Muni Power Grabs

Municipal Utilities, Tax-exempt Debt, and the Competitive Market

Table of Contents

I. Introduction

II. Municipal Utilities and Tax-exempt Debt

III. Tax-exempt Debt and Electric Industry Restructuring

IV. Related Policy Recommendations

V. Conclusion

About the Authors


I. Introduction

Electric industry restructuring is transforming how Americans receive electric power. Twenty-four states have already passed restructuring laws; in many other states restructuring is imminent. 1 Meanwhile, Congress is considering a string of bills that would impose a nationwide mandate to restructure the industry, and few doubt that eventually one of those bills will pass.

The underlying key to electric industry restructuring is to allow customer choice and competition in what has traditionally been an almost exclusively monopolistic industry.2 Not surprisingly, moving even part of an industry from monopoly to competition means big changes in the industry. But a quick glance at the debate over restructuring the electric industry shows that some participants want to keep the industry very static, with the same players and many of the same rules. Some players in this debate want the cost savings that competition brings but not the new business structures, new approaches, innovation, winners, and losers-in a word, change-that competition brings.

One battlefield in the war over a dynamic versus a static view of industry restructuring is over how restructuring will integrate government-owned municipal utilities into the competitive market. Municipal utilities were created in an era without competition, created so cities would have an option if they were unhappy with their private-power company.3 Now, with restructuring, municipal utilities would like to retain all of the advantages government policies have created for them over the years, using these advantages to compete against private providers of electricity. For example, they don’t pay taxes; they have access to lower-cost tax-exempt debt; and they have preferential access to cheap power generated by federal hydropower facilities.

On the other hand, private, investor-owned electric utilities would like to see municipal utilities compete without any special privileges, paying full tax equivalents, forgoing lower-cost, tax-exempt debt, and competing with all comers in bidding for electricity from the federal Power Marketing Authorities.4

The battle over these issues is largely being fought in Washington, D.C. in the context of the seemingly ever-imminent federal restructuring bill. Naturally, both sides have proposed various compromise positions, but their starting points are clear enough. In 1999 the battle in Congress focused to a large extent on the issue of tax-exempt debt. The issue is difficult to capture in just a few sentences, but the sense is as follows.5 Current tax laws allow municipal utilities to issue tax-exempt debt, which means they pay 2 to 4 percentage points less interest on their debt, for a cost of capital roughly 20 to 25 percent lower than investor-owned utilities pay. In the old, noncompetitive world that differential didn’t matter much. But in a restructured electric industry, the difference in debt costs is significant, giving municipal utilities a marked advantage in competing with investor-owned utilities. Municipal utilities want to maintain that advantage as they begin to compete. Investor-owned utilities (IOUs) want municipal utilities to convert all debt into taxable debt if they decide to compete. Naturally, both have proposed compromise positions as the battle has evolved.

One unintended consequence of tax-exempt debt, though, is to create a bias towards public ownership of infrastructure facilities even where there are private providers, such as in the electric industry.

This paper outlines the debate over tax-exempt debt, the major solutions that have been proposed, and the tradeoffs those solutions imply. The paper also suggests short-term and long-term alternatives most likely to enhance competition (along with a few other closely related policy recommendations):

  • In the short-run any federal restructuring bill should require that municipal utilities finance all facilities used to compete in the open market with taxable debt.
  • In the long-run policies must be reshaped to avoid favoring any one set of market participants. That will mean creating a set of rules that allows private and government utilities, and non-grid, self-generating power sources as well, to compete on market terms, without government policy picking the winners.

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II. Municipal Utilities and Tax-exempt Debt

Municipal utilities go back to the infancy of the electric utility industry when cities unhappy with private utilities or unable to attract a utility created their own city-owned utilities. By the New Deal era, municipal utilities were seen as a source of potential competition for investor-owned utilities. Municipal creation of a utility when dissatisfied with the service provided by an IOU is often called “franchise competition,” and, in Franklin Roosevelt’s words, is the “birch rod in the cupboard” to help ensure good service and low rates from investor-owned utilities.6 To further foster the creation of municipal utilities, a series of New Deal and later laws hammered out a system of “preference power” whereby state and local government utilities would receive low-cost federal hydropower, and IOUs would not.7

This cost-of-power bias in favor of government-owned utilities was compounded by the cost-of-capital advantages of tax-exempt financing. Tax-exempt bonds are designed to make it as easy and low-cost as possible for government entities to invest in infrastructure. Purchasers of tax-exempt bonds do not have to pay federal taxes on the income earned from them. As a result, buyers are willing to accept a lower interest rate on the bond, which saves the issuer money. One unintended consequence of tax-exempt debt, though, is to create a bias towards public ownership of infrastructure facilities even where private providers exist such as in the electric industry.8

The number of municipal utilities in the United States has shrunk steadily from roughly 3,000 in the 1920s to just over 2,000 today as munis have consolidated or been privatized.

This and other unintended consequences of municipal utilities’ access to tax-exempt debt have tremendous consequences for the electricity market emerging as restructuring moves forward. Specifically, municipal utilities want to use tax-exempt debt in order to:

  1. Expand their numbers by encouraging cities to municipalize investor-owned utilities to gain access to tax-free financing;
  2. Expand their service areas and operations at the expense of IOUs; and
  3. Enter into a wide range of purely commercial ventures such as selling power wholesale or to retail pools for a profit, and non-electric services such as cable TV, bottled water, or appliance repair, areas where government entities compete head on with a robust private market.

