fossil fuel subsidies

It's been almost two years since Earth Track and Oil Change International released a detailed review of oil and gas subsidies to Master Limited Partnerships (MLPs).  The paper documented the favored exemptions that MLPs receive from standard corporate tax rules and how they primarily benefitted oil and gas companies; the increasing use of IRS private letter rulings to broaden the range of activities able to shelter natural resource-related income from corporate taxation; concerns that efforts to expand eligibility to renewable energy would also dramatically expand exemptions for fossil fuels and conventional electric power generation; and the possibility that the revenue losses from MLPs were being greatly underestimated by the federal government.

Growing push to move energy assets off the corporate tax roles

The key pressures driving "MLP-ification" (an apt term popularized by an equity research team at Goldman Sachs) remain:  an effort to bypass corporate income taxation for large swathes of energy assets, while still allowing access to public equity markets through listed shares.  The tax-bypass challenge isn't just limited to MLPs, and is raising increasingly important policy questions regarding tax collections and cross-sector tax neutrality.  This matters to economic development because political decisions are creating differential tax burdens by industry; and it matters to renewable energy and climate change because the vast majority of the publicly traded energy enterprises escaping federal corporate income taxes are in the fossil fuel sector.

Real estate investment trusts (REITs) also allow publicly-listed partnerships to avoid corporate level taxation.  Like MLPs, tax-favored REITs have been around for decades.  Yet, a similar process of IRS rulings have gradually broadened the definition of eligible property:  most recently, power transmission assets have entered the pool of REIT-eligible assets.   The chart below, developed by Professor Felix Mormann (University of Miami and Stanford), succintly summarizes this expansion (full set of slides here):

Another new entry to tax-favored energy structures is the "YieldCo," an MLP-variant that bypasses limitations in MLP eligibility to open corporate tax avoidance to solar, wind, and hydro assets as well.  While not technically exempt from corporate income taxes, the YieldCo structure forms a "synthetic MLP" to avoid corporate taxes using expenses and high depreciation deductions.

There is no doubt that all of these structures reduce the cost of capital and/or boost margins for eligible players.  But while the energy sector is an important part of our economy, it is not the only part or even necessarily the most important part. 

Tax favoritism for some types of assets or industries over others introduces political bias into which economic sectors succeed.  If one wishes to argue that any taxation of corporate income is inefficient and should be replaced with other mechanisms of raising revenues, that may well be a debate worth having.  But using an arbitrary or politicized process to exempt energy or real estate enterprises from corporate taxation while other worthy sectors face normal tax rates is hardly a logical underpinning for the competitive market that the US purports to be.

Recent trends show continued growth in MLP assets, and increased use of other favored corporate structures for holding energy assets as well

Here's a brief review of some of the major MLP-related themes emerging since our paper was released:

1)  Eligibility continues to expand; IRS proposed rule puts brakes on some sectors, though challenges likely.  The number of private letter ruling requests to the IRS on whether particular income streams qualified for MLP status rose sharply, reaching well more than 30 in 2013.  Despite the growing number of requests for rulings, in the vast majority of the cases the IRS ruled in favor of the petitioners.  As a result, the number of firms and industries successfully able to avoid corporate income taxes through the MLP rules grew steadily.  As the number of petitions continued to rise, however, the IRS decided a more formal evaluation was needed.  The Service released a draft of those guidelines on May 6th.

Although the rules remain open for comment, a  number of early conclusions are being drawn:

• Paper industry-related MLPs, once considered an impending extension of those created for fossil fuel activities, no longer seem likely.  The IRS has argued that because paper requires additive processing of wood and pulp (e.g., the addition of chemicals), it would fail one of its eligibility tests.  Other timber-related activities that don't require chemicals or other substances to manipulate the properties of the wood would be remain eligible -- saw mills or bark mulch production, for example.  Thomas Ford of Andrews Kruth LLP argues the published interpretation is a material change in IRS policy, reversing a private letter ruling from two decades ago. 
• Companies that sell fuels in bulk to airlines or government customers would produce eligible income; general retailers would not be. Fuel terminalling and storage can be organized as an MLP as well. 
• Fuel refining eligible for MLP treatment is not entirely consistent in the IRS proposal.  Olefin production was deemed eligible under prior letter rulings, for example, but appears to be excluded now (existing MLPs would get a 10 year transition period).  Production of natural gas liquids would be eligible if the product was also found naturally in petroleum fractions, but not (as with methanol) if it is always manufactured. 
• Many fracking support operations remain eligible, so long as they are recurring, central to well production, and specialized.  Water delivery is not, so could not be organized as an MLP.  However, water service companies that remove and treat water as well as deliver it would be.

