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”

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.

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