Statements of the Hon. Wally Herger, a Representative in Congress from the State of California

Mr. Chairman and Members of the Subcommittee.

I would like to make a few comments to underline the importance of recognizing and providing strong support to the nation’s solid-fuel biomass power industry. This unique asset provides both reliable electricity and an extraordinary range of public benefits including measurable reduction in the risk and severity of wildfires, waste management services to agriculture, improved air quality, and a solid base of rural employment across the nation.

The biomass power industry converts more than 20 million tons of wood waste and other organic residuals into clean electricity every year. It makes productive use of materials that would otherwise be an environmental liability. Unfortunately, the industry has been destabilized by the volatility in our energy markets and rising costs. The productivity of our industry is diminishing and the public benefits provided are increasingly at risk.

I have introduced legislation (HR 1657) to remedy this situation by providing a much-needed production tax credit to this important industry, and I am heartened by the growing list of bipartisan cosponsors who have joined me in this important effort.

Independent research sponsored by the U.S. Department of Energy recently confirmed that the monetary value of the environmental and economic benefits of the biomass power industry – separate from the renewable electricity itself – is approximately 11.4 cents per kilowatt hour of electricity produced. I recommend that the committee recognize the singular importance of this finding which is quite significant and far in excess of the public benefits generated by any other energy technology. It tells us two things.

First, we learn that the value of the industry’s environmental and economic benefits are nearly double the cost of the electricity it produces. In other words, the public receives an environmental and economic reward when biomass power is generated. Second – and equally important – the value of the public benefits are more than six times greater than the 1.7 cent cost of the tax credit proposed in my legislation. From a public policy perspective, Congress would be well served by approving a tax credit that delivers such an extraordinary rate of return.

I would like to emphasize the fact that the nation’s biomass power industry is dependably producing clean electricity right now at a time when we are confronted with electricity shortages, in my state and elsewhere, that threaten our economy, our public health and our safety. While other renewable energy technologies may also make meaningful contributions to our electricity supply over time, few are as important in the present. We simply cannot afford to see a decline in biomass energy output and its inherent public benefits at a time when we have a clear responsibility to provide the American people with an uninterrupted supply of much needed electricity.

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Mr. Chairman and Members of the Subcommittee:

No discussion of the effect of the federal tax laws on production, supply and conservation of energy would be complete without acknowledging the significant role that capital cost recovery rules play in this regard. The electric power industry is one of the most capital-intensive industries in this country. The ability to recoup investment costs, including the depreciation and amortization of assets, is of critical importance to its viability and the nation’s access to reliable power.

The electric industry is rapidly changing to one in which generation is becoming fully competitive at a time when there is a growing need for new energy supply. However, the capital recovery rules that have applied in the past under a regulatory framework are now inadequate. Generating companies are no longer guaranteed a specified rate of return on their investment, and current tax law serves as a disincentive to upgrading and building more generation capacity at a time of increasing demand.

To efficiently meet our nation’s energy needs through adequate and reliable power, the electric supply industry requires the same ability that other industries have to more rapidly depreciate assets for Federal income tax purposes. I have introduced legislation, H.R. 1802, the "National Energy Security Act of 2001," that would amend the Federal income tax laws to allow electric generation facilities to be depreciated over seven years. Identical provisions are included in comprehensive legislation (S. 389) introduced by Senator Frank Murkowski (R-AK) in the Senate.

The Nation’s Inadequate Energy Supply Underscores the Need for New Investment.

The need for new investment to meet growing demand, to maintain the reliability of the electric system, and to ensure adequate energy supply across the nation has become clear. The energy crunch in California, preceded by spikes in the price for spot power in the Midwest, and power outages in cities such as New York and Chicago, has visibly underscored the need for new generation. Real events, supported by numerous studies, identify regions that will have dangerously narrow capacity margins within the next decade. The ability to obtain cost recovery must be provided to encourage the construction of new or improved electric generation facilities.

Other Capital-Intensive Industries Are Given Shorter Lives.

In stark contrast to the 15- or 20-year depreciation lives for electric generation assets, facilities for other capital-intensive manufacturing processes, such as pulp and paper mills, steel mills, lumber mills, foundries, automobile plants, shipbuilding, and even cigarette manufacturing plants are depreciable for Federal income tax purposes over seven years. Chemical plants and facilities for the manufacture of electronic components and semiconductors can be depreciated over five years.

There is no sound justification for these types of distinctions in today’s competitive environment. For example, according to tax law, investment in pollution control equipment at other types of manufacturing facilities have shorter depreciable lives, but not at electric generation facilities. As the electricity industry evolves and becomes competitive, it is important for it to have the same types of tax incentives to encourage modernization and increase productivity as those available to other industries.

