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Report to the Honorable Richard H. Baker, House of Representatives:
June 2003:
Tennessee Valley Authority:
Information on Lease-Leaseback and Other Financing Arrangements:
GAO-03-784:
GAO Highlights:
Highlights of GAO-03-784, a report to the Honorable Richard H. Baker, House of Representatives
Why GAO Did This Study:
Concern about the implications of the Tennessee Valley Authority’s
(TVA) debt on its future competitiveness prompted Representative
Richard Baker to ask GAO to determine TVA’s planned and actual use of
nontraditional financing arrangements (which, to date, has consisted
primarily of lease-leaseback arrangements), who is at risk under TVA’s
lease-leaseback arrangements, and whether TVA’s accounting for the
lease-leaseback arrangements complies with applicable standards and
requirements.
What GAO Found:
TVA has traditionally financed its operations with cash generated from
operations, the issuance of bonds and notes, and in the past,
appropriations. However, in fiscal year 2000, it began to use
alternative forms of financing (primarily lease-leaseback
arrangements) and is considering expanding their use. The lease-
leaseback arrangements involve the refinancing of 24 combustion
turbine power generators that are used during periods of peak demand
for power. The lease-leaseback arrangements accounted for about $945
million of the $992 million raised by alternative financing
arrangements as of May 31, 2003.
After the power generators were constructed, TVA leased them to
private investors for 50 years and simultaneously leased them back for
20 years. Under these lease-leaseback arrangements, TVA received cash
from the private investors, which was obtained by issuing debt in the
public market and through the investors’ own equity. TVA is
responsible for making lease payments for 20 years, at the end of
which it has the option to purchase the private investors’ interest in
the assets. TVA retains legal title to the assets under the
arrangements but relinquishes sufficient interest in the assets so
that the equity investors are entitled to certain tax benefits. The
equity investors pass on some of these benefits to TVA in the form of
more favorable financing rates. As a result, TVA is able to lower
costs over the first 20 years of the arrangement. However, to retain
use of the assets after the 20-year period, TVA would have to purchase
the equity investors’ remaining interest in the assets at the assets’
fair market value at that time. Depending on the fair market value,
TVA is at risk of incurring higher overall costs than under
traditional debt financing. In large part, the determination as to who
will be the net beneficiary of these arrangements and the implications
to the federal treasury will hinge on the future value of the assets.
TVA’s lease-leaseback arrangements have been accounted for and
reported in compliance with applicable standards and requirements for
financial reporting, budgetary reporting, and debt cap compliance.
TVA’s lease-leaseback arrangements are treated as liabilities in its
financial statements and classified as debt in the President’s Budget.
However, they are not counted against the debt cap in the TVA Act.
While the lease-leaseback arrangements are not considered debt for
purposes of financial reporting and debt cap compliance, they have
substantially the same economic impact on TVA’s financial condition
and future competitiveness as traditional debt financing.
What GAO Recommends:
GAO is not recommending any actions by TVA, but does raise a matter
for congressional consideration. The Congress may want to consider
amending the TVA Act to clarify whether TVA’s statutory debt cap
should include alternative sources of financing that have the same
impact on TVA’s financial condition and competitive position as
traditional debt financing.
TVA generally agreed with our analysis but expressed concern regarding
including alternative sources of financing in its debt cap. Because we
believe current law does not clearly and unambiguously address whether
the amount of the lease-leaseback arrangements should be counted
against the debt cap, we continue to believe the Congress may want to
consider revisiting this matter.
www.gao.gov/cgi-bin/getrpt?GAO-03-784.
To view the full product, including the scope and methodology, click
on the link above. For more information, contact Linda Calbom at (202)
512-9508 or calboml@gao.gov.
[End of section]
Letter:
Results in Brief:
Background:
Objectives, Scope, and Methodology:
TVA's Current and Contemplated Use of Alternative Financing
Arrangements:
TVA Retains Legal Ownership of Assets, but Both TVA and the Private
Equity Investors Are at Financial Risk:
Lease-Leaseback Accounting Complies with Applicable Standards and
Requirements:
Conclusions:
Matter for Congressional Consideration:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
Description of Lease-Leaseback Arrangements:
Alternative Financing Options Being Considered by TVA for Future
Capital Projects, Including the Restart of Browns Ferry Nuclear Plant
Unit 1:
Legal Ownership and Risk If the Lease-Leaseback Arrangements Do Not
Work Out as Planned:
Classification of Lease-Leaseback Arrangements According to Generally
Accepted Accounting Principles, OMB Guidance, and the TVA Act:
Organizations Contacted:
Appendix II: Analysis of TVA’s Treatment of the Fiscal Year 2002
Lease-Leaseback Arrangement for Financial Reporting Purposes:
Appendix III: Comments from the Tennessee Valley Authority:
Appendix IV: GAO Contact and Staff Acknowledgments:
GAO Contact:
Acknowledgments:
Tables:
Table 1: TVA's Use and Consideration of Alternative Forms of Financing
as of May 31, 2003:
Table 2: Key Details of Fiscal Year 2000, 2002, and 2003 Lease-
Leaseback Arrangements:
Table 3: Summary of Key Advantages/Disadvantages under Lease-Leaseback
Arrangements:
Table 4: Summary of TVA's Early Termination Options under the Fiscal
Year 2002 Lease-Leaseback Arrangement:
Table 5: Summary of Risks to TVA and Equity Investor under Various
Options Included in the Fiscal Year 2002 Lease-Leaseback Arrangement:
Table 6: Applicable GAAP Standards:
Table 7: Fiscal Year 2002 Accounting Entries for the Fiscal Year 2002
Lease-Leaseback Arrangement:
Figure:
Figure 1: Key Events Related to TVA's Fiscal Year 2002 Lease-Leaseback
Arrangement:
Abbreviations:
CBO: Congressional Budget Office:
CFO: Chief Financial Officer:
EPAct: Energy Policy Act of 1992:
FASB: Financial Accounting Standards Board:
FIN: Financial Accounting Standards Board Interpretation:
FTB: Financial Accounting Standards Board Technical Bulletin:
GAAP: generally accepted accounting principles:
IG: Inspector General:
OGC: Office of General Counsel:
OMB: Office of Management and Budget:
SFAS: Statement of Financial Accounting Standards:
TVA: Tennessee Valley Authority:
Letter June 30, 2003:
The Honorable Richard H. Baker
House of Representatives:
Dear Mr. Baker:
This report responds to your June 13, 2002, request that we review the
Tennessee Valley Authority's (TVA) use of lease-leaseback financing
arrangements.[Footnote 1] When the Congress gave TVA the authority to
self-finance in 1959 by amending the Tennessee Valley Authority Act of
1933 (TVA Act), it established a limit on TVA's ability to incur debt
through the issuance of bonds and notes (debt cap). The debt cap
currently stands at $30 billion.
Recently, you and other members of the Congress have expressed concern
about the potential impact of TVA's debt on its future competitiveness.
TVA officials have also indicated that TVA's financial condition and
competitive prospects could be improved by reducing debt and the
corresponding financing costs. In the 5-year period from October 1,
1997, through September 30, 2002, TVA reduced its outstanding
debt[Footnote 2] from $27.4 billion to $25.3 billion, or about $2.1
billion. At the same time, TVA entered into "alternative financing"
arrangements[Footnote 3] (primarily lease-leaseback arrangements) to
refinance new power plants that result in long-term obligations similar
to debt,[Footnote 4] but which are not counted toward this debt limit
or reported as debt on its financial statements. While not reported as
debt, these alternative financing arrangements are included as "other
liabilities" on TVA's balance sheet.
Your concern about the future implications of TVA's debt and other
financing obligations prompted you to ask us to review TVA's use of
lease-leaseback financing arrangements. Specifically, you asked us to
determine (1) what lease-leaseback financing arrangements have been
used by TVA to date and the extent to which these and other alternative
financing arrangements are being considered for future use, (2) who has
legal ownership of the assets financed through lease-leaseback
arrangements and who is at financial risk if the projects do not work
out as planned, and (3) whether TVA is properly accounting for the
lease-leaseback arrangements for the purposes of financial reporting,
budgetary reporting, and debt cap compliance.
Results in Brief:
TVA has traditionally financed its operations with cash generated from
operations, the issuance of bonds and notes, and in the past,
appropriations. In fiscal year 2000, TVA began to use alternative
financing arrangements and is considering expanding their use.
Virtually all of TVA's alternative financing is in the form of lease-
leaseback arrangements, which totaled about $945 million as of May 31,
2003. TVA entered into the lease-leaseback arrangements in fiscal years
2000, 2002, and 2003 to refinance 24 existing power generators that
were designed for use during periods of peak demand for power. After
financing the construction of the power generators, TVA leased them to
private investors for 50 years and simultaneously leased them back for
20 years. TVA is responsible for making lease payments for 20 years, at
the end of which it has the option to purchase the private investors'
remaining interest in the units at the prevailing market price. TVA has
also implemented or is considering additional alternative financing
arrangements, including offering power discounts that would allow its
distributors to prepay for power in return for a discount on future
power purchases. According to TVA officials, the key reason TVA is
considering these additional alternative financing arrangements is to
finance the restart of Browns Ferry Nuclear Plant Unit 1, which is
expected to cost about $1.8 billion.
