back on these items with the perspective of months, years or decades of further experience. 

With this installment, we turn to an article that was published in the October 2005 issue of the Project Finance NewsWire featuring Keith Martin, a partner in Chadbourne's Project Finance group.

Financing Pollution Control

Any power company planning to install new pollution control equipment should consider whether it is possible to get the US government to pay part of the cost.

US power companies are expected to have to spend between $40 and $60 billion on additional pollution control between now and 2015 to comply with rules announced this past year by the US Environmental Protection Agency to reduce three pollutants. The new rules require reductions in sulfur dioxide, nitrogen oxide and mercury emissions from power plants by as much as 70% between now and 2018.

If, as expected, the United States also eventually takes steps to reduce greenhouse gas emissions from power plants, then the cost will be much more.

The US government pays part of the capital cost of new pollution control through tax subsidies. The tax benefits can cover as much as half the capital cost.

One problem with tax subsidies is that they are sometimes a challenge to use. US utilities and other companies in capital-intensive industries often lack the tax base to use them effectively because of the tax depreciation and other benefits to which they are already entitled from past investments.

This article explains the various tax subsidies that a power company might tap to bring down the cost of pollution control. Broadly speaking, there are four. It also discusses how to share in the value indirectly if the company is not in a position to use them effectively because of an inadequate tax base.

Rapid Depreciation

The first step is to figure out how rapidly the new pollution equipment can be depreciated for tax purposes. The faster the cost of equipment can be written off, the greater the tax savings from the depreciation deductions on a time-value basis.

Most pollution control equipment is depreciated like the power plant to which it is attached.

Thus, equipment at power plants that burn biomass can be depreciated over five years using the 200% declining-balance method. That means that a larger share of the cost is deducted in the first two years than in each of the remaining years. Five-year depreciation is worth 29.8¢ per dollar of capital cost. That is the present value of the tax savings from the depreciation deductions for a company that is subject to a 35% tax rate; the calculation uses a 10% discount rate. "Biomass" for this purpose means all organic material -- for example, wood, manure, rice hulls -- but does not include coal, oil or gas or products of such fuels. The power plant must be a "qualifying small power production facility" for regulatory purposes. That means that it must be no more than 80 megawatts in size. It would be a good idea for the plant owner to certify the plant as a "small power QF" with the Federal Energy Regulatory Commission. The plant must burn biomass directly rather than gasifying it or converting it to some other form of "synthetic fuel" before use as fuel.

Other power plants are depreciated over seven, 15 or 20 years depending on the fuel and whether the electricity is primarily for sale to third parties or is used by the power plant owner to power his or her own factory. Depreciation over seven years is worth 27.8¢ per dollar of capital cost. Seven-year depreciation is available for pollution control equipment at power plants that burn refuse or other solid waste. Depreciation over 15 years is worth 19.9¢ per dollar of capital cost. It applies to simple-cycle gas-fired power plants and to plants at factories that generate electricity for use by the factory. Depreciation over 20 years is worth 17¢ per dollar of capital cost. Combined-cycle power plants and plants that burn coal are depreciated over 20 years.

The next step is to figure out whether it is possible to write off the cost faster than the rate at which the power plant is depreciated.

This might be true in two situations.

One is where the pollution control equipment can be amortized separately on a straight-line basis over either 60 or 84 months under special rules in section 169 of the US tax code. "Straight-line" amortization means the cost is deducted in equal amounts each month during the period. Amortization over 60 months is worth 27.3¢ or 24.6¢ per dollar of capital cost, depending on whether the equipment is added to a simple-cycle gas-fired power plant or to a coal plant or combined-cycle gas plant. The amortization is worth the most at a simple-cycle gas plant. The amortization is worth 23.2¢ per dollar of capital cost if taken over 84 months.

Pollution control equipment can be amortized over 60 months only if installed at a power plant that was in operation before 1976. Both air and water pollution control equipment qualifies.

Amortization over 84 months is available at newer power plants, but only for coal-fired power plants and then only for equipment that controls air pollution. The plant must be "primarily" fueled by coal, and the pollution control equipment must be new equipment that was acquired after April 11, 2005.

Equipment does not have necessarily to trap pollution at the back end of the power plant. Equipment at the front end that prevents pollution also qualifies, but if the equipment has multiple functions, then the cost must be allocated between pollution control and other functions, and only the cost allocated to pollution control can be written off over 60 or 84 months.

There are three other hoops through which a power company must jump before it can claim rapid amortization.

First, both the state and federal environmental agencies must certify that the equipment complies with their environmental standards. (A taxpayer argued in court in 1978 that it was entitled to rapid amortization even though it failed to get its pollution control properly certified. The US Tax Court said no.) Second, the equipment cannot significantly "increase the output or capacity, extend the useful life, or reduce the total operating costs of the plant" or "any unit thereof" or alter the nature of the production process. Finally, the Environmental Protection Agency -- one of the two environmental agencies that must certify the project -- cannot certify it "to the extent" that the plant owner will recover the cost of the pollution control through recovery of wastes -- for example, by using ash for paving roads.

Only part of the cost qualifies for rapid amortization -- 80% at most -- and it is only 60% for pollution control at a combined-cycle gas plant or coal-fired power plant. The remaining cost is depreciated normally. Thus, for example, 60% of the cost of pollution control at a new coal-fired power plant might be amortized over 84 months, while the remaining 40% of the cost is depreciated over 20 years.

The other situation where it may be possible to write off the cost faster than the rate at which the power plant is depreciated is where the equipment can be depreciated separately. That may be true where the equipment recovers usable material -- in addition to trapping pollutants -- or where it is owned by a separate company that either leases the equipment to the power plant owner or uses it to provide services in a pollution control business for hire.

Ordinarily, the way US tax depreciation allowances work, a company must decide what business it is in, and then most of its assets are depreciated over the same period. The Internal Revenue Service publishes tables that show the depreciation periods for different industries.

However, certain equipment can be depreciated separately. This is true of equipment that qualifies as a "waste reduction and resource recovery plant." The limits of what qualifies are unclear. Pollution control is most likely to fit under this heading if it is at a coal-fired power plant and is used for "material recovery," meaning that it not only traps pollutants, but also recovers usable material from them. However, there is also room for argument that mere waste reduction is enough. The IRS description of what qualifies mentions equipment used for "ash handling." Regardless, the equipment must trap "solid waste." Therefore, equipment to deal with waste gases does not qualify. Qualifying equipment can be depreciated over seven years using the 200% declining-balance method. The tax savings from this depreciation are worth 27.8¢ per dollar of capital cost.

Another way to get faster depreciation for pollution control equipment than the depreciable life of the power plant is to have a third party own the equipment and use it in a pollution control business. It would either lease the equipment to the power company or use it under contract to provide pollution control services. The equipment should be depreciable in such cases over seven years. However, the challenge is to find a way to structure the arrangement so that the lease or service contract is respected for tax purposes. The IRS might recharacterize the arrangement as something else. This challenge in discussed in more detail below.

Other Possibilities

Some power companies may be able to get money back from the US government that they paid in taxes as far back as 1998 to cover part of the cost of new pollution control. A massive energy bill that President Bush signed on August 8 lets any power company that had tax losses in 2003, 2004 or 2005 use the losses in one of the years to get a refund of federal income taxes that the company paid within the five years before the loss year.

An election to do this must be made between 2006 and 2008.

The company must spend the money on pollution control (or electric transmission assets). It can only elect to carry back losses equal to 20% of the amount it spent on such property the year before the election is made. The refund must be spent on property that the taxpayer will own.

Some pollution control equipment can be financed at reduced interest rates with tax-exempt debt. State and local governments can finance roads, schools, hospitals and other public facilities -- including municipal power plants -- using tax-exempt bonds. Private projects are ordinarily not supposed to be financed in this manner. However, Congress made exceptions for 15 types of projects that it considers quasi-public in the sense that they provide some public benefit. One of the 15 is "solid waste disposal facilities." Power plants that burn solid waste fit in this category; tax-exempt financing can be used to pay for the cost of equipment through the stage at which the plant produces its first marketable product. Pollution control equipment to trap ash and other solids at the back end of a coal-fired power plant also qualifies. It is not uncommon to see 20% to 25% of the cost of such a power plant paid with such financing.

There is a tradeoff. Equipment financed with tax-exempt debt must be depreciated more slowly -- on a straight-line basis over a longer "class life." It is a math exercise to determine whether the savings on interest costs are worth the loss of tax savings from having to use slower depreciation. A rough rule of thumb is that the tax-exempt interest rate must be at least 100 basis points less than the taxable rate to make the tradeoff worthwhile. However, there is no tradeoff to the extent pollution control equipment qualifies for rapid amortization over 60 or 84 months.

