Attorney Comments on Treasury Output Regulations

FROM: Glenn S. Miller

DATE November 10, 2003

RE: Overview of Purpose of November 12th Meeting With TRANSLink

[1] The purpose of this memorandum is to give you a brief overview of the purpose and goals of the meeting to be held between officials of the United States Department of the Treasury ("Treasury"), Commissioner Nora Brownell of the Federal Energy Regulatory Commission ("FERC"), TRANSLink Transmission Company, LLC, and certain bond lawyers representing public participants in TRANSLink. This memorandum is intended to be a summary only and should not be interpreted as a comprehensive discussion of tax issues affecting electrical deregulation.

[3] Due to the tax exempt bond financing of the transmission assets of a number of public utilities, it has been necessary for the Treasury to promulgate certain regulations contained in Treas. Reg. section 1.141-7 (the "Output Regulations") that, among other things, set forth the consequences of certain arrangements between ITCs and utilities holding bond-financed assets. The Output Regulations are generally thought to have been an effort by the Treasury to accommodate the interests of the FERC and other agencies of the Federal government in permitting deregulation of the electrical transmission grid to occur while preserving certain Treasury concerns about the private use of government-issued tax exempt bonds.

[4] The Output Regulations contain a safe-harbor consisting of four criteria that, if met, would allow RTO or ITC membership by public power companies that have issued tax-exempt debt and would allow these entities to issue future tax-exempt debt to finance expansion of their network. The four criteria are:

1. Operation of transmission lines by the independent entity must be approved by FERC;

2. The transmission lines must continue to be owned by a "governmental" person;

3. The independent entity cannot bear the risk of loss of transmission facilities owned by the government person; and

4. The independent entity's compensation must not be based on a share of "net profits" from the tax-exempt facilities.

Treas. Reg. section 1.141-7(g)(1)(ii).

II. The Role of TRANSLink

[5] TRANSLink will function as an ITC in accordance with FERC's independence rules, including FERC Order No. 2000.³ TRANSLink will participate in one or more RTOs, also in compliance with FERC Order No. 2000.

[6] TRANSLink has attempted to satisfy all of the criteria of the Output Regulations. First, TRANSLink's structure and purpose will have been approved by FERC prior to any electricity transmission, thereby satisfying criterion one. Second, the utility transmission owners ("Public Power Participants") will retain ownership of all of their transmission facilities. Their relationship with TRANSLink will be through operating agreements, with TRANSLink's sole role as that of exercising functional control over the transmission assets. Therefore, criterion two is satisfied.

[7] Third, the Public Power Participants will retain economic ownership of all transmission facilities managed by TRANSLink and will bear all risk of loss with respect to those transmission assets (with none of that risk being borne by TRANSLink). TRANSLink has no responsibility to reimburse the Public Power Participants in the event of a diminution in value or casualty loss with respect to the tax-exempt facilities. As described above, TRANSLink is purely a pass-through entity and absorbs no losses from the use of the tax- exempt facilities. Therefore, criterion three appears to be satisfied.

[8] Fourth, as a result of the design of TRANSLink's rate arrangements, TRANSLink will not share in any of the profits (or have a rate of return on the facilities under its control) resulting from the operation of the Public Power Participant transmission facilities, thus satisfying the fourth criterion. TRANSLink is not entitled to any margin between the amounts paid by ratepayers to TRANSLink for the use of transmission facilities owned by the Public Power Participants and the amount TRANSLink must pay to the Public Power Participants. TRANSLink, in effect, merely passes through amounts collected from the ratepayers. A component of the rates TRANSLink charges to the ratepayers will include a charge to reimburse TRANSLink for its administrative costs and overhead (without any additional markup or margin). Such charges are therefore paid by the ratepayers for services rendered to the ratepayers and not by the Public Power Participants.

III. Purpose of the Meeting

[9] Various bond lawyers have expressed concerns that the existing language of the Output Regulations may not be sufficiently broad to allow them to give "clean" bond opinions to their public utility clients that participation in the proposed TRASNLink structure (and similar ITC structures) will not adversely affect their tax exempt bonds.

[10] The purpose of the meeting is threefold, therefore:

[11] First, to allow Commissioner Brownell to explain FERC's position on ITCs and offer FERC support for a drafting of Output Regulations that are consistent with the FERC's deregulation goals. Commissioner Brownell may also express support for the TRANSLink model.

[12] Second, to allow bond lawyers from a number of firms to explain their concerns about the existing Output Regulations and suggest ways their concerns could be addressed. For instance, some of the bond lawyers have asked whether the Output Regulations would be violated if a public utility who's assets are managed by an ITC also was a shareholder of the ITC.

[13] Other bond lawyers have questioned how narrowly the term "risk of loss of transmission facilities" in the Output Regulations should be defined. Should the definition be limited to damage to or diminution in value of transmission lines or should it be interpreted to apply to economic loss due to ratepayer nonpayment? If, for example, a ratepayer fails to make a payment to an ITC, may that loss be absorbed by the ITC or must it be passed through to the public utility? Does this answer change if the loss was due to a billing mistake by the ITC? Finally, the question has arisen whether an ITC can share in gross profits (as opposed to "net profits") arising from a transmission facility under management.

[14] Third, to discuss the TRANSLink model as an example of a "FERC approved" ITC model and whether the TRANSLink model satisfies the Output Regulations.

²For example, in Order No. 2000, a January, 2000 rule that outlined FERC's support for the development of RTOs to manage the operation of large portions of the grid, FERC stated that "a properly formed RTO should include all transmission owners in a specific region, including municipals, cooperatives, Federal Power Marketing Agencies (PMAs), Tennessee Valley Authority and other state that RTOs formed either as for-profit transmission companies or not- for-profit independent system operators, FERC concluded that it would "not limit the flexibility of proposed structures or forms of organization for RTOs," noting that it was "prepared to accept a transco, ITC, hybrid form, or other form as long as the RTO meets our minimum characteristics and functions and other requirements." Order No. 2000 at 31,036. Accordingly, FERC was implicitly supportive of for-profit transmission providers participating in RTOs that were managed as either for-profit or not-for-profit entities. FERC's support for organizations that would include for-profit and not-for- profit entities was reaffirmed in a FERC rehearing order regarding TRANSLink last fall, in which FERC stated that "[W]e believe that successful RTO development must include public power and we are heartened by the fact that the TRANSLink proposal has attracted so much interest by public power participants." TRANSLink Rehearing Order at P. 26.

³Regional Transmission Organizations, Order No. 2000, 65 Fed. Reg. 809 (Jan. 6, 2000), III FERC Stats. & Regs. ¶ 31,089 [Regs. Preambles] (2000), order on reh'g, Order No. 2000-A, 65 Fed. Reg. 12,088 (Mar. 8, 2000), III FERC Stats. & Regs. ¶ 31,092 (2000), petitions for review pending sub nom. Public Util. Dist. No. 1 of Snohomish County v. FERC, Nos. 00-1174, et al. (D.C. Cir.).