Source: Energy Information Administration, as reported in Public Power,”U.S. Electric Utility Statistics”, 1996, Jan-Feb, 1998, p.43.

A. Making More Munis

The number of municipal utilities in the United States has shrunk steadily from roughly 3,000 in the 1920s to just over 2,000 today as munis have consolidated or been privatized.9 In the last decade, only 12 new municipal utilities were created, but that may be about to change in a big way, as about 150 communities are now considering municipalization.10 Some argue that this trend reflects a reaction to perceived problems with IOUs. They claim that restructuring has shifted the attention of IOUs away from their city alone and towards regional and national opportunities for growth.11But in many cases, cities pushing for municipalization actually are trying to capitalize on restructuring to gain access to tax-exempt debt to fund some utility improvements and expansions and to gain access to a new revenue stream.12nbsp;

The politics of municipal electric utilities go well beyond issues of service quality. Last year the prospect of retail competition prompted Tallahassee, Florida to consider selling its municipal utility. But it didn’t take long for everyone to realize that the city was in the electric business for the money-one-third of the city’s revenues come from the utility.13Tallahassee may get an unusual amount of revenue from its utility, but virtually all munis pay a percentage of revenues to the city general fund. That revenue is essentially a hidden tax with no strings attached, one that city leaders hesitate to give up.14

The allure of tax-exempt debt makes municipalization even more attractive. The Long Island Power Authority (LIPA) bought out Long Island Lighting Company (LILCo) in 1998 and by refinancing the IOU’s debt as tax exempt was able to cut rates 20 percent.15 LIPA can hardly claim it brought better management or service to LILCo’s operations, as it for some time considered contracting with another IOU to operate LILCo after the buyout.16

Standard & Poor’s has frequently expressed concern that the politicized decision-making process governing municipal utilities will make it difficult and risky for them to compete in a restructured market.

Many other cities are looking to follow suit, municipalizing IOUs and getting into the electricity business. Tax-exempt debt is making it attractive to convert private companies into government agencies, just when the nation is restructuring the electric industry to bring it into the world of markets and competition. That coming competition is making the electricity business riskier, as competition always does. Municipalization will put that risk squarely on the head of city taxpayers. The costs of buying out an IOU alone usually require taking on considerable new debt, and much of it is in the form of more costly taxable bonds.17 The law restricts cities’ use of tax-exempt debt to finance buying out an IOU.18 The risk and expense of paying off that debt fall on city taxpayers as well, and it isn’t trivial-LIPA borrowed $7.3 billion to buy out LILCo.19

Is this risk real? Professional analysts say “yes.” Moody’s has criticized public utilities for taking on debt in order to cut rates as a risky and financially unsound practice.20 Standard & Poor’s has frequently expressed concern that the politicized decision-making process governing municipal utilities will make it difficult and risky for them to compete in a restructured market.21

B. Making Existing Munis Bigger

One of the main bones of contention in the fight over terms of the federal restructuring bill is whether munis can use tax-exempt debt to finance efforts to expand outside their traditional territories.22 Munis do not just want to compete to keep their current customers; they want to grow, expand, and serve new customers in new places. To avoid conflict with the rural cooperative utilities, munis have formed a gentleman’s agreement not to go after rural coop customers. However, they see the territories of the IOUs as prime hunting grounds.23 There are already examples from California, where Arizona’s Salt River Project has used a for-profit arm called New West Energy to capture 12 percent of the industrial customers who have switched providers, and the Los Angeles Department of Water and Power (LADWP) made $80 million in profits in less than a year by selling electricity to the state power exchange.24 Ironically, LADWP considers itself “the primary beneficiary” of California’s competition so far, and thus may not open itself to competition anytime soon.25 And no wonder-as things are they can make millions in profits selling to a competitive market, without having to risk losing any of their customers to competitors.26

Expansion is important to the munis.27 The American Public Power Association (APPA) has keyed on the ability of munis to expand in its lobbying efforts over restructuring. APPA’s executive director argues that any restriction on munis’ ability to expand would emasculate them. He describes one bill that would require munis to refinance their debt as taxable debt should they decide to compete outside their traditional area as a “fix” to the problem that “is more like the way a veterinarian ‘fixes’ a pet.”28

Munis do not just want to compete to keep their current customers; they want to grow, expand, and serve new customers in new places.

C. Entering into Commercial Ventures

One of the most recent, and hottest, trends for munis has been establishment of purely commercial ventures, many completely unrelated to the electricity business. But the biggest profit-making venture for munis has been the selling of power in the deregulated wholesale market or in newly created retail power pools. For example:

  • Groups of munis have formed companies such as The Energy Authority and Energy New England to trade their excess power in the deregulated wholesale power market. This is a pure profit-making venture that does not serve the customers of the munis-yet they can use tax-exempt debt to finance the power they sell. And, unlike other wholesale power traders, they do not have to pay federal income taxes on their profits. Those profits may be considerable. Some munis have been reluctant to release profit figures, but the Bond Buyer reports that The Energy Authority’s net income in the first 9 months of 1999 was $55.7 million, up from $33 million in all of 1998;29 and that some munis have made millions in profits and enjoyed profit margins “in excess of 8 percent of sales.”30
  • Some government-owned utilities are using tax-exempt debt to build new power plants, confident that they can sell excess power for profits, despite the fact that industry restructuring makes the future value of generating assets, and future prices of power, very uncertain. For example, Santee Cooper, in South Carolina (a state-owned utility that operates like a muni), is planning a new 500 mw plant financed with $275 million of tax-exempt debt, saying, “Some regions in the country are going to need more capacity. . . so why not have a public utility provide it?”31
  • Arizona’s Salt River Project has used its for-profit arm to grab 12 percent of the industrial customers who have switched providers in California, and the Los Angeles Department of Water and Power (LADWP) made $80 million in profits in less than a year by selling to the state power exchange.32 Both utilities use tax-exempt debt to finance their profit-making ventures in direct competition with IOUs.