New Investments Are Required to Comply with Environmental Laws.

New environmental requirements for electric generating facilities may impair the value and useful life of existing assets. For example, clean air compliance requirements, such as those relating to the Clean Air Act amendments, new source performance review, state implementation plans, National Ambient Air Quality Standards, and the Environmental Protection Agency’s toxic release inventory, are requiring significant new investment in environmental mitigation technologies. In some cases, existing plants will have to be effectively abandoned and new generation plants constructed. This will require new capital investment, investment that the tax laws should encourage, not discourage as under current law.

Upgrades to Existing Generation Facilities Will Be Accelerated.

The current fleet of generating facilities must run to their full advantage during this period of potential energy shortfalls. To optimize their capabilities, these plants must be maintained and in many cases, upgraded to become more efficient and cleaner. For example, an existing facility may be retrofitted with new turbine blades to increase conversion efficiencies and production output. And some facilities must be upgraded to comply with new environmental requirements. Revisions in the tax law will accelerate the necessary maintenance and enhancement of critical facilities.

Deregulation Is Fostering Innovation and Efficiency.

Deregulation of electric generation is already fostering innovation. The preponderance of new generation facilities constructed a generation ago were nuclear or coal-fired facilities. Today, most new power plants are gas turbine facilities, often operated in combined-cycle or as co-generation facilities that produce steam for sale as well as electricity. These new state-of-the-art combined cycle generators operate at energy conversion efficiency levels of 70% compared to 40%-50% a decade ago. However, tax laws discourage the construction of these more efficient units – while regular gas turbine facilities are depreciable over 15 years, combined cycle units are depreciable over 20 years.

In addition, new developments, such as distributed generation, could render longer-lived generation assets functionally obsolete. Distributed generation is electricity produced on a customer’s site using fuel cells, micro turbines, or other small scale generating equipment that can displace power generated by a central station generating unit. With these types of rapid changes in the electric industry, it is unlikely that electric generation facilities will have the same useful lives as they have had in the past.

Cost Recovery of Existing Plants Is Uncertain.

Congress suggested in the legislative history to the Tax Reform Act of 1986 that one reason why electric assets are depreciated over longer periods is because of the certainty of cost recovery through rates. As the market for electric energy becomes competitive, this rationale becomes obsolete – there will be no more such certainty. Investors will demand a competitive return on their investments over much shorter periods of time. This new reality is inconsistent with the current tax rules that allow cost recovery only over 15-20 years.

Just as the electric industry is rapidly changing, there is a need for a legislative solution to cost recovery for electric generation assets. A robust electric power industry must have the same ability as other competitive, market-based industries to rapidly depreciate assets for Federal income tax purposes. The Federal tax laws should be changed to allow electric generation facilities to be depreciated over 7 years.

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Mr. Chairman and Members of the Subcommittee:

As a representative of a state which has a good deal at stake in the ongoing energy debate, I am pleased to have the opportunity to discuss aspects of the tax code that hinder or help the production and distribution of energy resources. The provision that I am going to focus on in this testimony is one that many have overlooked with regard to its potential effect on our energy needs. In my opinion, however, this is an area where a small change in the tax law could reap substantial benefits by providing capital for the energy infrastructure necessary to gather, process, and store energy products such as crude oil, natural gas, natural gas liquids, refined petroleum products and propane, and to transport them from the areas where they are produced to the areas throughout the country where they are needed.

Many of those in the energy business have long raised capital through partnerships, which allowed investors to have a direct stake in both the risks and the rewards of the business, including the tax benefits that have been placed in the Code to encourage energy production. Back in the early 1980s, searching for a way to reach a broader class of investors and make the partnership a more efficient form of raising capital, the Apache Oil Company created the first publicly traded partnership (PTP). Others soon followed suit, not only in the energy industry, but in real estate and other industries that used partnerships as well. PTPs, also referred to as master limited partnerships or MLPs, were a way not only to reach new investors but to finance business expansion without resorting to debt and to spin off undervalued assets and let them reach their full market value.

PTPs, as their name suggests, are simply partnerships the interests in which, known as "units," are traded on public stock exchanges. Traditional, nontraded partnerships required limited partners to invest a substantial amount of money, and it was very hard to dispose of a partnership interest. This meant that partnership investment was limited to affluent individuals who could afford to tie up a large amount of money for several years. The development of PTPs, with interests divided into liquid, affordable units, has opened partnership investment to the average, middle-class investor, thus broadening the base of individuals from whom partnerships could raise capital. For the individual investor, PTP units provide a steady stream of income through quarterly, tax deferred distributions, and, particularly in the energy partnerships, the potential for growth both in income and in value.

