Blowing Smoke

In 2006, Valero Energy congratulated itself on becoming North America's No. 1 oil refiner.

In its financial report summary reflecting on 2005, the company painted a picture of a scrappy underdog that fought its way to the top in large part through a shrewd, counterintuitive business model: Buying cheap, low-grade crude oil (called "sour crude") when demand for higher-grade oil ("sweet crude") was going up. This higher supply of crude widened sweet/sour margins. More than 60 percent of Valero's input of raw materials consisted of sour crude. This, combined with what Valero described in its 2004 report as buying refineries for "pennies on the dollar of replacement cost, and then investing in them to make them significantly more profitable," would make for a bright future.

Valero was also smart and determined enough to seek every available tax break from the states where its 13 U.S. refineries were located, including Texas, where it has six. The company's stable of lawyers also routinely contested its refineries' county appraisal values; Valero had a habit of suing the Harris County Appraisal District nearly every year. Apparently, the money spent on the lawyers was worth the potential overall savings.

In 2007, taxes were an especially important issue, because the company spent more than $1 billion to upgrade five Texas refineries to meet new U.S. Environmental Protection Agency standards for sulfur levels in diesel and gasoline. New and renovated equipment meant a higher appraised refinery value, meaning higher property taxes.

But Valero argued that these upgrades, in the form of equipment called hydrotreaters, qualified for a provision in the state tax code that granted businesses property tax exemptions on equipment installed solely to meet pollution-control regulations. The idea is essentially to not double-tax a business that has to incur great expense for equipment that meets a mandate but doesn't contribute to its bottom line.

After implementing the provision, generally known as Proposition 2, in 1993, the Legislature left the decision on whether a piece of equipment qualifies for the exemption up to the Texas Commission on Environmental Quality. In 2001, the commission's advisory board came up with a way to best deliver consistent rulings: The equipment in question needed to manage pollution "at the site" — language not included in the statute, but language the commission thought was fitting.

The advisory board even came up with a handy flowchart to illustrate the decision-making process: a rudimentary map of boxed text and arrows meant to cut through the crap and make the whole thing easy enough for a 12-year-old to understand. The commission's staff, executive director and three commissioners have relied largely on this chart to deliver consistent rulings for nine years.

Valero first applied for a tax exemption on its hydrotreaters in 2007. Using its handy-dandy flowchart, the office of TCEQ's executive director denied the application. Never one to give up easily, Valero appealed. The commissioners postponed hearing the argument until last January, when they did something that made county appraisers and school district administrators in Harris, Galveston, Jefferson, Moore and Nueces counties nearly pass out: Commission Chairman Bryan Shaw and Commissioner Buddy Garcia seemingly ignored the almighty flowchart and, instead of upholding the negative ruling, kicked Valero's application back to the executive director's office.

Shaw and Garcia seemed to buy Valero's argument that "at the site" should be interpreted broadly — that pollution abatement should be considered beyond just a property's fence line.

With that, according to county, city and school district officials, this relatively obscure appeal suddenly became a test case for all refineries across the state: If the "at the site" provision was interpreted in Valero's favor, it would open the floodgates for businesses to argue that they're reducing pollution somewhere and get a big break on property taxes.

It would set a dangerous precedent allowing billions of dollars to drop off tax rolls throughout Texas, they say. And officials in the taxing districts surrounding the refineries where Valero installed hydrotreaters say they would actually have to refund three years' worth of property taxes — an enormous lump sum that would drastically alter tax burdens.

Regular folks who didn't happen to have hydrotreaters sitting in their backyards would have to pay Valero's share of taxes, otherwise school buildings would fall into disrepair and have to be replaced with dirt-floor shacks. Cities would have to cut services; garbage would pile high on cracked sidewalks, open-air drug markets would sprout up because of the lack of police and there'd be no firefighters left to get cats out of trees.

Or at least that's how officials are making it sound. Valero says it only wants what state law already allows. You and your wallet are in the middle. Which is probably where the truth is.

Like a high school yearbook, every Valero report summary has a theme, and in 2006 (the year the 2005 summary was released) it was of course playing off its new position as No. 1: A hand, with index finger proudly extended toward the heavens, graced the cover. But looking inside, from a 2010 perspective, makes for some cringe-inducing moments, and not just for the cheesy hand-related puns ("a real hand up on the competition!").

