July 15, 2002
LILCO: The Ultimate Failure of Regulation
initiated an aggressive dividend policy, which it financed by borrowing.
For its part, the PSC implemented the target rate increases with little concern for LILCO's aggressive dividend policy or the shrinking Long Island economy. In late 1991 the PSC approved rate increases of 4.15 percent, 4.1 percent, and 4 percent for 1992, 1993, and 1994, respectively. These increases raised LILCO's average electric rate to 15.3 cents per kilowatt-hour (¢/Kwh) in 1994.
These last three rate increases produced a marked improvement in LILCO's cash flow. Free cash flow jumped $400 million, from negative $83 million in 1991 to $321 million in 1994. However, the dividend kept the balance sheet from improving, and the equity ratio stayed below 30 percent. Indeed, until 1994 LILCO continued to finance its dividends by borrowing. Between 1989 and 1994, LILCO borrowed $583 million to pay dividends, an amount that accounted for most of its $630-million increase in debt during those years (see table below).
The continuing balance-sheet weakness had the important secondary effect of keeping the PSC worried about LILCO's financial condition, which was no doubt why LILCO pursued such an aggressive dividend policy. The larger the dividend, the weaker the balance sheet, and the more willing the PSC was to raise rates. LILCO simply outwitted the PSC, and Long Island paid the price.
The Political Leveraging
In the midst of his 1994 campaign, Cuomo proposed a takeover of LILCO by the Long Island Power Authority (LIPA), a state agency dominated by public power advocates. LIPA would acquire all of LILCO's outstanding securities at a cost of about $9 billion, and it was claimed that tax-exempt refinancings would enable rates to be cut 10 percent.
The takeover was opposed by Cuomo's opponent Pataki, who championed competition as a means of reducing electric rates and labeled the takeover "corporate welfare." Pataki won the election, which killed Cuomo's takeover proposal. However, Pataki had committed himself to a rate reduction,which could have been accomplished in a pending rate case in which LILCO was requesting a rate freeze for 1995 and 1996, and a 4-percent increase for 1997. A rate reduction of 10 percent would have discharged Pataki's campaign promise and diffused any future takeover attempts by LIPA's public power advocates.
Pataki quickly remade the PSC. He elevated Republican Harold Jerry to the chairmanship and appointed a Republican colleague, John O'Mara, to the Commission. The term of Democrat Lisa Rosenblum expired in February, and Pataki allowed her to continue, but held the authority to replace her at any time. Pataki had put his stamp on the PSC.
Inexplicably, however, Pataki's PSC froze base rates for 1995 as LILCO had requested, but deferred its decision on rates for 1996 and 1997. The PSC's decision was driven by the continuing weakness of LILCO's balance sheet and a desire to ensure that LILCO had access to capital markets.
The PSC failed to consider the strength of LILCO's free cash flow, which was financed by $410 million that LILCO was allowed to collect from ratepayers
as a return on its Shoreham
intangibles. That same amount could