Sidley Austin LLP notes that

The Proposed Regulations appear designed to establish uniform and balanced standards for determining qualification across various types of activities, while remaining true to the directives of the legislative history to the enactment of Section 7704(d)(1)(E). Nonetheless, perhaps constrained by the legislative history, the Proposed Regulations reflect a substantial amount of arbitrariness in the application of the announced standards, and set forth industry-specific applications of these standards.

I'm not fully fluent in lawyerese, but the undertones here seem (and in comments from other law firms) seem clear:  industry challenge of the IRS proposed rule is likely.  And, despite some restrictions on MLP growth, it is also clear from the IRS proposed rules that a growing set of functions in the fossil fuel production and delivery system will remain eligible to operate as tax-exempt MLPs.  Further, by eliminating the need for a private letter ruling, the process of asset conversion to tax-exempt MLPs may actually accelerate after the IRS regulations are finalized.

2)  The market capitalization of tax-exempt MLP fossil fuel assets continues to grow sharply.  The primary driver of this growth appears to be a continued migration of assets from taxable corporate forms to MLPs, as other possible factors seem to be working in the opposite direction.  Lower oil and gas prices and concerns over rising interest rates, for example, have both dampened the rate of increase in MLP share prices.  Further, we have seen some very significant MLP-reversals, where MLP assets were "re-corporatized" due to strategic (i.e., non-tax) factors.  Foremost here was the merger of Kinder Morgan MLPs back into the parent company, a deal estimated to be worth more than $70 billion.  This one transaction alone, absent growth of new MLP assets, would have lopped an equivalent of about 18% of the estimated MLP market cap value when our paper was done (and more than 20% of natural resource-focused MLP portion).

Earth Track and OCI's review of MLPs in mid-2013 found a market cap of all MLPs at about $400 billion, of which about $325 billion was natural resource-related (primarily oil and gas).  The National Association of Publicly Traded Partnerships (NAPTP) periodically prepares an industry overview of MLPs called "MLP 101".  The last public version of this document in October 2013 estimated market cap of MLPS at $490 billion, of which $422 billion was for natural resource MLPs (see Slide 33)  -- again, primarily oil and gas. 

Despite the slowdown and the loss of three MLPs related to Kinder Morgan, the MLP sector has continued to grow.  Total MLP market capitalization as of May 12, 2015 was $679 billion based on an Earth Track review of listed MLPs.  Of this, 77% was associated with fossil fuels -- most heavily oil and gas midstream operations, as has been true in the past as well.  Despite this growth in market cap, official estimates by the Joint Committee on Taxation of revenue losses to the US Treasury from the MLP structure holding this growing pool of assets (JCX-97-14, p. 24) have barely changed -- and are flagged at a maximum of $1.2 billion/year through 2018.

Other items of note:

• A handful of renewable energy firms (about $6 billion in market cap) somehow qualified as MLPs and were listed on NAPTPs census. 
• There has been robust growth in financially-oriented MLPs as more and more large private equity firms seek to tap less expensive capital via public markets using an MLP share listing.  These firms comprised just under 19% of total MLP market cap.  Most of these firms have substantial investments in the fossil fuel sector (often through private partnerships that are part of their investment portfolios), though the fossil fuel share of total investments is not known.  Many of these firms also have highly compensated executives (some of the wealthiest people in the country, in fact) who are also benefitting from subsidies to carried interests in their funds, taxed at lower capital gains rates rather than standard income tax rates.
• A subset of MLPs have chosen to be taxed as corporations rather than as tax-exempt MLPs.  This choice seems rather odd at first, as firms rarely volunteer to be taxed at a higher rate than the minimum required by law.  However, further inspection shows that the vast majority of the MLPs choosing this path are in the oil and gas marine transport business, and are often organized outside of the United States.  While additional research would be needed to conclusively determine why this is happening, the likely explanation is that these firms are able to access special tax rates, often in tax havens, that generate an even lower effective tax rate (combining the tax hit at both the corporate and and unitholder levels) than would be possible as a pass-through MLP.  This is probably a function of the "Alternative Tonnage Tax" that allows tanker firms to choose a (very low) tax on tonnage in lieu of paying corporate income taxes.   The law was passed in 2006 in the US, but similar regimes existed for longer in other countries.  It provides yet another interesting, though not well-quantified, subsidy to the price of oil we see as consumers.

3)  Expansion of tax-exempt corporate structure to renewable assets via REIT and YieldCo structures.  As noted above, energy assets have been shedding corporate tax liability via at least three main venues:  MLPs, energy-related REITs, and YieldCos. 

Two years ago, federal legislation to expand MLP eligibility was being pushed heavily (primarily by Senator Christopher Coons of Delaware).  My concern was that the legislation would (a) make it impossible to ever kill tax-subsidies to oil and gas MLPs (indeed, oil state reps like Lisa Murkowski seemed to recognize this angle, and were co-sponsors of the Coons bill); and (b) open the tax exemption to a larger set of energy assets than perhaps had been intended.  This seemed likely to include power generation and transmission of all types.  Yet, when the revenue loss of the Coons bill was scored by the US Joint Committee on taxation, they estimated an average of only $130 million/year over the ten year period of estimates.  Details behind their calculations were not made public, so it was not possible to evaluate their scoping or assumptions.  But the figure still seems very low to me.

The successful roll-out of YieldCos may render MLP expansion moot.  In but a handful of years, YieldCos have gone from a theoretical construct to a growing number of firms and tax-favored assets.  With a current market cap of more than $25 billion, the sector is on-track to hit $100 billion within a few years according to Jeff McDermott of Greentech Capital Advisors.    A YieldCo-specific ETF has just been launched as well. 

A review of the corporate structure of YieldCos versus MLPs suggests that they have attributes that make them easier to invest in for some institutional investors (emphasis added):

Several factors differentiate a YieldCo from a MLP - including a more traditional tax treatment, which makes it easier to invest in for many institutional investors. First, a YieldCo is a corporation, not a partnership or limited liability corporation like a MLP. Second, assets often targeted for a YieldCo - such as renewable and contracted
conventional plants - are not "MLP-able" under current law. Third, YieldCo's are not eligible for pass through tax treatment, although often maintain significant tax shields and NOLs that mitigate cash tax outflows.1

It is notable that my concern about tax-favored status to conventional power plants emerging from MLP-expansion may actually materialize via the YieldCo structure instead.

What of the energy-related REITs?  Drop-downs of power transmission assets into tax-exempt REIT structures have begun, facilitated by the 2014 IRS ruling.  InfraReit, for example (ticker HIFR), holds a chunk of TX assets owned by the Hunt family (the nation's 13th wealthiest family according to Forbes) in a new, corporate framework exempt from corporate-level taxation. 

No, the Hunt family is not doing anything illegal:  they are simply leveraging existing law to their benefit.  But the policy trade-offs, and who benefits, are worth thinking about.  And the migration of transmission assets off of corporate tax roles is likely to accelerate -- a trend, by the way, that is most likely to help large scale, centralized conventional power generators while disadvantaging smaller scale distributed generators and energy efficiency. 

Energy-related REIT assets are a fast-growing share of the "non-traditional" REIT universe, according to data from SNL Financial gathered by Ernst & Young (page 15).  The Edison Electric Institute notes (page 6) transmission investments running more than $10 billion per year from 2011 forward by private utilities, so the scale of assets moving off of the tax roles via "WireREITs" could be as significant as we've already seen with MLPs and non-energy REITs.

The effort to push ever more low-cost capital into energy infrastructure of all types is happening in somewhat of a vacuum.  Lawmakers and lobbyists alike are ignoring the distortionary impact that these tax-exempt corporate forms for "special" industries have on the equality of business opportunity within the country.  We should not be.