Profit-making ventures are always a gamble, that is their nature, but when a muni loses money in one, it is not voluntary investors who lose out, but the muni’s captive customers, and all to often, city taxpayers.

These activities raise three major problems:

  1. The munis love to look at the upside of selling their excess power for profit, and even invest in more capacity to generate more excess power, but they ignore the risks inherent in profit-making ventures. If power prices fall as other generating plants come online, munis could wind up with excess power and no market and have trouble paying off the debt used to build their generating plants. Or they could have trouble meeting contracts-the Spingfield, Illinois, muni is being sued because it could not provide the power it promised in several contracts.33 Profit-making ventures are always a gamble, that is their nature, but when a muni loses money in one, it is not voluntary investors who lose out, but the muni’s captive customers, and all too often, city taxpayers.34
  2. Government-owned utilities arose to provide electricity when the private sector has failed to do so. Selling power for profit in a competitive market-competing with IOUs-does not further that governmental purpose. Instead, it involves government-owned firms in the market, where their access to tax-exempt debt, and the fact that they pay no federal taxes on their profits, distorts the market and discourages competition.
  3. In a bizarre twist, the public cannot get information about the profit-making ventures of the munis that they own. Officials at munis who claim to be making large profits in the wholesale power market will not divulge the size of those profits. Customers and taxpayers might be concerned that they would do the same if they suffered losses. Unlike the IOUs who have to disclose profits and pay taxes on them, there is no regulatory or taxing authority that can require munis to reveal their profits or losses-so they will not do so. Indeed, one muni official indicated that the reason they would not disclose the size of their profits is because of the battle in Congress over their use of tax-exempt debt.35 Another says that “from a competitive standpoint it’s not really in our long-term interest to release that [information].”36 Any financial information about a government-owned entity is public information-a muni’s accountability is to its customers and city taxpayers who clearly have to be told what is being done with their money.

Unlike the IOUs who have to disclose profits and pay taxes on them, there is no regulatory or taxing authority that can require munis to reveal their profits or losses-so they will not do so.

Some munis go well beyond these electric power profit ventures and see themselves competing with private industry in nearly every field, including package delivery, health care, emergency services, and education.37 The American Public Power Association has endorsed these ideas, publishing a guide with the heft of a telephone book called Business Opportunities for Public Power: A Comprehensive Guide for Understanding and Implementing New Products and Services. The guide explores business opportunities for munis in appliance repair, environmental waste management, security systems, cable TV, and other services.

These suggestions ought to be of real concern to policy makers for several reasons. First, commercial ventures are by their nature risky. Companies go out of business in all of those services every year. What happens when a muni goes into one of these businesses and fails? Their electricity customers pick up the losses, or else all the city’s taxpayers do. Consider fiber-optic telecommunications systems, one popular option.38Over 70 munis have built or plan to build such systems and to compete directly with existing telecommunications companies.39 Dozens of them have already lost millions of dollars, and some cities have had to raise taxes to cover the losses. For example, Glasgow, KY has lost more than $1.4 million on its utility’s cable TV venture, a loss made up by “ratepayers, Glasgow electric officials, and the Tennessee Valley Authority.”40 In other towns, customers who don’t use cable TV are still paying for its facilities in their electric rates. Paragould (Arkansas) Light & Water spent $3.2 million to build its cable TV business, and now the city has had to raise taxes to cover losses.41

Neither the muni’s electric customers or city taxpayers had any say about risking their money on a cable TV venture. Customers just thought they were signing up for electricity. No one should be forced to make investments in commercial ventures. If individuals want to invest in cable TV, plenty of firms offer stock in the marketplace.

Over 70 munis have built or plan to build such systems and to compete directly with existing telecommunications companies. Dozens of them have already lost millions of dollars, and some cities have had to raise taxes to cover the losses.

A second concern about these muni commercial ventures is that there is no way to shield many of the capital investments for such commercial ventures from the utility operations of a muni. Hence, muni utilities can use tax-exempt debt to finance buildings, repair yards, fiber-optic systems, and other facilities that can be used for commercial ventures. This outcome corrupts the purpose of tax-exempt debt, which is to fund infrastructure for the public good, not offices for cable TV operations.

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III. Tax-exempt Debt and Electric Industry Restructuring

In the context of problems with tax-exempt debt rules under current conditions, the prospect of nationwide restructuring has made the issue a public-policy crisis. One way or another, rules governing the use of tax-exempt debt in a competitive market are vital to restructuring.

A. Background

The crisis over use of tax-exempt debt by munis in a restructured market erupted soon after California restructured its market at the beginning of 1997. If any of the state’s munis wanted to participate in the market, they were required to participate in the Independent System Operator (ISO) arrangement, meaning they had to let the ISO control use of their transmission facilities. But muni facilities’ assets were financed with tax-exempt debt, and some thought ISO participation would violate the rules on use of tax-exempt debt, because nongovernmental entities (IOUs) would be using the muni transmission facilities, too. (The ISO will send whatever power down whatever transmission line is most efficient.) The munis pressed for an analysis, and a joint congressional committee report in October 1997 concluded that ISO participation did violate the limits on the use of tax-exempt debt.42

The munis argued that the current rules did not reflect restructuring and pushed hard for a resolution. For the California munis, especially the largest, serving Los Angeles and Sacramento, time was critical. They could not enter the market until the issue was resolved. Key congressmen working on federal restructuring bills wanted to resolve the crisis through legislation, but when no bill was passed in 1997, the IRS decided to issue temporary regulations.

