Touted as a panacea for stranded costs, securitization would forever shield rates from market scrutiny.

We consumers display an amazing talent to squander the fruits of our labor on the whim of the moment. Examples might include bungee jumping, vanity license plates or pet rocks. Or just about anything you might find in a magazine stuffed in the back of an airline seat.

Now make way for electric utility restructuring, where the latest fashion calls for securitization of uneconomic costs. (I deliberately avoid the industry's euphemism of "stranded" costs.) Will securitization aid consumers, as claimed by its advocates, or will it go down as just another bad idea that was once very popular?

Much of the debate runs rife with doublespeak. It tends to diminish and confuse the subject. Do proponents seek a bailout? Or is this a "win-win" proposition as advertised by proponents? Perhaps the biggest problem with securitization is that it might be seen as a panacea for all projects that become uneconomic.

The truth is at once more simple and profound. Securitization is mostly a refinancing option (em paid for by customers to recover the cost of bad investments. Utilities with uneconomic costs, their shareholders and potential underwriters are the only ones that stand to benefit from securitization. Estimates on the size of the market for these financial assets would make even Carl Icahn sit up and take notice. Salomon Brothers estimates that the market could approach $50 billion. An analyst at Fitch Investors Service stated that it could reach $100 billion.

A Perversion of Process

From a public interest standpoint, a major drawback with securitization is that it effectively bypasses the regulatory process. It converts the utility's opportunity to recover its costs and earn a return into a guarantee protected by legislation. Whether or not securitization is viewed as a problem depends on the interpretation of the so-called Regulatory Compact.

A great deal has been written on the subject of the Regulatory Compact. Some have claimed the compact is a fiction recently invented by the industry. Others have said the compact is an ironclad covenant etched in blood. As often happens, the truth is somewhere between. A tacit agreement of sorts does exist between regulators and utilities. The agreement is more complicated than how it is often portrayed.

Briefly stated, the compact grants the utility an exclusive (but limited) franchise to operate in a service territory free from competition. This was a "special privilege" that could be granted or withheld at the discretion of the state or federal government. In exchange, the utility was required to serve all customers without discrimination. Its profits were regulated to ensure that its prices remained reasonable.

The obligation is not, as it is often characterized, an obligation imposed by regulators that binds ratepayers to the utility. There was never, nor is there now, a concurrent obligation to buy on the part of utility customers. If such an obligation did exist, utilities would have the right to charge industrial customers that installed their own on-site generating plants. Or, utilities would chase down residential or industrial customers that moved to a new area. Moreover, the fact that rates vary considerably, even between neighboring utilities, suggests that some are not keeping their end of the bargain of charging reasonable rates.

The regulatory process that has developed over the last 90 years was intended to act as a surrogate for competition, although an imperfect one. The elaborate process of rate cases, prudence reviews, used-and-useful tests, automatic fuel and other cost pass-throughs, were all intended to mimic a competitive market. Never was regulation a substitute for competition. After-the-fact reviews of management decisions gave gas utilities a much-needed incentive to draw up their plans with the same degree of care found at competitive firms. Regulators worked simply to safeguard consumers, not to impose a standard of perfection on any one company.

In broad terms, there is nothing inconsistent with introducing competition to control costs and value utility assets. The U.S. Supreme Court on several occasions has upheld the right of a state to change the manner in which utility assets are valued and costs are recovered. %n1%n Of course, a state remains free to provide compensation for uneconomic assets, as legislatures in Rhode Island and California have done. But the Constitution does not mandate compensation.

Even supporters of 100-percent recovery must realize it is not wise public policy to place such recovery forever beyond the oversight of the public utility commission or the emerging competitive market. In this sense, securitization marks a form of permanent regulatory and market bypass. Estimating all future recovery today ignores future market price changes, provides poor incentives to mitigate uneconomic costs and locks in a payment stream for the utility that may prove completely inappropriate in the future.

Should investors worry about buying a security backed by the promise of politicians to pay the principal and interest for the next one to two decades? Might some future legislator have a change of heart? One possible scenario envisions a grassroots revolt against the Competition Transition Charge, or CTC (see sidebar). What customer would not question a charge seen as a bailout for a monopolist's poor record of cost management?

Other asset-backed securities based on consumer debt (em such as credit cards, auto loans or home equity loans, which together account for almost 80 percent of the outstanding securitized market %n2%n (em are backed by a diverse group of consumers obligated to repay their loans. In the case of these utility bonds, backing comes only from the pledge of the legislature. Behind that pledge lie uneconomic assets. Putting their money in a security backed by the revenue stream of the utility's economic assets may prove wiser for investors. These assets should be based on an assessment of the company's future competitiveness (as with an ordinary corporate bond) rather than on the utility's impaired assets. Investors should look at the legislation and determine for themselves the likelihood for continued payment.

