Proposition 26 Update: Court of Appeal Rules that Unsupported Electric Utility Transfers to General Funds Require Voter Approval

California’s Constitution makes all local taxes subject to voter approval. Proposition 26 amended the provisions to declare that all levies imposed by a local government are taxes subject to voter approval unless the levies meet one of seven exceptions. In one of the first important appellate decisions under Proposition 26, the Third Appellate District Court of Appeal ruled that the City of Redding’s practice of transferring a payment in-lieu of property tax (called a “PILOT”) from its electric utility to the general fund is a tax.

Citizens for Fair REU Rates v. City of Redding (C071906, filed January 20, 2015) is primarily important to cities that operate electric and natural gas utilities. Yet aspects of the court’s analysis of Proposition 26 are of interest to local agencies that operate water, sewer, and refuse collection utilities, even though Proposition 218 already prohibits local agencies from transferring revenues from these utilities to general funds. Proposition 218 exempts electric and natural gas utilities from its operation. 

Redding operates a municipal electric utility. The City has since 1988 transferred funds from the utility to the general fund, representing the property tax that the utility would pay if it were privately owned. The challengers argue that the PILOT violates Prop. 26 because it causes Redding’s electric rates to exceed the cost of providing electric service. If Prop. 26 applies, the rates must fit into one of seven exceptions or they would require two-thirds voter approval. The exception for charges that do not exceed the reasonable cost of providing the service is the potentially applicable exception.     

Redding made, and the court rejected, three principal arguments to avoid Prop. 26. 

• The City argued that the rates are not “imposed” and, therefore, not subject to Proposition 26 because customers had other options. The court rejected this argument, reasoning that a “theoretical but unrealistic way to escape” the fee is not sufficient. The court’s reasoning leaves open the possibly that some charges, such as wholesale water charges, are not “imposed” because there are more realistic ways to avoid the charges. 
• The City argued that the utility’s other revenue sources – wholesale power sales – were sufficient to fund the PILOT; therefore, the PILOT did not cause retail rates to violate the cost of service requirement. The court concluded that the existence of other revenue is irrelevant: the PILOT itself must be based on costs, or it is a tax. This argument, if it eventually prevails, might in some circumstances justify transfers in the water, sewer, and refuse collection context.
• The City argued that the PILOT was adopted before the effective date of Proposition 26, which does not operate retroactively. The court rejected this argument, finding that the PILOT was not a fixed transfer compelled by ordinance or charter, and the City Council had to act each year to implement it in the annual budget. Other agencies may be able to demonstrate that their transfer structures were fixed prior to enactment of Proposition 26. 

Two other aspects of the case are intriguing. First, the dissent would have upheld the PILOT on the grounds that a payment in-lieu of taxes is a “cost” to the utility. If that argument were to prevail, it might justify PILOTs in the water, sewer, and refuse collection context. Second, the court offers the view that low-income- and senior discounts funded with ratepayer revenue can be justified under Proposition 26. 

The court sent the parties back to the trial court to determine whether the PILOT
could be justified by the costs the utility imposes on the City. Citizens is not final and a request for rehearing is likely followed by a petition for review to the California
Supreme Court. We will keep you posted. 

For more information about this case and Proposition 26, please contact John Bakker at 800.464.3559 or jbakker@meyersnave.com.