Fall 2003

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Cal-Tax Commentary 

Carol Evans is vice president of the California Taxpayers’ Association (Cal-Tax).

In an attempt to find a gold mine, many cities throughout California are inadvertently traveling down a path riddled with land mines.

That’s the message the California Taxpayers’ Association has been delivering to local governments in California that have considered the risky prospect of municipalizing their local electric systems or forming “spot’ municipal utilities.

As the state’s budget mess compounds local government’s financial pressures, an increasing number of cities are turning to the prospect of municipalization as a potential way to raise additional revenues. Unfortunately, many of these local governments are unaware of the serious risks involved with creating and running a business as complex as an electric utility. Rather than creating a dependable new revenue source, municipalization actually exposes cities and their taxpayers to significant financial liabilities.

In an effort to assist local policy makers, Cal-Tax has produced a new, in-depth study outlining the significant risks to taxpayers, electricity consumers and local governments associated with municipalization. The study is entitled “Limited Area Municipalizations. A Study of Limited Municipalization Methods and the Fiscal Impact to Governmental Agencies. The author is Steve Spears of the SAER Group. (His background is described below.)

Key findings of the study reveal:

• Significant Market Risk: Most cities proposing spot municipalization have no electric generation facilities and no real leverage in negotiating long-term power contracts. This leaves them at the mercy of the wholesale market, where they will be competing with entities that have considerably greater leverage and experience managing energy commodity risk. Even if the city has generation facilities, the high cost and volatility of natural gas (the single largest cost factor in the generation of most electricity) illustrates a costly risk that will be borne by cities.
• Outage Risk – Operating Risk and Financial Risk: Any utility is inherently subject to the risk of power outages, caused by events beyond its control. Extended high temperatures, earthquakes, or employee error can reduce available margins or destroy distribution infrastructure, thereby resulting in blackouts. These events can create operation and financial risks. The operating risks turn on whether the small spot muni will have sufficient operations personnel to maintain the system and restore service. The financial risk turns on whether the small spot muni will have sufficient financial resources to pay for the restoration of service and to cover any potential third-party liability caused by the outage.
• Limited Revenue Bond Financing Option and General Fund Exposure: To finance the purchase and/or construction of spot municipalization infrastructure, several cities have proposed the issuance of revenue bonds (an option limited by law). Even if revenue bond financing is used, the revenue stream from the limited area in the spot muni likely will not be sufficiently diverse to satisfy credit rating agencies, bond insurers and bondholders. These individuals likely will require additional security for the bonds, requiring the city to expose its general fund revenues as a backstop.
• Unpredictable Redevelopment Agency Financing Option: In our opinion, the use of redevelopment agency dollars for this purpose is inappropriate, an unnecessary drain on the resources of redevelopment agencies and, given the state’s current proposal to shift money from redevelopment agencies over to K-12 schools, places unwise reliance on future redevelopment agency revenue.
• Risky Third-Party Financing Option: A few cities have expressed interest in obtaining financing through a corporate partner. Venture financing through a taxable private corporation results in higher borrowing costs at taxable (vs. tax-exempt) interest rates. Questions are also raised concerning the recourse rights of the corporate lender and/or bondholders in the event of default due to mismanagement, failure of the electric utility enterprise, or catastrophic damage or destruction of the distribution system.  Finally, in the event of failure of the corporate partner to uphold operating and management contract provisions or credit failure of the corporate partner, questions are raised concerning the rights of successors to the corporate partner.
• Lack of Sufficient City Fiscal Strength to Take on Risks: In our opinion, cities at this time can ill-afford to take on additional financial risk and the responsibilities of entering the electric utility business. Our research indicates most cities have major financial commitments and, with the ongoing state budget crisis, face a very uncertain fiscal future.
• Unanticipated and Uncertain Regulatory Risk: Despite the fact that municipal utilities are “self-regulated,” they must nonetheless deal with a number of regulatory risks and costs. For example, the California Public Utilities Commission (CPUC) recently handed down a decision that directly impacts the financial viability of new spot municipal electric utilities. Under this decision, the customers of cities forming spot munis must pay for their fair share of the high cost of power purchased under the California Department of Water Resources (CDWR) during the state’s energy crisis.
• Management Risk: Private sector contractors likely will not accept liability for the adverse results of a contractor’s bad decision without adequate compensation for that exposure. In fact, a contractor predictably will attempt to refer all or most risky decisions to the public oversight agent.
• Significant Revenue Loss to Federal, State and Other Neighboring Local Government Entities: According to a recent Cal-Tax study, revenue loss to federal, state and local governments from municipalization efforts in the Southern California Edison service territory alone are anticipated to range from almost $78 million to over $125 million over the next 10 years. This results from the loss of property tax revenue, federal and state income tax revenue and franchise fee revenues when a government utility replaces a private, tax-paying corporation.

In short, for cities facing uncertain fiscal futures, municipalization is not a fail-safe way to raise revenues. In fact, quite the opposite is true. The city, businesses, residents and taxpayers must consider this substantial financial exposure when public officials attempt to go into the business of delivering electricity.

The complete Cal-Tax study can be found at http://www.caltax.org/Municipalization.pdf