Each state has a limited capacity to issue tax-exempt debt to finance private projects. The developer must secure an allocation of scarce "volume cap." States are limited to $75 times population or $225 million a year.

It may also be possible to claim a federal tax credit -- in addition to rapid depreciation or amortization -- by tackling pollution control at the front end before the fuel is burned. This applies only to coal-fired power plants. Either an existing coal plant would have to be retrofitted or a new plant built. They would have to use an "advanced" technology for burning coal. The tax credit is 15% of the capital cost of the new equipment installed. To be considered an "advanced" technology, the project must have a design net heat rate of 8,350 Btus/kWh with 40% efficiency of energy conversion. (A majority of the energy in fuel is lost as the fuel is converted into electricity.) The plant must also be designed to meet certain pollution standards, including 99% removal of sulfur dioxide and 90% removal of mercury. The US tax code describes a series of assumptions that should be made in calculating the heat rate.

The IRS must certify that a project qualifies. The fuel must be at least 75% coal. The plant must have a nameplate capacity of at least 400 megawatts. No more than $500 million in total tax credits can be taken nationwide for advanced coal projects; the IRS will have to allocate the credits among competing applicants.

The "basis" used to calculate depreciation on the power plant must be reduced by 15%. In other words, in cases where a tax credit is claimed, only 85% of project cost could be depreciated.

Structured Finance

Not all power companies are in a position to use tax subsidies. Any company in this position should consider whether it would do better to have a third party that can use the tax breaks own the pollution control equipment and share the benefit in the rent it charges for use of the equipment or the fees it charges for contract services to control pollution at the plant.

Even if the power company can use the tax breaks, a third party owning the equipment can probably get a faster tax writeoff for it -- depreciation over seven years using the 150% declining-balance method -- while the power company would be stuck in many cases using 15-year or 20-year depreciation. The difference is worth another 8¢ to 11¢ per dollar of capital cost in additional tax subsidy.

Both approaches present special challenges.

The "lease" of the pollution control equipment might not be viewed as a real lease by the IRS. That would prevent the third party from claiming the tax depreciation. This is a problem in any case where the IRS considers the equipment "limited use property," meaning that it is like a chimney on a factory. It is hard to see the third party having any ability in practice to remove the equipment at the end of the lease. Concerns about limited use property are more likely to be an impediment to leases of pollution control equipment at coal-fired power plants than at gas-fired plants, since the scrubbers, baghouses, electrostatic precipitators and other equipment used to control coal emissions are more likely to be custom designed and constructed.

The reason the IRS has a problem with leases of limited use property is it believes the lessor is a hostage of the lessee. The lessor has no other use for the equipment than to leave it in place at the lessee's plant, with the result that the equipment will be used in practice for its entire economic life by the lessee. Pollution control leases compound this likelihood. The power company cannot operate its plant without the equipment, which tends to compel it to buy the equipment at the end of the lease if given an option to do so. The IRS has trouble with leases where the lessee is certain to end up with the equipment at the end of the lease term.

Another hurdle to overcome is that the lessor must expect a meaningful "residual" interest in the equipment after the lease ends. It may be hard to show such a residual if there is no market -- including no rental market -- in used equipment.

An alternative is to have the third party own the equipment but use it to provide services to the power company. The special challenge in that case is to show how the "service contract" differs from a situation where the power company is using the equipment itself to provide the services (in which case the power company would probably be viewed as the owner). Section 7701(e) of the US tax code has a list of six factors that the IRS uses to evaluate purported service contracts. The challenge is difficult, but probably not insurmountable.

The third party would need to finance the equipment. A lender will think hard about how it can realize on the collateral if the third party defaults. There is not much of a market in used pollution control equipment, and the lender may not want to put the power plant out of compliance with its air or water permits. Also, loan documents usually require that any "improvements" to the power plant must become part of the collateral package for the debt secured by the power plant. A bank lending to a third party that will own just the pollution control equipment would be wise to get the power plant lenders to acknowledge that the pollution control is not part of the collateral for their loan.

Another structure that has potential, but that is complicated to implement, is to have the power company admit the third party as a partner in an entity that owns the power plant. The third party contributes the capital cost for the new pollution control equipment. It is allocated the tax depreciation from it and an amount in taxable income and cash that corresponds to what it would have received from a long-term lease of the equipment to the power company. However, partnerships are not the same thing as direct ownership of the pollution control equipment by the third party. The third party would also have an interest, as a partner, in the power plant.