The Wires Charge: Risk and Rates for the Regulated Distributor
Open-access tariffs hold the key to capturing the gains promised by electric restructuring.
In a restructured electric industry, unbundling the cost of the wires from power generation may well prove more important than dealing with stranded costs. In fact, stranded costs eventually will take care of themselves, whether by direct recovery, indirect recovery or no recovery. Without proper unbundling, however, a restructured industry could force competitors to pay inflated access fees to the distribution utility.
The matter has drawn a lot of attention. For example, the National Association of Regulatory Utility Commissioners has commissioned a study of using performance-based ratemaking for the functionally separated activities of transmission and distribution. Indeed, most restructuring legislation pays at least lip service to PBR. Nevertheless, more traditional regulation (based on a rate of return) generally provides the benchmark from which other, more progressive methods are developed. Thus, public utility commissions will likely face two key tasks in setting open-access fees: 1) identifying and separating the costs of the wires from generation; and 2) allocating the wires costs among distribution customers.
Separating wires and generation costs implies another key step: unbundling the return and capital structure assigned to wires. What was formerly an implicit return assigned to the wires business must now become part of the formula for determining the open-access fee. Here, the wires business should carry a much lower risk than generation, both today and in the future. Thus, the rate of return required for capital invested in wires should be much lower than it has been overall for the traditional, vertically integrated, investor-owned utility.
The impact of this change is substantial. We estimate that the correct return on equity for the wires-only part of electricity supply runs some 2 percentage points less than the old, traditional equity return rate for the integrated enterprise. Given an average equity return of 12 percent, this difference means that the return portion of an open-access fee based on cost of service is nearly 20 percent lower than the old, allowed rate of return. And then there is the question of capital structure - the proper allocation of debt leverage and income tax deductions to the wires portion of the business. Certainly, most observers see the wires utility evolving as more highly leveraged than the competitive generation business.
All told, we have found that the method of allocating risk, capital structure and returns among electric sectors could produce a $3 swing (10-15 percent) in a typical monthly residential wires charge. This swing could eat up more than 10 percent of the projected competitive savings for residential customers served by an average electric utility.
Nevertheless, regulators must tread carefully. Set access fees too high, and potential gains from restructuring may be forfeited. But with rates set too low, be prepared to sacrifice service quality and reliability. Resolving the proper rate of return and capital structure in deregulation could preserve a large share of the competitive savings for residential customers.
Playing the Cost Game
Electric utilities no doubt recognize that their financial interest lies in shifting as many rate-base items as