Under the lease-leaseback financing arrangements, TVA retains legal
title to the assets, but transfers sufficient interest in the assets to
a private equity investor to allow the investor to claim tax benefits.
As a result of the transaction, TVA received cash from private
investors who financed their investments primarily by issuing debt in
the public market through trusts, but also invested some of their own
equity capital. Based on our analysis of the fiscal year 2002 lease-
leaseback arrangement,[Footnote 5] the net economic benefits of the
transactions to TVA, the private investor, and the federal treasury
depend largely on the future value of the assets. TVA is at risk of
incurring higher costs, compared with traditional debt financing, if it
purchases the equity investor's remaining interest in the
assets[Footnote 6] at the end of the 20-year leaseback period for an
amount higher than its expected savings in financing costs, or if it
terminates the arrangement prior to the end of the 20-year leaseback
period.
If TVA decides not to purchase the private investor's remaining
interests in the assets, it could lose the electricity generated by the
assets and may need to purchase electricity or build additional
generating capacity. The private equity investor is at risk of not
achieving its projected rate of return or of incurring a loss if the
fair market value of the assets at the end of the 20-year leaseback
period is lower than expected. The private equity investor is also at
risk of not achieving its projected rate of return if TVA terminates
the arrangement prior to the end of the 20-year leaseback period under
certain scenarios. The federal treasury could ultimately experience a
net benefit or loss under the arrangement, depending on whether the
private equity investor's tax deductions exceed its taxable income.
TVA's lease-leaseback arrangements have been accounted for and reported
in compliance with applicable standards and requirements for financial
reporting, budgetary reporting, and debt cap compliance. For external
financial reporting purposes, the lease-leaseback arrangements are
financing obligations according to generally accepted accounting
principles (GAAP). GAAP does not require the lease-leaseback
arrangements to be characterized as debt on the external financial
statements, but it does require that they be reported as liabilities,
and TVA classifies them as such in its financial statements. For
budgetary reporting purposes, the Office of Management and Budget (OMB)
has concluded that the lease-leaseback arrangements should be treated
as debt, and they have been classified as such in the federal budget
just as if they had been bond issues. For purposes of compliance with
TVA's debt cap, current law does not clearly and unambiguously address
whether the amount of the lease-leaseback arrangements should be
counted against the debt cap; therefore, TVA's position that they
should not be counted against the debt cap is not unreasonable. While
the lease-leaseback arrangements are not considered debt for purposes
of financial reporting and debt cap compliance, they have substantially
the same economic impact on TVA's financial condition and future
competitiveness as traditional debt financing. Therefore, we are
including a matter for congressional consideration regarding clarifying
the TVA Act to address whether these types of alternative financing
arrangements should count against TVA's debt cap.
In written comments on a draft of this report, TVA's Chairman generally
agreed with the report, but expressed concern over our suggesting that
the Congress may want to consider amending the TVA Act to clarify
whether the debt cap should include alternative sources of financing
such as lease-leaseback arrangements. However, based on our analysis of
the law and its legislative history, we conclude that the current law
does not clearly and unambiguously address whether the amount of the
lease-leaseback arrangements should be counted against the debt cap.
Therefore, we have made no changes to the report in response to this
comment.
Background:
TVA is a multipurpose, independent, wholly-owned federal corporation
established by the TVA Act. The act established TVA to improve the
quality of life in the Tennessee River Valley by improving navigation,
promoting regional agricultural and economic development, and
controlling the floodwaters of the Tennessee River. To those ends, TVA
erected dams and hydropower facilities on the Tennessee River and its
tributaries. To meet the subsequent need for more electric power, TVA
expanded beyond hydropower, adding coal-fired power plants and nuclear
generating units to its power system.
From its inception in 1933 through fiscal year 1959, TVA received
appropriations to finance its internal cash and capital requirements.
However, in 1959, the Congress amended the TVA Act to authorize the use
of debt financing. Under this legislation, the Congress ended the
appropriations that had financed the TVA power program and required
that TVA's power program be "self financing" through revenues from
electricity sales.[Footnote 7] For its capital needs in excess of funds
generated from operations, TVA was authorized to borrow by issuing
bonds and notes. TVA's authority to issue bonds and notes is set by the
Congress and is currently $30 billion. However, the Congress did
continue to appropriate money for certain nonpower programs (e.g.,
flood control and navigation) through fiscal year 1999. Since fiscal
year 1999, the Congress has not appropriated money to pay for nonpower
programs, and power revenues have been used to pay for them.
Under the TVA Act, as amended, TVA is not subject to most of the
regulatory and oversight requirements that commercial electric
utilities must satisfy. The act vests all authority to run and operate
TVA in its three-member board of directors. Legislation also limits
competition between TVA and other utilities. The TVA Act was amended in
1959 to establish what is commonly referred to as the TVA "fence,"
which prohibits TVA, with some exceptions, from entering into contracts
to sell power outside the service area that TVA and its distributors
were serving on July 1, 1957. In addition, the Energy Policy Act of
1992 (EPAct) provides TVA with certain protections from competition,
called the "anti-cherry picking" provisions. Under EPAct, TVA is exempt
from having to allow other utilities to use its transmission lines to
transmit ("wheel") power to:
customers within TVA's service area. This legislative framework
generally insulates TVA from direct wholesale competition. As a result,
TVA remains in a position similar to that of a regulated utility
monopoly.[Footnote 8]
The electric utility industry in the United States is undergoing major
changes, the outcomes of which will affect consumers. The federal
government and nearly half the states have undertaken efforts to
introduce competition in the wholesale and retail electricity markets,
respectively. Federal actions have already resulted in the introduction
and expansion of regional wholesale electricity markets. Some states
have also introduced competition into retail markets, though these
efforts remain in an early stage of development. Most states have
either not yet begun to introduce planned restructuring or are not
currently considering the introduction of retail competition. Because
of the ongoing restructuring efforts in the electric utility industry,
TVA management and many industry experts expect that in the future TVA
will likely lose its legislative protections from competition.
We have issued reports[Footnote 9] indicating that TVA's high debt and
related interest expense could place it at a competitive disadvantage
if it lost its legislative protections from competition. In July 1997,
TVA issued a 10-year business plan with steps it believed were
necessary to better position itself for an era of increasing
competition. Two key strategic objectives of the plan were to (1)
reduce the cost of power primarily by reducing debt and the
corresponding financing costs and (2) increase financial flexibility by
reducing fixed costs. To help meet these objectives, the plan called
for TVA to reduce its interest expense by reducing its debt by about
one-half of its 1997 level, to about $13.2 billion. To increase its
financial flexibility and generate cash that could be used to reduce
debt, TVA increased its electricity rates beginning in 1998 and planned
to reduce certain expenses and limit capital expenditures. TVA's plan
to reduce debt while it is still legislatively protected from
competition was intended to help it achieve its ultimate goal of being
in a position to continue to offer competitively priced power.
However, TVA has fallen behind in meeting the debt reduction goal in
the original 10-year plan and consequently has revised this goal
downward. Over the first 5 years of the 10-year plan (through September
30, 2002), TVA reduced its debt by about $2.1 billion. By reducing
debt, and refinancing some debt at lower interest rates, TVA has
reduced its annual interest expense from about $2.0 billion in fiscal
year 1997 (35 percent of total expenses) to about $1.4 billion in
fiscal year 2002 (22 percent of total expenses). TVA now expects to
reduce its debt by about $3.3 billion by 2007 rather than the planned
$14.2 billion, which represents about $11 billion less debt reduction
than planned in 1997. The revised debt reduction goal is due to several
factors, including increased capital expenditures for new generating
capacity and environmental controls. TVA's ability to reduce debt in
the near term will be significantly affected by its recent decision to
restart the Browns Ferry Nuclear Plant Unit 1.
Objectives, Scope, and Methodology:
To determine what lease-leaseback financing arrangements have been used
by TVA to date and the extent to which these and other alternative
financing arrangements are being considered for future use, we reviewed
several documents, including TVA's audited financial statements, a TVA
Inspector General (IG) report on TVA's use of lease-leaseback
arrangements, a Congressional Budget Office (CBO) report on leases and
lease-leasebacks, and the fiscal year 2003 and 2004 President's
Budgets. We also interviewed officials from TVA, private electricity
industry officials familiar with lease financing, and officials from
OMB and CBO.
To determine who has legal ownership of the assets financed through
such arrangements and who is at financial risk if the projects do not
work out as planned, we obtained and reviewed copies of the lease-
leaseback arrangements entered into in fiscal years 2000 and 2002, and
December 2002, which covered 20 power generating units. We limited our
detailed analysis to the fiscal year 2002 lease-leaseback arrangement
because, based on our limited review of the fiscal year 2000 and
December 2002 lease-leaseback arrangements, we found them to be
structured similarly to the fiscal year 2002 arrangement. In addition,
according to TVA officials, the fiscal year 2000 and 2003 arrangements
are structured similarly to the fiscal year 2002 arrangement. Our
detailed analysis included a review of TVA's and the private equity
investor's cash flows under various alternatives included in the fiscal
year 2002 lease-leaseback arrangement to determine who is at risk. We
also interviewed officials from TVA's Office of IG, Chief Financial
Officer Organization, and Office of General Counsel; OMB; and CBO.