One such moment had to do with stricter requirements for low-sulfur diesel and gas the U.S. Environmental Protection Agency rolled out in 2000. Under these "Tier II" standards, sulfur in gasoline would have to drop from 300 parts per million to 30 ppm by 2004. Diesel sulfur limits would need to be slashed from 500 ppm to 15 ppm by 2006.

For the last three years, Valero lawyers have told the Texas Commission on Environmental Quality that the company only bought hydrotreaters to meet the Tier II standards.

As Valero spokesman Bill Day says, "Those are expensive pieces of equipment that Valero would not have purchased if it was not required to under this EPA requirement...It makes it actually more expensive to make the fuel — it adds to our costs."

Which, if true, means Valero meets one of the tax-exemption requirements. The thing is, the company historically told its shareholders something different.

While news of stricter sulfur standards may have caused many refiners to cross their arms and pout, Valero was nothing but stoked. Or at least that's the way it was spun in the 2005 summary: "To meet the new low-­sulfur specifications for fuel, many refiners are relying on sweet crudes, which has further widened the sweet/sour price differential." At the same time, because of "limited refining capacity of upgrading" medium and heavier sour crude, those supplies were high. For a company that depended largely on cheap sour crude, the field was wide open. Or, as Valero put it: "These bullish fundamentals have played right into Valero's hands!"

The language in its full financial report filed with the U.S. Securities and Exchange Commission may not have contained as many side-splitting puns, but it reflected a nonchalant attitude toward the expenditures required to meet Tier II. "Valero expects that most of the required capital improvements or changes in operating parameters will be consistent with many of Valero's existing or forecasted strategic capital projects or emission reduction projects already planned for the next several years."

And in its 2007 financial report summary, Valero touted the $1.2 billion it spent on refinery equipment for low-sulfur product in Texas, Louisiana and California: "Reflecting the significant projected growth in U.S. and global demand for diesel, as well as the move towards cleaner-burning fuels, Valero marked 2007 with the completion of major projects focused on increasing production of ultra-low-sulfur diesel."

The summary used words like "strategy" to describe these expensive improvements, as in: "Together with its planned future investments, are examples of the company's strategy to convert low-cost feedstocks into premium, cleaner-burning fuels, particularly [ultra-low-sulfur diesel]."

While Valero may have imagined a bright future overflowing with rivers of sour crude that other refiners turned up their noses at, it, like every other company in 2006, had no way of knowing the good times would come to a crashing halt. By April 2010, the refiner reported its fourth consecutive quarterly loss.

At the same time, the counties where its refineries were located were experiencing the strains of recession. Although Texas was faring better than the rest of the country, cities and school districts still suffered budget shortfalls.

Day suggests it's only because of the recession that taxing districts have brought exaggerated claims to the attention of the media.

To which Bernardo Garcia of the Harris County Appraisal District half-jokes, "Thank God for the recession."

A big, energetic man with an inexplicable passion for tax law, Garcia is HCAD's general counsel and de facto mouthpiece when it comes to Valero. He says Day might be right, in a way — if the economy were chugging along and taxing districts didn't have to look under couch cushions for every extra penny, HCAD might not have ever noticed that Valero was gunning for such a big tax break. Garcia says that, if Valero gets the exemptions, state law would force taxing districts to refund the three years' worth of disputed taxes. He estimates this to be about $11 million for the Houston Independent School District and about $5 million for the county and city. (Because Valero originally submitted its request in 2007, it might technically be eligible for a three-year refund — but it's the only refinery in that position. While other refineries can apply for 2010 and subsequent years, they are not entitled to retroactive exemptions. According to TCEQ, there are eight pending refinery applications and another 12 are expected to file.)

Garcia is flabbergasted that two TCEQ commissioners even entertained Valero's "at the site" argument, which is this: Everyone gets the concept of a scrubber on a smokestack reducing levels of emissions a refinery belches into the air. That is clearly a site-specific environmental benefit.

Same with extracting sulfur from diesel and gas: The process itself obviously occurs in the refinery, and the low-sulfur product is sold to drivers who live around the refineries. Thus, everyone gets to drive through a low-sulfur life, thanks to Valero. (This, despite the fact that the hydrotreating process actually increases air pollution at the site.)

