more to purchased power to satisfy capacity needs, but with an increase in risk. And purchased power will become even more significant if today's vertically integrated utilities spin off the generation function. Either way (spinoffs or vertical integration), utilities must address this added risk: through fair compensation, and by correctly assessing the true cost of supply alternatives in resource planning.1

When utilities sign long-term purchased-power contracts that include a fixed-cost component, they incur financial, regulatory, market, and supply risks, as well as the risk associated with a declining rate base. Nevertheless, regulators often do not augment return on equity to compensate. This failure imposes consequences. Over the past few years, numerous companies have had bond ratings lowered, or not increased, due to purchased-power obligations.

FINANCIAL RISK

Financial theory often breaks risk down into two components (em business risk and financial risk. Business risk denotes the uncertainty associated with the level of operating earnings. Financial risk marks the additional risk a company takes on by assuming fixed-cost obligations. For example, as more debt is added to the capital structure, a company faces more fixed charges (i.e., debt payments); bondholders and stockholders both run the risk that operating revenues will fail to cover expenses and return on capital. Thus, as the share of debt rises in capital structure, bondholders and stockholders will demand a higher return to compensate for the higher leverage and financial risk.

Purchased-power contracts

generally contain two forms of charges (em energy charges (a variable cost) and capacity charges (in take-or-pay contracts, a fixed cost). Even though purchased-power obligations are placed off the balance sheet, they nonetheless represent fixed obligations that impose a financial effect similar to incurring an equivalent amount of debt. That is why some rating agencies have referred to purchased-power fixed charges

as "debt equivalents." Thus, purchased-power commitments lead the investment community to regard utilities as having more leverage than shown on their balance sheets.2

Two other aspects of these fixed payments leave a utility financially worse off than if it had constructed its own plant.

First, a utility that constructs its own plant recoups a return on investment (interest charges and return on equity, along with associated taxes), plus a return of investment (depreciation). Of these amounts, only the interest payments represent a fixed cash outlay. However, a utility's capacity payments under a purchased-power contract cover the interest, return on equity, taxes, and depreciation of the selling plant's owners, and the entire amount of the payment is fixed. Therefore, a larger fixed payment is associated with a purchased-power contract than with a comparably sized, self-built plant.

Second, a utility finances plant construction in part with fixed-cost capital (i.e., debt) and in part with equity, the return for which is taxable. Under regulation, it collects funds (return on equity and taxes) to help cover the fixed costs of the debt for the plant in question. However, most jurisdictions allow no return on equity, and no tax, associated with purchased-power payments, so that coverage