There are currently about 50 PTPs on the market, operating primarily in natural resource and real estate related industries as well as a smattering of others. The most exciting story is to be found in the energy sector: although those PTPs are only about half the total number, they represent, according to their 10-Ks for 2000, close to two-thirds of PTP market capital, 71% of total assets owned by PTPs, and 90% of total revenue earned by PTPs. Several PTP equity offerings early in 2001 have probably raised these figures. Every new PTP to enter the market in the past few years has been in the energy business.

These PTPs are helping to address the current energy situation. They are exploring and developing offshore oil and gas supplies. They are gathering, storing, transporting, and marketing crude oil, refined petroleum products, natural gas, and natural gas liquids. They are operating refineries, fractionation plants, and natural gas processing plants. They are building pipelines and transporting a range of petroleum products through them from energy-producing areas to virtually every state in the union. They are marketing, distributing, and selling propane and propane-related products and services at both the wholesale and the resale level.

So what’s the problem? It is this: PTPs could be doing far more of all these activities, developing more energy infrastructure and sending far more products through the system, but are prevented from doing so by a small provision of the tax code. In order to engage in all these activities to their maximum potential, PTPs need to raise equity capital, and under current tax law they are limited to raising it from the individual, or "retail" investors. While access to these investors has been part of the engine that drives PTPs, the individual segment of the market is not, in itself, large enough to provide the capital that these energy companies need.

One of the sources that PTPs would like to tap is mutual funds, which are becoming an ever more important part of the capital markets. 15 years ago, only about 6% of equity securities were held by mutual funds; now the figure is 20%. According to the Investment Company Institute, almost $7 trillion in capital is currently invested through mutual funds.

Mutual funds, however, are very reluctant to invest in PTPs–not because they not a good investment, but because of the tax code. In order to maintain its tax status under the Regulated Investment Company (RIC) rules, a mutual fund must receive 90% of its gross income from specific sources. Income from a partnership (whether it be the share of partnership income allocated for tax purposes or the cash distributions) is not on the qualifying list. This means that if a mutual fund receives more than 10% of its income from PTPs (along with other "nonqualifying" income), it will lose its RIC status. Faced with this possibility, as well as the burden entailed in keeping track of income percentages, most mutual funds turn away from PTPs.

This, combined with the lack of institutional investment caused by the UBIT rules, forces PTPs to raise capital almost exclusively from individual investors. And while these investors are certainly a sizeable share of the market, they do not make the large share purchases that mutual funds and institutions do. Moreover, individual investors are increasingly making their investments through mutual funds. The result is that PTPs, compared other equity issuers, are extremely limited in the amount they can raise in any one offering and in the frequency with which they can go to the market.

Recently I had the opportunity to speak with several executives of these partnerships. They talked about the frustration they feel in trying to raise the large amounts of capital needed to expand and build new energy infrastructure when they can raise only limited amounts of equity capital in any one offering and don’t want to increase their debt burden. These companies have done a lot with the capital they have raised, but they all feel they could do much more if they were freed from this constraint.

There is no policy reason for PTPs to be treated any differently than any publicly traded security when it comes to mutual fund eligibility. The reason that partnerships were left off the qualifying income list was that before PTPs emerged, partnerships were highly illiquid, often risky investments, not the sort that was appropriate for a mutual fund. It was also felt that a mutual fund might be too closely involved with a nontraded partnership’s business. None of these concerns applies to PTPs–they are liquid, they are safe–fully regulated by the SEC, filing the same reports as corporations–and the mutual fund, as a PTP investor, would be one of tens of thousands of unitholders, not a manager of the business.

For all these reasons, I am pleased to be the sponsor this year of legislation that was introduced by Chairman Thomas in the 105th and 106th Congresses. The Publicly Traded Partnership Equity Act (H.R. 1463) simply adds income derived from a PTP to the list of qualifying income sources under the RIC rules. This bill has cosponsors from both parties, including some members of this Subcommittee. During the 106th Congress it was approved by both the House and the Senate as part of the Taxpayer Refund and Relief Act of 1999, which was subsequently vetoed by the President.

It is time that we freed these energy companies to do what they do best–build and operate the infrastructure that will deliver needed energy supplies to communities across the country. This is a simple, low-cost, and effective way to increase the capital flowing into the energy industry. It is an appropriate part of any energy bill that may come out of this Subcommittee and the Committee as a whole, and I urge that it be included.