As the industry’s regulatory risks and capital requirements expand, financing will come with a higher price tag—and another cost pressure in the ratemaking process.
Main Street Gold Mine
Funds collected for cost-of-removal liabilities could finance capital spending.
Last year Public Utilities Fortnightly noted that recession-related demand destruction was pressuring industry operating margins and financial returns in the electric industry and that conservation and environmental demand destruction were likely to continue that pressure for the foreseeable future. The author correctly concluded that “companies that aren’t earning their allowed return on equity (ROE) due to depressed energy sales are looking to regulators to make them whole. Going forward, rate treatment largely will determine who the winners will be (see “ The 40 Best Energy Companies ,” September 2009) .
Many utilities are proposing capital intensive smart-grid initiatives, often as a means of facilitating conservation and demand response. While the federal government is providing some funding for a smart-grid roll out via matching grants under the American Recovery and Reinvestment Act of 2009, the winners likely will be those utilities that are successful in obtaining regulatory approvals to capture in customer rates the up-front capital costs of smart-grid and environmental expenditures. 1 Consequently, many electric utilities, such as Baltimore Gas & Electric Co. (BGE), are pursuing non-traditional Main Street capital funding approaches for environmental and infrastructure initiatives. The Maryland Public Service Commission, however, rejected BGE’s request to obtain up-front ratepayer financing in the form of an incremental surcharge, questioning both the proposed Main Street funding and the purported efficiency and economics underlying its smart-grid Initiative. 2 Only after BGE removed the tracking surcharge in its amended filing in August did the commission approve the company’s smart-grid plan.
Utilities and regulators in many states face similar tensions, without any apparent easy solutions. However, industry might be overlooking an important source of capital for smart-grid and similar investments: depreciation accounts already collected to cover future cost-of-removal liabilities.
Main Street vs. Wall Street
Regulatory commissions use a rate-base/rate-of-return model to set utility prices. The traditional regulated rate-of-return model assumes utilities obtain capital from third-party investors ( e.g., Wall Street) and earn a return on these capital investments by charging their customers ( e.g., Main Street). Contrary to this traditional model, however, some utilities have obtained— and many more are requesting—Main Street advance-funding requests for the smart grid and environmental spending projects in their rate-base calculations.
Main Street funding requests usually involve one or more of the following: 1) the inclusion of future plant additions in rate base; 2) special revenue-requirement surcharges; and 3) increased depreciation rates, all of which provide increased cash flow to the utilities. Regardless of the form, these Main Street funding approaches result in customers, rather than investors, providing capital in advance.
Depreciation expense allocates a portion of an asset’s cost to a particular year. In turn, depreciation drives utility prices because the higher the expense, the higher the price. Unlike other expenses, such as payroll, there