The IRS temporary regulations, effective for three years, for the most part established the munis’ ability to compete in the marketplace, within and outside current service areas, using facilities financed with tax-exempt bonds.43 As long as private use (a use that may not be eligible for tax-exempt debt financing) by muni facilities is triggered by a state or federal mandate, the IRS will consider such use permissible. Only when munis take deliberate action that lead to private use would they violate the conditions of using tax-exempt debt. But many directly competitive actions by munis are not defined as deliberate actions. If a muni has power made excess by the loss of customers to competitors, it can sell that power outside its traditional service area without creating a private use. Also, any short-term contracts (less than 180 days) to sell power outside their traditional service area are permissible. The rapid changes unleashed by restructuring have made short-term contracts dominate the market.44 Thus, the munis can basically do as they please.

In an almost perfect irony, once the IRS regulations were issued, both the Los Angeles and Sacramento munis decided not to enter the competitive market. Perhaps they made these decisions because in the interim they found the profits from selling power in a competitive market, without actually having to compete, to be too attractive.

B. Two Sides of the Debate

The IOUs and the munis have very different perspectives on how tax-exempt debt ought to be treated in a restructured electricity market.45 The result has been a flurry of bills in Congress for the last three years, none of which had passed by late 1999. Each successive set of bills has offered more or different compromise elements, but the fundamental positions of the two groups have remained fairly consistent.

The IOU View

The IOUs have not formed a completely unified camp on all issues related to tax-exempt debt, but their basic and compromise positions remain fairly clear.46

  • There is no legitimate governmental purpose in encouraging or even allowing munis to extend their market share, so no special subsidies or benefits should be extended to such efforts;
  • Any shift in customers and revenue to munis and away from IOUs will mean a loss of tax revenue for all levels of government;
  • If a muni makes substantial sales outside of its traditional service area, all new debt for generation and transmission should be taxable, and the munis should be subject to federal income taxes with respect to earnings from sales made outside their service territory;
  • Munis ought to have a choice: a) to sell only within their traditional service area and continue to use tax-exempt debt, or b) to enter into the competitive market as a commercial entity and be treated as such, including loss of future use of the tax-exempt debt privilege;
  • For munis that choose option b), above, existing tax-exempt debt must be refinanced as taxable debt at the end of its current term;
  • Ongoing short-term and excess power sales outside of service areas should not be exceptions to the above principles;
  • Smaller munis (population less than 10,000) may be exempted.

The Muni View

As with IOUs, munis are not wholly unified on tax-exempt debt issues,47 but they have remained consistent on most of the basic and compromise issues:48

  • Munis and IOUs have different missions, and the tax laws reflect those differences;
  • Cities have an inherent right to form a government-owned utility, and the tax laws are designed to support that right;
  • In a competitive market, munis ought to be able to expand and win customers wherever they choose. Tax-exempt debt and exemption from federal income taxes support the municipal alternative;
  • If a muni chooses to compete outside its traditional service area, it may not issue any more tax-exempt debt for building new generation facilities, but:
      1. All existing debt remains tax-exempt, and should be exempted from existing private-use restrictions (at the time the debt was issued, they did not anticipate the private-use impacts of restructuring);
      2. The muni can still use tax-exempt debt for transmission and distribution facilities, and for upgrading and expanding existing generation facilities;
      3. If state restructuring law requires a muni to open up to competition, even if only for its transmission system, it should retain access to tax-exempt debt;
  • Short-term sales outside of the traditional service area should not preclude the use of tax-exempt debt;
  • If a muni chooses to open its service area to competition, and loses customers, it can sell the newly excess power outside its service area without triggering the loss of using tax-exempt debt in the future; and
  • All transmission facilities (government and IOU owned) should be transferred to a nonprofit “TransCo” to be managed on a collective basis.49

C. A Third Way

The goal of policy must be to create a legal framework for a competitive electricity market that does not pick winners, but allows customer choice and market forces to choose who will succeed and who will fail. Innovative, well-managed utilities that focus on customer service, whether privately or government-owned, will thrive while others fail, provided there is no policy that shores up the fortunes of poorly run utilities. If the market is allowed to work, consumers will determine who provides them with electricity.

A Short-term Solution to Tax-exempt Debt Issues

It is a fundamental truism that if the government gives an artificial advantage to some participants in a market, prices and trade are distorted, and competition is diminished. At the same time, public policy makers must take into account the transition from monopoly to competition and the changes it effects on the industry. As the Joint Committee on Taxation put it, “If certain electric service providers [are] permitted to retain their ability to receive tax-exempt financing in a competitive marketplace, those providers might have a considerable cost advantage over other competitors in a deregulated market.”50 An objective of policy should be to minimize the differences between the players’ capital costs. The Clinton administration reached the same conclusion, and its restructuring plan recognizes that the cost-of-capital playing field must be level for restructuring to work.51 The IOUs’ and munis’ baseline positions are both too extreme to meet that goal.

The goal of policy must be to create a legal framework for a competitive electricity market that does not pick winners, but allows customer choice and market forces to choose who will succeed and who will fail.

