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Return on Equity: Gen Sector Issues

Ratemaking Special: A survey of recent retail rate cases for electric and gas utilities.

Fortnightly Magazine - November 2005

weight to other factors, as well. Interest rates, it said, were near 40-year lows. It added that the gap between yields on short- and long-term Treasury bonds was decreasing, despite a recent increase in the federal funds rate. The PUC also took note of a letter published in a recognized trade journal confirming that "investors currently expect single-digit returns from utility investments."

Purchased Power Contracts: Extraneous Effects

In states where the major investor-owned electric utilities have divested themselves of a large portion of their generating assets, the utilities must rely increasingly on wholesale purchased-power contracts to serve retail customers. Also, credit-rating agencies have tended to treat those long-term purchased power obligations as the equivalent of debt capital, affecting utility financial ratios such as interest coverage, cash flow to debt, and debt to equity. The theory, known as "debt equivalence," presumes that the payments for purchased power represent a sort of substitute for interest payments that the utility otherwise would owe on bonds issued to borrow money if it chose instead to build its own generating fleet.

This theory, however, poses problems for state regulators in rate cases and ROE findings. How do adverse credit ratings affect a utility's risk profile? How do they affect a utility's supply portfolio and its long-term resource planning?

Now, in California, in a recent case setting cost of capital for the state's three major investor-owned electric utilities, a PUC has provided some answers. ()

First, the PUC agreed that in ROE determinations it can and should take account of the impacts of adverse financial ratings that stem from the debt-equivalence theory. Second, however, it advised that it would not consider such debt equivalence effects as justifying a separate inquiry on cost recovery outside of the ROE determination-i.e., in areas such as resource planning.

In particular, the PUC ruled that the utilities, as part of their annual ROE applications, should include testimony on credit rating and capital structure impacts, including mitigation recommendations, of debt equivalence on their purchased-power contracts.

Information to be provided in that regard should include:

  • Current credit ratings from Moody's and Standard & Poor's;
  • Expected impacts on ratings due to debt equivalence;
  • Capital structure and ROE with and without debt equivalence;
  • Financial ratios for debt to capital, cash-flow interest coverage, and cash flow to debt, both with and without adjustments for debt equivalence; and
  • Pre- and post-tax financial ratios.

The PUC explained that debt-equivalence risks would be assessed along with other financial, regulatory, and operational risks used in setting ROE plus use of a balanced capital structure reasonably sufficient to ensure confidence in the financial soundness of the utility.

Benefits From Competition: A Re-appraisal

An order from Arizona illustrates what can happen after a long time interval between rate cases, when state regulators re-appraise the value of electric restructuring, along with earlier but failed forecasts of how competition would yield efficiencies and savings in wholesale power costs.

In what it cited as the first full-blown rate review for Arizona Public Service Co. (APS) in 14 years, the commission allowed an ROE of 10.25 percent. More