HOUSE BILL NO. 280 "An Act relating to natural gas; relating to a gas storage facility; relating to the Regulatory Commission of Alaska; relating to the participation by the attorney general in a matter involving the approval of a rate or a gas supply contract; relating to an income tax credit for a gas storage facility; relating to oil and gas production tax credits; relating to the powers and duties of the Alaska Oil and Gas Conservation Commission; relating to production tax credits for certain losses and expenditures, including exploration expenditures; relating to the powers and duties of the director of the division of lands and to lease fees for the storage of gas on state land; and providing for an effective date." 10:48:19 AM Co-Chair Hawker introduced Conceptual Amendment 4, which clarifies that the benefit of the use of last-in, first-out (LIFO) inventory management would apply only to open-access storage facilities that qualify for the financial incentives in HB 280. He emphasized that the LIFO preferential accounting treatment would not apply to privately-owned or proprietary storage, defined as the warehouses in which a producer stores their own gas before delivery. Co-Chair Hawker MOVED to ADOPT Conceptual Amendment 4: Page 6, line 17, following "facility" INSERT "regulated under AS 42.05.990(4)" Page 12, line 12, following "facility" INSERT "regulated under AS 42.05.990(4)" Co-Chair Stoltze OBJECTED for discussion. MARCIA DAVIS, DEPUTY COMMISSIONER, DEPARTMENT OF REVENUE testified that the department supported the amendment. Co-Chair Stoltze WITHDREW his objection to the amendment. There being NO further OBJECTION, Conceptual Amendment 4 was ADOPTED. 10:52:07 AM Representative Gara queried the administration's position on HB 280. Ms. Davis noted that the department supported improving and encouraging a broader scope of well expenditures, a concept applied statewide by the governor's bill as well as to Cook Inlet. She pointed out that the governor's bill differed in that it had a core concept of exploration credits, whereas HB 280 had capital credits at its core. She acknowledged that the issue could be approached from both sides; each has different structural changes that must be made. Ms. Davis pointed out that the only other difference was that the governor's bill has a 30 percent credit, while HB 280 has a 40 percent credit. She thought the change might be justified as the 40 percent credit is targeted solely for Cook Inlet. Ms. Davis reported that the administration's first question relates to HB 280's definition of the class of allowable costs as Cook Inlet well lease expenditures for the exploration and development phase. She thought the definition was simplified as essentially a lease expenditure that meets the Internal Revenue Code (IRC) 263 (intangible drilling cost rules). The department is concerned because of two pending U.S. Congress bills that would repeal the IRC provision, SB 1087 and SB 888. The intangible drilling cost definition is close to the department's qualified lease expenditure definition under AS 43.55.023 [Alaska's Clear and Equitable Share (ACES), Alaska oil and gas production tax credits, here called "023"]. Since the definition of capital lease expenditures is in place after a long regulatory process, she encouraged the committee to consider using the same definition, which includes the IRC 263 definition; this would enable Cook Inlet explorers and developers to understand the rule without waiting for further regulations. Co-Chair Stoltze asked whether Congress would deal with the IRC issue within the next 30 days. Ms. Davis replied that regulations already in place that incorporate the same concept and scope of cost might make the process easier. Ms. Davis turned to the administration's second question; on the production phase of the credit, HB 280 has done a good job of restricting the costs allowed to those that are wellhead and below. She cautioned that theoretically, the costs associated with abandoning, plugging, or suspending a well could directly relate to processes of operating a well. She questioned whether the committee wanted a credit for stopping production, when the intent is to add or increase production. 10:57:40 AM Representative Gara questioned whether the credit as written in HB 280 would go to existing work that is not an enhancement. Ms. David replied that the credit is broader (although limited to Cook Inlet) and designed to cover costs that are related to the operation of a well. The credit is restricted to lease expenditure costs from the wellhead down, including day-to-day operations. She pointed out that lease expenditure is a broader concept than an intangible drilling cost and not designed to encourage the continued status quo operation of Cook Inlet wells as in addition to the life-cycle of the production phase. Representative Gara asked whether the credit as currently written differentiates between capital costs that are expended for enhancements and capital costs that are expended for continuing operations. Ms. David replied that he was correct. 