To determine whether TVA is properly accounting for the lease-leaseback
arrangements for financial reporting purposes, we reviewed
authoritative accounting literature related to accounting for leases.
We also reviewed TVA's accounting journal entries for the fiscal year
2000 and 2002 arrangements. In addition, we interviewed officials from
TVA's Chief Financial Officer Organization, Office of General Counsel,
IG Office, and external financial auditor. To determine whether TVA's
lease-leaseback arrangements are being treated properly for budgetary
reporting purposes, we reviewed various budget-related documents,
including the fiscal year 2003 and 2004 President's Budgets and OMB
guidance for the classification of leases. We also discussed the
budgetary treatment of the lease-leaseback arrangements with TVA and
OMB officials. To determine whether TVA's lease-leaseback arrangements
are properly treated for the purposes of debt cap compliance, we
reviewed the TVA Act and the legislative history related to the act,
and interviewed officials from TVA's Office of General Counsel.
Additional information on our scope and methodology is contained in
appendix I.
We conducted our work from July 2002 through May 2003 in accordance
with generally accepted government auditing standards. We requested
written comments from the chairman of TVA or his designated
representative on a draft of this report. TVA's chairman provided
written comments, which are reproduced in appendix III. We also
received written and oral comments of a technical nature, which we
incorporated as appropriate.
TVA's Current and Contemplated Use of Alternative Financing
Arrangements:
In fiscal year 2000, TVA began entering into alternative financing
arrangements (primarily lease-leaseback arrangements) to fund certain
capital requirements. These arrangements increase TVA's long-term risk
and obligations. However, in our opinion it is unclear whether the
current law requires that the lease-leaseback arrangements be counted
toward the $30 billion debt cap in the TVA Act. TVA has used lease-
leaseback financing arrangements to refinance 24 combustion turbine
power generators that are used during periods of peak demand for power.
Through May 31, 2003, these arrangements had raised about $945
million,[Footnote 10] and a customer power discount prepayment program
had raised about $47 million. In addition, TVA is considering using a
combination of alternative financing options to fund future capital
projects, including the restart of Browns Ferry Nuclear Unit 1.
Lease-leasebacks are financing arrangements under which an owner of
property raises capital by leasing the property to another party and
then simultaneously leasing the property back to retain use of it. TVA
entered into lease-leaseback financing arrangements in fiscal years
2000, 2002, and 2003 that involved a total of 24 combustion turbine
power generators that had been previously constructed. TVA officials
told us they decided to use this type of financing primarily because it
lowered their financing costs. According to industry officials, lease
financing (i.e., sale-leaseback and lease-leaseback arrangements) are
commonly used in the utility industry and have been in existence since
the late 1980s.
In addition to the lease-leaseback arrangements, on October 8, 2002,
TVA began its Discounted Energy Units program. This power discount
program allows TVA's power distributors to prepay a portion of the
price of firm power they plan to purchase from TVA in the future. In
return, the distributors receive a discount on a specific quantity of
the future power they purchase from TVA. The quantity of power varies
based on an implied interest rate associated with TVA's estimated cost
of borrowing for a given period. As of March 24, 2003, 34 distributors
had signed up to prepay about $47 million for the future delivery of
power. This program is expected to run annually through fiscal year
2007.[Footnote 11]
TVA hired a consultant to assist it in exploring other alternative
financing options, and to solicit and evaluate proposals to finance the
restart[Footnote 12] of Browns Ferry Nuclear Plant Unit 1, which TVA
officials estimate will cost about $1.8 billion. TVA expects to receive
a final report by June 30, 2003, after which TVA's management plans to
recommend specific actions to its board. In addition to its traditional
debt financing and the newer alternative financing options discussed
above, TVA and its consultant are considering:
* a second power discount program that would allow TVA's largest
customer to prepay for approximately one-half of its power needs for a
15-year period in return for a discount on this power over the course
of the agreement;
* entering into lease-leaseback arrangements for its currently
operating Browns Ferry nuclear units and common plant, and the assets
that will be acquired to meet the requirements of the Clean Air Act;
and:
* entering into joint ventures with private sector investors.
Table 1 summarizes TVA's use and consideration of alternative forms of
financing.
Table 1: TVA's Use and Consideration of Alternative Forms of Financing
as of May 31, 2003:
Dollars in millions.
Lease-leasebacks; Existing: $945; Under: consideration: 0; Total:
$945[A].
Customer prepayment programs; Existing: 47; Under: consideration:
$1,500; Total: $1,547.
Undefined options for financing the Browns Ferry restart; Existing:
0; Under: consideration: 1,800; Total: $1,800.
Total; Existing: $992; Under: consideration: $3,300; Total:
$4,292[B,C].
Source: GAO analysis of information from TVA.
[A] The lease-leaseback arrangements that TVA entered into in fiscal
years 2000, 2002, and 2003 raised $945 million. Based on lease payments
made to date, the outstanding liability balance for these arrangements
was $861 million as of May 31, 2003.
[B] According to TVA officials, the total amount of alternative
financing arrangements that TVA is ultimately likely to enter into is
significantly less than $4.3 billion because the proceeds from the
customer prepayment programs would likely be used to finance most of
the Browns Ferry restart.
[C] The total of the alternative financing arrangements being used and
considered by TVA ($4.3 billion) as of May 31, 2003, plus TVA's
outstanding debt as of December 31, 2002 ($25.2 billion), was less than
TVA's debt cap of $30 billion.
[End of table]
TVA Retains Legal Ownership of Assets, but Both TVA and the Private
Equity Investors Are at Financial Risk:
The lease-leaseback financing arrangements allow TVA to retain legal
title to the assets while transferring sufficient property interest in
the assets to the private equity investors so that they may claim tax
deductions that can be used to offset the taxable income from the lease
payments and any potential gain on the sale of the assets.[Footnote 13]
Our analysis of the fiscal year 2002 lease-leaseback arrangement shows
that the net economic benefits of the transactions to TVA, the private
investor, and the federal treasury will depend on the future value of
the assets. The future value of the assets largely determines whether
TVA's financing costs are higher or lower than under traditional debt
financing, whether and the extent to which the private equity investor
earns a return on its investment, and whether the tax implications to
the federal treasury are positive or negative.
Key Aspects of TVA's Lease-Leaseback Arrangements:
As described previously, TVA used lease-leaseback arrangements to
refinance 24 combustion turbine power generators in fiscal years 2000,
2002, and 2003. Prior to entering into the lease-leaseback
arrangements, TVA initially financed the construction of the assets,
which have an expected useful life of 40 years, with a combination of
cash generated from operations and borrowings, as necessary, to manage
its daily cash flow needs. After the assets were constructed, TVA
entered into the lease-leaseback arrangements. Under these
arrangements, TVA agreed to lease the assets to the private equity
investors for a 50-year period and immediately received the full
amount, approximately $945 million, due under the 50-year leases. The
equity investors agreed to lease the assets back to TVA for a period of
20 years. Over the 20-year leaseback period, TVA is required to make
semiannual lease payments.
In order to raise the approximately $945 million in lease payments made
to TVA, the equity investors relied on a combination of their own
equity and the issuance of debt in the public market. To help issue the
debt, TVA hired a financial services company, which established trusts
to sell certificates to the public.[Footnote 14] TVA's lease payments
are used to pay the debt certificates issued to the public. Although
TVA was not a direct party to the certificates, TVA's lease payments
are being used as security for and to directly service the debt. TVA's
obligation to make lease payments is unconditional throughout the term
of the certificates. TVA's legal obligation to make lease payments
takes priority over its obligation to pay principal and interest on its
senior debt obligations, and TVA's lease obligation was cited by
Standard & Poor's as substantiation for assigning a triple-A
rating[Footnote 15] to the trust certificates. On a present value
basis,[Footnote 16] over the 20-year leaseback period for the fiscal
year 2002 arrangement, TVA's lease payments will total approximately
$294 million, of which approximately $277 million will be distributed
to the certificate holders. The excess $17 million will be distributed
to the equity investor.
At the end of the 20-year leaseback period, TVA has the option of
purchasing the equity investor's remaining interest in the assets over
the remaining 30-year period of the 50-year lease. If, after 20 years,
TVA elects to exercise the purchase option, it would pay the fair
market value of the assets, subject to certain maximum amounts set in
the lease-leaseback arrangements. Once TVA provides notice that it
intends to purchase the equity investor's interest in the assets,
negotiations between TVA and the equity investor will commence to
determine the fair market value of the assets. If they cannot agree on
a fair market value within 90 days of TVA's notice, the fair market
value will be determined by an independent appraisal procedure. Table 2
shows the key details of the lease-leaseback arrangements and the lease
proceeds to TVA.
Table 2: Key Details of Fiscal Year 2000, 2002, and 2003 Lease-
Leaseback Arrangements:
Details: Date; Lease-leaseback arrangements: FY 2000: September 27,
2000; Lease-leaseback arrangements: FY 2002: November 14, 2001; Lease-
leaseback arrangements: FY 2003: December 20, 2002; Lease-leaseback
arrangements: FY 2003: May 5, 2003.
