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The Wires Charge: Risk and Rates for the Regulated Distributor

Fortnightly Magazine - September 1 1997

It is important to note that for the investor holding a portfolio of the two in the same levels as before (60 percent generation and 40 percent wires), there is no net effect. The average return to their bundled equity holdings will remain at about 11.5 percent.

In the past, where generation was combined with transmission and distribution, the higher overall return was justified because of the relative riskiness of generation. In the open-access regime, generation will be separate from transmission and distribution and its riskiness should also stand separated in the open-access ratemaking process. The effect is substantial. The return on an investment portion of the open-access wires tariff can be overstated by 20 percent or more by incorrectly assessing the appropriate rate of return and assigning the old allowed rate of return.

Income Tax Allocations

The allocation of income tax expenses between the wires and generation business also will play a key role in unbundling the cost of capital. And here, risk and capital structure are again important. Interest on long-term debt is an expense item; dividends paid to equity owners are not. The more leveraged the firm is (value constant), the lower its income taxes. Leverage reduces tax liabilities.

The amount of income tax expense that a utility should properly include in its open-access fees depends on the correct assignment of equity return and leverage to the wires part of the business. Public utility regulators generally cannot force utilities to adopt specific capital structures. They also cannot force firms to minimize that cost of capital by increasing how much debt financing that they employ. However, regulators can set open-access tariffs at a level that reflects the true cost of supplying the wires service. This tariff can be calculated using the appropriate and optimal capital structure and rate of return.

Using the previously determined debt-equity ratio of around 1.6 and a required equity return of around 9.4 percent, income taxes for the wires business can be calculated directly. The important point is that the true, implied income tax liability of the wires business is much smaller than the implied income tax liability on generation. (See Table 1 for the parameters used to calculate the proper taxes on the wires business based on total income taxes paid in the past.)

With the proper capital structure in place, the correct taxes on the wires portion of income is about 23 percent of the historical total. In other words, a utility paying $500 million in income taxes in 1997 as a fully integrated, regulated electricity supplier, would pay less than $115 million for the wires portion of its business as an unbundled supplier of generation and wires services in 1998. The details of this calculation are available from the authors.

Rate Design: Allocating Fees by Customer Class

Once the state commission has determined the revenues required to recover the cost of wires service, the next issue is to allocate these fees across customer classes. Open-access fees should be levied on a per-customer basis rather than on a kilowatt-hour basis. The reason for this