10:59:52 AM Co-Chair Hawker disagreed. He clarified that the administration's concern related to Amendment 2 (previously adopted by the committee). He stressed that the amendment was intended to address intangible drilling costs related to exploration and development and not the demobilization period. He thought the department could clarify the intent through regulation or the issue could be dealt with in the legislative process. Ms. Davis agreed with Representative Hawker's remarks about the exploration and development phase. She was focusing on the on-going production phase. She was referencing processes related to operating a well, one of the categories. Another category is moving fluids to assembly. She thought HB 280's definition of the cut-off at the wellhouse was good. Co-Chair Hawker noted that the well maintenance processes facilitate and enhance recovery and lengthen the productivity of an individual well site. He agreed that the intent is to grant the benefit of the costs in calculating lease operating expenses. Representative Gara asked whether Co-Chair Hawker would be open to language targeting the credit to enhanced production, whether for a new well or a substantial expansion of an existing production effort. Co-Chair Hawker believed such language would be overly restrictive as the bill is attempting to give the greatest possible latitude to encourage production. He pointed out that the biggest issue is wells at the end of production. He stressed that maintaining production is a challenge; he did not want to create anything that would require extensive regulation, but wanted to promote production in Cook Inlet. 11:03:36 AM Representative Gara also wanted to expand and continue production and questioned how to make the distinction. Ms. Davis responded that the governor's goal has clearly been to provide tax relief or tax credits only where the state receives some benefit in return. The question would be whether the costs could be considered for wells at the end of production. She claimed that language in the governor's bill stipulated that well cost should increase or enhance production from a known pool. She thought the definition could establish that the well could be upgraded through the expenditures. Co-Chair Stoltze noted that the governor was historically sensitive to Southcentral issues. Co-Chair Hawker wanted to err on the side of promoting investment in the Cook Inlet rather than erring on the side of having the loss of credit compromise an investment decision by an investor. 11:06:36 AM Representative Gara hoped to work on language that would not deprive someone of a credit if the credit would keep them from closing a well; he also did not want to grant the credit where it was not appropriate. Ms. Davis turned to the administration's third question, which related to Amendment 2. The department is concerned about including an indirect cost element in a credit that is supposed to be about direct costs. She stated that subsection (o)(3) in the amendment represented a substantial departure from other credits; a credit is described in the subsection as being allowed based on a cost associated with overhead expenditure. Under current regulations describing lease expenditures (Section 165), credits are supposed to be direct costs. A direct cost used to include overhead, but 165(b) was amended to remove a reference to overhead. Overhead is considered an indirect cost. Current regulation tries to bypass the "nitpicking" approach of trying to detail how overhead is calculated under all the various agreements. Instead, calculation is made by taking a flat percentage of direct costs; 4.5 percent of the taxpayer's total direct cost is allowed as an indirect cost. 11:09:17 AM CODY RICE, PETROLEUM ECONOMIST, TAX DIVISION, DEPARTMENT OF REVENUE (via teleconference), reported that preliminary information had been prepared and shared with the co- chairs. Ms. Davis added that the data regarding Cook Inlet credits has been made available to the committee in written form. 11:11:01 AM Co-Chair Hawker responded regarding subsection (o)(3), stating that the degree to which the legislature wants to allow credits for the lease operating expenses in Cook Inlet is a policy call. He added that the intent of HB 280 was to maximize the attractiveness of investments in the inlet for new drilling, expanded drilling, and maintenance activities. Representative Gara questioned whether the overhead allowance would default to existing regulation if (o)(3) were not in Amendment 2. Ms. Davis replied that there would be the basic underlying lease expenditure allowance for overhead, or 4.5 percent of the taxpayer's total direct cost. The taxpayer would then take the dollar amount identified and be able to deduct that overhead from the gross profits. In this manner, the amount would be used as a lease expenditure deduction against the sales price to arrive at a production tax value and would not be incorporated into any of the other credit provisions to obtain an additional benefit associated with the expenditure. She agreed that it was a policy call whether to apply the 4.5 percent charge against the expenditures identified as the Cook Inlet well lease expenditure application and then add it to the credit amount. The department would have to make a regulation describing the process. Representative Gara asked whether the number would default to 4.5 percent without subsection (o)(3) in Amendment 2. Ms. Davis noted that the 4.5 percent operating expense deduction would be there regardless of what happens with HB 280. Representative Gara asked whether HB 280 would add a credit on top of the 4.5 percent. Ms. Davis responded that the amount would be in addition; like other credits, the lease expenditures are the base amount of all the costs that get deducted from the proceeds to arrive at a production tax value. In addition, different subsets of costs are considered to calculate a credit; a specific expense might get used as a deduction to create the net tax and also be part of a credit. 