• 1Source: Goldman Sachs Equity Research, "Juncture to Restructure: YieldCo 101," May 14, 2014.

I'm happy to announce the release of Fossil Fuel Subsidies:  Approaches and Valuation, a paper I wrote with Masami Kojima at the Bank.  Masami has written about fossil fuels for many years, often focusing on the functioning of the price mechanism in oil markets.

The working paper takes a deep dive into the main subsidy measurement approaches used to estimate global subsidies to fossil fuels -- including estimates produced by the IEA, IMF, OECD, and the World Bank.  We look at the many challenges regarding data acquisition and valuation, how these challenges are likely to affect reported estimates, and important factors that contribute to large differences between global estimates. 

Recognizing that available budgets to track and value fossil fuel subsidies are always limited, we also identify some promising options for increased institutional cooperation going forward.  These initiatives would broaden the informational base on fossil fuel subsidies overall, and help to standardize subsidy measurement and key data inputs.

Cross-institutional collaboration is already growing, and key staff from all of the institutions we looked at graciously provided their time to review drafts of our paper and to contribute their ideas for future improvements.  It is my hope that this trend that will continue to accelerate in the years ahead.

More than most mainstream publications, The Economist has regularly covered energy subsidies and consistently called for their elimination.  Too many newspapers pick and choose which subsidies they care about.  The Wall Street Journal, for example, rails on subsidies to renewables -- particularly wind and corn ethanol.  But government largesse to fossil fuels and nuclear power always seems to be illusory figments of greenie imaginations.  Midwest publications too often turn a blind eye on subsidies to ethanol or the corn (and water) that makes it. 

The Economist has been more even-handed in trying to get markets working and price signals behind technological transformations.  Their January 17th piece "The Oil Crash Has Provided a Once-In-A-Generation Opportunity," focusing on fixing policy failures in the energy sector, is no exception.  They call for stripping subsidies to all forms of energy as a way to right precarious government finances and to more accurately price carbon.  And on top of simply eliminating subsidies to carbon that flow from subsidies to fossil fuels, they call as well for a carbon tax to address the non-internalized environmental damage associated with today's patterns of fossil fuel production and consumption.

The core of their argument is this:

• When energy prices are soaring, it is hard to boost taxes and eliminate subsidies because consumers are already stretched.

• The falling prices of fossil fuels, along with technological innovations in substitutes, allow a transition to real energy prices to be done at a much lower political cost.

• Politicians should fix energy prices during this window.  They should eliminate subsidies to consumers, and they should fix fuel taxes (such as the one in the US that funds our nation's highways) to bring them in line with inflation-adjusted values and current funding requirements.
• Even better would be the addition of a tax on carbon to more accurately align the market prices on carbon-based fuels with their social impacts.  "As fuel prices fall," the magazine notes, "a carbon tax is becoming less politically daunting."

The approach makes sense.  Indeed, we'd surely be in a better place if these recommendations were to be implemented quickly.

The rub is that the article simplifies both the interactions between energy resources and the manner in which governments provide energy subsidies.  As a result, lower prices do not mean that constraints to reform have all gone away. There are three main impediments:  subsidy type, the political power of the beneficiary, and subsidy interactions between different energy options.

1)  The optimal time to reform subsidies varies by the type of subsidy.  For energy consumers (which include large industrial users as well as households), The Economist is spot-on:  the time for reform is now.  Lower prices create political wiggle room for reform because many energy consumers are less attuned to the rate of decline in energy prices than they are to the fact that their absolute prices are lower than they were a year or two ago.  Long-time structural flaws in energy pricing systems -- such as the exemptions that most US states provide to all fuel and power consumers from sales taxes -- should also be corrected so energy is on a equal basis with the other goods and services in an economy.

For energy producers, however, the exact opposite is true.  The rapid decline in fuel prices has led to financial losses, layoffs, cancelled projects, and growing fiscal distress on the producer side.  There were some fat years before today, so we've not yet seen waves of bankruptcies.  However, the shift in fortunes has been quick.  The optimal time to have rid ones statutes of producer subsidies was during the fat years (see graphic) when fuel prices were surging:  2007-08 (before the credit collapse), or again the past few years when prices for fuels were again quite high. 

