NORTHERN STATES POWER DISAGREES WITH ALLOWING A RATE-BASE OFFSET DERIVED FROM A SEPARATE NONREGULATED ENTITY.

SUMMARY: Arne Sather, tax manager, Northern States Power Company, Minneapolis, has requested a reexamination of the position taken in the proposed normalization regulations that would permit a rate-base offset derived from a separate nonregulated entity. He further requests that such procedures be found in violation of the normalization provisions.

Northern States Power Company (NSP) a regulated public utility operating in the states of Michigan, Minnesota, North Dakota, South Dakota and Wisconsin submits the following comments regarding the proposed regulations dealing with indirect methods of understating the federal income tax cost of regulated utility operations.

NSP agrees with the comments of the Edison Electric Institute of which NSP is a member. To illustrate and reinforce the comments of the Edison Electric Institute, NSP offers the following company- specific comments that relate to typical events that have impacted the consolidated tax payments in past years.

To my knowledge, none of the regulatory authorities that govern the rates of NSP have ever proposed a tax expense to be included in cost of service that would be less than the actual tax expense resulting from the profit generated by the utility operations in their jurisdiction. Our rate commissions have always concluded that there is a direct relationship between the regulated operating profit and the current tax expense including the deferred tax that is traceable to accelerated depreciation. The following examples illustrate the possible tax consequences that could happen and the possible economic impacts.

1. Plant abandonment

In 1979, our Wisconsin subsidiary decided not to complete a power plant that was under construction. The abandonment loss of $70 million far exceeded the taxable income of that entity, creating a large net operating loss. The consolidated return did not show a loss because of the profits of other entities. As the estimate payments were made during 1979, the parent corporation paid the Wisconsin corporation the amount of consolidated tax savings caused by the abandonment loss. Similarly, when the 1979 return was filed the remaining tax reduction related to the loss was paid to the Wisconsin corporation.

In this situation, the regulated loss entity benefited from the ability of the commonly owned corporations to file a consolidated return. The benefit was strictly timing because sooner or later the Wisconsin corporation would have been able to use the net operating loss to offset other earnings. If, however, the federal income tax of the Minnesota corporation that was allowed as a cost of service for the year 1979 was limited to the actual consolidated tax paid to the government plus the required deferred tax related to accelerated depreciation, the rates collected from our Minnesota customers would have decreased by about $30 million. The $30 million decreased federal income tax only slightly less than the total of federal deferred income tax and investment tax credits that the Minnesota corporation recorded for the year 1979.

This direct tax expense reduction to the cost of service of the Minnesota entity by the use of a net operating loss incurred by the Wisconsin entity is prohibited by the proposed regulations. NSP agrees that this prohibition is correct and within the broad responsibility imposed upon the Treasury Department to implement the intent of the normalization provisions of the code. NSP does not agree that the regulations should be written so that the deferred tax of one entity can be used to offset the rate base of another entity.

Allowing for poetic license in the above example, please assume that the Wisconsin corporation could not immediately carryback the $70 million loss and could only recover the related tax benefit as a carryforward to future years. Assume further that the Public Service Commission treated the $30 million consolidated tax savings as cost- free capital for the purpose of reducing rates in Minnesota resulting in a $3 million rate reduction. In terms of cash flow the Wisconsin Corporation is out $40 million, $70 million loss less the $30 million tax benefit. The economic loss is real. The Wisconsin corporation now has $40 million less of retained earnings. The utility customers that would have used the plant if it had been built and the shareholders will share in this economic loss. The time value of money related to the consolidated return privilege has no relationship to the customers of the Minnesota company. The advantage of the tax savings relating to the abandonment loss belongs to the entity (its customers and shareholders) that is now out the $40 million.

There are three parties to a situation where a net operating loss produces a consolidated tax savings: first the entity that incurred the loss; second the federal government that allowed the consolidated return to decrease its tax revenue; and third the profitable corporation that created the income.

Going back to the power plant example, the Wisconsin corporation incurred the loss of $70 million, the federal government allowed the $30 million tax decrease and the Minnesota corporation made a profit and paid the tax related to its separate profit. But the customers of Minnesota did not give up anything. The shareholder equity that is used to determine rates in Minnesota is still intact. The current tax payment is the same. Instead of paying the federal government $30 million more, it paid the Wisconsin subsidiary the $30 million according to the same schedule of estimate and return payments as it would have if the loss had not occurred.