11:15:51 AM Representative Doogan queried the sponsor, related to Amendment 2, subsection (o)(1), about possible problems with "intangible drilling and development costs" under the Internal Revenue Code. Co-Chair Hawker responded that he did not know. He noted other concerns about Alaska codes that are changing. ROGER MARKS, CONSULTANT, HOUSE FINANCE COMMITTEE, explained that there is precedent in statute for citing other tax codes as they exist on certain dates. He suggested that it would be very straightforward to say: "Cite the tax code as it existed on the effective date of the bill." Representative Doogan asked for clarification. Ms. Davis responded that the challenge when a particular federal law is repealed is finding out what it used to say. The reference would be to the code not as an applicable law but as a law that embodies acceptably descriptive language. The department might have to embody the new language through regulation if the code was repealed and became difficult for taxpayers to find. Representative Doogan wanted to make sure that the legislature was not making a law that would "blow up." Co- Chair Hawker discussed differences in the approaches. Representative Doogan asked whether the language was flexible enough to take into account the possibility that the statute cited might go away. 11:19:56 AM Ms. Davis offered to check with the Department of Law. She assured the committee that language would be checked with Legislative Legal Services to make sure the state statute is viable. Representative Gara asked how the provision could be written to include the governor's proposal to apply the credit to enhanced production or operations. Ms. Davis explained that currently the bill has the underlying AS 43.55.023 (ACES) 20 percent capital credit, which would be unaffected. The underlying AS 43.55.023(a) could not be used to the extent that a taxpayer would prefer to utilize subsection (m) [Section 11] as a credit. Instead of the 20 percent credit, the taxpayer would be electing a 40 percent credit for a narrower subset of allowable expenses called Cooked Inlet well lease expenditures. The option for the taxpayer would be an AS 43.55.023 20 percent credit; to the extent that the credit is related to exploration and development, there is the AS 43.55.025 25 percent credit. Cook Inlet would be a 40 percent credit. One of the options has to be chosen. Co-Chair Hawker noted that the enhanced investment credits were originally applied to the North Slope. The difference acknowledged higher risk with entitlement to higher credit. He added that the perimeters did not apply to Cook Inlet. Mr. Marks informed the committee how Amendment 2 was intended to be structured and operate: in the universe of lease expenditures, there are capital costs and operating or non-capital costs. Under the statute, the capital costs get a 20 percent credit under AS 43.55.023(a). Amendment 2 describes non-capital costs, which currently do not get credits under the tax. The costs are a sub-set of operating costs and do not include all operating costs. For example, (o)(s) says "does not include the processes of gathering, separating, and processing well fluids downstream from that assembly." He pointed out that those would still be considered lease expenditures under the statute, but the costs being addressed in subsections (o)(1), (o)(2), and (o)(3) are subsets of the costs that are not capital costs; they do not include all operating costs but are a subset that are involved with operating a well as described in (2). 11:24:58 AM Representative Gara summarized that HB 280 was written to take advantage of the "m" credit, which has been amended by Amendment 2. He asked whether the "m" credit is in place of the existing credits, whether 20 or 25 percent. Ms. Davis answered that the credit was an additional, alternative credit. Representative Gara asked for more information about the "Cook Inlet penalty." Co-Chair Hawker replied that the issue was addressed in Section 11. He explained that when the Petroleum Production Tax (PPT)/ACES tax structure was adopted, the Cook Inlet basin was set aside as an exception; the Economic Limit Factor (ELF) tax mechanism was grandfathered for the basin. The rest of state had significant increases in production taxes that did not apply to Cook Inlet. Co-Chair Hawker continued that the PPT/ACES system introduced the concept of credits that could be applied against tax liability for certain expenditures. He noted that it had been pointed out that spending a dollar in Cook Inlet would result in less tax liability to apply it to by special rule than if the dollar were invested elsewhere. He explained that a credit derived from an investment in Cook Inlet could be applied against a dollar of tax liability anywhere in the state. Co-Chair Hawker asserted that the biggest problem in the state currently was production decline and that the only way to address the problem was increasing investment in exploration and development. He thought it was inappropriate to disadvantage Cook Inlet in the competition for the capital. Representative Gara summarized his understanding of the situation and asked for more clarification. Ms. Davis explained that in Cook Inlet, a producer must first sell production then go through the ACES process of deducting Cook Inlet costs against that production to come up with the production tax value. The production tax value is then compared to a cap or ceiling on the tax (the ELF tax: zero for oil, and $0.17 per Mcf). If the ACES tax is