A universal reality for U.S. power generation developers is the challenge of obtaining funding in today’s tight credit markets. Financing exigencies make the level of security a developer must post of critical importance to its ability to achieve the return thresholds necessary for project development. The amount of security postings transmission owners require for interconnection agreements can be a major impediment for projects. These requirements, accordingly, have been debated and continue to evolve.

Wholesale Tax Advantages

Current Federal Energy Regulatory Commission (FERC) policies obligate generation project developers to make payments to transmission owners for the construction of interconnection facilities. From the tax perspective, these payments constitute the “income tax component of contribution“ (ITCC) and represent potentially taxable income to the transmission owner. FERC policy also imposes liability on the developer for any ITCC taxes the transmission owner will pay. The good news is that the Internal Revenue Service (IRS) has promulgated rules that provide the transmission owner a comprehensive “safe harbor for transfers under an interconnection agreement, effectively ensuring that the transmission owner should never have to pay any ITCC taxes.

The safe harbor rules are designed to confirm that the primary purpose of the interconnection facilities is to enable the generator to deliver its generation to wholesale markets and not primarily to enable the transmission owner to make retail sales of power to the generator. It is, however, theoretically possible in extreme cases (for example, if the generator consistently operates at capacity factors below 20%) that a generator will fail to comply with the safe harbor rules and subject the transmission owner to contingent ITCC tax liability.

FERC’s policy successfully protects the transmission owner from any possible exposure relating to ITCC. The transmission owner may require either that the developer make an upfront payment for the amount of possible tax gross up or post security in that amount. Transmission owners in almost every instance require developers to post security to cover any potential future ITCC liability. In the unlikely event a developer contravenes the safe harbor rules and the transmission owner is obligated to pay the tax, the transmission owner can enforce its rights in the security.

Real Cost of Security Posting

While the policy protects the transmission owner, the question remains whether this policy is cost effective and best advances energy policy, particularly the objective to encourage the development of more efficient, more environmentally benign power plants. The IRS safe harbor notices provide the generator explicit and easy-to-comply-with rules to avoid a taxable event for transactions under interconnection agreements. Not surprisingly, we are aware of no contribution under an interconnection agreement that has caused a transmission owner to incur an income tax liability. The facts are that the risk of any ITCC exposure, while admittedly greater than zero, is negligible; the corresponding cost to the developer of maintaining the security for the theoretically maximum amount of tax exposure exacts real costs and necessarily impedes project development.

In essence, the amount of ITCC security required is the taxable amount of the developers contribution multiplied by the transmission owners effective tax rate. If major interconnection facilities are needed—the costs of which can be in the eight-figure range or higher—at a 35% tax rate, the ITCC security requirement often exceeds seven figures.

Regulators, legislators, and consumer advocates tend to view a security posting requirement as a win/win, because it protects the utility and yet imposes no cost on the party posting security. That myopic view, however, ignores financial reality: Security posting is a zero sum game. Posting of security represents a real cost to the developer, depriving it of capital necessary to develop the project. The question that needs to be addressed is whether it is good policy to require a developer to set aside substantial sums every year, over the term of an agreement, to protect the transmission owner from a risk that most likely will never arise. Not to be overlooked are the administrative costs of the security that are imposed on the transmission owner to calculate, track, and maintain the ITCC security.

The right equation must be to compare benefits versus costs (both to the developer and to the transmission owner). Given the limited risk to transmission owner and real cost to developer, the ITCC security requirement warrants reconsideration.

Rational Security Policy Is Possible

The good news is that at least one major California utility, based on experience and a better understanding of the costs of administering the ITCC security in compliance with FERCs rules, has decided that the cost of an ITCC requirement exceeds its benefits. The transmission owner obtained authorization from FERC to waive the ITCC security requirement and retained the option to reinstate the requirement at a later point, if necessary. This is a win/win approach that others should follow.

Why stop there? Regulators and parties supposedly benefitting by the security posting should constantly assess security requirements and challenge whether the benefits warrant the costs being imposed. It may be that the optimal result for all constituencies in the energy arena is to reduce arbitrarily imposed security amounts and allow scarce capital to be redirected to more productive purposes.

Margaret H. Claybour (margaretclaybour@dwt.com) is an associate in the Davis Wright Tremaine LLP Energy Practice Group.