Water & Sewer Authority Comments on Proposed Public Utility Accounting Regs

Re: REG -- 104385-1

Dear Sir/Madam:

[1] Enclosed for filing in the above docket is an original and eight (8) copies of Comments And Request For Clarification Of The District Of Columbia Water And Sewer Authority. Also enclosed are five (5) duplicate originals to be stamped in and returned in the self-addressed, postage pre-paid envelope and returned to this office.

[2] If there are any questions, please do not hesitate to call.

[4] In further support of its position, WASA respectfully states as follows:

I. WASA's Interest in This Proceeding.

[5] WASA is an independent authority of the District of Columbia government that provides drinking water, wastewater collection and treatment to more than 500,000 residential, commercial and governmental customers in the District of Columbia, and also collects and treats wastewater for 1.6 million customers in Montgomery and Prince George's counties in Maryland, and Fairfax and Loudoun counties in Virginia. WASA's Blue Plains wastewater treatment facility, the largest advanced wastewater treatment facility in the world, is located in the District of Columbia. WASA is a major consumer of electricity with respect to its drinking water and wastewater treatment operations.

[6] WASA is a longstanding, and major, customer of Potomac Electric Power Company ("Pepco"). Pepco is a regulated electric utility that, at present, provides transmission and distribution services and is a wholly-owned subsidiary of Pepco Holdings, Inc. Pepco delivers electricity at regulated rates in Washington, D.C., and major portions of Prince George's and Montgomery counties in Maryland. Pepco's electric distribution activities in Washington, D.C. are regulated by the District of Columbia Public Service Commission ("DC PSC").

[7] During 2000, Pepco sold the majority of its generation assets to unaffiliated entities that are not subject to rate of return regulation, with total sale proceeds exceeding $2.9 billion. In anticipation of Pepco's sale of its generation assets, Pepco and certain of its customers, including WASA, entered into a settlement on June 30, 1999 ("Phase I Settlement").¹ Among other things, the Phase I Settlement established a mechanism whereby Pepco would share with its customers a portion of the proceeds realized from the sale of its generation assets, to the extent sale proceeds exceeded the assets' net book value. The Phase I Settlement originally provided that the customers' share of the sale proceeds would be distributed over a five-year period. However, the DC PSC has since approved Pepco's proposal to instead implement a one-time flat bill credit for residential customers. The DC PSC approved the Phase I Settlement by order dated December 30, 1999, which order is now final and non-appealable.²

[8] On May 8, 2001, Pepco filed its proposed plan for implementing the Phase I Settlement's provisions regarding distribution of generation asset sale proceeds between Pepco and its customers. By order dated October 10, 2001, the DC PSC ordered that further proceedings be held with respect to Pepco's proposed Divestiture Sharing Plan ("Divestiture Sharing Proceeding"), in order to determine whether Pepco's calculation of the amount of the proceeds to be shared with its customers was consistent with the requirements of the Phase I Settlement.³

[9] In the Divestiture Sharing Proceeding, Pepco took the position that the Phase I Settlement did not require the EDIT/ADITC reserves to be included in the sharing calculation. Pepco also took the position that, if the DC PSC interpreted the Phase I Settlement as requiring the EDIT/ADITC be included in the sharing calculation, then the enforcement of that interpretation would cause a normalization violation such that Pepco could be precluded from using accelerated depreciation in the future. In support of its position, Pepco referenced certain private letter rulings as consistent with its position concerning a normalization violation. However, at no time has Pepco sought a private letter ruling that would address Pepco's unique circumstances. Moreover, Pepco alleged in the Divestiture Sharing Proceeding that it did not discover until after the Phase I Settlement was negotiated that including the EDIT/ADITC in the amount available for sharing would allegedly contravene the normalization rules.

[10] WASA and other parties to the Divestiture Sharing Proceeding contended that the Phase I Settlement does require that the EDIT/ADITC be taken into account in determining the amount of sale proceeds available for sharing with customers. Including the EDIT/ADITC in the amount available for sharing would not result in Pepco returning all of the EDIT/ADITC reserves, but rather would allow Pepco effectively to retain a portion of those reserves as a result of the sharing mechanism.

