[BETA] Fortnightly

In an article entitled "Rate Unbundling: Are We There Yet?" (PUBLIC UTILITIES FORTNIGHTLY, Feb. 15, 1996, p. 30), authors Susan Stratton Morse, Meg Meal, and Melissa Lavinson urge regulators to unbundle the cost of capital to recognize that the business risk of electric generation exceeds that of transmission and distribution (T&D). The authors explain:

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"[O]ne of the biggest challenges facing regulators is to encourage the benefits of competition while protecting electric consumers from excessive rates that produce windfall profits for shareholders."

They continue:

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"For example, over the past few years, California lOUs have asked for a higher allowed return on common equity (ROE) to compensate shareholders for the additional risk associated with competition in the electric generation sector."

The Independent Energy Producers Association (IEP) had asked the California Public Utility Commission (CPUC) to consider a new approach to regulating the cost of capital for California electric utilities. Susan Stratton Morse testified on behalf of the IEP. The IEP offered this premise: Unless utilities disaggregate the risks of providing unbundled services, along with rates and the allowed shareholder returns, customers of investor-owned utility companies (lOUs) will end up overpaying for certain services, such as T&D, while underpaying for others, such as generation. Moreover, utility generation services would gain an unfair advantage over generation-only competitors. In a November 1994 decision, the CPUC agreed the IEP and stated that any future unbundling of services should consider an unbundling of the ROE and rates for such services.

The authors rely on telephone and natural gas utility data as a proxy for electric generation and T&D because no market information on common stocks is available for stand-alone electric utilities engaged solely in generation or solely in T&D. The authors calculate ROE differences between certain telephone and natural gas utilities presumed to operate in competitive or non-competitive markets, and assume that electric generation and T&D were both financed with the same mix of debt and equity, implying no difference in financial risk. They also rely upon a decision from the Federal Energy Regulatory Commission (FERC) now several years old to provide quantitative support. That reliance raises questions.

Morse et al. state that, "at a minimum, the ROE (return on common equity) for generation is at least 15 percent higher than the overall ROE for the combined generation/T&D utility." They also assert that their analysis, using proxy natural gas and telephone utilities (em and calculations using the capital asset pricing model (CAPM) (em implies an ROE differential of 175 basis points for Southern California Edison Co.

In essence, the authors claim that "the challenge in unbundling the cost of capital comes not in proving the theory to be fair and equitable, but in determining how and when to do it." Nevertheless, they provide no evidence to confirm their assumption that differentials in investment risk (the sum of business and financial risks) derived from calculated ROEs for telephone and natural gas proxy utilities should equal whatever may be the differential in ROE business risk between electric generation and T&D.

Preliminary Analysis

An ROE set by a regulatory agency