Nowhere are the failings of traditional utility regulation more evident than on Long Island. The New York Public Service Commission (PSC) has raised rates for the Long Island Lighting Co. (LILCO)...
Purchased Power: Risk Without Return?
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
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 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