Whether or not Garcia buys gas from Valero stations, he definitely doesn't buy the company's argument. No one living in Harris County benefits environmentally from what goes on in Valero's refineries.

But if the TCEQ winds up buying it, he says, "the floodgates will open because now this new rule will apply to any pollution control device that controls pollution anywhere, not just in Harris County."

He elaborates: "What about catalytic converters? Catalytic converters are no different than low-sulfur gas because they control pollution at the tailpipe. They don't control pollution where the catalytic converter is manufactured." Same for a company that manufactures air or water filters, he says.

Besides the "at the site" issue, Garcia and other officials argue, buying the hydrotreaters was purely a business decision, not an environmental one — an argument that appears to be supported by the self-congratulatory language in Valero's earlier financial report summaries.

And arguing before the TCEQ commissioners last January, officials were trying to prove just that. Tony Brown, a lawyer representing the Galveston County Appraisal District, said bluntly of the hydrotreaters, "It is a business decision to put it in." Marathon Oil's Texas City refinery, he pointed out, does not have desulfurization equipment, opting instead to sell its product as an intermediate inside the Marathon system, as well as externally.

Amy Keith, a lawyer for the Jefferson County Appraisal District, suggested that Valero could have instead chosen to purchase crude that doesn't have such high sulfur levels to begin with. (To this, Bill Day says, "That's 100 percent false. And I question her expertise in refining.")

Siding with those lawyers, as well as with TCEQ's executive director, that hydrotreaters were purely an investment and not a burden, were the Texas Conference of Urban Counties, Harris County Commissioners Court and the Office of the Public Interest Counsel.

At the same meeting, Valero representative Jim Greenwood offered the counterpoint: Valero employs more than 10,000 Texans, and last year paid $174 million in taxes, $130 million of which were property taxes. Because Valero is not a drilling and exploration company, it buys crude at world market prices, making for an "extremely competitive business with razor-thin margins."

So, as Day points out, for a company like Valero, hydrotreaters are not simply an investment. "It was a cost that we had to bear in order to stay in business. And the alternative would not have been doing something cheaper. The alternative would have been — in very likely terms — shutting a refinery or two down and putting people out of work."

But while Day also says the company has never asked for a three-year refund, Garcia says taxing districts "have to issue a refund whether they like it or not. If Valero or any other company wants to give up that refund, they have to literally take that check and re-­endorse it back to the jurisdiction. However, they can't just say, 'Oh, don't issue us a refund.'"

Moreover, he adds, "Is that bait?...Are they trying to say, 'Look, we'll give you $25 million today, but we're going to end up making $100 million down the road in the future'? That's how jurisdictions are looking at it."

Of course, it's somewhat difficult to tell completely what jurisdictions are looking at, since there exists a giant question mark in the debate, namely: How much is a hydrotreater even worth?

The three approaches to appraisal are cost, income or market value. Unlike houses, which can be reasonably appraised using market values, complex technical equipment without a huge market is harder to appraise. In the absence of any other data, officials in the various taxing districts have relied on the cost Valero stated on its TCEQ applications. In the Houston refinery, for example, Valero listed its diesel hydrotreater at $238 million and its gas counterpart at $66 million, so presto, the Harris County Appraisal District says $304 million will drop off the tax roll.

The problem is, using those values yields some weird, seemingly improbable results — depending on whom you talk to. The Harris County Appraisal District appraised Valero's entire Houston refinery at roughly $305 million for 2009, suggesting the refinery was worth $1 million before the hydrotreaters. In 2007, the refinery was valued at $227 million, meaning the entire refinery was worth less than the diesel hydrotreater alone.

As Day says, "It defies logic to think that one piece of equipment in a refinery would have that type of appraised value." He says that appraisal districts have never accounted for depreciation. Moreover, he predicts the districts may be singing an entirely different tune if Valero gets the exemption and appraisers have to officially enter a value into the tax roll.

"It's impossible for anybody to say what the appraised value of this particular unit will be until Valero gets this exemption and then the appraisal districts take that hydrotreater off of the tax roll, and I guarantee you the value that they give it at that time [when] they take it off the tax roll will not bear any relation whatsoever to the things they're saying today..."

Yet one refinery appraiser told the Houston Press that, as illogical as these ratios may appear, they can still be accurate.

