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The Wires Charge: Risk and Rates for the Regulated Distributor

Fortnightly Magazine - September 1 1997

of electric utilities nationwide.

The next problem is to unbundle the equity rate of return allowed in the past into its generation versus wires components. We can unbundle the equity rate of return by assigning different betas to generation and to wires to mimic the financial market. For instance, since wires are much less risky than generation, we assume a beta in wires of 0.4, and a beta in generation of 0.9, which is still less than the overall market. This split unbundles the risk of generation and wires.%n9%n

The capital base of a fully integrated electric utility (the rate base in the regulated enterprise) is split between generation and wires approximately 60-40. Thus, a generation beta of 0.9 and wires beta of 0.4 gives the historical average beta for the integrated enterprise of 0.7. Assuming a generation beta of 0.9 and a wires beta of 0.4, the proper equity return to generation is 12.9 percent and 9.4 percent for wires. That is, we expect that the equity return to generation assets will be approximately 12.9 percent in the financial market and that regulatory commissions should set the allowed rate of return to wires at approximately 9.4 percent. Note, however, that most of these numbers must be confirmed through additional research.

Optimizing the Capital Structure

The determination of the utility's capital structure and the assignment of an approved debt-equity ratio will play a significant role in unbundling the cost of capital and allocating a true cost of service to the wires business. About half the value of electric utilities is debt.%n10%n How much of this debt should be implicitly assigned to generation and how much to wires?

Since generation is the riskier enterprise, it will have a lower implied debt-equity ratio, and of the overall average debt-equity ratio of approximately 1, the implied ratio for wires is greater than 1. A split of the historical average that imputes a debt-equity ratio of 1.6 to wires and 0.6 to generation maintains the assumption that commissions have imposed the correct ratio for the unbundled company in the past. The debt- equity value of 1.6 for wires comes from the debt-equity ratio of certificated air transport that we found in prior research.%n11%n

Average long-term debt rates for public utilities are about 1 point higher than the long-term, risk-free rate. The average interest rate on long-term debt for bundled utilities is around 8 percent. However, for the unbundled generation and wires functions, the appropriate implied rates will diverge. The rate on generation assets will rise, and the rate on the wires will fall due to relative risk levels. Assume the interest rates on debt in the two business segments are 8.5 percent for generation and 7 percent for wires.

When this is put together, we get an implicit weighted average cost of capital of 11.3 percent for generation and 7.9 percent for wires (see Table 1).

Notably, both the allowed equity return and the WACC for wires are considerably lower than they were in the bundled past. Of course, the returns to generation are commensurately higher.