October 25, 2001
FOR IMMEDIATE RELEASE

Update on Tax Relief for Property Used for Environmental Protection.
By Lester C. Rhodes

On October 23, 2001, the Texas Natural Resource Conservation Commission ("TNRCC") convened a public hearing on proposed revisions to Regulations dealing with tax relief for property used for environmental protection. The proposed revisions implement House Bill 3121, passed by the 77th Legislature, 2001, which require the commission to adopt specific standards for evaluating pollution control property use-determination applications and to provide an appeals process. The following written testimony was submitted by Lester C. Rhodes, Director, Ryan Valuation Services at the public hearing.
PROVIDED THE TEXAS NATURAL RESOURCE CONSERVATION COMMISSION

AT PUBLIC HEARING OF OCTOBER 23, 2001 REGARDING PROPOSED RULE CHANGES TO

30 TAC CHAPTER 17 - TAX RELIEF FOR PROPERTY USED FOR ENVIRONMENTAL PROTECTION

Lester C. Rhodes is the Director of Ryan Valuation Services (RVS), a division of Ryan & Company, Inc. RVs specializes in the valuation of complex industrial property for purpose of taxation. Mr. Rhodes is a Senior Member of the American Society of Appraisers, accredited in both the Machinery and Technical Specialties and the Real Property-Ad Valorem appraisal disciplines. He is also a Texas Certified General Real Estate Appraiser.

SPECIFIC CONCERNS

The proposed calculation of the percentage exemption set forth in § 17.17. Partial Determinations will likely understate the amount of the exemption to the disadvantage of the taxpayer. As proposed, the calculation is based in large part on two assumptions that are, in most cases, incorrect. The assumptions are:

1.    That capital cost/capacity relationships are linear, and
2.    That the prime-lending rate is an appropriate discount rate to estimate the present        value of pretax byproduct income.

Figure. 30 TAC §17.17 (b)




Figure. 30 TAC §17.17 (c)



Production Capacity Factor

The proposed method of determining a production capacity factor for use in calculating a percentage exemption assumes a linear relationship between capital costs at different capacities. This is rarely the case. First of all, a production capacity factor is necessary to adjust for size differences between the existing and replacement equipment because the more efficient and environmentally improved replacement equipment may be of different capacity than the existing equipment. A scale factor or size exponent should be added as a component of the production capacity factor because the capital cost of equipment of different capacities often varies exponentially rather than linearly due to economies of scale. In other words, as capacity increases, cost also increases but at a different rate. ¹The following example demonstrates the consequence of assuming cost/capacity relationships are linear rather than nonlinear. In the following example, use of the proposed production capacity factor produces an exemption estimate of 2.7%. The use of a scale factor provides an exemption estimate of 15.3%. As you can see, when cost/capacity relationships are nonlinear, the exemption is often understated using the method proposed by TNRCC.

PCF Calculation Comparison
	Capacity T/hr	Capital Cost	Cost/Ton
Old Equipment/Process	350.0	5,000,000	14,286
New Equipment/Process w/Pollution Control	550.0	8,200,000	14,909
As Proposed by TNRCC
Production Capacity Factor	0.64
Adjusted Capital Cost New Equipment/Process	5,218,182
Old Equipment/Process Cost	5,000,000
Exemption Amount	218,182
% Exempt	2.7%
As Recommended by RVS
Economy of Scale Factor (Chilton's Factor 2)	0.60
Production Capacity Factor	0.76
Adjusted Capital Cost New Equipment/Process	6,252,261
Old Equipment/Process Cost	5,000,000
Exemption Amount	1,252,261
% Exempt	15.3%

Net Present Value of Byproduct

For pollution control property that generates a byproduct, the exemption is reduced by the net present value of the byproduct. In appraisal practice, the process of converting income to a capital sum is called capitalization. Present value is estimated either by direct capitalization or by discounting future income benefits using an appropriate income stream and discount rate. It is difficult to classify the level of income in the proposed formulation (§17.17 (c)) of the byproduct value. It is not gross income, perhaps a modified operating income, but not net income or cash flow. Most commonly in the appraisal of complex property, cash flow is discounted using the weighted average cost of capital, and discount rates vary by industry and economic conditions.

The prime-lending rate is not an appropriate rate to discount income associated with complex industrial property. A more appropriate discount rate is one that is applicable to overall capital, both equity and debt. It is calculated by a weighted average of the rate applicable to equity and the rate applicable to the cost of debt in the proportions that would be normal for a company of the type being considered. Ibbotson Associates publish the Cost of Capital Yearbook that includes the weighted average cost of capital (WACC) for various industries for use as discount rates in cash flow analysis. The following tables contrast the TNRCC's proposed method of valuing byproduct income with our recommended changes. The proposed method estimates the amount of the exemption at 67.7% versus 80.2% estimated by using more conventional appraisal techniques.

Byproduct Calculation As Proposed by TNRCC			Byproduct Calculation As Recommended by RVS
Inputs			Inputs
ByProductValue	$1,800,000		ByProductValue	$1,800,000
-Storage&Transport	$500,000		-Storage&Transport	$500,000
=Income	$1,300,000		-Income Taxes	$455,000
Prime Lending Rate¹	7%		=Income	$845,000
Life (yrs)	10		WACC Discount Rate 1	8.5%
			Life (yrs)	10
Output			Output
PV Factor	7.02		PV Factor	6.56
Byproduct	$9,130,656		Byproduct	$5,544,399
Determination of Percentage Exemption			Determination of Percentage Exemption
Production Capacity Factor	1		Production Capacity Factor	1
Capital Cost New	$28,000,000		Capital Cost New	$28,000,000
Capital Cost Old	0		Capital Cost Old	0
Partial Percentage	67.4%		Partial Percentage	80.2%

¹Rates as of June 2001. Ibbotson WACC rate adjusted for growth.

CONCLUSIONS AND RECOMMENDATION

In summary, the proposed calculation of the percentage exemption in partial determinations understates the amount of the exemption. Allocating capital cost and converting income to a value estimate are complex, yet common appraisal problems and should be resolved using conventional appraisal methodology.

We understand the need for establishing rules that can be reasonably administered. The accuracy of the partial determination process can be greatly improved, with no additional burden of administration, by using an appropriate scale factor in determining the production capacity factor, substituting free cash flow as the byproduct income stream, and using a weighted average cost of capital as the discount rate.


¹ American Society of Appraisers. Valuing Machinery and Equipment, Washington: American Society of Appraisers, 2000. 101.

² C.H. Chilton, "Six-Tenths Factor Applied to Complete Plant Costs," Chemical Engineering, April 1950.

If you have any questions regarding this testimony, please call Mr. Lester Rhodes at 972.934.0022. You can also reach Mr. Rhodes by e-mail.

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