July 15, 2002
Unbundling Capital Costs: It Doesn't Add Up
G+T+D=? Why the sum of the future parts is greater than the present whole.
GENCO, TRANSCO, DISCO. IF THAT IS the future, then rates collected formerly by the integrated electric company (em with its generation, transmission and distribution functions (em will have to be determined again for each segment. One aspect of these rates (em the cost of capital (em has generated significant controversy. %n1%n
The task becomes particularly difficult, for example, if regulators should attempt to set the cost of capital for distribution before the integrated utility spins off that segment, or if a distribution company operates as a separate subsidiary controlled by a public utility holding company that also includes generation and transmission affiliates. Comparable-risk proxy companies may prove impossible to find in either case: Subsidiaries do not issue their own stock to the public; holding companies, which do issue stock, will still reflect the combined risk of generation, transmission and distribution, if not other businesses as well.
Some authors have turned to the telephone or gas industries for analogies of how risks will change in a restructured electric industry. %n2%n Another method would start with the integrated utility's cost of capital and partition it into estimates for the generation, transmission and distribution functions. This approach assumes the capital costs of these segments on a standalone basis to reflect a weighted average of the integrated company. Michael T. Maloney, Robert E. McCormick and Cleve B. Tyler described this approach in a recent article. %n3%n
Such an assumption ignores two realities. First, the newly formed independent segments of an integrated electric utility will prove riskier. Second, because of restructuring, each segment will face increased uncertainty.
Maloney et al. assume a beta for the wires business of 0.4 plus an equity ratio of 38.5 percent. These assumptions seem unwarranted. The mere act of splitting the business apart will make each of the newly formed independent segments riskier in the future. Disaggregation will not play out as a zero-sum game.
Distribution: No Track Record
Investment advisory services (such as the Value Line Investment Survey and Standard & Poor's) consider small companies a risky proposition. These new, disaggregated entities will be smaller than the aggregated utility from which they emerged. %n4%n By disaggregating, companies will lose the benefits of intra-company diversification and vertical integration. New management may come on board. The new companies will start up without a track record.
Without a script for restructuring, legislators or regulators could succumb to political pressure, creating event risk for disaggregated distribution companies. %n5%n Some jurisdictions face an imperative for lower rates, with cost being secondary. %n6%n
Moreover, distribution companies may be saddled with the job of billing for stranded costs and will be subject to all the other remnants of traditional regulation, such as lifeline rates, liberal (ratepayer-oriented) disconnect policies, etc. During the transition, and possibly after that, the "distribution" utility may take on obligation to purchase power for an unknown and varying group of its ratepayers as a provider of last resort. %n7%n This residual obligation presents three types of risk to a distribution company: