The allocation of capital credits from not-for-profit electric cooperatives based on electricity consumption is a cornerstone of the co-op business model. But capital credits become more complicated when a single member, such as a data center, consumes vastly more power than everyone else.

With data center development expanding across rural America, co-ops are seeking to fairly allocate and retire capital credits to these new large load entities while protecting their federal tax-exempt status and upholding reliability and affordability for all members.

“You should treat data center capital credits in a manner that protects your other members, is reasonable and fair to the data centers and all members, and addresses or seeks to mitigate the risk inherent in serving data centers,” said Ty Thompson, NRECA vice president and deputy general counsel for director and member legal services.

In an interview, Thompson discussed co-op strategies for the allocation and retirement of capital credits for data centers.

What capital credit considerations arise when electric cooperatives serve extremely large loads like data centers?

Thompson: The issue often arises because of the size of data centers. Most likely, they’re going to be allocated a lot of capital credits. Some data centers have suggested forfeiting their right to capital credits in exchange for a lower rate. And that sounds good in theory, but it’s problematic from a tax perspective.

The IRS takes the position that to be a member for tax purposes, you’ve got to, among other things, have the right to capital credits. If you don’t have the right to capital credits—if you forfeit that right—then it’s likely the IRS would say you are not a member for tax purposes and any income received from you would be non-member income. Considering the size of the bills that the data centers would be paying, that would probably cause an electric cooperative to fail the 85% member income test and lose its tax exemption. For this reason, it is advisable for a data center not to forfeit its right to capital credits.

What capital credit allocation strategies are emerging for co-ops serving or considering serving data centers?

Thompson: Based upon the investments and risks in serving data centers, you can typically support different treatment for the data centers. Whatever treatment is decided upon needs to be reasonable and fair and needs the co-op board of directors’ authorization. The reasons for the different treatment should be documented in board meeting minutes.

Assuming they are allocated capital credits, because of the size and nature of these loads, that would probably be a fairly large number. If you dump the data center into a big bucket with all your members, they may dwarf the other members as far as what is actually allocated to them. That seems unfair or at least indicates a reason to revisit allocation methods. One potential approach involves capital credit classes.

The general federal cooperative tax law paradigm and general utility law paradigm require treating similarly situated members the same. But you may treat different groups of similarly situated members differently, provided the different treatment is reasonable and fair. So, applying that to data centers in the capital credit context, there seems to be interest in creating a separate capital credit allocation class for data centers and similarly situated members.

Conceptually, a separate capital credit allocation class for data centers effectively means they would have their own bucket. Any operating margins, after accounting for appropriate expenses, they generated during the year would go in the data center bucket. They would not impact—positively or negatively—the allocations of other members.

Are there concerns with retiring large amounts of capital credits to data centers, and what paths are co-ops exploring here?

Thompson: One approach is to also create a separate capital credit retirement class for data centers and similarly situated members. That would provide the ability to retire their capital credits on a different timing and method than you would other members. That helps protect the cooperative and other members against some of the risk inherent in serving data centers.

The risk includes spending a lot of money to construct or acquire facilities to serve the data centers and/or acquiring power to serve them. If a data center becomes insolvent, if new technology arises and decreases the need for or use of data centers, or if data centers no longer need or can pay for the same amount of energy, then you have a significant amount of potentially stranded assets or unfunded liabilities. Other large loads may not pose a similar risk.

A corresponding approach is to have a longer retirement cycle—at least compared to your typical member—to help protect against the risk. For a data center, because of the risk, you might hang on to those capital credits for the depreciable life of the underlying assets, including the electric distribution system as a whole, or the original and renewed lengths of the relevant contracts.

Cooperatives have also been interested in addressing cash flow concerns that might arise when you retire and pay the capital credits. Some cooperatives have explored an accelerated retirement discounted to present value so there would be less of a cash flow challenge. Instead of waiting until the end of the typically longer retirement period, you accelerate the retirement to a shorter period and discount it to present value. The actual cash going out is smaller, and that benefits current and future members by mitigating the need for rate increases to pay the retirements. It has some tax implications as well, but it is possible.

What can co-ops do to prepare for fair and reasonable allocation and retirement of capital credits as more data centers set up shop in their territory?

Thompson: From a macro perspective, the idea of having separate capital credit allocation classes and retirement classes for data centers and similarly situated members seems appealing to many electric cooperatives. The concept is not new but, outside of different business lines, there hasn't been a strong reason to utilize the concept in the past. Data centers provide a unique basis and reason for utilizing the concept.

It would be wise to authorize or set up the capital credit allocation and retirement classes before or while the data center is being constructed or before providing service.

Make sure all this is not inconsistent with your bylaws or state law and pursue any bylaw amendments that may be needed or helpful.

It would be helpful if the agreement with the data center acknowledged there may be capital credit classes with allocations and retirements different from other members, and authorized discounting accelerated capital credit retirements to present value.

Address the issues in your agreement with the data center and have your board adopt the appropriate policies that would allow you to do what you want to do.

The three big areas involved are the bylaws, the contract with the data center, and board policies. As with most capital credit issues, work with your cooperative attorney and tax adviser.

For more information about capital credit considerations for data centers and capital credit classes generally, NRECA voting members may explore the NRECA Legal Reporting Service editorial, NRECA’s Bylaw Revision Guide and Capital Credits Task Force Report.