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The Wires Charge: Risk and Rates for the Regulated Distributor

Fortnightly Magazine - September 1 1997

with the incumbent host utility. Nonetheless, the competitive price will be set at the margin by open-access providers. The fees they are forced to pay the host utility for the wires service will be the baseline from which the competitive price of electricity service is built.

The appropriate capital structure and rate of return questions have implications beyond access fees. If regulators ignore these arguments and allow the historical WACC for the unbundled distribution company, we will see an increase in the stock prices of distribution companies. Stock owners are now gaining the same historical rate of return for a less risky asset. Stock prices of distribution companies will rise if the wrong rate of return is allowed.

The essential debate in electric restructuring will not likely revolve around the stranded costs of generation assets. Instead, the question looming before commissions around the country will be finding the true costs of distribution and transmission activities. Answering this question is independent of the valuation of generation assets, especially if fees are assessed on a per-customer basis.

Michael T. Maloney and Robert E. McCormick are professors of economics at Clemson University, Clemson S.C. Last year they collaborated on an extensive study on electric utility deregulation, prepared for the Citizens for a Sound Economy Foundation: Customer Choice, Consumer Value: Analysis of Retail Competition in America's Electric Industry. Cleve B. Tyler is an economics graduate student at Clemson.

Table 1

Capital Cost

Risk-free rate: 6.6% Risk premium: 7.0%

Debt Equity Interest Rate Beta Return to WACC

Ratio on Debt Equity

Generation 0.6 8.0% 0.9 12.9% 11.1%

Wires 1.6 6.6% 0.4 9.4% 7.7%

1If a certain cost truly is a cost of generation, then in a competitive market for generation the price will allow for its full recovery. Competition ensures that all costs get paid on average and at the margin in the long run. If that cost is allowed to appear on the accounting books as though it were a wires costs, then the integrated utility will effectively recover that cost twice. Such a result is economically inefficient.

2Re South Carolina Elec. & Gas Co., Docket No. 95-100, Order No. 96-15, Jan. 9, 1996, 167 PUR4th 154 (S.C.P.S.C.). See also, "Depreciation Reserve Soaks Up Stranded Investment," PUBLIC UTILITIES FORTNIGHTLY, Feb. 15, 1996, p. 45.

3Cajun Elec. Power Co-op. v. FERC, 28 F.3d 173 (D.C.Cir.1994).

4See Maloney, McCormick, and Mitchell, "Managerial Decision Making and Capital Structure," Journal of Business, 66(2) (April 1993):189-217.

5In a simple problem where there is only debt and equity, the WACC is the long-term debt rate paid by the company times the proportion of long-term debt to total capital in the firm plus equity return times the proportion of equity to the value of the firm.

6The equity beta is a financial economics expression for the coefficient of the relation between the return to a firm and the return to the overall market.

7Based on the 30-year Treasury bond rate as of July 8, 1997.

8That is, beta times the risk premium plus the risk-free rate, or 0.7 times 7 percent plus 6.6