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Purchased Power: Risk Without Return?

Fortnightly Magazine - February 15 1996

on such payments is effectively reduced to 1.0 times. Other

things being equal, coverage

problems are more likely under a purchased-power regime.3

REGULATORY RISK

Regulators may delay or deny recovery of purchased-power costs. They may decide that the utility will not need the power down the road, or that the resource is "too expensive."

With regulatory review an ever-present risk, purchased power means "heads you win, tails I lose." Risk mounts without reward. If regulators find all aspects of a contract acceptable, utilities receive only one-for-one recovery of expenses; if regulators find fault with the purchased-power arrangement, utilities can receive a penalty or disallowance. The risk/ return equation has become skewed.

SUPPLY RISK

Supply risk from purchased power takes at least three forms: 1) The plant may fail to come on line; 2) once on line, the plant may prove unreliable; or 3) third-party resources may lack diversity, relying too much on a single fuel.

If contracted purchased power fails to materialize, a utility may have to construct a plant itself on an accelerated (and costly) basis or face the market in a poor ("must buy") bargaining position. Under today's regulation, a utility still retains the obligation to serve; an independent power producer (IPP) does not. As for reliability, most IPP plants are new and have yet to establish a track record for long-term performance.

Much IPP generation burns natural gas. If utilities continue to increase their purchases, and such power remains predominantly gas-fired, the fuel supply will lose diversity. History has shown the danger of relying too much on one fuel, such as natural gas.4 A gas shortage could cause a severe electric capacity shortage given a confluence of two events: 1) customers suddenly wish to return to full utility service due to a curtailment in their own gas-fired supply of power, and 2) gas-fired IPPs are unable to fulfill their contracts and deliver power to the utility.

SOME POSSIBLE SOLUTIONS

Despite the asymmetric nature of risk inherent in purchased-power contracts, utilities and regulators nevertheless can choose among several options to deal with the problem.5

Raising the common equity ratio, either in fact or through regulatory imputation, would mitigate/compensate for the increased financial risk of purchased-power commitments (see table on next page). The table shows base-case scenarios for a company both before and after a purchased-power commitment. Before the commitment (columns 1 and 2), the company carries a 55-percent debt ratio and a 45-percent equity ratio. After the commitment (columns 3 and 4), the market perceives the equity ratio as only 40.91 percent. Selling sufficient new common equity (columns 5 and 6) can return the market-perceived common equity ratio to 45 percent.6 Imputing a higher common equity ratio for ratemaking (columns 7 and 8) would also return the market-perceived equity ratio to the pre-purchase level of 45 percent.

In the alternative, the allowed return on equity could be raised to compensate for increased risk flowing from purchased-power commitments. To adjust the return on equity upward to account for increased leverage caused by the debt equivalence of purchased-power commitments: 1) use classic