[11] The parties supporting inclusion of the EDIT/ADITC reserves in the amount available for sharing also advanced several arguments why this approach would not constitute a normalization violation. In this regard, WASA contended that the Divestiture Sharing Proceeding was not a rate proceeding and that the allocation to customers of a portion of the asset proceeds did not affect Pepco's cost of service. They also contended that the private letter rulings cited by Pepco involved facts readily distinguishable from those at issue in the Divestiture Sharing Proceeding.

[12] In addition, WASA noted that the semi-annual agendas published for the Department of the Treasury ("Treasury") and the Internal Revenue Service ("Service") included a pending project that was the precursor to the instant NPRM.⁴ Based on this notice, WASA took the position in the Divestiture Sharing Proceeding that it would not oppose a decision by the DC PSC to defer ruling on the EDIT/ADITC issue pending the outcome of the anticipated NPRM. Pepco opposed WASA's deferral proposal. However, following the March 4, 2003 publication of the NPRM, Pepco promptly informed the DC PSC of the NPRM and requested the DC PSC to defer any decision on the EDIT/ADITC issues in the Divestiture Sharing Proceeding until the Service issued final regulations or stated that its regulations project will be terminated without the issuance of any regulations. WASA responded to Pepco's position, stating that the DC PSC need not await the outcome of the NPRM because, as stated in the NPRM, the Service and the Treasury already had concluded that "neither former section 46(f)(2) nor section 203(e) of the Tax Reform Act suggests that the EDIT and ADITC reserves ultimately should not be flowed through to ratepayers." Pepco responded to WASA's position arguing, inter alia, that the proposed rules do not suggest that immediate flowthrough of the EDIT would ever be permissible.

[13] To date, the DC PSC has not issued a decision on any of the issues raised in the Divestiture Sharing Proceeding.

II. The Service And Treasury Properly Concluded That The Normalization Provisions Of The Code Do Not Suggest That EDIT And ADITC Reserves Should Not Ultimately Be Flowed Through To Customers.

[14] The NPRM correctly notes that the normalization provisions were added to the Code when electric utilities were vertically integrated, with a single utility performing generation, transmission, and distribution functions. Under that structure, it was a virtual certainty that all amounts in EDIT and ADITC reserves would be flowed through to customers for the simple reason that the regulated utility would own the assets associated with the reserves throughout their useful lives. Thus, the normalization provisions were simply silent on the proper treatment of EDIT and ADITC reserves in the event that the associated assets were sold prior to the completion of the flowthrough process.

[15] The private letter rulings referenced in the NPRM were issued as vertical integration in the electric utility sector was giving way in some jurisdictions to the sale and deregulation of generation assets. The Service did not initially respond to the restructuring of the electric utility sector with regulations that reconciled the purpose of the normalization provisions with this new environment. Instead, as noted in the NPRM, the letter rulings "were based on the principle that flowthrough is permitted only over the assets's regulatory life and when that life is terminated by deregulation no further flowthrough is permitted." There is no indication in any of the letter rulings that consideration was given to the Congressional intent underlying the creation of EDIT and ADITC in the first place, i.e., to provide cost-free capital for a limited period of time, as well as the underlying assumption that an asset's regulatory life would correspond to its useful life. Instead, the letter rulings attempt to force-fit the mechanics of the regulatory life approach to situations where it no longer made sense, leading to harsh and unfair results. Indeed, the effect of the letter rulings was to allow utilities to retain reserves for which they had no equitable claim. This was particularly unfortunate in the case of EDIT, where the letter rulings could have resulted in the utilities retaining amounts collected from customers to pay future taxes that, as a result of the reduction in corporate tax rates, would not have to be paid.

[16] WASA applauds the Service and Treasury for having now undertaken the necessary review and coming to the well-reasoned conclusion that the normalization provisions do not suggest, much less require, that EDIT and ADITC reserves ultimately not be flowed through to customers of the regulated utility. The normalization provisions must be interpreted in light of the change in circumstances that has occurred in the electric utility industry in order to avoid the inequitable consequences that have resulted from the overly rigid "regulatory life" principle relied upon in the case- by-case letter rulings.