We recommend the following principles:

  • It is not the goal of restructuring to preserve or expand government provision of electricity, nor is it to eliminate it;
  • However, munis that want to enter the competitive market must be treated like corporate entities. Those that can will compete and survive. The others will likely be bought out or otherwise privatized;
  • Since the only justification for monopolies is overwhelming problems with competition, and restructuring is predicated on the ability to have competitive generation markets and to give customers choice, all munis should be required to compete on a “level playing field”;
  • Some reasonable, though not overlong period may be granted to allow munis to prepare for competition. But, they should remember that their delay gives the IOUs a head start;
  • Munis should be able to choose whether to compete outside their traditional service areas or not. Short-term sales expected to be ongoing, and requirements contracts, along with longer-term actions outside their traditional service areas constitute such a choice; and
  • Upon making the choice to enter the market, munis must forgo any future use of tax-exempt debt and must refinance a portion of their existing tax-exempt debt as taxable debt. The portion refinanced will be equivalent to the share of the utility’s total revenue represented by the revenue from sales outside their traditional service area. The refinancing must occur by the end of its current term.

A Long-term Solution to Tax-exempt Debt Issues

The long-term policy goal ought to focus on making the electric market as much like other product markets as possible. Government-owned utilities must transition fully into the market; and policies must change to make competition and contestability in power generation and delivery as complete as possible.

The first step to making the electricity market a competitive one is the restructuring process that is underway-deregulating and changing policies so that customer choice, not political action, determines how power is delivered to customers. The second step is managing the transition of government-owned utilities into true corporate entities that work within the same rules as do IOUs. This would not only prevent market distortions, but would restructure munis so that they can more readily compete, free of politicized decision-making and bureaucratic red-tape.

The process of corporatizing a muni involves no change of ownership, but it does involve a major restructuring of the enterprise. Instead of being a government department, the muni is legally converted into an incorporated, for-profit business, with the government as its sole shareholder. The new corporation has a board of directors, run by a chairman (usually from the private sector), and the board selects a chief executive officer (also recruited, in most cases, from the private sector). The corporation is freed from all government personnel and procurement regulations and is instead subject to ordinary corporate law. It pays the same taxes as any other business, including local property taxes to the municipalities where it has facilities, and is subject to corporate accounting standards. To the extent that it makes a profit, it pays dividends to its shareholder, the government that owns it.

Other key elements of the corporatization model include:52

  • Management and budget standards are based on outputs, not inputs;
  • The government sets overall policy, but does not approve line-item budgets (which are inputs, not outputs) or subject management decisions to second-guessing. Only its major investment decisions and overall performance goals, on a several-years-at-a-time basis, would be subject to city oversight. The muni would have full control of its assets, personnel, and programs;
  • Munis could be regulated in one of two ways: 1) oversight provided by a municipal utility commission, a kind of a mini-PUC, charged with overall output-oriented policy responsibility and protection of consumers from any form of monopoly pricing or practices, but having no power to review inputs, or 2) the muni could be subject to full state PUC and FERC regulation;
  • Munis would have full control over personnel decisions (personnel are an input), and would be free to hire, fire, and compensate based on merit;
  • For management, success is based on performance agreements that hold the enterprise accountable. The city negotiates an annual policy statement with the muni’s board, and the board translates this into a performance contract with the CEO. The CEO, in turn, works out performance agreements for his management team, and so on, down the line. In this way, while politicians give up the ability to micromanage, they gain far more in terms of ultimate control over outputs;
  • Our model also entails accrual accounting (GAAP) to aid policymakers and taxpayers in realistically assessing the utility’s true financial situation.

Corporatization would convert a muni into a more productive and competitive enterprise, free of politicized decision making, that is held accountable by its customers and city taxpayers for its financial performance, while insulating them from the business risk of traditional government enterprise. And for the city, a corporatized muni, paying taxes, represents a more predictable revenue stream than a traditional muni that transfers revenues in a market that makes revenues uncertain.

It is important to recognize that corporatization is not privatization-the government remains the shareholder in the firm. But the corporatized muni now functions financially, legally, and operationally in a competitive market as an equal player-tax-exempt debt no longer enters the picture. Once a muni is corporatized, the city could look at the company’s capital structure and see whether seeking equity investors makes sense.

Corporatization would convert a muni into a more productive and competitive enterprise, free of politicized decision making, that is held accountable by its customers and city taxpayers for its financial performance, while insulating them from the business risk of traditional government enterprise.

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IV. Related Policy Recommendations

Besides the issue of tax-exempt debt, a number of related policy issues must be resolved to make the electricity market functional and competitive.

A. Focus on Competition

The main purpose for any federal (or state, for that matter) restructuring legislation should be to create a competitive order. In other words, such legislation should create the basic rules of the road that allow competition and markets to flourish and innovation to occur. Restrictions should be minimal and only where there remain significant problems with free competition. The focus now is on generation, but a case can already be made that distribution is more contestable than most people recognize and that technology makes it more so every year. Once source of competition is non-grid power. Cogeneration and other sources of distributed power are increasingly attractive to firms and other good-sized consumers of power.53 Competition is already showing that some will pay a premium for green power, and such steps as repealing PURPA would help the alternative power industry innovate rather than relying on mandated market share. All of this will put competitive pressure on transmission and distribution systems and help us move towards deregulating those parts of the market as well.

As with municipalization, no compelling public interest justifies government-owned utilities embarking upon commercial ventures such as appliance repair, cable TV service, and others.

