By JOE BEL BRUNO
As it moves into the new world of public-private partnerships, the Los Angeles Department of Water and Power has come face-to-face with a thorny problem protecting the tax-exempt status of its municipal bonds.
A misstep could be dangerous if the DWP bonds lose their tax-exempt status, it could trigger millions of dollars in losses to investors, which the DWP would be forced to cover.
“You are talking about the tax-exempt status of their outstanding bonds, and L.A. has an agreement to never break that (status),” said Mitchell Rappaport, an analyst with the San Francisco-based Large Power Council. “The laws are very restrictive and breaking them would have significant repercussions.”
In a memo circulated to the City Council last week, Ronald Deaton the city’s chief legislative analyst singled out the tax-exemption question as a concern that could have a major impact on the alliance. He said the issue must be settled, or it could “alter the nature of the proposed” partnership.
DWP officials say they have no intention of losing the tax-exempt status on $2.7 billion worth of outstanding bonds.
But they also acknowledge that protecting that status has become a key issue in current negotiations for a strategic alliance with Duke/Louis Dreyfus, a joint-venture of a North Carolina utility and a Connecticut-based trading company.
“This is a big problem but we will not break promises to the bondholders to maintain these bonds as tax-exempt,” said B.C. Monk, a DWP spokesman. “Private use has been an issue ever since deregulation was proposed, and we are just one of the first few to deal with it.”
The alliance, which must still be approved by the City Council, calls for Duke/Louis Dreyfus to help sell power generated by the DWP to other energy customers using sophisticated energy trading techniques developed by the private sector.
Duke/Louis Dreyfus would be guaranteed half of whatever income is generated by selling power outside Los Angeles.
The public-private alliance was made possible through legislation signed by Gov. Pete Wilson last year that phases in competition among the state’s public power providers.
The plan will force head-to-head competition among investor-owned and municipal-owned utilities. But the legislation left many problems unaddressed including the status of tax-free financings once a a private partner comes on board.
The city has hired outside consultants to determine what will happen when Duke reaps a profit through power sold from plants built using tax-exempt bonds. The tax-exemption was designed so that profits can be turned over to the municipality, and not to a private corporation.
“Overall it’s an issue,” said Dan Aschenbach, a vice president with Moody’s Investors Service, a Wall Street firm that rates the DWP’s outstanding debt.
“It puts any municipal-owned utility in a very delicate situation, where the loses could be severe,” he said.
Federal law has closely dictated what a municipality can and can not do under deregulation. Legislation enacted in 1986 limits what tax-exempt bonds can be used for. As a result, the Internal Revenue Service placed strict limitations on how for-profit companies can use publicly-financed power plants, he said.
On a power plant financed entirely through tax-exempt money, only 10 percent of the output can be sold for profit on the open power markets.
If it goes above 10 percent, the DWP would be forced to call the bonds and re-issue the securities as taxable. The new bonds would inflate the interest rate by about 25 percent.
“On one hand they are being told that competition is a forgone conclusion, but then the tax laws prohibit them from competing in a broader market,” Aschenbach said.
The DWP has hired the bond counsel firm of Orrick, Herrington & Sutcliffe to examine if joining the alliance would impact the tax-exempt status. In particular, the firm is looking for ways that the tax code would allow the city to maintain the tax-exempt status while at the same time exceeding the 10 percent limit.
Larry Sobel, a partner in Orrick’s L.A. office, said protecting the tax-exempt status has been a priority. He said not all the DWP’s plants have been financed through bonds, and that those that aren’t would likely be used exclusively by the alliance.
But Sobel acknowledges that navigating around the tax laws is uncharted territory. “There are limitations in the contract,” he said. “If they didn’t have those restrictions, there would certainly be more flexibility. But you create the best opportunities with what you have.”
In fact, some power analysts say the tax-exempt status might actually be impeding the DWP.
“Tax complications may limit or greatly impede muni utilities from taking advantage of this new competitive market,” said Gary Krellenstein, an analyst with Lehman Brothers. “What has been a boom to them over the years may now be an albatross around their necks.”
Without the limitations, he said, municipals would be able to sell much more power in markets outside their own service areas. At stake for the DWP is the production of about 1,000 megawatts of excess power capacity and an ability to produce even more than that in the future.
Bill McCarley, the DWP’s former general manager who resigned earlier this year over a salary dispute, says the tax issue is a problem industrywide. He contends that the tax-exemption would at some point hinder competition.
“This is a sticking point that needs to be addressed on a national level,” said McCarley. “It’s been my position to grandfather in all the existing debt, and not permit any tax-exempt issues to be sold in areas that are subject to competition. This would level out the playing field.”