Details: Combustion turbine power generators financed; Lease-leaseback
arrangements: FY 2000: Four units at Gallatin Fossil Plant and four
units at Johnsonville Fossil Plant; Lease-leaseback arrangements: FY
2002: Eight units at Lagoon Creek site near Brownsville, Tenn; Lease-
leaseback arrangements: FY 2003: Four additional units at Lagoon Creek
site near Brownsville, Tenn; Lease-leaseback arrangements: FY 2003:
Four units at Kemper County, Miss; Lease-leaseback arrangements:
Total: Twenty-four units.
Details: Lease proceeds to TVA; Lease-leaseback arrangements: FY 2000:
$300 million; Lease-leaseback arrangements: FY 2002: $320 million;
Lease-leaseback arrangements: FY 2003: $162 million; Lease-leaseback
arrangements: FY 2003: $163 million; Lease-leaseback arrangements:
Total: $945 million.
Details: Portion of lease proceeds funded from the private party's
equity; Lease-leaseback arrangements: FY 2000: $45 million; Lease-
leaseback arrangements: FY 2002: $48 million; Lease-leaseback
arrangements: FY 2003: $28 million; Lease-leaseback arrangements: FY
2003: $28 million; Lease-leaseback arrangements: Total: $149 million.
Details: Portion of lease proceeds funded from debt issued by trusts;
Lease-leaseback arrangements: FY 2000: $255 million; Lease-leaseback
arrangements: FY 2002: $272 million; Lease-leaseback arrangements: FY
2003: $134 million; Lease-leaseback arrangements: FY 2003: $135
million; Lease-leaseback arrangements: Total: $796 million.
Details: Maximum purchase price; Lease-leaseback arrangements: FY 2000:
$243 million; Lease-leaseback arrangements: FY 2002: $260 million;
Lease-leaseback arrangements: FY 2003: $126 million; Lease-leaseback
arrangements: FY 2003: $126 million; Lease-leaseback arrangements:
Total: $755 million.
Details: Equity investors' expected purchase price; Lease-leaseback
arrangements: FY 2000: $110 million; Lease-leaseback arrangements: FY
2002: $115 million; Lease-leaseback arrangements: FY 2003: $53 million;
Lease-leaseback arrangements: FY 2003: $56 million; Lease-leaseback
arrangements: Total: $334 million.
Source: GAO analysis of information from TVA and TVA's IG.
[End of table]
The key events involved in the fiscal year 2002 lease-leaseback
arrangement are shown in figure 1.
Figure 1: Key Events Related to TVA's Fiscal Year 2002 Lease-Leaseback
Arrangement:
[See PDF for image]
[End of figure]
Under the lease-leaseback arrangements, TVA retains legal title to the
assets but relinquishes sufficient interest in the assets so that the
equity investors are entitled to certain tax benefits that are not
available to TVA. As we discuss in more detail later, these
transactions have implications for the federal treasury because they
result in both tax deductions and income.
Table 3 shows the key advantages and disadvantages for TVA and the
equity investors under the lease-leaseback arrangements. These
advantages and risks are discussed in more detail in the following
sections.
Table 3: Summary of Key Advantages/Disadvantages under Lease-Leaseback
Arrangements:
Advantages; TVA: * Receives cash proceeds up front; * Reduces costs
over first 20 years of lease by transferring tax benefits to the equity
investor that were not available to TVA; * Maintains operational
control and retains legal title of the assets; * Excludes financing
obligations from its debt cap; * Potential for lower costs over the 50-
year lease period depending on cost to purchase the equity investors'
interest in the assets at the end of the 20-year leaseback period; *
Has flexibility to decide whether it wants to purchase the equity
investor's interest in the assets at the end of the 20-year leaseback
period, or to exercise one of the early termination options; Equity
investor: * Receives the tax benefits associated with the assets that
were not available to TVA; * Obtains economic interest in the asset,
which TVA has the option to purchase back at the end of the 20-year
leaseback period; * Opportunity to earn an attractive rate of return,
if the fair market value of the asset after 20 years is at the expected
amount and TVA or another party purchases its interest; * Assumes no
operating responsibilities; * Faces low risk of TVA defaulting on
rental payments or not properly maintaining assets.
Disadvantages; TVA: * Has to repurchase the equity investor's interest
in assets at end of 20-year leaseback period in order to regain full
rights to the assets and retain generating capacity; * Risks higher
costs under the lease-leaseback arrangements with the repurchase of
assets or exercise of early termination options, compared to
traditional debt financing; Equity investor: * Risks receiving a lower
return or incurring a loss if the fair market value of the assets is
lower than expected at the end of 20 years; * Assumes risk of lower
return if its income in a particular year is not sufficient to take
full advantage of the tax deductions.
Source: GAO analysis of information from TVA and TVA's IG.
Note: TVA retains legal title and is responsible for maintenance and
repair costs and any modifications to the facility that might be
required by law.
[End of table]
Risk to TVA under Fiscal Year 2002 Lease-Leaseback Arrangement:
Under the fiscal year 2002 lease-leaseback arrangement, TVA will incur
lower financing costs over the 20-year leaseback period, compared to
traditional debt financing. TVA's discounted payments over the 20-year
leaseback period would be approximately $28 million[Footnote 17] less
under the fiscal year 2002 lease-leaseback arrangement than they would
have been under traditional debt financing. However, TVA would not own
all rights to the assets under the lease-leaseback arrangement, as it
would under traditional debt financing.
In its assessment of the benefits of entering into the fiscal year 2002
lease-leaseback arrangement, TVA did not consider scenarios under which
it would purchase all interest in the assets at the end of the 20-year
lease period or exercise one of the options to terminate the
arrangement early. Our analysis of the arrangement considers the full
50-year lease period, covering the expected 40-year useful life of the
assets, including a possible decision by TVA to purchase the equity
investor's remaining interest in the assets at the end of the 20-year
leaseback period. As this analysis suggests, there is no way of knowing
with certainty whether this arrangement will end up being more
advantageous to TVA or more lucrative to the private investors.
In large part, who will benefit from this arrangement depends on the
fair market value of these generating units at the end of the 20-year
leaseback period. Depending on the cost to TVA to repurchase the equity
investor's remaining interest in the asset, it may be at risk of
incurring higher costs under the lease-leaseback arrangement, compared
to traditional debt financing. For example, if TVA repurchases the
equity investor's interest in the assets at the amount expected by the
equity investor[Footnote 18]--a lump sum payment of approximately $115
million at the end of the 20-year lease (present value of $42 million)-
-its discounted payments will be approximately $14 million higher under
the lease-leaseback arrangement than they would have been under
traditional debt financing. If TVA repurchases the equity investor's
interest in the assets at the maximum amount set by the terms of the
fiscal year 2002 lease-leaseback arrangement--a lump sum payment of
approximately $260 million (present value of $94 million)--its
discounted payments will be approximately $66 million higher, compared
to traditional debt financing. Although TVA may elect not to repurchase
the equity investor's remaining interest in the assets at the end of
the 20-year leaseback period, TVA would lose control over the
electricity generated by the plants over the next 30-year period and
may need to purchase power plants or acquire additional electricity to
meet the needs of its customers.
According to TVA's leasing advisor, one of the primary advantages of
the arrangement is TVA's prerogative to decide whether to reacquire
full interest in the assets at the end of the 20-year leaseback period,
which enables TVA to assess their value at that time and determine
whether it would be economically advantageous to purchase the remaining
interest in them. TVA's leasing advisor highlighted recent market
volatility to illustrate the importance and value of this flexibility
to TVA. Due to a favorable market for combustion turbines at the time
TVA entered into the fiscal year 2002 lease-leaseback arrangement, TVA
received $320 million in lease proceeds for assets that were initially
constructed for about $226 million. However, TVA's leasing advisor told
us that, since TVA refinanced the assets, the market for combustion
turbines has declined, and units similar to TVA's have traded for as
much as 50 percent less than the amount at which TVA refinanced its
assets. This market volatility makes it impossible to know at this time
the net impact of the arrangement on the respective parties.
If the market for these power generating units remains depressed at the
end of the 20-year leaseback period, TVA's purchase price to reacquire
interest in the assets may fall to a level that would be beneficial to
TVA. TVA would realize lower financing costs under the arrangement if
its purchase price at the end of the 20-year leaseback period were
lower than its savings in financing costs to that point--approximately
$28 million (present value).
Also, in analyzing its potential costs under the lease-leaseback
arrangement, TVA officials told us that they did not consider any of
TVA's early termination options (see table 4 for a summary of these
options) because they do not expect to use them. They said the early
termination options were included in the arrangements for TVA's benefit
and provide additional flexibility in case of unexpected circumstances-
-for example, damage to the assets or a change in the law making it
illegal for TVA to lease the assets. TVA will assess the feasibility of
the early buyout options at the time they become available. If the
assets' fair market value at the time of the options is at an amount
for which TVA concludes that purchasing the assets at the buyout price
would be advantageous, TVA may exercise one of its early buyout
options. Due to significant termination costs, our analysis[Footnote
19] shows that, if TVA exercises its 2009 early buyout option, its
discounted payments will be approximately $25 million more under the
lease-leaseback arrangement than they would have been under traditional
debt financing. If TVA exercises its 2017 early buyout option, its
discounted payments will be approximately $54 million higher. The early
buyout options are intended to provide flexibility to TVA, in the event
that the assets' fair market value is higher than expected. For
example, if at the time of the 2017 early buyout option date, the fair
market value of the assets is higher than expected, TVA can purchase
the equity investor's remaining interest in the assets at a set price
established in the lease arrangement and avoid the possibility of
paying additional value for the assets 4 years later at the end of the
20-year leaseback period.
