Duff & Phelps Credit Rating Co. has released a report advising that a properly structured plan for securitization of stranded utility investment should address third-party credit risk.
Rate Unbundling: Are We There Yet?
rather than later.
Unbundling now would prevent utilities from gaining an unfair
advantage (from possible cross-subsidies) as they compete in the generation-only business.
CALCULATING THE UNBUNDLED COST OF CAPITAL
This increased risk in the generation function, coupled with recently filed open-access transmission tariffs, argues for unbundling the cost of capital now (em even though both functions are still regulated.
Traditional cost-of-capital models rely on comparable groups. In today's world, however, identifying comparable groups for unbundled electric utility functions is problematic, if not impossible. Currently, the closest thing to a generation comparable group in the United States is the universe of independent power producers (IPPs); as a "comparable" to utility generation, however, this group presents problems. First, only a small subset of the group are publicly traded as stand-alone companies. Many, if not most, of the major players are themselves
subsidiaries of electric utilities. Second, these companies do not have the same franchise rights enjoyed by regulated utilities. Third, IPPs employ different financing and ownership structures that make comparisons to utilities difficult. For a transmission comparable group, there are currently no "pure-play" T&D companies in the United States, except perhaps for municipal utilities. The ownership and financing structures of the municipals, however, are even further removed from those of the IOUs.
In light of the difficulties associated with uncovering comparable groups, one may ask: Can proxies be used? In our opinion, certain proxies are valid for use in determining unbundled ROEs. In fact, we have developed a simple method, using two proxies, to estimate the potential magnitude of the ROE differential between generation and T&D functions.
Proxy 1. First, we looked for available proxies for pure-play generation company ROEs (see the caveats listed above). One such proxy is from the FERC decisions granting market-based rates for EWGs, which are at least an approximation of generation-only companies. In the Ocean States Power I and II cases7, for example, the FERC approved market-based rates that included an ROE component 15 percent higher than the FERC's generic benchmark ROE for utilities. In the Nevada Sun-Peak case, the FERC stated that a reasonable ROE would approach or exceed 15 percent, the upper end of the range it considered appropriate for traditional electric utilities.
Another such proxy is from reported ROEs for publicly traded IPPs. At the time of this analysis, those ROEs ranged from 15.1 to 17.9 percent for AES, California Energy, Destec, and Magma. These results are also consistent with a recent paper by David P. Wagener that estimated an implied cost of equity for IPPs of 16.9 percent.8
Based on those proxies, we estimated that, at a minimum, the ROE for the generation function is at least 15 percent higher than the overall ROE for the combined generation/T&D utility. Consider SCE as an illustrative example.
Based on the split between generation rate base and T&D rate base for the utility and the assumption of identical capital structure for the generation and T&D functions, we calculated an
implicit ROE for SCE's T&D function.9 That analysis produced a differential of 326 basis points, as shown in Table