Oncor’s Uncertain Future: A Critical Analysis of the Hunt Family’s Proposed Acquisition of Oncor Energy

May 8, 2016

On March 24th, the Texas Public Utility Commission approved a controversial proposal by the Ray L. Hunt family to purchase and restructure Oncor Energy, the state’s largest electric utility.[1] However, in its approval, the Commission declined to rule on what is perhaps the most contentious part of the plan: whether Oncor must share with ratepayers a portion of the $250 million tax savings that the utility will receive after restructuring.[2] The answer to that question—which has been reserved for a separate proceeding—may make or break a deal that could change the game for the utility industry statewide.[3]

 

The proposed deal follows a dramatic ten years for Oncor’s parent company, Energy Future Holdings Corp. (“EFH”). In 2007, in what was then the largest leveraged buyout in American History, a group of investors including KKR, TPG, and Goldman Sachs Capital Partners bought EFH for $45 billion, with expectations rooted in climbing natural gas prices.[4] Not more than six years later, EFH filed for bankruptcy with over $42 billion in debt.[5] The proposed Hunt family buyout would be a “path forward”[6] out of those bankruptcy proceedings, but with the deal’s conditioned approval, investors must now decide if they can live with the PUC’s proposed 12 pages of restrictions.[7]

 

The proposed transaction is as follows: OV1, a subsidiary of Hunt Consolidated, Inc. will acquire Energy Future Holding’s indirect majority interest of Oncor. Oncor will be separated into two companies: (1) Oncor AssetCo, which will hold all of Oncor’s transmission and distribution assets, and (2) Oncor Electric Delivery Company (“OEDC”), which will operate the assets held by Oncor AssetCo and hold all of the Certificates of Convenience and Necessity and personal property related to that operation. The equity capital for the transaction will be provided by a group of investors including the Hunt family, creditors of the Texas Competitive Electric Holdings Company LLC, and other investors designated by the Hunt family.

 

The most contentious issue brought to light in the proceedings surrounds the investors proposed Real Estate Investment Trust (REIT) structure, which will allow investors to save nearly $250 million dollars in income tax.[8] The question is whether a utility organized as a REIT may collect the value of those unrealized federal income taxes from utility ratepayers in the same manner as a utility organized as a partnership or corporation.

 

In favor of collection of federal income taxes from utility ratepayers, the investors have argued the following:

 

  1. Allowing the collection of federal income taxes will not increase rates. Because Oncor is currently a pass-through entity that does not pay actual taxes while receiving a 35% tax allowance, the 35% tax allowance that the purchasers seek would result in no change to the ratepayers.

 

  1. The Commission and judicial precedent demonstrate that utilities are entitled to include an income tax allowance in their rates as a matter of law. The Purchasers cite Suburban Util. Corp. v. Pub. Util. Com’n of Texas, 652 S.W.2d 358 (Tex. 1983), in which the Supreme Court held that “”[t]he income taxes required to be paid by shareholders of a Subchapter S corporation on a utility’s income are inescapable business outlays [and t]heir elimination from cost of service is no less capricious than the excising of salaries paid to a utility’s employees would be.”

 

  1. The Commission has consistently disregarded actual taxes paid by a utility’s owners, and the Texas Supreme Court has rejected the argument that utility rates should reflect actual taxes paid. In support of this argument, the Purchasers cite Util. Com’n of Texas v. GTE-Southwest, Inc., 901 S.W.2d 401 (Tex. 1995), in which the Supreme Court rejected applying the “actual taxes” formula, reasoning that “the income tax calculation is no different from other elements of utility ratemaking. . . the tax expenses will always be a hypothetical amount because the components which produce the calculation of income tax have been adjusted from the test year amounts.”

 

  1. Regulatory predictability, which is essential for garnering the investment in the utility industry that is necessary to meet the state’s needs, requires applying the income tax allowance.[9]

 

In response, advocates for ratepayers have argued:

 

  1. There is no precedent directly addressing the appropriate federal income tax allowance for a REIT in utility ratemaking.

