Regulatory Challenges of Tax Cuts and Jobs Act of 2017 NASUCA Mid-Year Meeting June 26, 2018

Tiffany Murray Deputy Consumer Counselor with the Indiana Office of Utility Consumer Counselor (OUCC) All comments in this presentation are my own and do not necessarily represent the opinions or positions of the OUCC, the Utility Consumer Counselor, NASUCA, or Governor Eric Holcomb.

Tax Cuts and Jobs Act - Impact on Regulated Utilities 21% Federal Tax Rate applicable to all investor-owned utilities Interest expense deduction limitations are not applicable to regulated utilities 100% deduction of capital asset costs is not available to regulated utilities Contributions of cash and capital assets to water and sewer utilities are now considered taxable income for those utilities

Tax Investigation Indiana Utility Regulatory Commission “The Commission recognizes that the approved tax reform will create benefits for utility customers because of the reduced federal tax burden on…investor-owned utilities…Accordingly, the purpose of this investigation is to review and consider the impacts from the Act and how any resulting benefits should be realized by customers.” (Commission order dated January 3, 2018)

Tax Investigation Indiana Utility Regulatory Commission “The Indiana Office of Utility Consumer Counselor (OUCC) looks forward to fully participating in this case on behalf of ratepayers throughout Indiana. We welcome today’s order, knowing that the Commission has taken quick action to open this investigation. As the OUCC’s staff continues to examine the new federal tax law, its complexities, and its implications for Indiana utilities and their customers, we will focus diligently on appropriate ratepayer relief as allowed by state law.” William Fine, Utility Consumer Counselor

Tax Investigation Indiana Utility Regulatory Commission (continued) Initiated an investigation into the impact of tax reform on investor-owned utility rates and charges (Cause No. 45032) Being conducted in two phases: Phase I – Adjust customer rates and charges to reflect the 21% federal tax rate Phase II – Will address excess deferred income taxes, over-collection of 2018 federal income tax expense, and any other tax-related issues All rate-regulated investor-owned utilities in Indiana are parties to this case All utility rates and charges that include federal income tax expense are subject to this investigation

Tax Investigation Timeline January 1, 2018 - Effective date of TCJA January 3, 2018 - IURC opened investigation March 26, 2018 - Utility Phase I filing date April 19, 2018 - OUCC Phase 1 filing May 1, 2018 - Effective date of Phase I tariffs June 19, 2018 - Utility Phase 2 filing date August 21, 2018 - OUCC and Intervenor Phase 2 filing September 21, 2018 - Utility Rebuttal 10/24 – 11/9, 2018 - Hearings

Income Tax Expense in a Regulated Environment Income tax expense included in customer rates is calculated based on a utility’s “book” income, not its tax income Regulated utilities recover both current and deferred income tax expense through rates Deferred income taxes are created when a utility’s expense for tax purposes differs from the expense recorded for book purposes Depreciation expense is one of the primary components of a utility’s accumulated deferred income taxes (ADIT)

Income Tax Expense in a Regulated Environment (continued) Accumulated deferred income taxes represent an interest free “loan” from customers to the utility A utility recovers taxes through rates that exceed the taxes it currently owes to the government and may not owe for many years into the future Accumulated deferred income taxes are included in a utility’s capital structure (as zero cost capital) for purposes of determining the utility’s weighted average cost of capital

Income Tax Issues Addressed by Commission Investigation

Federal Income Taxes Embedded in Rates (Phase 1 Issue) Income tax expense included in recoverable operating expenses for most investor-owned utilities has been based on a 35% federal tax rate Commission ordered investor-owned utilities to recalculate the income tax expense embedded in rates based on a 21% federal tax rate and file revised tariffs by March 26, 2018 “The revised Rates and Charges shall be designed to remove the difference between (1) the amount of federal taxes that the given Rate or Charge was designed to recover based on the tax rate in effect at the time the Rate or Charge was approved, and (2) the amount of federal taxes that would have been embedded in the given Rate or Charge had the new tax rate applicable…been in effect at the time of approval.” Almost all investor-owned utility rates will be decreased as a result of the Commission’s investigation

Excess Deferred Income Taxes (Phase 2) Accumulated Deferred Income Taxes (ADIT) have been valued at 35% Utilities must “re-value” their ADIT balances using a 21% income tax rate The difference between the prior AIDT balance (35%) and the new ADIT balance (21%) is known as Excess Deferred Income Taxes Excess deferred income taxes represent the portion of the interest-free customer loan (ADIT) that utilities must repay to their customers How quickly this “loan” is repaid to customers depends upon whether the ADIT is “protected” or “unprotected” Protected ADIT refers to ADIT created due to the difference between book and tax depreciation expense All remaining ADIT is unprotected

Excess Deferred Income Taxes (Phase 2) (continued) IRS regulations dictate how quickly protected ADIT can be repaid to customers Rules require the use of the Average Rate Assumption Method (ARAM) Average rate is based on the remaining useful life of the underlying assets Payback period will vary based on a utility’s circumstances and age of its utility plant Expect this payback period to vary between 20 – 45 years The Commission has discretion in determining the payback period for unprotected ADIT. The payback period will most likely be less than that used for protected ADIT and will differ between utilities depending on the facts and circumstances of each utility.

