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Rate Unbundling: Are We There Yet?

Fortnightly Magazine - February 15 1996

cost of capital for these IOUs. A method that more accurately

reflects the actual risks associated with the electric services portion of the utilities on an unbundled basis is recommended.



In the final decision for the 1995 cost-of-capital proceedings, the CPUC stated that "unbundling costs of capital is economically sound, will send correct price signals to energy markets, and will mitigate cross-subsidies. The utilities should address unbundling of costs of capital in any future proceedings that aim to unbundle electric or gas rates and services."11 So far, little progress has been made toward this end.

Since this decision, PG&E, SDG&E, and SCE have filed open-access transmission tariffs with the FERC. In SCE's proposal, for example, transmission rates were determined using SCE's weighted-average (i.e., bundled) cost of capital, as specified by the FERC. Because the unbundled cost of capital for transmission would likely have been lower than the utility's weighted-average cost of capital, it is likely that the transmission rates approved by the FERC will be higher than appropriate. In fact, unbundling the cost of capital would not only result in a lower ROE for transmission services, but would also likely result in lower debt costs and/or higher debt/equity ratios, all of which would reduce the overall cost of capital component of revenue requirements for transmission services.

We performed an illustrative calculation for SCE to provide a rough estimate of the savings that could result by determining transmission rates on an unbundled basis. Using conservative estimates for ROE, return on debt, and capital structure for the transmission function alone, we estimated that unbundling the cost of capital could result in savings on the order of 2 to 8 percent of the overall cost of service under the open-access tariff. In terms of dollars, for a customer buying 500 MW of transmission service on SCE's system, a 6-percent reduction in the tariff would result in savings of roughly $750,000 per year.


As long as utility electric services remain bundled, and as long as none of these services is opened to competition, the difference in risk between the generation function and T&D function of an IOU does not really matter much for ratemaking. However, competition exists in the generation sector today, and unbundling of electric services is occurring now. As a result, the cost of capital component of each utility service function needs to be determined separately. By doing so, resulting rates will be appropriate for the services provided, and customers will pay for only the services they use.

As demonstrated, estimating ROEs using traditional models requires a series of complicated, data-intensive calculations. And, since there currently are no truly comparable groups, the exercise becomes that much more problematic. The concept of finding pure-play comparables among utility services, even those in a holding company structure, seems unrealistic as well. Until market-based solutions are available, simple proxies can be used.

Finally, acceptance of unbundling the cost of capital must extend beyond California and should be considered at the FERC as well. Because certain tariffs, such as most open-access transmission tariffs, are under