higher, the producer only pays taxes to the cap. All of the lease expenditures applied to get to the cap comparison stay in Cook Inlet. Any other lease expenditures not needed to get to the cap are now free to be exported by the taxpayer to other regions (usually the North Slope). Ms. Davis added that the reason for the de-coupling legislation moving through the Senate was the discovery that several Cook Inlet producers have Cook Inlet expenses that they are able to utilize under the current system and apply to reduce tax liability caused by North Slope oil. She emphasized that credits resulting from an expense can be used anywhere regardless of where the expense was. The credit gets applied at the bottom line of the final tax bill. 11:31:53 AM Mr. Marks provided an example of how Section 11 was intended to operate: If under ACES, the Cook Inlet tax was $100 and under ELF the tax was $50, and a taxpayer had $200 in credits, the credits are reduced by the $50 difference. The resulting $150 credits could then be used to offset North Slope tax. Representative Gara requested further clarification. His understanding was that a producer who pays a lower Cook Inlet tax does not have that much to write off from; he believed the amendment would help a producer who also has North Slope operations to write off the expenses. 11:33:17 AM Co-Chair Hawker pointed out that the provision was not new, but the producer had to discount the amount of credit available to write off Cook Inlet tax liabilities. Ms. Davis added that Section 11, subsection (m) related to lease expenditures. She asserted that lease expenditures are the larger expenses, and are the ones being emphasized: specifically, Cook Inlet lease expenditures up to the amount of the tax ceiling. The ones above the line can currently get applied elsewhere; the ones below the line cannot. She believed the provision would change the situation and allow the ones below the line to also be moved elsewhere. Co-Chair Hawker interjected that the tax credit generated in Cook Inlet is allowed to be used at full face value anywhere in the state. Representative Gara questioned whether the amendment would change the current ability of a producer to write off more lease expenditures than they are paying in taxes. Ms. Davis replied that under current law, a producer cannot utilize lease expenditures that were used to get to the cap. The new provision would change that and let the producer add the additional batch of lease expenditures to those that can be used elsewhere. Representative Gara queried the administration's opinion on the provision. Ms. Davis replied that the administration has not proposed a change in the current "ring-fencing" laws as part the governor's bill. She noted that the governor wanted to know what the trade-off would be for the state for reducing the tax burden or providing a credit; when credits are given, there should be a return. She thought it was a policy question whether additional Cook Inlet incentives would provide return for the state. 11:37:06 AM Co-Chair Hawker asserted that there would be "full value" and not doubling for investment. He stated that the provision was intended to level the playing field in order to encourage a developer/investor operating in both the North Slope region and in Cook Inlet to put money into the Cook Inlet. He emphasized the need for fuel in Southcentral. Co-Chair Stoltze noted that representatives from Chugiak Electric Association were present and that they had about a quarter of a million people with concerns about the issue. Ms. Davis stated that the administration agreed that trying to level the playing field is important; however, the starting point is a bill that does not have a level playing field with respect to tax rates because of substantial incentives for the inlet. She stressed that the policy call related to how much additional incentive the legislature feels Cook Inlet producers need. Co-Chair Hawker acknowledged that there is an inequitable tax base. He argued that investor risk needed to be recognized; attracting investment is currently very difficult. The gas in Cook Inlet is expensive to access and has disadvantages that offset much of the tax value differentials. He agreed that a policy call is needed. He asked whether the state wanted to make an effort to make exploration and drilling in Cook Inlet more attractive to either new, independent, well-capitalized producers, or to existing explorer/producers. He argued that there was no cost to the state to attempt the enhanced access to existing tax credits offered in the bill. 11:41:32 AM Representative Gara stated that he was more comfortable with the governor's method of spending money for new work. He thought that without enhancements, the bill could reduce the tax payments the state would receive and increase the credits it pays out. He opined that with the governor's credit, the money would come only if production was enhanced or extra action was taken to prevent the loss of production. Representative Fairclough queried the current tax rate on gas outside the Cook Inlet. Ms. Davis replied that there is not much gas. She conjectured that for a taxpayer on the North Slope producing gas only, the tax would be 25 percent of the production tax value (profit at the point of production minus lease expenditures). She cautioned that every taxpayer is different because of varied mixtures of oil and gas. She calculated that given gas at $4.50 with cost of $2.50, the rough estimate would be $0.50 to $0.70 per Mcf. Co-Chair Hawker added that the cost depends on the market. In addition, due to other legislation, gas produced and consumed in-state pays ELF rates just like the Cook Inlet. Ms. Davis agreed. 