By use of the consolidated return, the Federal government gave up $30,000,000 in the year 1979 rather than over a period of years in the form of net operating loss carryforwards. Assuming the $30 million has a time value of $3 million, the federal government gave up the $3,000,000 time value of money by allowing a consolidated return but the Minnesota customer is neutral.

SUMMARY

Any procedure that misapplies the tax benefit to the detriment of the entity that generated the tax benefits and thereby reduces the ratepayer's obligation of a second entity to pay the current tax cost plus the required deferred tax related to accelerated depreciation is just another roundabout way of avoiding the normalization requirements of the code.

2. Nonregulated Subsidiary

Assume for the purpose of this example, XYZ Corporation, a wholly owned subsidiary of NSP, began operating a waste wood to energy plant for a paper manufacturer. The plant qualified for various tax credits and accelerated depreciation. The plant generated net operating losses for XYZ which reduced the consolidated tax liability. NSP paid XYZ the consolidated benefit in the form of cash payments equal to the tax savings generated by the tax credits and net operating losses.

The consolidated equity capital of NSP and XYZ is separated by the ratemaking process into shareholder capital that supports the needs of the regulated businesses and shareholder capital that supports the needs of nonregulated subsidiaries. Essential to this separation is the process that traces the deferred tax to the type of machinery investment that caused the tax deferral. Regulated deferred tax is traced to regulated machinery and nonregulated deferred tax is traced to nonregulated machinery. The investment in a power plant boiler less the deferred tax related to that boiler determines the "rate base", i.e., the net bondholder and shareholder equity on which the electric customer is obligated to pay a rate of return.

These proposed regulations would allow the investment in a power plant boiler less the deferred tax related to that boiler and also less the deferred tax related to the XYZ waste wood boiler to determine the net bondholder and shareholder equity on which the electric customer is obligated to pay a rate of return.

Clearly the portion of shareholder capital of the consolidated entity that is devoted to the regulated business and the portion of the shareholder capital that is devoted to the nonregulated business is kept separate in all phases of the ratemaking process through the use of rate base.

The reasoning given in the preamble to the proposed regulations states that "(c)onsolidated tax savings are similar to the deferred tax arising from the allowance of accelerated depreciation on public utility property." While this statement is true, the conclusion that ". . . it is not inconsistent with the normalization requirement for a regulatory commission to share the benefits of this cost-free capital with ratepayers through a reduction in the utility's capital costs reflected in its rates", does not follow. If rates can be reduced by the deferred tax benefits of property unrelated to the utility property considered in rate base, the normalization requirements can very easily be avoided.

The deferred tax related to accumulated depreciation on the power plant boiler is a proper offset to rate base because the customer paid that deferred tax through rates. The deferred tax related to the XYZ waste wood boiler is not a proper offset to the utility rate base because XYZ's separate shareholders built the waste wood boiler, incurred the separate risk and losses and XYZ's shareholders are entitled to the tax law incentives that Congress has created specifically to encourage investments in property like the waste wood boiler.

SUMMARY

NSP Minnesota ratepayers and the ratepayers of the Wisconsin company have separate interests, separate financial statements, separate rate determinations, separate depreciation calculations for financial accounting and tax accounting purposes, and separate tracings of deferred taxes. The fact that a consolidated return is filed is not a reason to mix and match the tax benefits between entities in a manner that inappropriately reduces the rates.

Similarly the XYZ Corporation has separate operations and tax benefits. It is just as inappropriate to mix and match the separate tax benefits of NSP and XYZ as it is to inappropriately apply the tax benefits of NSP and the Wisconsin Company. XYZ if you will has its own "rate base". It consists of the investment made in the waste wood boiler less the deferred tax granted to XYZ by Congress. The regulated portion of the business has provided no investment nor risk capital to support the waste wood boiler. Congress gave the investment incentive to XYZ and it is inconsistent with the normalization principles to transfer the incentive to the NSP ratemakers.

The purpose of these examples is to describe in real terms the potential impact of the rate base offset on the future investment decisions of NSP. Although NSP would not expect the rate commissions of the states in which we operate to vary from their past practice of calculating the utility tax expense on a stand alone basis, the proposed regulations would make the possibility a cloud on NSP's ability to invest in nonregulated energy related enterprises which is our present intention.

NSP therefore respectfully requests that the position taken in the proposed regulation that would permit a rate base offset derived from a separate nonregulated entity be reexamined and such procedures found violative of normalization provisions.

Northern States Power Company appreciates the opportunity to present its views on these proposed regulations. If you have any questions please call Arne Sather at (612) 300-5658.

Sincerely,