B. Open Access to Federal Power

Besides tax-exempt debt, the other government policy that distorts electric markets is the preferential access by munis and coops to subsidized federal hydropower. Again, since generation is becoming a fully competitive market, governments should be exiting from the business of owning generation assets. Sound arguments exist for privatizing the Tennessee Valley Authority (TVA) and the Power Marketing Authorities (PMAs).54 An even stronger case exists for selling federal power on an open-auction basis to all comers. Open auctions would ensure that the taxpayers no longer have to support the TVA and PMAs. Instead, they would get a fair price for the power generated by assets built with their tax dollars. It would also make federal hydropower a simple, cheap source of power for the whole nation and not a regionalized source of distortion in the market.55

C. Put an End to Municipalization

Municipalization is an antiquated policy tool devised as a substitute for competition. Designed to be used as a last resort, that justification no longer exists with the advent of restructuring. Municipal government should no longer be allowed to get into the commercial and competitive business of providing electricity. Taxpayers should not allow their city governments to municipalize electric utilities, nor should federal tax policy encourage it.

D. Put an End to Commercial Ventures for Government Entities

As with municipalization, no compelling public interest justifies government-owned utilities embarking upon commercial ventures such as appliance repair, cable TV service, and others. Already we see two inimical results of utilities’ commercial ventures:

  • Taxpayers and electricity customers are footing the bill for losses in utilities’ commercial ventures, which are inherently risky. Those same taxpayers and customers were not asked if they wanted to back such ventures.
  • Government enterprises inherently distort competition. They are often exempt from regulations that constrain private firms; they have access to taxpayer funds in ways private firms do not; and they are often politicized in their management. Consequently, they never really compete on a level playing field with private firms. The solution to this set of circumstances is to require government utilities to stick to their core mission-providing electricity.

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V. Conclusion

The tax-exempt debt issue is consuming the bulk of the ire and fire in the debate over a national electric industry restructuring policy. Most of the proposals to date have been designed to satisfy specific interests or to find compromises between them, rather than to create the best-possible competitive order of the electricity market. This paper proposes an approach more directed towards a long-run, competitive market in electricity that creates minimal interference with markets and innovation. Our concept proposes tax policies designed to keep the cost of creating and transmitting electricity as low as possible. The result is a system that benefits all, ensuring a thriving market to serve all customers and allowing all existing members of the industry a chance to participate in a way that does not distort the market.

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About the Authors

Adrian T. Moore is Director of Economic Studies and Deputy Director, Reason Public Policy Institute. He is an expert on transit and infrastructure trends and issues and has written extensively on government management, infrastructure, transit, and privatization policy. Mr. Moore is co-author of Curb Rights: A Foundation for Free Enterprise in Urban Transit (Brookings Institute Press, 1997). Mr. Moore received an M.A. in history from California State University-Chico, an M.A. in economics from the University of California-Irvine, and is completing his Ph.D. in economics at the University of California-Irvine.

Jeff Woerner is a Research Assistant for Reason Public Policy Institute. He has written on transportation and electricity policy. Mr. Woerner received an M.A. in economics from California State University, San Diego.

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About RPPI

Under the leadership of Executive Director Lynn Scarlett, Reason Public Policy Institute’s peer-reviewed research fuses theory and practice to craft workable policy changes that foster individual responsibility, choice, and competition. Reason Public Policy Institute believes that a dynamic world, conductive to discovery and innovation, is essential to prosperity and human progress. Reason Public Policy Institute’s work involves six main programs:

Not content to simply research the issues, Reason Public Policy Institute takes seriously its role as an educational institution, maintaining a comprehensive outreach program. Through extensive marketing efforts, we ensure that our ideas reach the media, relevant interest groups, policy makers, and public officials who shape the public policy climate.

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1. The Dept. of Energy’s Web site “Status of State Electric Industry Restructuring Activity,” (www.eia.doe.gov/cneaf/electricity/chg_str/regmap.html) provides a regularly updated picture of restructuring activity. As of October 1, 1999, DOE showed the following breakdown of state activity. States that have restructuring legislation: Arizona, Arkansas, California, Connecticut, Delaware, Illinois, Maine, Maryland, Massachusetts, Montana, Nevada, New Hampshire, New Jersey, New Mexico, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Texas, and Virginia. States that have restructured through a regulatory order: Michigan, New York, and Vermont. All other states are investigating the issue in their legislature or by commission.

2. Current restructuring schemes are focused on making the generation of electric power fully competitive and offering customers greater choice in selecting power providers. Most likely, the transmission and distribution of electricity will remain a regulated monopoly service.

3. For an overview of the birth of municipal utilities as a substitute for more direct competition see Clinton A. Vince and Cathy J. Fogel, “Franchise Competition in the Electric Utility Industry.” Electricity Journal, vol.8, no.4, (1995), pp. 14-27.

4. A great deal about both points of view can be learned from the American Public Power Association Web site (www.appanet.org/appahome.html), the Edison Electric Institute Web site (www.eei.org), and the testimony archived at the House Commerce Committee Democrat electricity restructuring page (www.house.gov/commerce_democrats/comdem/electric/elechome.htm) or the House Judiciary Committee hearing page (www.house.gov/judiciary/fc0728.htm).

5. To read a much more detailed discussion, see the pair of reports issued by the Joint Committee on Taxation: “Federal Income Tax Issues Arising in Connection with Proposals to Restructure the Electric Power Industry.” JCS-20-97, October 17, 1997; and “Federal Tax Issues Relating to Restructuring of the Electric Power Industry,” JCX-72-99, October 15, 1999.

