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)...
Rate Unbundling: Are We There Yet?
2. We believe this figure represents a conservative estimate, since this method yields relatively low generation ROEs compared to our proxies. Using a generation-only ROE of 15 percent would have increased the ROE differential between generation and T&D by more than 500 basis points.
Proxy 2. Second, we looked at beta differentials in two recently deregulated industries: natural gas (transmission and distribution) and telecommunications (long-distance and local service). In the gas industry, the betas of pipelines and local distribution companies differed by about 0.28. In the telecommunications industry, betas of AT&T and the regional Bell companies vary by 0.21 to 0.26.10 Using these as proxies for the generation and T&D functions, we estimated a likely beta differential between generation and T&D of 0.25. ROE differentials can be derived from beta differentials using the Capital Asset Pricing Model (CAPM):
ROE difference = Beta difference x (Rm-Rf)
This analysis produced an ROE differential of 175 basis points for SCE:
1.75 = 0.25 x 7.0FN
Based on these results, with bundled ROEs, customers purchasing T&D services only would be overcharged and would subsidize other utility functions. The cross-subsidy that would occur is not insignificant. For 1995, for example, the ROE component of total revenue requirements is $678 million for SCE, at an allowed ROE of 12.1 percent. Based on unbundled ROEs of 13.92 percent for generation and 10.66 percent for T&D, the resulting cross-subsidy is roughly $45 million per year.
Our proxy methods and example provide only a first cut approximation of the potential magnitude of the differential in appropriate ROEs and the resulting cross-subsidy for the different utility functions. It assumes that the appropriate unbundled capital structure for the utility's generation and T&D function is the same as its current bundled ratemaking capital structure. In fact, full unbundling would appropriately include adjusting each function's capital structure based on relative risk, which could in turn affect the overall cost of capital associated with each function.
Looking forward, if and when generation is operating in a truly competitive market, generation ROEs could be determined using a market-based approach as opposed to traditional ratemaking models. Such an approach would work only if: (i) regulated utilities had divested their generation assets such that the resulting GenCos are competing on a level playing field with other power producers; or (ii) to the extent that divestiture does not occur, assurances are made that there is no cross-subsidization across utility functions (i.e., the generation arm of the utility is not subsidized through inappropriate allocations of utility costs to the T&D function).
In addition, the current method of using comparable utilities and market betas to calculate the allowed ROE for utilities is just as inappropriate as maintaining bundled ROEs for the generation and T&D components of these IOUs. For example, many of the IOUs provide gas services, which certainly have different risk profiles than the electric-related services component. Most IOUs also have subsidiaries that are involved in unregulated activities. The risks associated with gas services and these unregulated subsidiaries, however, are included in the betas used to determine the overall