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Gauging Risks: Rising Interest Rates and Industry Restructuring

Fortnightly Magazine - March 1 1995

the state's electric industry.)

The CPUC rejected the utilities' analysis, finding the decline in stock prices unacceptable in estimating compensable risk for ratemaking purposes. It noted that prices rebounded after the initial reaction, and called the market's bumpy reaction a biased response to the investigation's "wake-up call." The CPUC concluded that the "Blue Book" proceedings changed the timing of investor risks but not their magnitude: Investors should have fully understood the scope and importance of competitive risks; however, they apparently believed the impact lay far in the future. The CPUC, therefore, found a separate upward adjustment of 0 to 20 basis points adequate to fairly compensate investors for possible but uncertain nondiversifiable risks.

The debate is far from over, however. CPUC president Daniel Fessler issued an artfully worded separate opinion that points out several areas of concern. First and foremost, approval of the increased ROEs would translate into higher rates for energy services. Quoting the CPUC's own statements in its restructuring proposal, Fessler emphasized that "a major goal of the restructuring" is to "lower the cost of electric service to California's residential and business customers." While not denying increased risks, Fessler said:

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"Commission decisions which translate into rate increases exacerbate rather than resolve this disparity. In addition to their damaging impact upon California's economy, rate increases, like a prescription of laudanum to one afflicted with dropsy, may well kill the utility patient with kindness."

Fessler added that care should be taken to avoid the impression that the CPUC might automatically roll over the increased ROE figures into PBR departure points. Fessler said such a move would "avail California nothing" if the starting point for measuring utility efficiency is "larded with excess exactions on our electric and gas service customers."

A Key to Stranded Investment?

Southern California Edison Co. (Edison) had argued that a separate ROE premium was needed because investor risks are "asymmetric" (em that is, the potential for investor losses is not balanced by a equivalent opportunity for investor gains. Under the traditional regulatory compact, a utility trades its ability to raise prices to market levels in exchange for the obligation to serve all consumers at a rate pegged to cost of service. However, if the cost of stranded investment is allocated solely to shareholders, the risk of doing business becomes asymmetric (em investors must pay if things turn bad, but cannot reap rewards if market position turns out better than expected. In addition, Edison argued that the CPUC's restructuring proposal imposes several other asymmetric risks: 1) increased competition will undercut rates and returns, 2) California utilities could offer retail wheeling before utilities in neighboring states, and 3) ongoing obligations to serve customers that leave the system may force utilities to build uneconomic assets.

The CPUC said that asymmetric risks did not warrant a bonus in the current proceeding, noting that share prices should drop if the opportunity for losses exceeds the opportunity for gains. The CPUC also said that Edison had failed to account for terms in the restructuring proposal that might offset the added risk of losses, such