6. Vince and Fogel, “Franchise Competition,” p. 17.

7. Ibid, p. 17, and Randall W. Hardy, “Federal Power at Market Prices? Be Careful What You Ask For,” Public Utilities Fortnightly, vol. 137, No.15 (August 1, 1999), p.24ff.

8. In many other nations around the globe, where there is no tax-exempt debt, there is far more private investment in infrastructure than in the United States. See, for example, Privatisation International Annual Report 1998, (London: Privatisation International), 1999.

9. This does not mean that munis are a shrinking industry. Between 1993 and 1997, munis’ sales (in kwh) increased 13 percent, and revenues increased 11.9 percent, compared to growth of 8.5 percent and 7.7 percent, respectively, by IOUs. See Energy Information Administration, table on U.S. Sales to Ultimate Consumers and Associated Revenue by Class of Ownership, 1992 through 1997, www.eia.doe.gov/cneaf/electricity/esr/t40.txt.

10. Ola Kinnander, “Communities’ Drive to Acquire Utilities May Lead to Increased Debt Issuance,” Bond Buyer, July 24, 1998, p.1.

11. Ibid.

12. The incentive that tax-exempt debt creates to municipalize even efficient IOUs has long been recognized by economists. See for example Michael Crew and Paul R. Kleindorfer, Public versus Private: Alternative Ownership Scenarios for Electric Utilities, Policy Study No. 121 (Los Angeles: Reason Public Policy Institute, June 1990), p.21.

13. Christopher Swope, “Power Politics.” Governing, (July, 1998), pp.42-45.

14. Muni’s “tax equivalent payments” to the local government from 1992 to 1996 average a bit over 3 percent of revenues for those with generation assets, a bit less for those without. And their average payments have fallen since 1994, nearly 20 percent for munis with generation assets and nearly 5 percent for those without. In contrast, IOUs during the same period paid an average of well over 12 percent of revenues in taxes, and have seen their payments increase slightly. Data from Energy Information Administration, Electric Power Annual 1996, Volume II, (Washington, D.C.: Department of Energy), February, 1998.

15. This number ought to make you stop and think. Nationwide, munis’ average power rates are 25 percent lower than IOUs’ rates for residential customers, 15 percent lower for commercial customers, and the same for industrial customers. The munis have long claimed that only a small fraction of that price difference is due to using tax-exempt debt. But the LILCo story paints a different picture. Moreover, the munis have consistently maintained that if they had to pay for capital at the same price that IOUs do, their ability to compete would be severely hampered, and many would opt out of competition. For more details on the deal, see “Inquiry Into How LIPA Chose Bond Underwriters Is Ended,” New York Times, August 26, 1999, Section B; Page 5; Column 5.

16. Charles E. Bayless, “Times Up for Public Power.” Public Utilities Fortnightly, vol.136, No.13, (July 1, 1998), p. 34.

17. Kinnander, “Communities Drive,” p.1

18. The Omnibus Budget Reconciliation Act of 1987 changed the tax code so that tax-exempt debt used to municipalize an IOU is subject to the state volume cap, where it must compete with other uses of tax-exempt debt. Hence, tax-exempt debt is mostly used to finance only small municipalizations. But, since the new muni will be able to use tax-exempt debt for new capital investments, and be exempt from federal income taxes, tax policy still favors municipalization. For more on the details of the 1987 Act, see Haward A. Cooper, “New Tax-exempt Bond Regs Assist Governmentally-owned Utilities in the Competitive Marketplace,” CCH Power and Telecom Law, May/June 1998, p. 45.

19. “Inquiry Into How LIPA,” New York Times.

20. Charles Gasparino, “New York Power Authority Moves to Issue Bonds to Help Utilites Compete Agianst Private Firms,” Wall Street Journal, February 4, 19998, p.C24.

21. Based on repeated statements in S&P press releases from 1995 through 1997. See www.standardpoor.com

22. For more on this see Section III below.

23. David W. Penn, “Competition, the Consumer, and Local Decision Making: Public Power’s Important Role,” Electricity Journal, vol.10, No. 9 (November, 1997).

24. Ola Kinnander, “Wild West Power Plays: Salt River Unit Gains; LA May Delay Competition,” Bond Buyer, May 21, 1999.

25. Ibid.

26. Current rules (See section IIIA below) allow municipal utilities to sell power to power exchanges or pools, thus indirectly competing with other utilities to sell power, without having to take the formal step of competing head-to-head for new customers or to retain existing ones. And in the process they retain the right to use tax-exempt debt and don’t pay federal income taxes on their profits.

27. The munis’ attitudes are not monolithic. Some would just as soon be fenced off from competition, and some IOUs share that attitude. Along with opportunity, competition brings risk and requires vigorous effort to stay ahead-monopolies can be much more comfortable.

28. Michael Stanton, “Senator Says Power Debt Can Maintain Tax Exemption,” Bond Buyer, November 12, 1997, p.1.

29. Ola Kinnander, “The Energy Authority Inc. Earns Healthy Returns for Members,” Bond Buyer, November 5, 1999, p.1.

30. Ola Kinnander, “Municipal Utilities Finding the Wholesale Energy Trade Lucrative,” Bond Buyer, October, 11, 1999, p. 32.

31. Robert Whalen, “S.C. Utility Builds Again,” Bond Buyer, February 22, 1999, p.1.

32. Kinnander, “Wild West.”

33. Kinnander, “The Energy Authority, Inc.” p.1

34. Both ratepayers and taxpayers have had to pay for failed muni commercial ventures. One or the other will have to pay for any judgements against the Springfield muni, and see examples of muni cable TV ventures below.