 

  1. Because under Public Utilities Regulatory Act (“PURA”), utility rates must be “just and reasonable,” providing the utility with only a “reasonable rate of return”, allowing a 35% tax allowance would be unreasonable given the structure of the proposed transaction.

 

  1. There are many instances where the Commission considers certain tax benefits of upstream entities in utility ratemaking. The Consumers cite PURA § 36.509, which requires certain tax benefits to be credited to customers, and PURA § 36.060 which explains that, if an expense is included in the rate base, the related income tax benefit must be included in income tax expense to reduce the utility’s rates. The consumers note that these requirements must be applied whether a utility is a pass-through or stand-alone entity.

 

  1. In cases where the Commission has allowed a utility that is a pass-through entity to collect a 35% tax allowance, those determinations followed fact specific inquiries, and those situations were significantly distinct from a REIT structure that thy have no precedential value in this situation, as the Purchasers claim.

 

  1. Because the REIT structure allows for avoidance of all or nearly all income tax liability (the maximum amount of income on which a REIT can be taxed is 10%), the appropriate income tax allowance should be 3.5%, representing the standard 35% tax allowance afforded to utilities multiplied by 10%, the maximum taxable income.[10]

 

After reviewing these arguments, the commission granted a highly conditioned approval to the proposed deal, allowing Hunt to structure Oncor into a REIT. But the PUC has declined to address the issue of whether the REIT will be able to collect the full 35% tax allowance from ratepayers that has been standard in the industry, making clear that it “may force the utility to share some of those tax savings directly with ratepayers, potentially lowering their bills.”[11]  While Commissioners Anderson and Marquez have both voiced support for sharing the savings with ratepayers, Chairman Nelson has warned that requiring such sharing could ruin the deal.[12]  As it stands now, a decision on this contentious issue could take over a year, and Hunt officials have yet to comment on whether investors will move forward given the commission’s decision.

 

 

[1] Joint Report and Application of Oncor Electric Delivery Company LLC, Ovation Acquisition I, LLC, Ovation Acquisition II, LLC, and Shary Holdings, LLC for Regulatory Approvals Pursuant to PURA §§ 14.101, 37.154, 39.262(l)-(m), AND 39.915, PUCT Docket No. 45188, Order (March 24, 2016).

[2] Jim Malewitz, PUC Approves Buyout of Oncor Electric by Hunt-led Group, The Forth Worth Star-Telegram (March 24, 2016), http://www.star-telegram.com/news/business/article68019537.html.

[3]  Robert Walton, Texas PUC Approves Hunt-Oncor Acquisition, but Questions Still Linger, Utility Dive (March 28, 2016), http://www.utilitydive.com/news/texas-puc-approves-hunt-oncor-acquisition-but-questions-linger/416357/.

[4] David Carey & Richard Bravo, Biggest LBO Failure is Energy Purgatory for KKR, Bloomberg News (February 25, 2013), http://www.bloomberg.com/news/articles/2013-02-25/biggest-lbo-failure-is-energy-future-purgatory-for-kkr.

[5] Mike Spector, Emily Glazer & Rebecca Smith, Energy Future Holdings Files for Bankruptcy, Wall St. J (April 29, 2014), http://www.wsj.com/articles/SB10001424052702304163604579531283352498074.

[6] Walton, supra note 3.

[7] Id..

[8] Application of Oncor Electric Delivery Company LLC for Authority to Change Rates, PUCT Docket No. 35717 (pending).

[9] Initial Brief of Ovation I, L.L.C., Ovation Acquisition II, L.L.C., and Shary Holdings, L.L.C., PUCT Docket No. 45188 (March 27, 2009).

[10] Texas Industrial Energy Consumers’ Initial Brief, PUCT Docket No. 45188 (March 27, 2009).

[11] Malewitz, supra note 2.

[12] Id.

Caroline Ellerbe is a third-year law student at The University of Texas School of Law. She graduated from Princeton University in 2010 and will be joining Latham & Watkins in Houston after graduation.