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Spending Capital as if It Mattered

Infrastructure challenges are redefining utility capital-planning methods.

Fortnightly Magazine - May 2007

regulatory outcomes—faster investment recognition and more certain capital recovery.

Traditional regulatory approaches to investment recovery focus on ex post demonstration of investment need and tariff adjustment through periodic rate cases. Under those circumstances, the large and continuing capital programs that many companies are undertaking can pose serious risks to balance sheets, credit ratings, and cash flow. Both baseline investments and next-stage investments carry the inherent risks that come with promising but unproven technologies, long-term construction cycles, and the unavoidable uncertainties of an evolving market.

A regulatory process that compounds those inherent risks through second-guessing on prudence, and through extended delays in rate-base recognition, confronts the utility with two choices. One choice—in many cases the prudent one—is to continue deferring investment, necessary as it may be in the long term, until the regulatory environment is more accommodating. The other is to swallow the risks and proceed, recognizing that delays in investment recognition will impose higher costs through stress on credit ratings and through accumulation of the carrying costs of capital.

A natural nexus exists between companies and their regulators around minimizing long-term costs to customers and avoiding rate crises. To capitalize on that nexus requires a different set of regulatory mechanisms than the traditional investment-recovery frameworks of prior investment cycles.

Those new mechanisms depend on a changed working relationship with the regulator. In place of the adversarial “barter” mode of regulation, common ground should be sought through information-based collaboration that focuses on a convergent interest—the minimization of costs and risks.

Movement toward this different approach can be found in the various construction cost “riders” and investment carve-outs that a number of regulators have provided. By providing some mix of investment pre-approval, immunity from later prudence reviews, and annual recovery of expenditures, these riders improve cash flow, mitigate risk, and lower total cost. To date these mechanisms have been targeted toward expenditures that have been mandated by governmental agencies, determined as critical to the existing system infrastructure, or recognized by regulatory bodies as requiring special consideration in light of circumstances. Companies like Xcel Energy, Duke Energy, and TXU have had great success in attaining responsive regulatory recognition for expenditures for environmental improvement, transmission infrastructure, and/or mandates for conservation and network improvement.

Utilities can strengthen their credibility and channel regulatory oversight in constructive directions by engaging the regulator in both after-the-fact examination of lessons learned and root-cause analysis, as well as contemporaneous review. Collaborative review, particularly with respect to externalities that affect factor costs, such as labor availability, raw-materials escalation, and delays from regulatory review, can provide vital mutual insight.

Armed with this understanding, regulators may be amenable to tailored incentives for project construction performance. In contrast to performance-based ratemaking based on broad financial performance indicators, these incentives would target specific outcomes (cost, schedule, etc.) that both management and the regulator recognize as critical to project success and create the potential for some form of shared benefits.

This approach would provide significant benefits:

Cash-Flow Preservation. More of the cash flow needed to support ongoing annual investment increments would become available from internal operations,