35. Kinnander, “Municipal Utilities,” p. 32.

36. Kinnander, “The Energy Authority,” p.1.

37. So says Dick Silverman, GM of Arizona’s Salt River Project (a government-owned utility), in Ken Brown, “SRP Faces Many Issues in Competition,” Phoenix & Valley of the Sun Business Journal, March 13, 1998, p.9.

38. Alan H. Richardson, “Red Threats in the 90’s,” Public Power, November/December 1997.

39. Len Grzanka, “Utility Diversification: Munis Find Cable TV a Costly Business,” Public Utilities Fortnightly, September 15, 1998, p. 34. A look through the Nov/Dec 1999 issue of the American Public Power Association’s journal, Public Power, finds two full page adverstisements, and one smaller, from technology firms offering to partner with munis on cable TV, Internet, and other telecommunications ventures.

40. Ibid, p. 34.

41. Ibid, p. 34. Grzanka examines a number of case studies and shows how over-optimistic revenue projections and misunderstanding competition and marketing have led to financial losses and tax increases in many cities where utilities have tried the cable TV business.

42. Joint Committee on Taxation, “Federal Income Tax Issues.”

43. The rules were published in the January 22, 1998 Federal Register. For summaries and discussion, see Cooper, “New Tax-exempt Bond Regs”; Todd H. Cunningham and Dan M. Reidinger, “Regulatory Review,” Electric Perspectives, July/August, 1998, pp. 68-72; and Frank Shafroth, Treasury Offers Guidance for Municipal Utilities, Nations Cities Weekly, January 26, 1998, p. 1.

44. A recent examination of FERC rate filings showed that all were for sales lasting three months or less, revealing that the current rules would allow munis to compete for almost all market transactions taking place in today’s market using tax-exempt debt. See the study by the EOP Group and OnLocation, Inc., cited in a letter from Edison Electric Institute to the IRS regarding the temporary regulations, dated April 22, 1998, p. 20.

45. The National League of Cities (NLC) has generally sided with the muni point of view, perhaps even more militantly than the munis themselves. The NLC generally argues that tax-exempt debt is a municipal right, that any constraints on it are preemptive, and that Congress should craft rules that give cities freedom over when and how to use tax-exempt debt.

46. The IOU position is not monolithic. For one thing, some IOUs see a market niche in partnering with munis that seek to expand and compete, so they see no problem with the current rules. But many other IOUs are concerned about a level playing field for future competitive markets. For an overview of the main IOU position as represented by the Edison Electric Institute, see Cunningham and Reidinger, “Regulatory Review,” and the EEI Web site www.eei.org. The Bond Buyer has assiduously covered the various relevant bills before Congress. For example, see Michael Stanton, “Senator Says Power Debt Can Maintain Tax Exemption,” Bond Buyer, November 12, 1997, p.1; Ola Kinnander, “Senate Committee to Debate Municipal Utility Bond Limits,” Bond Buyer, July 23, 1999, p.1; and Ola Kinnander, “Deregulation: Public Power Community Scowls At Electricity Restructuring Bill,” Bond Buyer, October 29, 1999, Pg. 5.

47. The source of their division is telling. Some observers point out that it is the larger, more indebted, munis who are screaming about the need to protect their existing tax-exempt debt and that some munis would have no problem with having to convert to private debt if they were going to compete. Ola Kinnander, “Public Power: Muni Utilities Vary in Their Need for Legislative Relief,” Bond Buyer, June 30, 1998, p.5. Munis that have used high debt, and arguably fiscally imprudent, strategies in the last decade would have to raise rates far more to cover refinancing debt at private rates than would munis that have chosen lower debt, and arguably more prudent, strategies. Depending on how final legislation treats debt used to finance different types of facilities, the total tax-exempt debt that could be affected is between $70 billion and $100 billion.

48. The American Public Power Association Web site, www.appanet.org/appahome.html, is a rich mine of information on public-power positions on issue and on specific legislation. Also, see the bills supported by APPA, such as HR 721 (106th Congress).

49. Details on this recommendation can be found in Large Public Power Council, “Uncrossing the Wires: Transmission in a Restructured Market,” December 1998, www.lppc.org/uncross.pdf.

50. “Federal Tax Issues,” 1999, p.9.

51. The administration’s act is called the Comprehensive Electricity Competition Act (Department of Energy), home.doe.gov/policy/ceca.htm.

52. Our model for corporatizing municipal utilities draws upon a breadth of experience with similar efforts in the United Kingdom, Australia, and New Zealand. See Barry Spicer, David Emmanuel, and Michael Powell, Transforming Government Enterprises: Managing Radical Organizational Change in Deregulated Environments (Australia: Centre for Independent Studies, 1996). The General Accounting Office and the National Academy of Public Administration have recommended corporatization of the federal PMAs. See GAO, “Federal Power-Options for Selected Power Marketing Administrations’ Role in a Changing Electricity Industry” (Washington, D.C.: RCED-98-43, 1998).

53. There are even specialty software programs to help customers figure out if distributed power makes sense for them, William D. Siuru “Solving the Distributed Energy Puzzle,” Public Power, Nov/Dec 1999, pp. 18-19.

54. See Douglas A. Houston, Federal Power: The Case for Privatizing Electricity, Policy Study No. 201, (Los Angeles: Reason Public Policy Institute, March 1996).

55. The market distortions and subsidies associated with federal preference power are discussed in GAO “Federal Electricity Activities: The Federal Government’s Net Costs and Potential for Future Losses,” (Washington, D.C.: AIMD-97-110, 1997).

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