[BETA] Fortnightly

How risky are utility investments today? Regulators have always faced this question when setting the return component of rates under traditional rate base/rate of return regulation. With major industry restructuring looming, risk issues have become proportionately more important and complex. California regulators, for example, have increased the return for the state's electric utilities to account for investor worries over the pace of restructuring in the "Blue Book" proceeding. Performance-based regulatory (PBR) reform efforts, new environmental regulations, and swings in interest rate trends have also been cited to support utility risk bonuses. Yet, in many cases, regulators have refused to award bonus adjustments, finding such changes to be well known and reflected in the standard financial models used in setting return on equity (ROE) (see box on page 44).

Nevertheless, regulators have acknowledged that restructuring might increase utilities' cost of capital. While finding that consumers might benefit from restructuring and competition at the retail level, the Connecticut Department of Public Utility Control (DPUC) advised careful consideration of "downside risks." In particular, the DPUC cited the potential for escalating financing costs and an increased risk of financial failure.

The possibility that shareholders might be left to cover high-cost investment stranded as a result of increased competition in the electric market has also figured in the ROE debate. At the same time, the question of whether investors assume the risk of paying for uneconomic utility investments has become a focal point in the policy debate over stranded costs.

Just What California Needed?

Over the past several years, the California Public Utilities Commission's (CPUC's) annual ROE proceeding has served as a forum for debate on the newest issues affecting the utility industry. Most recently, debate focused on added financial risk stemming from electric utility reliance on purchased power. This year, falling interest rates and electric industry restructuring took center stage. Specifically: Do utility investors deserve an increased return now that regulators intend to expose monopoly companies to increasing levels of competition? The CPUC added a bonus to its ROE award, finding that investors had not expected the restructuring to be pushed along at such a fast pace. Citing rising interest rates, the CPUC also increased ROE for the state's major energy utilities 70 to 120 basis points above the 1994 baseline ROE of 11 percent. (It had reduced ROE in 1993 based on predictions that interest rates would stay low.)

The risk associated with industry restructuring proved a more contentious issue. Utilities argued in favor of an investor bonus for risk, claiming that the "Blue Book" restructuring might 1) make recovery of economic assets uncertain; 2) prohibit cost-shifting among customer classes, resulting in rate and revenue concessions; 3) eliminate current balancing account protections; and 4) emphasize incentive ratemaking. As evidence of the rulemaking's financial downside, the utilities noted that 1) stock prices for California electric utilities had declined, and 2) credit-rating agencies and brokerage firms predicted increased risks. (In fact, after the CPUC approved the ROE increase, Moody's Investors Service downgraded the senior debt of California's three largest investor-owned electric utilities, citing intensifying competitive pressures in