As shown in table 4, TVA can also terminate the lease-leaseback
arrangement in the case of burdensome events, obsolescence, or loss, in
which case our analysis shows that TVA's discounted payments will be
from approximately $7 million to $16 million higher under the lease-
leaseback arrangement than they would have been under traditional debt
financing.
Table 4: Summary of TVA's Early Termination Options under the Fiscal
Year 2002 Lease-Leaseback Arrangement:
Early termination options: Early buyout options; Description: On two
specified dates (May 1, 2009, and May 1, 2017) TVA has the option of
terminating the leasing agreement and acquiring all interest in the
assets; TVA's cost to terminate[A]: May 1, 2009 - $301 million; May
1, 2017 - $271 million; Present value (as of November 1, 2001) of TVA's
cost to terminate: May 1, 2009 - $206 million; May 1, 2017 - $123
million.
Early termination options: Termination due to burdensome event;
Description: Upon at least 30 days' notice, TVA can terminate the
lease-leaseback arrangement if (1) a change in the law or the
interpretation of the law makes it illegal for TVA to continue the
lease or make payments under the lease, and the transactions cannot be
restructured to comply with the changes in a manner acceptable to all
parties, or (2) subject to certain exceptions, one or more events
outside of TVA's control occur that could or would obligate TVA to make
indemnity payments under the arrangements; TVA's cost to terminate[A]:
November 1, 2020 - $112 million; May 1, 2002 - $338 million;
Present value (as of November 1, 2001) of TVA's cost to terminate:
November 1, 2020 - $42 million; May 1, 2002 - $329 million.
Early termination options: Termination due to obsolescence;
Description: Any time after 5 years and with 6 months' notice, TVA can
terminate the arrangement if TVA's board of directors determines in
good faith that the assets are either economically or technologically
obsolete, surplus to TVA's needs, or no longer useful in TVA's trade or
business; TVA's cost to terminate[A]: November 1, 2020 - $112
million; May 1, 2007 - $297 million; Present value (as of November
1, 2001) of TVA's cost to terminate: November 1, 2020 - $42 million;
November 1, 2006 - $229 million.
Early termination options: Event of loss; Description: TVA can
terminate the lease-leaseback arrangement in the case of (1) loss of
any unit or use thereof due to destruction or damage to such unit or
the common facilities that is beyond economic repair or that renders
such unit permanently unfit for normal use or (2) seizure,
condemnation, confiscation, or taking of, or requisition of title to or
use of, any unit by any governmental authority following exhaustion of
all permitted appeals or TVA's decision not to pursue such appeals;
TVA's cost to terminate[A]: November 1, 2020 - $112 million; May 1,
2002 - $338 million; Present value (as of November 1, 2001) of TVA's
cost to terminate: November 1, 2020 - $42 million; May 1, 2002 -
$329 million.
Source: GAO analysis of information from TVA and TVA's IG.
[A] Termination costs vary depending on when, within the 20-year lease
term, the arrangement was to be ended.
[End of table]
Risk to Private Parties under Fiscal Year 2002 Lease-Leaseback
Arrangement:
As part of the fiscal year 2002 lease-leaseback arrangement, private
investors paid $320 million to TVA; $272 million of this payment was
raised from debt investors, and $48 million was raised from a private
equity investor. The debt portion of the payment was funded through the
issuance of certificates to the public. As discussed previously, the
principal and interest owed on the certificates are, in effect, to be
satisfied through TVA's ongoing lease payments over the 20-year
leaseback period. TVA's obligation to make lease payments is
unconditional throughout the term of the certificates. Based on TVA's
unconditional obligation to make lease payments,[Footnote 20] we
concluded that the bondholders are at minimal risk of losing the
principal and interest payments they are owed.[Footnote 21] The minimal
risk to debt holders is also reflected in the triple-A rating given to
the certificates by Standard & Poor's.
However, the equity investor may be at risk of realizing a lower return
than expected or a loss under certain scenarios.[Footnote 22] As part
of the fiscal year 2002 arrangement, the equity investor made a $48
million payment to TVA and, in return, receives certain benefits,
including (1) cash in the amount by which TVA's lease payments exceed
the amount of principal and interest owed on the certificates--about
$17 million (on a present value basis) over the 20-year period, (2) the
ability to sell the assets, or the power they generate, after the 20-
year leaseback period, and (3) tax benefits that can be used to offset
taxable income.
The equity investor's expected return is based on TVA electing to buy
back interest in the assets at their fair market value at the end of
the 20-year leaseback period. If TVA chooses to do so, the equity
investor is at risk of losing money on the arrangement. The equity
investor's discounted cash disbursements, under this scenario, would
exceed its discounted cash proceeds by approximately $25 million.
However, the equity investor would own certain interest in the assets
and would be able to sell its interest to another party or use the
assets to raise revenue.
In entering into the arrangement, the equity investor projected an
after-tax rate of return of about 5.3 percent, according to TVA's
leasing advisor.[Footnote 23] The equity investor expected that the
lease to TVA would go the full term (20 years), and, at the end of the
lease term, the price paid by TVA to reacquire interest in the assets
would be about 36 percent of the fair market value of the assets at the
inception of the lease. However, if TVA decides to purchase the equity
investor's interest in the assets and the fair market value of the
assets is lower than anticipated, the equity investor is at risk of not
achieving its projected rate of return or of realizing a loss. If TVA's
purchase price at the end of the leaseback period is below 36 percent
of the asset's fair market value at the inception of the lease, the
equity investor is at risk of not earning its projected rate of return.
If the purchase price is less than 30 percent, the equity investor is
also at risk of losing money on the arrangement.[Footnote 24]
In addition, as discussed above, TVA has options to terminate the
lease-leaseback arrangement early. According to our analysis, if TVA
exercises either of its two early buyout options, the equity investor
will earn in excess of its projected rate of return. However, if TVA
terminates the arrangement early due to burdensome events,
obsolescence, or loss, the equity investor will be at risk of earning a
return lower than its projected after-tax rate of 5.3 percent. A
summary of the risks to the equity investor and TVA is included in
table 5.
Table 5: Summary of Risks to TVA and Equity Investor under Various
Options Included in the Fiscal Year 2002 Lease-Leaseback Arrangement:
[See PDF for image]
Source: GAO analysis of information from TVA and TVA's IG.
Notes: We defined risk for TVA as incurring higher costs, as compared
to a traditional debt financing. We defined risk for the equity
investor as incurring a loss or earning a lower return than expected.
If TVA elects not to exercise its purchase option, the equity investor
may purchase title to the assets for $1.
[End of table]
In addition, the lease-leaseback arrangements could have implications
for the federal treasury. For the equity investor, these transactions
create tax deductions that would not be available to TVA as a tax
exempt entity, but also generate income in the form of lease payments.
Whether the transactions result in a net loss or a net gain to the
federal treasury depends largely on if and when the equity investor's
rights to the assets are sold and for what amount. For example, based
on our analysis of the fiscal year 2002 lease-leaseback arrangement, if
the equity investor sells the assets at the end of the 20-year
leaseback period for an amount that is less than 8 percent of the
original cost, the equity investor's tax deductions would have exceeded
its income and the arrangement would result in a net loss to the
federal treasury. If, on the other hand, the sales price were to exceed
8 percent of the original cost, the equity investor's income would have
exceeded its tax deductions and the arrangement would result in a net
gain to the federal treasury.
Lease-Leaseback Accounting Complies with Applicable Standards and
Requirements:
TVA's lease-leaseback arrangements are classified as liabilities in
TVA's financial statements, as required by GAAP, and are classified as
debt for budgetary reporting purposes, as required by OMB guidance. In
addition, because in our opinion the relevant statute is unclear as to
whether the arrangements should be counted against TVA's statutory debt
cap, TVA's position that they should not be counted against the cap is
not unreasonable.
TVA, with concurrence from its external auditor, appropriately recorded
its lease-leaseback arrangements on its balance sheet as an increase to
cash and as a financing obligation (increase to liabilities) while
retaining the assets on its books at historical cost.[Footnote 25] See
appendix II for a more detailed analysis of TVA's treatment of the
fiscal year 2002 lease-leaseback arrangement.
While GAAP does not require lease-leaseback arrangements to be
classified as debt on the financial statements, it does provide
guidance for classifying them as liabilities. Although the issuance of
debt is an integral part of the lease-leaseback arrangements, the legal
structure of the arrangements allows them to be recorded as liabilities
instead of debt. We believe this is a distinction without a meaningful
economic difference because, in this case, debt and liabilities have
very similar characteristics. Since TVA is required to make semiannual
payments for the duration of the 20-year leaseback period, provided no
early buyout or termination options are exercised, future sacrifices of
economic benefits are reasonably assured and an obligation to render
payment clearly exists. Thus, while the lease-leaseback arrangements
are not treated as debt for financial reporting purposes, they are in
essence debt because they have substantially the same economic impact
on TVA as traditional debt financing. Moreover, officials at Standard &
Poor's and some state regulators generally view the lease-leaseback
arrangements as debt.
