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Purchased Power: Risk Without Return?

Fortnightly Magazine - February 15 1996

capital structure/cost of equity theory propounded by Miller and Modigliani; 2) employ a technique of unleveraging and releveraging beta, as suggested by Hamada; or 3) measure the incremental

increase in cost of equity caused by taking on purchased-power commitments.

These adjustments can be applied to either the equity ratio or cost rate of equity that will be used to determine the allowed return on the equity portion of rate base. Such calculations may be adequate now when the rate bases of utilities generally are large relative to purchased-power commitments. However, if

purchased-power commitments become relatively large and rate base relatively small, any adequate return to compensate for risk might have to be allowed on the value of the purchased-power commitment itself, rather than on rate base.7

One final approach to compensating a company for purchased-power risk would be some type of incentive mechanism. For example, if a purchased-power contract results in savings over the life of the contract, the utility should be allowed to share some percentage of these savings. Such a mechanism would provide some compensation to the utility in question, and would also give the utility an incentive to save as much money as possible when making purchased-power arrangements. t

Robert Rosenberg, principal of Benrose Economic Consultants in New York City, has more than 25 years' experience in regulatory economics. He works in areas as diverse as rate of return, financial integrity, royalties, and economic effects of EMF.

The Declining Rate Base

If utilities buy more power outside, and slow construction of new plants, depreciation on existing plant may come to exceed new capital investment, causing rate base decline:

. Earnings will fall if tied to rate base.

. The utility will become smaller and riskier.

. Deferred taxes will reverse and suddenly come due, as the utility pays more in cash taxes than it collects through rates.

1. The fact that a highly-leveraged IPP is able to bid what seems to be a low price to provide purchased power does not take into account the fact that the IPP effectively borrows the electric utility's credit strength in being able to leverage itself so highly. That is certainly part of the overall cost to the utility for accepting the contract and should not be ignored.

2. Rating agencies now adjust capital structure ratios and interest coverage ratios to reflect the debt equivalence of fixed payments associated with purchased-power contracts.

3. Even under the several alternative purchased-power risk-mitigation scenarios discussed later in this article, pretax interest coverage would still decline from the pre-purchased power level. The calculations demonstrating this are not presented here in order to simplify the analysis.

4. See, for example, "Electric Reliability: How PJM Tripped on Gas-Fired Plants," by John Hanger, PUBLIC UTILITIES FORTNIGHTLY, May 1, 1995, p. 27.

5. The following discussion covers only increased financial risk of purchased power and in no way covers any increased business risk that may result.

6. Selling new common equity may not be feasible at times due to company-specific or general market conditions. However, even if new equity cannot be