Over-collection of 2018 Income Taxes (Phase 2) 21% federal income tax rate went into effect on January 1, 2018 Most utility rates in effect since the beginning of the year include embedded federal income taxes at a 35% rate Therefore, utilities are collecting income tax expense in rates that they will not owe to the government The Commission’s January 3, 2018 order initiating the tax investigation also required utilities to track the amount of excess taxes being collected through rates Phase II of the Commission’s investigation will deal with how these over-collected income taxes should be repaid to customers

Isn’t this a rate change outside of a base rate case? While this issue hasn’t been pressed yet in Indiana, the Commission’s tax order from 1986 is instructive: In interest of absolute accuracy reviewing each affected utility’s rates in the context of a full rate case would clearly be preferred. However, we realize that such an undertaking would likely take several years. During that time any savings experienced by the utility as a result of the decreased federal tax rate would be lost forever to those utilities ratepayers. The actions of this Commission must, by statute, be based and predicated upon findings that those actions are in the public interest. It is most difficult, if not impossible, to find that a potential rate reduction should be delayed for a number of months or years to be in the best interest of the ratepaying public.

Contributions-in-aid of Construction Contributions to water and wastewater utilities can be a significant source of funding Cash Contributions Many water and wastewater utilities require a fee from new customers to help fund expansion of the utility to serve growth (treatment plants, booster stations, lift stations) Regulated water and wastewater utilities must also follow the Commission’s “main extension rules” when extending services to new customers. These rules require the customer to pay for the main extension less a three year revenue allowance. Over the next 10 years, as other customers connect to this extension, the original customer receives refunds of its original cost, thereby spreading the cost of the extension to all customers being served.

Contributions-in-aid of Construction (continued) Contributions of Plant When developers build a new housing addition, they build the water and wastewater infrastructure (distribution mains, etc.) to the utility’s specifications and then “donate” it to the utility Prior to the Tax Cuts and Jobs Act, these contributions were not considered to be taxable revenues for a water or wastewater utility Now these contributions will be considered taxable Cash contributions may need to be grossed-up to recover the income taxes due from the customer Utilities have three options regarding the collection of taxes for main extensions

Contributions-in-aid of Construction (continued) An applicant for a main extension has 3 cost options: Option 1 – Pay the cost of the extension including the tax impact and retain eligibility to receive refunds. Option 2 – Pay cost of extension exclusive of tax impact and retains eligibility to receive refunds. Option 3 – Either: (a) pay the cost of extension, including tax impact and retain eligibility for refunds or (b) pay the cost of the extension exclusive of taxes and forfeit all rights to refunds. The utility’s choice of options will depend upon its customer base. It may need to support or justify its choice to the Commission. Unclear at this time how the tax impact for contributed plant will be handled.

Key Points Indiana Utility Regulatory Commission has initiated an investigation to determine the appropriate review and consider the impacts from the Tax Cuts and Jobs Act and how any resulting benefits should b realized by customers Investigation to be conducted in two Phases Phase 1 deals with adjustment to income taxes embedded in rates and is being adjudicated on an expedited schedule to provide relief to customers quickly Phase 2 deals with all remaining tax issues and will take longer to adjudicate Utility rates for almost all investor-owned utilities will be decreasing as a result of the Tax Cuts and Jobs Act

Key Points (continued) Accumulated deferred income taxes represent an interest- free loan from customers to the utility. A portion of this loan is due back to customers as a result of the decrease in the federal income tax rate. How quickly this is paid back to customers will depend upon whether the deferred tax is “protected” or “unprotected.” Protected deferred taxes will be paid back over the average remaining life of the utility’s assets (20 – 45 years). Unprotected deferred taxes will be paid back over a period of time determined by the Commission. The benefit to customers from the reduction in deferred taxes will be determined in Phase 2 of the investigation

Additional Information regarding this investigation can be found on the OUCC’s website at http://in.gov/oucc/2891.htm You are welcome to visit this page to keep tabs on this case going forward. Thank You for the opportunity to speak to you today!