TVA's lease-leaseback arrangements are treated as debt in the fiscal
year 2004 President's Budget, in accordance with OMB guidance. TVA
originally treated the fiscal year 2000 lease-leaseback arrangement as
an obligation rather than debt, but OMB questioned this treatment when
TVA's fiscal year 2003 budget submission treated the 2002 lease-
leaseback arrangement similarly. Based on criteria for classifying
leases established in OMB Circular A-11, OMB officials concluded the
lease-leaseback arrangement was equivalent to the purchase of assets
financed by the issuance of agency debt because (1) TVA retains legal
ownership of the assets, (2) the present value of TVA's lease payments
is very high compared to the fair market value of the assets, and (3)
TVA controls use of the assets.
Under OMB's current treatment of the lease-leaseback arrangements, the
lump-sum cash proceeds TVA receives from the private parties at the
inception of the lease-leaseback arrangements are treated as borrowing.
In addition, interest payments made to the private parties are scored
as outlays in the budget as they are made. All of TVA's lease-leaseback
arrangements are now treated as debt in the President's
Budget.[Footnote 26] While TVA has disagreed with OMB's position that
the lease-leaseback arrangements should be treated as debt, it
recognizes OMB's authority to decide how the arrangements should be
presented in the President's Budget.
TVA's decision not to treat the lease-leaseback arrangements as debt
for purposes of its statutory debt cap is not unreasonable. Section
15d(a) of the TVA Act authorizes TVA to "issue and sell bonds, notes
and other evidences of indebtedness…in an amount not exceeding
$30,000,000,000." It is TVA's position that Section 15d of the TVA Act
effectively provided TVA with two new ways to acquire power system
assets. One way is by selling bonds (section 15d(a)) and the other way
by entering into leases, lease-purchase agreements, and power purchase
agreements (section 15d(g)). The limitation in section 15d(a) applies
to bonds, notes, and other evidences of indebtedness (collectively
referred to in the statute as bonds).
In TVA's opinion, the language, structure, and legislative history of
section 15d clearly demonstrate that lease obligations are not bonds
for the purpose of the limitation. TVA asserts that the descriptive
references of the bonds in section 15d make sense when applied to bonds
as the traditional financial instrument but not to TVA's obligations
under the lease-leaseback arrangements. TVA also asserts that the
legislative history demonstrates that the Congress was aware that the
limitation of TVA's authority to issue bonds did not limit TVA with
respect to leases, lease-purchase agreements, and power purchase
agreements. Therefore, it is TVA's position that the section 15d
limitation on bonds does not apply to the lease-leaseback arrangements.
Based on our analysis of the law and its legislative history, we
conclude that the current law does not clearly and unambiguously
address whether the amount of the lease-leaseback arrangements should
be counted against the debt cap. However, there is support for the view
that bonds are treated as separate means of financing the expansion of
facilities from leases and lease-purchase agreements. There is also
support for the view that, although bonds are covered by the ceiling in
section 15d(a) of the TVA Act, leases and lease-purchase agreements are
not. Finally, there is support for the view that lease-leaseback
arrangements are sufficiently analogous to lease and lease-purchase
agreements to support the conclusion that they are not bonds for the
purpose of section 15d(a) of the TVA Act. Therefore, TVA's decision
that its lease-leaseback arrangements should not be treated as debt for
purposes of the debt cap in section 15d(a) of the TVA Act is not
unreasonable, even though these arrangements have the same impact on
TVA's financial condition and future competitiveness as traditional
debt.
Based on our discussions with OMB officials, they are also of the
opinion that the TVA Act is unclear regarding whether TVA's lease-
leaseback arrangements should be counted against the $30 billion bond
ceiling established by section 15d of the TVA Act. As a result, the
fiscal year 2004 President's Budget proposes that legislation be
drafted to ensure that lease-leaseback arrangements and other
arrangements equivalent to traditional debt financing are included
under TVA's debt cap.
Conclusions:
TVA has entered into substantial (about $945 million) lease-leaseback
arrangements with private investors and is considering expanding its
use of these and other nontraditional financing arrangements. While the
lease-leaseback arrangements provide TVA with a lower cost of financing
over the first 20 years, they also pose risks. The savings in financing
costs TVA achieves over the first 20 years will be lowered by (1) costs
it will incur if it purchases the remaining interest in the assets or
replaces the assets or (2) revenue it will forgo due to loss of
generation capacity. The risk that TVA's total costs under the lease-
leaseback arrangements could be higher than under traditional bond
financing is offset by two advantages: (1) TVA has the ability to walk
away from the assets at the end of 20 years if they have become
obsolete or their generating capacity is no longer needed and (2) the
TVA Act has been interpreted such that the arrangements do not count
against TVA's statutory debt cap, thereby allowing TVA to maintain
ready access to capital in the debt market. However, these arrangements
essentially have the same economic impact on TVA's financial condition
as traditional debt and therefore could negatively affect TVA's future
competitiveness. The federal treasury could experience a net benefit or
loss, depending on whether the private equity investor's tax deductions
exceed its taxable income, with the ultimate impact depending largely
on the future value of the assets.
Matter for Congressional Consideration:
The Congress may want to consider amending the TVA Act to clarify
whether the debt cap should include alternative sources of financing
(such as lease-leaseback arrangements) that have the same impact on
TVA's financial condition and competitive position as traditional debt
financing.
Agency Comments and Our Evaluation:
In written comments on a draft of this report, TVA's Chairman generally
agreed with the report and characterized it as a fair and thorough
analysis on this complex subject. However, the Chairman expressed
concern over our suggesting that the Congress may want to consider
amending the TVA Act to clarify whether the debt cap should include
nontraditional sources of financing such as lease-leaseback
arrangements. He pointed out that both TVA and its outside counsel are
of the view that the current statute and legislative history are clear
in the authority provided to TVA to issue debt securities (to which the
debt cap applies) and to enter into leasing arrangements (to which the
debt cap does not apply).
As stated in the report, based on our analysis of the law and its
legislative history, we conclude that the current law does not clearly
and unambiguously address whether the amount of the lease-leaseback
arrangements should be counted against the debt cap. Therefore, we have
made no changes to the report in response to this comment. TVA's
written comments are reproduced in appendix III.
TVA also provided us with oral comments of a technical nature, which we
have incorporated into the final report as appropriate.
As arranged with your office, unless you announce the contents of this
report earlier, we will not distribute it until 30 days from its date.
Then we will send copies of this report to appropriate House and Senate
committees, interested members of the Congress, TVA's board of
directors, and the Director of the Office of Management and Budget. We
will also make copies available to others upon request. In addition,
the report will be available at no charge on GAO's Web site at http://
www.gao.gov.
If you or your staff have any questions on matters discussed in this
report, please contact me at (202) 512-9508 or calboml@gao.gov. Major
contributors to this report are listed in appendix IV.
Sincerely yours,
Signed by:
Linda M. Calbom
Director, Financial Management and Assurance:
[End of section]
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
Description of Lease-Leaseback Arrangements:
To describe the lease-leaseback arrangement(s) used to date, we did the
following:
* Interviewed officials from the Tennessee Valley Authority's (TVA)
Office of Inspector General (IG), TVA's external auditor, and the
Office of Management and Budget (OMB).
* Reviewed TVA's annual reports and the fiscal year 2003 and 2004
President's Budgets.
* Interviewed representatives of the investor-owned utility members of
TVA Exchange Group, Standard & Poor's, the Electric Power Supply
Association, and the Edison Electric Institute.
* Reviewed a sample of annual reports and financing statements of
electric utilities.
* Obtained and reviewed copies of the lease-leaseback arrangements
entered into in fiscal years 2000 and 2002, and December 2002, which
covered 20 of the 24 generating units.
* Limited our detailed analysis to the fiscal year 2002 lease-leaseback
arrangement. Based on our limited review of the fiscal year 2000 and
December 2002 lease-leaseback arrangements, we found them to be
structured similarly to the fiscal year 2002 arrangement. In addition,
TVA officials told us that the fiscal year 2000 and 2003 arrangements
are substantially the same in structure as the fiscal year 2002
arrangement.
Alternative Financing Options Being Considered by TVA for Future
Capital Projects, Including the Restart of Browns Ferry Nuclear Plant
Unit 1:
To identify proposals under consideration for financing future capital
projects, including the restart of Browns Ferry Nuclear Plant Unit 1,
we:
* interviewed officials from TVA, OMB, and the Congressional Budget
Office (CBO);
* reviewed a TVA IG report on TVA's use of lease-leaseback financing;
* reviewed TVA's proposed 2003 and 2004 federal budgets; and:
* reviewed recent press reports related to TVA.