III. The Service And Treasury Should Clarify That The Proposed Rules, If Adopted, Would Allow The Phase I Settlement To Be Enforced According To Its Terms Without Jeopardizing Pepco's Ability To Use Accelerated Depreciation In The Future.

[17] WASA understands the purpose of this rulemaking proceeding is to adopt regulations of general applicability regarding the treatment of EDIT/ADITC in the context of the sale by a regulated utility of generation assets to entities not subject to rate of return rate regulation. However, WASA respectfully submits that this rulemaking proceeding also is the appropriate forum for the Service and Treasury to consider the implications of the proposed regulations on sales of generation assets that occurred prior to the effective date of the new regulations in cases where:

[19] The NPRM contemplates that a utility will be permitted to elect to apply the proposed rules to property that becomes deregulated generation property before March 4, 2003. However, the NPRM does not address the situation where the utility, prior to the issuance of the NPRM, voluntarily agreed to a settlement under which the EDIT/ADITC reserves are taken into account in determining the amount of the sale proceeds that would be shared with the utility's customers over a period shorter than the remaining life of the associated assets. WASA respectfully submits that allowing the utility to honor such a settlement, without jeopardizing the utility's ability to use accelerated depreciation in the future, is consistent with the rationale underlying the NPRM.

[20] In this regard, the NPRM states that "Congress provided a schedule for flowing through the reserves so that utilities would have the benefit of cost-free capital for a predictable period." The NPRM further states that the proposed regulations do "not impose on utilities any burden unanticipated prior to deregulation and provide the flow-through originally anticipated by ratepayers, utility commissions, and utilities." Thus, the goal of the proposed regulations is to adhere to the intent of Congress while not upsetting the expectations of the utilities, their customers or their regulators.

[21] If a utility, in the absence of regulations that explicitly addressed the flowthrough of EDIT/ADITC reserves upon the sale of regulated generation assets, voluntarily agreed with its customers to return a portion of the EDIT/ADITC reserves on an accelerated basis as part of a settlement resolving the allocation of the gain on the sale of regulated generation assets, the expectations of the utility, its customers and its regulator are not upset, but rather are modified to reflect the parties' preferred outcome. In these circumstances, both the intent of Congress and the public interest support allowing the parties to obtain the benefit of their settlement bargain without threatening the utility's right to use accelerated depreciation in the future. Accordingly, WASA requests clarification by the Service and Treasury in the final rule issued in this proceeding that, in cases where each of the four factors enumerated above is present, enforcement of the settlement will not jeopardize the right of the utility to use accelerated depreciation in the future for its remaining regulated assets.

²Formal Case No. 945, In the Matter of the Investigation into Electric Service and Regulation Practices, Order No. 11576 (December 30, 1999).

³Formal Case No. 945, In the Matter of the Investigation into Electric Service and Regulation Practices, Order No. 12203 (October 10, 2001). Although the exact amount of the EDIT is in dispute in the DC PSC proceeding, it is undisputed that the amount associated with Pepco's service to District of Columbia customers is at least $11 million.

⁴See, e.g., "Unified Agenda, Department of the Treasury, 31 C.F.R. Subtitle A, Chs. I and II, Semiannual Agenda and Fiscal Year 2001 Regulatory Plan, Part XV, Project 2827," 66 Fed. Reg. 25957 (May 14, 2001).

⁵As noted above, the issue of whether the Phase I Settlement required the EDIT/ADITC to be included in the amount available for sharing is in dispute in the Divestiture Sharing Proceeding. That dispute will be resolved by the DC PSC.

⁶The normalization rules apply only in ratemaking proceedings that involve the establishment of rates for regulated utility assets. Thus, section 168(i)(9)(A)(i) provides that: "[T]he taxpayer must, in computing its tax expense for purposes of establishing its cost of service for ratemaking purposes and reflecting operating results in its regulated books of account, use a method of depreciation with respect to such property that is the same as, and a depreciation period for such property that is no shorter than, the method and period used to compute its depreciation expense for such purposes."