April 30, 1985. Other parties to the proceeding and interested persons will have 20 days in which to file comments with the FERC. The impact of TAPS tariffs on the collection of federal tax receipts is one of several important concerns that have been taken into account by the Department in determining the interest of the United States in the TAPS litigation including, of course, any proposed settlement of that litigation. The United States has a twofold interest in the rates charged by the TAPS owners: the maximum possible efficient development of crude oil resources on the North Slope of Alaska and the enhancement of the federal government's fiscal interest in tax and leasing revenues derived from the production of crude oil there. The Department of Justice has taken into consideration both of these important concerns. The maximum possible efficient development of North Slope petroleum resources must be the primary focus of our efforts, because only through achievement of that goal will consumers experience the benefits that the Department has sought throughout the litigation. Moreover, an efficient TAPS tariff will also generate the proper level of leasing and production and, hence, protect the overall fiscal interests of the United States in North Slope petroleum resources. Because the wellhead price of North Slope petroleum resources bears an inverse relationship to the level of the TAPS tariff, the latter is a critically important factor in decisions regarding leasing, exploration, development, production and enhanced recovery of ANS crude oil, the nation's most important petroleum resource. The challenged TAPS tariffs, and tariff-setting methodologies such as those advocated by the system's owners, reduce the overall production of ANS petroleum below the maximum possible efficient level. They do so by reducing the number of leasing opportunities, 2/ by reducing the incentive of oil companies to explore and develop the lands they do lease, by raising the size and revenue threshold that must be achieved before a particular oil find is considered commercial, and by increasing the amount of expected additional revenue that must be realized to justify enhanced recovery efforts. Also, if pipeline tariffs contain unreasonably high profits for the system's owners, non-owners 2/ Both the federal government and the State of Alaska balance the environmental and social costs of leasing against the potential revenue to be realized in terms of bonuses, royalties and taxes in deciding whether to open particular areas for exploration. Bonuses, royalties and severance taxes, as well as income and windfall profit taxes on production, vary with the wellhead price. will suffer a competitive disadvantage as compared with the owners in developing North Slope oil resources. Uncertainty as to the level of future tariffs compounds the damage by increasing financial risk and, hence, the cost of capital required for exploration and development. 3/ The overall effect, then, of excessive tariffs will be less competition to develop the nation's most important crude oil resource, less production in the hands of non-TAPS-affiliated oil companies and less overall production of crude oil by the United States. Those who ultimately bear the burden of excessive tariffs are, of course, U.S. consumers. The North Slope has been a principal factor in checking the power of OPEC to raise or maintain high world crude oil prices. Also, the Department believes that less concentrated ownership of North Slope oil will place downward pressure on crude oil and gasoline prices on the West Coast, which the Department has identified as a separate market. 4/ It is for these reasons that the Department and the State of Alaska have advocated a TAPS tariff methodology that not only limited the returns of the pipeline owners to just and reasonable levels, but that also concentrated returns to capital and depreciation charges in the pipeline's early years. This methodology will permit tariffs to fall toward the marginal cost of operating the pipeline as crude oil resources become more difficult to find and more costly to develop. Since the retroactive reduction of 1978, or even 1984, tariffs will not result in one additional drop of oil being found or produced on the North Slope, both the Department and Alaska concluded that the primary emphasis of the litigation should be - - 3/ Extremely lengthy lead time is needed to explore and develop crude oil resources in Alaska. Between the time tracts are leased and the time oil is produced, a minimum period of five and probably as much as ten years of exploration and development effort is required. Accordingly, in order to enhance crude oil recovery from the North Slope, the focus should be on tariffs during the period beyond 1990 and more likely beyond 1995. The proposed settlement reduces tariffs to very low levels in dollars of constant purchasing power during that period. 4/ Outer Continental Shelf Federal/State Beaufort Sea Oil and Gas Lease Sale No. BF, Advice and Recommendations of the U.S. Department of Justice to the Secretary of the Interior Pursuant to Section 205 of the Outer Continental Shelf Lands Act Amendments of 1978 (January 24, 1980). on the future. 5/ The proposed settlement achieves the tariff time-profile that the Department and Alaska have sought since the beginning of the litigation. It also limits pipeline profits to a level consistent with the Department's litigation position. If the proposed settlement is adopted by the FERC for the entire pipeline, overall crude oil output on the North Slope of Alaska should be enhanced and more companies should be. involved in North Slope exploration and development. While the Department is strictly responsible only for advocating its goals of competition and economic efficiency in the TAPS litigation before the FERC, it has also endeavored to consider the impact of TAPS tariffs on the federal treasury. In preparing its presentation to the FERC during the litigation, the Department of Justice consulted with Department of the Interior officials responsible for leasing and evaluating North Slope crude oil resources and with the Office of Tax Analysis of the Department of Treasury, which is responsible for calculating projected tax receipts in connection with legislation and federal budgetary policies. addition, while the Department was considering the proposed settlement and drafting the settlement agreement, we conferred with the Internal Revenue Service and satisfied ourselves that the proposed settlement would not prejudice the ability of the IRS to calculate or collect windfall profit taxes. 