Know Your Adversary

How tax subsidies fuel Spectra Energy’s dark energy future

By Owen Crowley

Market Realist recently ran an excellent, must-read investor’s guide to Spectra Energy. This report describes Spectra’s corporate structure and details Spectra Energy (SE) and affiliates’ plans to build out gathering, storage and transmission infrastructure across the USA and Canada. It provides a fact base for understanding the frothy exuberance about Spectra & friends among energy investment boosters.
To fully appreciate Market Realist’s report, however, you need to understand how Spectra Energy Corp attracts capital investment. The two main dimensions are Spectra’s revenue model, and a tax loophole, described below.

spectra map

A sweet deal for fossil fuel transporters

Spectra’s revenue derives from transmission fees rather than commodity pricing. This means Spectra’s distribution affiliates make money as long as gas, natural gas liquids (NGLs) or oil go from anywhere to anywhere. Commodity price volatility—risky to commodity investors—presents an opportunity for Spectra’s distribution arm to make more money as gas, NGLs and oil move due to price arbitrage.
But the real kicker is that Spectra’s distribution arm in the USA is a “master limited partnership” or MLP. After Spectra builds a pipeline, it immediately “drops down” the pipeline asset into an MLP it controls, Spectra Energy Partners (SEP). MLPs have a very special status under US tax law. They are fictitious “partnerships,” which means they avoid income tax on earnings as long as they distribute their earnings every year.
The Economist article, “Rise of the distorporation”

The Economist magazine article, “Rise of the distorporation” describes how MLPs are empowering capital, while disempowering investors and shifting wealth to select classes. Also, look here for a deep dive into charts and graphs related to this segment of the energy industry.

This tax dodge is available to fossil fuel transporters but not sustainable energy transporters, and is in effect a subsidy for fossil fuel distribution. The result is a roughly 30% boost in investment returns, compared to the same activities, were they conducted by a non-MLP. Distributions on established MLPs range from 2 to 4 times market averages, and can be even greater for exploration companies. Distributions such as this are taxable income for investors.

But wait, there’s more—for Spectra Energy

There a is privileged class among MLP stakeholders—the general partner. The general partner actually manages the MLP, and holds “incentive distribution rights,” entitling the general partner to receive a higher percentage of the distributions. Spectra Energy Corp is the general partner of Spectra Energy Partners.
The general partner can skim as much as 50% off the top as distributions increase, with the result that all other investors get less. In addition, the general partner, unlike other investors, can treat these distribution as capital appreciation.
This means that in addition to avoiding corporate tax, the general partner pays much lower capital gains tax, and then only at some future date. When estate law is factored in—for example, inheritance tax loopholes—a general partner may avoid tax altogether. Tax subsidies such as the ones that selectively benefit MLPs cost society dearly, not only by incentivizing destructive energy, but also by making everyone else pay more tax. (This is why tax loopholes are also known as “tax expenditures.”)

When the scheme collapses

Of course, all “good” things must come to an end. The big risk around MLPs—one that funds managers desperate to project growth may choose to overlook—is that the moment an MLP’s revenue falters, the value of investors’ stakes in the MLP falls off a cliff. This stems from the fact that there is no capital appreciation on MLP stakes.
To avoid tax, MLPs distribute all their earnings every year (or more commonly, every quarter). Industry insiders—including general partners like Spectra Energy Corp—will see this coming and will be the first to avoid losses by heading for the exit. But municipal and pension funds that invest in these MLPs will not be able to move as quickly.
All the more reason for such funds to divest from such assets and all fossil fuels.

spectra 2

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2 Responses to Know Your Adversary

  1. tsentropa says:

    Yes, participation in MLPs by renewable energy would level the playing field. But it is a matter of debate whether this would be a Good Thing. There is increasing recognition that market distorting subsidies and preferences drive bad decisions. Even renewables can be done wrong.

    There are other ways to finance large investments with long term payoffs, as evidenced by the fact that this country’s great infrastructure projects predate the existence of MLPs.

    When an MLP collapses, the equity value of all investors including the General Partner takes a hit. But until that time, the General Partner has pocketed income significantly greater in relation to equity than that of all other “partners”, and thus comes out a winner. Moreover, the General Partner has greater access to information to drive early divestment decisions, advantageous to the General Partner and disadvantageous to other “partners”.

    To say that the General Partner’s outsized payback will deter others from investing is fallacious in multiple respects. First, distributions can be structured by the General Partner so that all “partners” benefit from greater than market returns, making the MLP attractive as an investment. The General Partner gets a greater proportion of these rents, but that does not completely erase the rents that accrue to common “partners”. Second, even if the vast majority of investors shy away from the MLP, there will always be investors who for one reason or another buy in. All the investors who do not buy in are irrelevant. Third, the assertion assumes that all investors are rational, have equal access to information, and are making decisions solely on the present value of the MLP’s returns. Such rational market assumptions are a gross oversimplification, as evidenced by market bubbles and bad investment decisions. In the real world you have situations resembling those of municipal pension fund managers, who face inexorable demographics (aging population) exacerbated by promises of outsized retirement benefits handed out by politicians seeking to hold down current day labor costs. A fund manager under such pressure may be tempted by the short-term returns of an MLP, while leaving the longer term consequences to his or her successor.

  2. Ran Kohn says:

    This is not a particularly helpful or accurate article and frankly many of us interested in promoting renewable energy are constantly urging congress to add renewable energy to the list of permitted MLPs. We are not going to get to use this financial instrument if we focus on taking it away from others.

    MLPs are financial instruments designed for large projects that have large upfront cost that will take a long time to recoup the investment and thus the financing is designed so that investors can receive the benefits of a tax deduction for participating in the build up and a share from the income. The distributions are taxable to the individuals and entities that invest in them. And while MLPs can collapse as a result of either poor planning, execution or unexpected events, in general when that happens everyone who has a ownership and that includes the General Partner looses big time. Finally, suffice it to say that a General Partner that takes an outsized payback will have a hard time interesting investors in their project.

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