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Mitigating "Mandated" Rate Hikes

How to develop balanced revenue-backed financing to manage the impacts of governmental mandates.

Fortnightly Magazine - May 2007

Severe upward pressure on electric rates after a decade of stability has regulators, legislators, utility executives, consumer advocates, and myriad other stakeholders searching for solutions. Often this upward pressure on rates is associated with governmental mandates ranging from market-based supply requirements to renewable energy portfolios to mandates to build base-load power plants. In some regions, rate shock is occurring or is predicted, along with harsh economic and social impacts. The mandates often are a given. The challenge is meeting these mandates without the burden of large rate increases.

Revenue-backed financing (RBF) can mitigate many of these mandate-driven rate increases significantly. RBF programs must, however, be designed to eliminate the inefficiencies and inequities that can be associated with revenue set-aside programs. Without the proper incentives, either regulatory or market-based, these RBFs unintentionally may push the critical balance among the 3Rs of risk, responsibility and reward out of kilter, causing inefficiencies that threaten the sustainability of RBF generated savings.

Revenue-backed financing commonly is provided through bankruptcy remote debt instruments often referred to as Special Purpose Vehicles (SPVs), usually supported by pledges of non-by-passable and irrevocable revenue streams set aside for a particular use. RBF is similar to what often is referred to as securitization or even asset-backed financing, but has been renamed here to focus on its particular feature of revenue pledges and how there is a need to introduce incentives that create balance and avoid losses associated with inefficiency that generally have been overlooked. Although the bonds usually are rated “AAA,” the costs of the bonds may not be that much lower than those paid by a utility for other investment-quality bonds. RBF often is done off-balance sheet to protect existing utility investors from changes in the utility’s capital structure. The bulk of the savings from RBF come from changes in the capital structure that the guaranteed revenue stream permits. For example, the cost of a 100 percent RBF program today can be about 7 percent, while the tax-adjusted cost of financing a traditional 50/50 debt-equity utility capital structure is in the neighborhood of 13 percent. On $500 million base-load generating station, the first year’s savings could be about $30 million and $600 million over the life of the asset, assuming a 40-year useful life of the plant. This translates to rate relief of similar amounts.

The set aside of revenues by regulators for specific purposes is not uncommon. The rate covenants coupled with municipal guarantees that allow a municipal utility to finance all of its external capital needs with debt shows that the market has allowed the benefits of highly leveraged capital structures in the past when the debt repayment is adequately ensured. A fairly common revenue set-aside has been fuel adjustment clauses. Stranded costs recovered through irrevocable and non-by-passable charges were

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