11:45:03 AM Representative Gara was concerned that he had no way to assess the tax credit being granted in HB 280 for gas storage. He queried the administration's position on the issue. Ms. Davis replied that there have been many other bills relating to corporate income tax credits. She stated that the administration regarded the issue as a policy call with respect to what extent particular conduct should be incentivized. She noted that in HB 280, the state would be getting gas storage in exchange for granting a corporate income tax credit, which would be consistent with the administration's policy of providing credits in exchange for an agreed-upon action. Representative Gara requested more information about the gas storage credit. He thought there would be a maximum credit of $15 million based on an allowable cost of $1.50 per thousand cubic feet of storage capacity. He did not know how to analyze whether the allowable cost was the fair amount. ROBYNN WILSON, INCOME AUDIT MANAGER, TAX DIVISION, DEPARTMENT OF REVENUE (via teleconference), thought the issue was a policy call. She believed the issue had been addressed in the fiscal note. 11:48:35 AM Mr. Rice pointed to page two of fiscal note 4 (attached to CSHB 280(RES), a prior version of the bill) and quoted: In 2004, the Federal Energy Regulatory Commission (FERC) estimated the median cost-of-service rate for [gas] storage at $0.64/Decatherm. One Decatherm is equal to one Mcf of natural gas if the natural gas contains 1,000 Btu/cubic foot. Escalating this cost for inflation produces a 2009 cost-of-service rate of approximately $0.72/Mcf of [gas] storage service. Mr. Rice clarified that the calculation is not adjusted for potentially higher costs in Alaska. However, he thought the estimate was close. Representative Gara asked whether the state would pay $1.50 when the cost of creating the storage would be $0.72. Mr. Rice replied that he could not definitively say what the cost of gas storage would be in Alaska. He could say that escalating the median cost of service for providing gas storage, according to FERC, results in a price of approximately $0.72 per Mcf; the credit is $1.50 per Mcf, or roughly double the median cost of service. Representative Gara asked whether HB 280 would grant $1.50 per Mcf or up to $1.50 of the actual costs. Co-Chair Hawker responded that the credit is calculated at $1.50 per Mcf of new gas storage capacity opened within a certain timeframe (before 2015). Representative Gara asked whether an entity could be paid more to create gas storage than it costs them. Co-Chair Hawker responded absolutely not; the credit was benchmarked based on available information (which is imprecise) to approximate at 10 percent on cost. Representative Gara questioned how the state could know what the storage would cost. He pointed to differing numbers. 11:52:51 AM Co-Chair Hawker reported that proprietary conversations were held with entities interested in investing and putting together a major open-access gas storage facility in the Cook Inlet. Representative Gara stated that he had no way of analyzing how much of the cost the state should be paying. Co-Chair Hawker called attention to other information in fiscal note 4: an expectation that the amount of the credit would approximate the corporate income tax from operating such a facility for about 16 years. He stated that the goal was to allow the investor to recover their costs. The costs would ultimately be passed to the consumer, but the intent was to not have the additional costs be burdened by additional state taxes. He stressed that the bill was intended to be a private sector bill and not a major government subsidy of gas storage. Mr. Marks pointed out that looking at the credit as being a high percentage of the corporate income tax liability says more about the liability than about the credit. He maintained that in a gas storage facility, the only income the facility would have is its return on equity; in the big picture, that would be fairly small, depending on debt equity and the length of the life of the asset. He stated that for regulated facilities, the income piece would be small, and the credit could dwarf the income tax liability. Representative Gara did not care how the credit related to how much someone would pay in taxes. He wanted to make sure that the state would not pay more in the credit than an entity paid to build the facility. Co-Chair Hawker stressed that the credit was calculated to approximate 10 percent of the cost of building the storage facility. Representative Gara suggested adding that the credit could not exceed ten percent of the costs. Co-Chair Hawker stated that [exceeding ten percent of the costs] would be "highly unlikely." He maintained that the point of the volume metric approach to determining the credit was to specifically avoid having to go through a huge regulatory process in determining eligible and non-eligible costs. The question was the cost of the facility and what would be included. He emphasized that the intent was to determine and easily calculate the credit available using a credible third party as the benchmark, using the Alaska Oil and Gas Conservation Commission (AOGCC) to certify the working volume capacity of a facility. HB 280 was HEARD and HELD in Committee for further consideration. 11:57:54 AM Co-Chair Hawker referred to potential amendments.