Asking that we not use his name, he explained that "A refinery may, if you look at the cost of the equipment in the refinery...easily top $1 billion. But if you...value that refinery based upon the income it produces, the value of the property may be substantially less than the cost of the individual components in the refinery."

Ultimately, Garcia says, Valero has never provided any documentation on how it arrived at the costs it listed on its applications, and that has kept all the appraisers in the dark.

"Valero has never submitted anything, either to TCEQ or to the appraisal district, to substantiate how they came up with that value. Zero. Zilcho. Zippo."

As difficult and mysterious as it may seem right now, finding a real value for the hydrotreaters is likely possible. What's more enigmatic is why TCEQ Commissioners Bryan Shaw and Buddy Garcia punted the appeal back to the executive director's office.

Shaw and Garcia approved the "at the site" provision and its attendant flowchart in 2008, and have always issued decisions accordingly. So what's different about Valero? Why would two commissioners not trust the judgment of the agency's staff and executive director?

Apparently, the public does not deserve an answer to that question. We left messages for the commissioners with the TCEQ's communications office and never heard back. Of course, we weren't too surprised after what happened to KHOU reporter Jeremy Rogalski in March. When Rogalski tried to get into a public TCEQ hearing, security closed the door in his face. And according to Rogalski's report, "And when we later approached Chairman Shaw during a recess in the hearing, we were blocked again. Andrea Morrow, TCEQ spokesperson, grabbed this reporter's arm while Chairman Shaw slipped out a side door."

Shaw, an associate professor in Texas A&M's Biological & Agricultural Engineering Department, has an impressive résumé: He's a member of the EPA's Science Advisory Board and the U.S. Department of Agriculture's Agricultural Air Quality Task Force. Shaw, a global warming skeptic, is well aware of critics who accuse him, and the commissioners in general, of having a pro-industry bias. Shaw didn't miss out on a chance to launch the first volley when Southern Methodist University professor and environmental activist Al Armendariz took over the regional EPA office overseeing Texas. Shaw issued a statement congratulating Armendariz while at the same time saying, "I hope Dr. Armendariz recognizes that this position is too important to be used as a podium for environmental activism. I urge Dr. Ar­men­dariz to use sound science in his decisions."

To be sure, Shaw is all for exercising regulatory restraint. Governor Rick Perry not only appointed Shaw to the TCEQ in 2007, but to the Texas Environmental Flows Advisory Group. And in November 2008, he created something called the Texas Advisory Panel on Federal Environmental Regulations, appointed Shaw and told them to issue a report that same month on the "potential impacts to Texas of [the EPA's] proposed framework for regulating greenhouse gas emissions through the Federal Clean Air Act."

To the surprise of exactly no one, the panel concluded that such regulations would cause "extreme economic hardships" for Texas. And to the surprise of exactly no one, Perry approved the findings.

Meanwhile, TCEQ Commissioner Buddy Garcia, who also voted to remand the Valero tax exemption issue back to the executive director, found himself in the midst of a lawsuit filed by state Senator Eliot Shapleigh. The El Paso Democrat accused Garcia and senior TCEQ members of meeting secretly with a Baker Botts lobbyist working on behalf of a company seeking TCEQ approval to renew an air permit for its copper smelter. After Shapleigh raised suspicions, he obtained documents showing that, after the meetings, the lobbyist reported to Baker Botts attorney Pam Giblin, who was representing the copper smelting company. (The permit was ultimately renewed.)

Giblin, a former TCEQ employee, also represents Valero in the property tax exemption issue. According to Shapleigh, she and fellow Baker Botts attorneys co-hosted a reception for Shaw on the occasion of his appointment. Representatives of Baker Botts and TCEQ have denied any accusations of collusion.

Meanwhile, as TCEQ commissioners busy themselves by not explaining to the public why there might be a big property tax hike, TCEQ staff is waiting for Valero to submit more documents explaining its case; there's always the possibility that the staff could grant a partial exemption.

Bernardo Garcia would still see that as a dangerous precedent — especially for small districts that depend in large part on refinery ad valorem taxes. And he says it would be a real affront for people living in the immediate vicinity of any refinery that would be granted such a break.

"I see my tax bill getting bigger," he says, "but I'm not breathing any better air or drinking cleaner water."


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