Did our politicians carpe diem?  Well, no.  In most situations, they missed that window entirely. Their arguments for inaction vary by time period, though it has been inaction all the same.  During surging energy prices, they commonly argued (doing their best to do so with a straight face) that nearly all of the supports weren't really subsidies.  During the current market environment, the politicians are more likely to focus on the challenging fiscal enviornment for producers and the additional jobs that would be lost from subsidy cuts. 

2)  Locking in lower subsidies requires political action, but the politics of subsidy reform vary across subsidy types and location.  Economics aside, the political environment drives the ability to deliver reforms, and this fact makes it difficult to achieve coherent reforms even within a country, let alone multinationally. 

Both subsidy creation and subsidy reform are creatures of political economy.   The economics certainly influence the political economy, particularly in the fringes -- such as where the very wealthy are being subsidized or the gross cost of support rises so large that the country is destabilized.  But for the majority of subsidies in place today, the political dynamics may run largely independent of the economic benefits of reform.

Consider what seems to be a no-brainer of a reform:  boosting the US federal excise tax on motor fuels for the first time since 1993 to stem the growing deficit in highway funding.  A rational review of the issue from either political perspective should conclude that increased fees make sense. 

Republicans should like the idea of users paying the full cost of the roadways rather than literally free-riding on the backs of general taxpayers. Democrats should like the idea that more highway funding creates construction jobs (often unionized) and makes it easier for workers seeking employment to travel to job opportunities.  Both groups should recognize that the purchasing power of the existing tax has dropped sharply, since it has not been adjusted for inflation in more than two decades; that the Highway Trust Fund tasked with building and maintainings the nation's interstate highway system is facing growing shortfalls; and that incremental improvements in fuel efficiency are reducing the excise fee per road-use mile even independent of inflation.

And yet inaction continues to be the norm.  Even with the large drop in gasoline prices over the past year, and the clear need, the political will to boost the tax may not exist.  Instead, boosting gasoline taxes continues to be a "third rail" of politics -- a reference to the electrified middle rail of some urban subway systems (including here in Boston) that if you touch it you die (or your political career does).

The politics of fossil fuel subsidies to consumers elsewhere in the world are thankfully a bit more mixed.  Much of the $550 billion or so that the International Energy Agency estimates flows in fossil fuel subsidies to consumers each year originates with interventions in fuel pricing.  The objective is to dampen price increases or to keep fuel prices low.  Ostensibly, this helps poor consumers make ends meet, but  empirical assessments by the IEA, IMF, and World Bank all indicate much of this support leaks to wealthier consumers. 

When prices fall, required levels of public support do generally fall under most of the pricing schemes now in place.  This is, of course, a helpful trend for governments who are trying to balance their budgets.  But unless the rules behind the price buffering mechanisms are permanently changed during the pricing downturn, the gains will quite often be reversed as soon as energy prices move back up recover.  (For a detailed review of price passthrough policies and reforms, see this paper by Masami Kojima of the World Bank).

Changing the rules can be done more easily when prices are low, but that doesn't mean the subsidies are gone for good.  If prices surge again, even with altered rules that curb government price caps or other supports, the political pressures to reintroduce the supports grow rapidly.  Many introduced reforms ultimately fail because of this dynamic.  Case studies, such as those in this IMF study, can help map a reform path that lasts.

Political reform of producer subsidies is almost always challenging as well, regardless of the direction of energy prices.  Because the benefits of existing policy are large and the beneficiaries concentrated, the incentive to invest in lobbying is quite large, and recipients invest heavily to delay reforms and expand benefits.  More established industries are often better at the political influence game than are startup firms or emerging technologies, and this dynamic is another reason why systemic reform treating all sectors equally (as The Economist rightly advocates) is challenging to achieve in practice.  The risk that subsidy reform will affect the newer, weaker industries while defining away the subsidies to the strong is quite real. Even in the Tax Reform Act of 1986, widely viewed as the model for eliminating special interest tax subsidies, the US Congressional Research Service notes that subsidies to oil and gas survived:

While the Reagan Administration did successfully reduce the number of energy tax provisions, the Administration did not accomplish all of their stated goals. Specifically, the primary tax incentives for oil and gas (expensing of IDCs and percentage depletion) were not eliminated, although they were scaled back...1

3)  Subsidy-related cross-fuel interactions.  All reforms have winners and losers, and even systematic elimination of fiscal subsidies to all fuels at once can affect industry sub-sectors in very different ways.  Here are some examples of the problem:

• New versus old subsidy beneficiary.  Support to renewable energy (including some no-so green resources such as ethanol and landfill gas) has been rising sharply in recent years.  However, subsidies to oil and gas have existed for 90 years; to large-scale hydro nearly as long; and to nuclear for more than half of a century.  Proponents of renewables argue it is unfair to eliminate their support when their competitors have benefitted at the public trough for so much longer.  Historical support, they argue, has been baked into the cost structure we see today from their competitors.  Yet subsidies need to end a some point, so how does it get done? 
• Fiscal versus environmental subsidies.  Clearly ending support to renewables without dealing with the environmental impacts of fossil fuels at the same time would be a recipe for failure.  This is because environmental damages from the fossil fuel cycle -- whether via ghg emissions or damages to land, air, or water resources -- are a significant factor in the competitive position of these fuels against renewables.  This cost advantage would remain even after fiscal subsidies were removed; demand and supply-side options with more favorable environmental footprints would be displaced. 
  
  The discussions around subsidy reform often focus on fiscal subsidies alone (spending, credit and insurance, etc.)  Yet, if support for renewables is to be removed at the same time as that to conventional fuels, the large external costs of fossil fuels on human health and environmental quality must be addressed concurrently.  Otherwise, it will be impossible to achieve the magazine's goal of a neutral energy playing field. 
• Legacy subsidized infrastructure.  The magazine argues that "the more cross-border pipelines and power cables the better," in reference to political opposition to the Keystone XL pipeline and the export restrictions many countries (including the US) place on energy products.  The core logic here is good:  price systems ration goods to their highest value uses, and trade allows that rationing to occur on a global scale.  But two factors impede this grand vision.  First, the legacy subsidies may be what enabled uncompetitive projects to move forward in the first place; absent such support they would never even have been built. 
  
  This is both a trade and an environmental issue, as the projects that win as a result may well be associated with imports (undermining local jobs or industries), or with harmful environmental impacts.  This issue is certainly relevant to the transport infrastructure to move tar sands to markets:  both the Keystone pipeline, other transport lines as well, and to the refineries focused on processing this type of crude.  But is is most important relative to the Alberta tar sands themselves, that were heavily subsidized for many years. The issue is also one that appears to be central in the push to drill for oil and gas in the Arctic circle. 
  
  Second, the infrastructure associated with the energy exchange may be moving commodities that are not properly addressing external costs, expanding the geographic range of the distortions.
  
  How should this legacy support play into current decisions?  Ignoring the subsidies entirely and starting fresh as though they never happened doesn't seem entirely fair.  And since pipelines and massive tar sand extraction sites last a very long time, these decisions will exacerbate environmental damages for decades to come.

Eliminating fossil fuel subsidies to consumers now makes sense.  Though low fuel prices may give cover to politicians to make such changes now, these reforms nonetheless do need to address issues of energy poverty from the outset, ensuring policies are in place to poorest once energy prices rise again. Otherwise, the subsidy reform "successes" will be short-lived.

User fees should also be brought up to appropriate levels, and clear exemptions from consumption taxes across many countries in the developed world should be eliminated as well.  It is also a very good time to establish even a quite low carbon tax -- one that gets the tax system structure right, and grows slowly over time according to pre-established rules that are nearly impossible to derail once in place.  These are all no regrets policies; indeed, had we implemented a low, but regularly-escalating carbon tax soon after the Rio conference in 1992, we'd be in a very different place by now. 

• 1Molly Sherlock, Energy Tax Policy: Historical Perspectives on and Current Status of Energy Tax Expenditures, (Washington, DC: US Congressional Research Service), May 2, 2011, p. 5.