6/ In Finally, I must caution that any attempt to compare federal tax receipts under the proposed settlement with those under another possible outcome of the case, such as "depreciated 5/ Given that uncertainty as to the level of tariffs increases capital costs, a tariff that is fixed now will do more to encourage oil production than the hope of an even lower tariff five years from now--the period of time the Department believes will be necessary to litigate this case to a final decision after all possible appeals have been exhausted. 6/ Because Crude Oil Windfall Profit Taxes are keyed to the wellhead price of crude oil produced in the Sadlerochit reservoir of the Prudhoe Bay field, the windfall profit tax liability of the Prudhoe Bay producers will not be fixed until the TAPS tariff is also fixed. Thus, a speedy resolution of the TAPS litigation through settlement will enhance the ability of the IRS to calculate the correct amount of windfall profit taxes due. To facilitate this process, the settlement agreement will require the TAPS owners to provide the Department of Justice with the identity and the amount of refunds paid to all shippers once the settlement is entered. This information could prove useful to the IRS in the collection of windfall profit taxes. If original cost methodology" referred to in your letter, is likely to yield either unrealistic or unreliable results. there were obvious and easily-calculated alternatives to the filed tariffs, this case would not have lasted almost eight years. There is, and continues to be, substantial disagreement between the pipeline companies and the Department over which methodology is most appropriate. Even among those who advocate a cost-based methodology, there is disagreement over whether that methodology should be depreciated original cost, which allows a nominal rate-of-return on historical cost, or trended original cost, which allows a real rate-of-return on an inflation-adjusted rate base. Even if one focuses on depreciated original cost alone, it is impossible to determine tariffs unless numerous further questions are answered and variables determined. These include: the rate-of-return on equity; whether it should be adjusted for inflation; the appropriate capital structure; the cost of debt; the period and method of depreciation; the method of calculating taxes ("flow through" or "normalized"; statutory or effective rate); whether various expenses should be capitalized or treated as current; and whether any of the funds expended to build the pipeline should be disallowed as imprudent. Then, of course, even if all of the methodological issues are determined, overall pipeline throughput, operating costs, and inflation must be projected in order to determine future tariffs. Once a stream of tariffs has been projected, these must be translated into a wellhead price. This must be compared with a separately determined "base price" below which the windfall profit tax does not apply. Further, the volume of oil that will be produced in each year that is subject to the windfall profit tax must be projected, as well as the amount of exempt enhanced recovery oil produced from the Sadlerochit reservoir and the overall level of exempt non-Sadlerochit production. Because exempt production is subject to a lower marginal tax rate than pipeline profits (because of the deductibility of state severance taxes and royalties), lost pipeline tax revenues from lower tariffs must be offset against higher windfall profit taxes. Any refunds on Sadlerochit oil shipped prior to January 1, 1983, the effective date of the Tax Equity and Fiscal Responsibility Act, Pub. L. 97-248, would also offset higher windfall profit taxes for the same reason. Even if one is able to agree upon the selection and the appropriate manner in which to weigh the many variables described above, the Department still believes it would be inappropriate to use whatever numerical result is obtained in evaluating the Department's decision to enter into the proposed settlement, regardless of whether overall tax receipts would be greater or less than receipts obtained under another possible - 5 outcome. First, recognition must be given to the cost, in terms of time and resources, of continued litigation and the possibility that it could result in tariffs closer to those advocated by the system's owners than those of the proposed settlement. This would jeopardize the certain benefits of the proposed settlement to the federal government's leasing program as well as the benefits to consumers of petroleum products. Moreover, if the proposed settlement serves these latter interests satisfactorily, the taxing interest of the United States should also be satisfied. Although artificially high tariffs will reduce windfall profit tax collections, this cannot justify setting artificially low or inefficient tariffs. In the Department's view, it would be inappropriate to enhance federal tax receipts at the cost of diminished overall consumer welfare. Determining whether to continue to devote resources to litigation or to accept a settlement is the kind of decision the Department constantly confronts. It involves the careful evaluation of the Department's litigation position in achieving the best possible result, a reasonably possible worst-case result, and the value of a litigated resolution that, in this case, would be at best several years away. The Department is confident that the outcome embodied in the proposed settlement, and the fact that it can be put in place now, will enhance overall North Slope exploration and development by providing proper economic signals and by removing uncertainty as to eventual tariff levels--our primary goal throughout the eight years of litigation since we first formally protested the proposed TAPS tariffs. Moreover, this goal will be achieved while stemming the substantial drain on public and private resources that continued litigation would entail. Approval by the FERC and its adoption as the basis for setting the tariffs of all the TAPS owners would serve the national interest in the efficient and competitive development of our crude oil resources, and would protect the proprietary and fiscal interests of the federal goverment as well. I trust this information will be of assistance to you and will alleviate your concerns. Your interest in this matter and in our efforts to promote competitive principles are greatly appreciated. Sincerely, Charles F. Rule Acting Assistant Attorney General |