Legal Ownership and Risk If the Lease-Leaseback Arrangements Do Not
Work Out as Planned:
To determine who has legal ownership of the assets financed by lease-
leaseback transactions, and who is at financial risk if the projects do
not work out as planned, we:
* obtained and reviewed copies of the fiscal years 2000 and 2002, and
December 2002 lease-leaseback arrangements covering 20 of 24 power
generating units;
* interviewed officials of TVA's IG, Chief Financial Officer (CFO)
Organization, and Office of General Counsel (OGC), OMB, and CBO;
* reviewed summary documents prepared by TVA's OGC and IG that identify
and explain the responsibility of the different parties to the
agreements;
* reviewed an economic analysis of the fiscal year 2002 lease-leaseback
arrangement prepared by TVA to compare its borrowing cost under
traditional debt financing with its cost under the lease-leaseback
arrangements;
* compared TVA's cash flow under the fiscal year 2002 arrangement to
traditional debt financing if TVA were to exercise the early buyout and
termination options in the fiscal year 2002 arrangement; and:
* analyzed the equity investor's cash flows under the fiscal year 2002
arrangement.
Classification of Lease-Leaseback Arrangements According to Generally
Accepted Accounting Principles, OMB Guidance, and the TVA Act:
To determine whether TVA was treating the lease-leaseback arrangements
according to generally accepted accounting principles in its external
financial statements, we:
* reviewed the accounting journal entries used by TVA to record the
fiscal year 2000 and 2002 lease leaseback transactions covering 16 of
24 power generating units in TVA's accounting system;
* interviewed officials of TVA's IG, CFO Organization, and external
financial statement auditor;
* reviewed authoritative accounting literature on accounting for leases
including Statement of Financial Accounting Standards (SFAS) 13,
Accounting for Leases, SFAS 66, Accounting for Sales of Real Estate,
and SFAS 98, Accounting for Leases, to evaluate TVA's accounting
treatment;
* obtained and reviewed annual reports for publicly traded utility
companies to identify financial reporting disclosures related to
leasing transactions; and:
* obtained and reviewed copies of the fiscal years 2000 and 2002, and
December 2002 lease-leaseback arrangements covering 20 of 24 power
generating units.
To determine whether the lease-leaseback arrangements are being
classified properly in the federal budget, we:
* reviewed the fiscal year 2003 and 2004 President's Budgets;
* interviewed officials from TVA, OMB, and CBO; and:
* reviewed OMB's Circular A-11 for guidance on how OMB classifies and
scores leases for budgetary reporting purposes.
To determine whether the lease-leaseback arrangements should be counted
toward the limitation on TVA's authority in the TVA Act to issue bonds
and notes, we:
* reviewed the fiscal year 2002 lease-leaseback arrangement;
* interviewed officials from OMB and TVA's OGC;
* obtained and reviewed a memo prepared by TVA's OGC summarizing its
position;
* reviewed the fiscal year 2004 President's Budget; and:
* reviewed and interpreted language included in section 15d of the TVA
Act, and reviewed the legislative history of the act.
Organizations Contacted:
During the course of our work, we contacted the following
organizations.
Federal Agencies:
* Tennessee Valley Authority:
* Congressional Budget Office:
* Office of Management and Budget:
Bond Rating Agencies:
* Standard & Poor's:
Customer Representative or Trade Groups:
* American Public Power Association:
* TVA Exchange Group:
* Electric Power Supply Association:
* Edison Electric Institute:
Electric Utilities:
* Entergy Corp.
* Duke Energy Corp.
Other:
* Dexia - Global Structured Finance:
[End of section]
Appendix II: Analysis of TVA's Treatment of the Fiscal Year 2002 Lease-
Leaseback Arrangement for Financial Reporting Purposes:
Authoritative Accounting Standards for Leases:
Table 6 lists authoritative accounting standards for leases (which
include the applicable standards for lease-leaseback arrangements) that
we reviewed to determine whether the Tennessee Valley Authority's (TVA)
treatment of the lease-leaseback arrangements for financial reporting
purposes is in accordance with generally accepted accounting principles
(GAAP). The Financial Accounting Standards Board (FASB) issues all
Statements of Financial Accounting Standards (SFAS), Financial
Accounting Standards Board Interpretations (FIN), and Financial
Accounting Standards Board Technical Bulletins (FTB).
Table 6: Applicable GAAP Standards:
Standard: SFAS-13[A]; Title: Accounting for Leases.
Standard: SFAS-66[A]; Title: Accounting for Sales of Real Estate.
Standard: SFAS-71[A]; Title: Accounting for Effects of Certain Types of
Regulation.
Standard: SFAS-98[A]; Title: Accounting for Leases: * Sale-leaseback
transactions involving real estate; * Sales-type leases of real estate;
* Definition of the lease term; * Initial direct costs of direct
financing leases.
Standard: FIN-23[A]; Title: Leases of Certain Property Owned by a
Governmental Unit or Authority.
Standard: FTB79-10[A]; Title: Fiscal Funding Clauses in Lease
Agreements.
Standard: FTB79-12[A]; Title: Interest Rate Used in Calculating the
Present Value of Minimum Lease Payments.
Standard: FTB79-14; Title: Upward Adjustment of Guaranteed Residual
Values.
Standard: FTB79-15; Title: Accounting for Loss on a Sublease Not
Involving the Disposal of a Segment.
Standard: FTB86-2; Title: Accounting for an Interest in the Residual
Value of a Leased Asset: * Acquired by a third party; * Retained by a
lessor that sells the related minimum rental payments.
Standard: FTB88-1; Title: Issues Relating to Accounting for Leases: *
Time pattern of the physical use of the property in an operating lease;
* Lease incentives in an operating lease; * Applicability of leveraged
lease accounting to existing assets of the lessor; * Money-over-money
lease transactions; * Wrap lease transactions.
Source: GAO analysis of GAAP.
[A] We performed a detailed review of these standards.
[End of table]
Summary of GAAP Accounting for Leases:
A lease is an agreement that conveys the right to use property, usually
for a specified period. Leases typically involve two parties: the owner
of the property (lessor) and the party contracting to use the property
(lessee).
A key accounting issue associated with leases is the identification of
those leases that are treated appropriately as sales of the property by
lessors and as purchases of property by lessees (e.g., capital leases).
A capital lease transfers the benefits and risks inherent in the
ownership of the property to the lessee, who accounts for the lease as
an acquisition of an asset and the incurrence of a liability. Leases
that are not identified as capital leases are called operating leases
and are not treated as sales by lessors and as purchases by lessees.
If, at its inception, a lease, including lease-leasebacks, meets one or
more of four criteria, the lease is classified as a capital lease per
SFAS No. 13, Accounting for Leases, paragraphs 6 and 7. The four
criteria are (1) ownership of the leased property is transferred to the
lessee by the end of the lease term, (2) the lease contains a bargain
purchase option, (3) the lease term is substantially (75 percent or
more) equal to the estimated useful life of the leased property, and
(4) at the inception of the lease, the present value of the minimum
lease payments, with certain adjustments, is 90 percent or more of the
fair value of the leased property.[Footnote 27] TVA's fiscal year 2002
lease-leaseback arrangements meet criteria 3 and 4 above and therefore
were recorded on the balance sheet in accordance with capital lease
accounting criteria.
According to SFAS No. 98, Accounting for Leases, and SFAS No. 66,
Accounting for Sales of Real Estate, the way a capital lease is
accounted for depends on whether you are the lessor or the lessee. The
lessor, TVA in the 50-year lease, would account for the lease as a sale
(sales-type lease) or financing (direct financing lease), whichever is
appropriate. A lease involving real estate is not classified by the
lessor as a sales-type lease unless (1) the title to the leased
property is transferred and (2) there is not any form of continuing
involvement in the daily operations. Since TVA did not transfer legal
title of the assets and continues to be involved in the operation and
maintenance of the turbine units and to control the distribution of
power produced by the facilities, TVA accounted for the lease proceeds
of $320 million as a direct financing lease resulting in financing
obligations.
Table 7 below shows the fiscal year 2002 accounting entries for the
fiscal year 2002 lease-leaseback arrangement.
Table 7: Fiscal Year 2002 Accounting Entries for the Fiscal Year 2002
Lease-Leaseback Arrangement:
[See PDF for image]
Source: TVA.
[End of table]
The accounting transactions for TVA's fiscal year 2002 lease-leaseback
arrangements are presented in its financial statements as follows:
* Outstanding lease financing obligations are included in the "Current
liabilities" and "Other liabilities" line items on the Balance Sheet.
* The cash proceeds were included in the "Proceeds from combustion
turbine financing" line item on the Cash Flow Statement.
* The lease costs are included in the "Operating and maintenance" line
item on the Income Statement.
In addition to the above journal entries, TVA records the normal
accounting entries related to construction, capitalization,
depreciation, and operation of the combustion turbine units consistent
with all other generating assets it owns. The fiscal year 2002 lease-
leaseback transaction assets were initially constructed at a historical
cost of $226.4 million. TVA depreciates the assets using the straight-
line depreciation method over the 20-year term of the leaseback
agreement.
