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Purchased Power Contracts: Marrying Production and Financial Efficiencies

Fortnightly Magazine - May 1 1996

Electric utilities incur indirect financial costs when they turn to unregulated generators (NUGs) to buy power. These indirect costs can lead to lower bond ratings and undermine competitive advantage, depending upon the type of contract.

In this case we analyzed the combined effects of NUG power purchases on generating and capital costs for a representative utility (Utility A) with a relatively large amount of NUG purchased power. We compared cost effects for four different types of purchased power contracts: 1) flat rate pricing, 2) on/offpeak energy pricing, 3) dispatchable energy pricing, and 4) actual cycle energy pricing (ACEP) (see sidebar on page 37 for definitions). We evaluated the total incremental costs with each contract as the exclusive means of purchasing NUG capacity, based on Utility A's existing and planned capacity and energy purchases from NUG resources. We addressed incremental differences in variable energy production costs but did not include or depend upon optimal capacity expansion choices by the utility.

Our findings showed the ACEP contract to be the most advantageous (em the one that draws the desired balance between efficient power contracting and management of financial risk. By including a capacity component based on plant availability, plus an energy component based on the plant's actual heat rate curve, the ACEP contract appears to allow for a dynamic price structure that addresses both the direct savings from dispatchability and the indirect effects on the cost of capital.

Bond Rating Adjustments

Bond rating firms typically adjust utility bond ratings by allocating a portion of the capacity obligations as a liability without a corresponding entry as an offsetting asset.

From the utility's perspective, NUG payments look much like fuel purchases under a long-term contract. But not so for credit-rating firms. Credit rating agencies view the capacity portion of NUG purchases as similar to an equipment lease with a long-term obligation to make payments to the NUG for delivered capacity. Since utility accounting practices do not recognize future obligations to make NUG payments associated with capacity purchases, the rating agencies perform off-balance-sheet adjustments to utility balance sheets. These adjustments reflect several classes of risk: regulatory risk (continued cost recovery of NUG payments), financial risk (revenues sufficient to cover NUG obligations), and market risk (maintaining competitive electric rates).

For example, when Moody's rates electric utilities, it evaluates purchases from NUGs on the basis of "financial flexibility," which reflects the operating flexibility of the power-purchase contract. Any rigidities imposed by a contract's structure that fail to mirror the economic and operating efficiency of traditional utility-owned generation are seen as reducing the company's financial flexibility. The proportion of contracted capacity payments made to a NUG that is characterized as balance sheet debt by credit rating firms is contingent upon the economic structure of the contract.

According to S&P, these adjustments "enable more realistic financial comparisons between companies meeting future resources through purchased power versus companies that build their own generating plants." Duff and Phelps considers long-term interutility purchases to pose the same type of financial liability as purchases from NUGs.

The utility can maintain its bond rating either by