Regardless of the State or the property being valued (personal or real) at an electric generation plant, the cost approach remains the predominant measure of value. Yet, the de-regulated marketplace eschewed that approach. Whether by an assessor, administrative body or State judicial or administrative tax appeal board (“courts”), the cost approach remains the dominating valuation approach. Why? According to cases, the electricity market is volatile, which makes projections difficult and, thereby, likewise, the application of the income approach. Conversely, the cost approach is seen as “less difficult” and volatile (meaning, of course, the assessor and court are not applying it fully). Practically, the result is that the standard of proof for electric generation plant assessment challenges remains higher than that applied to general commercial or residential properties. Coincidentally, the reduction in value for generation station also tends to have the greatest impact on a taxing jurisdiction’s tax base. Simply, and notwithstanding the de-regulated nature of the market (including its voluminous sales of generating assets), the archaic and maximum value seeking cost approach remains the predominant mode of valuation, resulting in many generation plants being over assessed.
The Marketplace for Generation Assets
When a market exists for property, the valuation must be by the
manner applied in the market. Whether a “market” exists
is a question of fact (not law). A “market” can be
defined in two manners: (1) a market for the sale (both new and
used) of the property (e.g., the sale of generation assets) or (2)
a “market” with respect to the direct or intrinsic
income generation of the real property (electricity prices,
capacity prices, etc.). If no market exists, the property tends to
be labeled “specialty property”; whereupon, the cost
approach is normally applied.
Following the Federal Energy Regulatory Commission’s Orders
888 and 889, numerous States embarked on unbundling and
de-regulating electric generation assets. As part of that process,
utility companies either totally or partially departed the
wholesale electric generation market, by divesting their generation
assets or spinning them off into deregulated independent power
producers. In addition, regional transmission organizations
(e.g., PJM, MISO, NYISO) developed, maturing the market
for the sale of electricity (and other energy commodities).
Valuation of Generation Assets Should be by the Income Approach
In valuing properties, most States agree that a recent sale of
the subject property between a seller that was under no compulsion
to sell and a buyer that was under no compulsion to buy is the best
indicator of value. That purchase price is often determined by an
income approach. Virtually never has a purchase price resulted from
applying the cost approach. Today, almost two decades after
de-regulation commenced, it is accepted that a market exists for
electric generation plants. Thus, one would assume that the
preferred valuation approach has become one other than the cost
approach. In particular, since market participants solely apply the
income valuation approach to determine value. Assessors and courts,
though, remain loathe to apply the income approach, finding it
cumbersome. That is, unlike, general commercial properties (where
the income approach takes comparable market lease income, deducts
market operating expenses (that tend to be stable and predictable)
and, then, applies a capitalization rate applicable for the area or
region in which the property is located, the income approach for a
generation station involves the discounted cash flow
(“DCF”) methodology. That means for each year of the
discounted cash flow a projection of the three forms of revenues
attributable to tangible property is made, followed by the
deduction for projected operating expenses, and the application of
a discount rate (taking into account an effective property tax
rate) to present value the annual cash flow to the valuation date.
With the increased presence of wind and solar, and their volatile
generation, market electricity price projections are more complex
but, generally, lower. Regardless, market participants apply the
DCF to determine a generation plant’s value.
Before applying the income approach, the initial inquiry is whether
the ingredients of an income approach are sufficiently (as opposed
to speculatively) in place. Also, the appraiser must recognize that
the income approach values the business enterprise, as opposed to
just the tangible property, requiring the appraiser to deduct the
value of any intangible property (e.g., working capital), and to
allocate the remaining tangible property value between the real and
personal property.
The underlying issue is market value. As the marketplace values
electric generation plants by the income approach (applying the DCF
methodology), the valuation of generation plants for assessment
purposes must be likewise. Even if applying the cost approach, the
assessor must account for all three forms of depreciation –
physical, functional and economic (not just physical). Functional
and economic obsolescence necessarily consider the market forces
and their implications on value; thereby, inherently addressing and
incorporating the market’s volatility (in particular, for
determining economic obsolescence). Unfortunately the cost approach
is often applied to avoid the full impact of depreciation from all
causes. Thus, for example, starting an appraisal with the cost to
reproduce or replace a coal facility, when no new coal stations are
being built, purposely inflates the valuation conclusion. The
legitimate starting point is the lower capital cost of a
replacement facility that produces the same output (which
eliminates the need for quantifying excess construction cost
obsolescence).
Overall, then, as natural gas prices declined and remained
significantly below former historical levels after 2008, due to
hydrofracking and the resultant surplus of natural gas in the
marketplace, coal based generation declined in the United States
from over sixty percent to under thirty-five percent of all forms
of electric generation. In contrast, natural gas plant generation
(mainly, combined cycle gas turbines) supplanted coal generation as
the major producer of electricity. The result has been sustained
lower electricity prices in the wholesale marketplace over that
decade (CCGTs plants produced electricity more efficiently and less
costly than coal plants). Projections of natural gas prices for the
foreseeable future remain at the sustained lower level that has
existed in the market since 2011. Combine lower electricity prices
with a general surplus of electric generation in the major
de-regulated markets (e.g., NYISO, PJM, ISO-NE, MISO and ERCOT),
and the value of nuclear, coal and CCGTs has declined over that
same decade period. Yet, assessments, generally, remained the same
or did not appreciably decline. As such, generation property (in
particular, coal and nuclear), generally, remain over assessed,
contributing to their growing unprofitability and financial
hardship of operation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.