[End of section]
Appendix III: Comments from the Tennessee Valley Authority:
Tennessee Valley Authority, 400 West Summit Hill Drive, Knoxville,
Tennessee 37902-1401:
Glenn L. McCullough, Jr. Chairman:
June 12, 2003:
Ms. Linda Calbom:
Director, Financial Management and Assurance:
U.S. General Accounting Office 441 G Street, NW Washington, DC 20548:
Dear Ms. Calborn:
Thank you for the opportunity to comment on GAO's draft report entitled
Tennessee Valley Authority-Information on TVA's Lease-Leaseback and
Other Financing Arrangements. We commend GAO for producing a fair and
thorough analysis on this complex subject.
As the report states, "TVA's lease-leaseback arrangements have been
accounted for and reported in compliance with applicable standards and
requirements for financial reporting, budgetary reporting, and debt cap
compliance." TVA entered into these arrangements in order to lower its
costs over the next twenty years by approximately $200 million.
We are concerned, however, about the report's recommendation that
Congress consider whether the TVA Act should be amended to clarify what
is counted under TVA's statutory debt cap. As explained in legal
opinions of TVA's General Counsel and of outside counsel, the current
statute and the legislative history are clear in the authority provided
to TVA to issue debt securities (to which the $30 billion debt cap
applies) and to enter into leasing arrangements (to which the $30
billion debt cap does not apply).
TVA is committed to continuing to reduce its debt over the long term
and has no intention of exceeding the $30 billion debt cap including
the lease-leaseback obligations. But we are concerned that an attempt
to redefine the meaning of "debt' for purposes of the TVA debt cap
could lead to less clarity over this issue, would create an
inconsistency with generally accepted accounting principles, could
prevent TVA from entering into public-private partnerships for some
projects, and would potentially preclude TVA's ratepayers from
receiving the benefits of alternative forms of financing.
We recognize and respect the fact that this issue is ultimately up to
the U.S. Congress.
Thank you again for the opportunity to provide these comments.
Very truly yours:
Glenn L. McCullough, Jr.:
Signed by Glenn L. McCullough, Jr.:
[End of section]
Appendix IV: GAO Contact and Staff Acknowledgments:
GAO Contact:
Robert E. Martin, (202) 512-6131:
Acknowledgments:
In addition to the individual named above, Rich Cambosos, Donald Neff,
Chanetta Reed, and Brooke Whittaker made key contributions to this
report.
(190068):
FOOTNOTES
[1] In substance, lease-leasebacks are financing arrangements under
which an owner of property raises capital by leasing the property to
another party and then simultaneously leasing the property back to
retain use of it.
[2] The outstanding debt balance does not include the portion of TVA's
appropriation investment that must be repaid to the U. S. Treasury.
This portion of the appropriation investment is not technically
considered lending by the Treasury and is not counted toward TVA's debt
cap.
[3] For purposes of this report, we define alternative financing as any
form of long-term financing other than funds generated from operations
and the issuance of bonds and notes.
[4] The term debt refers to TVA's issuance of notes and bonds.
[5] To determine who is at risk, we analyzed the fiscal year 2002
lease-leaseback arrangement. As discussed in our Objectives, Scope, and
Methodology section, our limited review found this arrangement to be
structured similarly to the fiscal year 2000 and December 2002
arrangements. In addition, TVA officials indicated that the fiscal year
2000 arrangement is similar to the fiscal year 2000 and 2003
arrangements.
[6] TVA's purchase price will be based on the fair market value of the
assets at the end of the 20-year leaseback term. According to TVA's
leasing advisor, since TVA entered into the lease-leaseback
arrangement, the market for power generators has decreased. As a
result, depending on the fair market value of the assets, the equity
investor may be forced to accept a lower purchase price and realize a
loss on the arrangement.
[7] The 1959 amendments to the TVA Act required TVA to begin repaying
the unpaid balance of the appropriations that TVA received from 1933
through 1959 to pay for its capital projects--hydroelectric and fossil
plants, transmission system, and other general assets of the power
program. The unpaid balance of the appropriations was $488 million as
of September 30, 2002. TVA makes annual principal payments (currently
$20 million) to Treasury from net power proceeds plus a market rate of
return (interest expense) on the balance of this debt. As of September
30, 2002, TVA had made total payments of about $3.4 billion--$945
million in principal and about $2.5 billion as a return on the
investment. In accordance with statutory requirements, these payments
are to continue until the debt is paid down to $258.3 million. TVA
expects to meet this goal by fiscal year 2014.
[8] However, TVA is subject to some forms of indirect competition. For
example, TVA has no protection against its industrial customers
relocating or expanding outside its service area or businesses deciding
not to move to TVA's service area for reasons related to the cost of
power. In addition, customers can decide to generate their own power.
[9] U.S. General Accounting Office, Tennessee Valley Authority:
Financial Problems Raise Questions About Long-term Viability, GAO/AIMD/
RCED-95-134 (Washington, D.C.: Aug. 17, 1995); Federal Electricity
Activities: The Federal Government's Net Cost and Potential for Future
Losses, Volumes 1 and 2, GAO/AIMD-97-110 and 110A (Washington, D.C.:
Sept. 19, 1997); and Tennessee Valley Authority: Debt Reduction Efforts
and Potential Stranded Costs, GAO-01-237 (Washington, D.C.: Feb. 28,
2001).
[10] On May 5, 2003, TVA announced lease-leaseback arrangements for
four power generating units in Mississippi that generated about $162.5
million in alternative financing. TVA officials told us that these
lease-leaseback arrangements are substantially the same in structure as
the preceding ones, but we did not obtain and review those contracts to
verify this.
[11] We did not analyze the risk of this program to TVA.
[12] TVA has not decided how it will finance the Browns Ferry restart,
but is considering a combination of financing options.
[13] The intent of the lease-leaseback arrangements is to enable the
private equity investor to take advantage of certain deductions for tax
purposes. Although the equity investors' total tax liability may not be
reduced as a result of the arrangements, the arrangements are
attractive because of the timing of the deductions, which are higher in
the first years, allowing the private equity investors to defer paying
taxes.
[14] The financial services company received nonrecourse notes from
special purpose entities set up by the equity investor and created
pass-through trusts to issue the debt certificates, which are backed by
the notes and assignments of the lease payments.
[15] A triple-A rating is the highest rating given to bonds by Standard
& Poor's.
[16] We calculated all present values as of November 1, 2001, so we
could analyze payments under the fiscal year 2002 lease-leaseback
arrangement as of the time the arrangement began. The 2002 arrangement
was dated November 1, 2001, and TVA's analysis calculated present
values as of November 1, 2001.
[17] TVA's projected discounted savings of approximately $26 million
did not consider transaction costs incurred under traditional debt
financing. When these transaction costs are considered, TVA's
discounted savings approximate $28 million, which we use in our
analysis.
[18] According to TVA's leasing advisor, the equity investor involved
with the fiscal year 2002 lease-leaseback entered the arrangement
expecting the fair market value at the end of the 20-year lease term to
be about 36 percent of the assets' fair market value at the inception
of the lease.
[19] Our analysis included TVA's total payments under the lease-
leaseback arrangement if TVA ended the arrangement early by exercising
an early buyout or termination option. We compared TVA's payments under
the lease-leaseback arrangement to TVA's potential payments under
traditional debt financing, assuming that TVA would continue to make
payments on its debt over the original 20-year period and would not
exercise an option to call the debt early. We believe TVA would not
choose to call its debt early due to high estimated costs it would
incur.
[20] Although TVA may terminate the arrangements before it has made all
of its rental payments, TVA would then be subject to significant
termination fees, which would be sufficient to pay off remaining
principal and interest owed on the certificates.
[21] This assumes that TVA remains solvent and financially able to meet
these obligations, which are not guaranteed by the federal government.
[22] We did not review the equity investor's actual cash flows. As a
result, our analysis represents only an estimate of the equity
investor's position, which we discussed with TVA and TVA's leasing
advisor.
[23] This return assumes that the equity investor is the owner of the
assets for tax purposes and that it continues to generate sufficient
taxable income against which it can offset the tax benefits it received
from the lease-leaseback arrangement.
[24] In addition, according to TVA's leasing advisor, the equity
investor must use leveraged lease accounting, which requires it to
estimate its income from the arrangement (based on the expected fair
market value of the assets at the end of the 20-year leaseback period)
and recognize this income over the life of the lease (20 years).
Because the equity investor has already recognized income based on the
assets' estimated fair market value at the end of the 20-year leaseback
period, if the actual amount received for the assets at the end of the
20-year leaseback period is lower than expected, the equity investor
will record a loss for financial reporting purposes.
[25] The assets included in the fiscal year 2002 lease-leaseback
arrangement have a historical cost of $226.4 million while cash
proceeds received by TVA from the lease-leaseback arrangement were $320
million.
[26] Based on its conclusion that all of TVA's lease-leaseback
arrangements are similar and should be treated consistently, in the
fiscal year 2004 President's Budget, OMB classified the fiscal year
2002 and 2003 lease-leaseback arrangements as debt and reclassified the
fiscal year 2000 arrangement as debt.
[27] Lessor must determine that two additional criteria are met to
account for the lease as a capital lease: (1) collection of the minimum
lease payments is reasonably predictable and (2) no important
uncertainties exist for unreimbursable costs to be incurred by the
lessor.
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