Bondholders face other risks. Although it might overturn some features of the legislation that

created the CTC, a court would not likely prohibit a state from allowing recovery. For example, should cogenerators pay the CTC? Qualifying facilities under the Public Utility Regulatory Policies Act might switch to a different backup supplier. In that case, a CTC imposed on QFs could violate PURPA's rule against rate discrimination. Similarly, a judge might overturn the "non-bypassable" feature that requires even self-generators to pay the CTC. The courts have yet to rule on these and other matters related to recovery of uneconomic costs. The laws passed so far offer no recourse for bondholders against the state itself (that is, from general tax funds) in case of default. In fact, if there was such a recourse for bondholders, would this raise a whole new set of concerns?

Who Is Secured

Clearly, the biggest beneficiaries of the securitization of uneconomic costs are the companies that use the option. A company using securitization would benefit in two ways. First, the company's above-market costs would be paid for by ratepayers and placed beyond the regulators' or the market's supervision. Second, the company would be placed in a competitive position any firm would like to be in (em that is, with questionable costs removed from the books. Other beneficiaries are of course the underwriters of the bonds, who would receive perhaps millions of dollars in fees, which may explain their enthusiasm for the concept.

But what about ratepayers? They would likely pay a lower annual cost in interest expense than what is currently in rates. (Whether total interest expense would be lower or higher would depend on the comparative length of the debt terms and the debt and equity terms being replaced.) However, allowing the utility a higher debt level could have the same result. Usually this would simply require a change in public utility commission policy. Also, securitization presumes that ratepayers are the ones who should pay. It is in the beneficiaries' interest, utilities with uneconomic costs, their shareholders and potential underwriters, to obscure this point and make it seem like an entitlement and place it beyond the regulators' and the market's control. t

Kenneth Rose is a senior institute economist at The National Regulatory Research Institute, at the Ohio State University, in Columbus. The views and opinions expressed here do not necessarily state or reflect the views, opinions, or policies of NRRI, the National Association of Regulatory Utility Commissioners, or NARUC-member commissions. The author thanks Ken Costello, Robert Burns and Doug Jones for helpful comments on an earlier draft.

And Where is the Collateral?

Definition. A financial security backed by a revenue stream pledged to pay the principal and interest of that security.

Purpose. To allow electric utilities to finance uneconomic costs with an up-front, lump-sum payment from the sale of a security or bond.

Benefits. The replacement or refinancing of the utility's existing capital structure of debt and equity with lower-cost debt. Plans approved so far require a passthrough to retail customers of any savings eventually realized from securitization.

Authorization. Requires legislation to create a transferrable property right to collect the utility's uneconomic cost from ratepayers. Such legislation determines the general guidelines on what the utility can collect from its current ratepayers. It also instructs the state's utility commission to determine the amount collected and to supervise a collection mechanism.

Mechanics. Typically, the utility will transfer the legislatively created property right to a designated trustee, who then issues a security or bond. The trustee then sells the security in the financial markets and pays the cash proceeds (less transaction costs) to the utility. The cash proceeds the utility receives should equal the discounted present value of the revenue stream.

The Customer Charge. The utility customer pays a "competitive transition charge," or CTC. (That term originated in California, and has since acquired wide usage across the country as a generic term for a charge assessed to ratepayers to recover a utility's uneconomic costs.) The CTC is generally designed as a "non-bypassable" obligation (to the extent such a thing exits) imposed on ratepayers by legislative fiat.

Investor Payout. The utility or distribution company collects the CTC from the customers. The funds are then transferred to the trustee, who then transfers it to the security holders (bondholders).

Collateral. Basically, a pledge by legislators to see that the securities will be paid in full, including principal, interest and financing costs. However, what is being refinanced are three main categories of potential utility uneconomic costs: 1) the portion of the utility's generating assets that exceeds market value; 2) costs incurred in above-market contracts to buy power from non-utility generators, and 3) regulatory assets or deferred debts (e.g., accounts payable to the utility over a long-term amortization period, the receipt of which is threatened by competition).

In other words, the assets refinanced are those assets on the utility's books that hold no real value. These securities only have a value because the legislators have promised to create and sustain the revenue stream from the CTC until the debt is paid.

Examples. California and Pennsylvania have adopted legislation that permits securitization of uneconomic costs. Many more states are considering it.

1The most recent case was Duquesne Light Co. v. Barasch, 483 U.S. 299, 109 S.Ct. 646 (1989). In footnote number 10, the Court stated that a "right requirement of the prudent investment rule would foreclose hybrid systems... [and] would also foreclose a return to some form of the fair value rule just as its practical problems may be diminishing. The emergent market for wholesale electric energy could provide a readily available objective basis for determining the value of utility assets."

2From a presentation by Howard Hiller (Solomon Brothers) at "Nuclear Power in a Competitive Era: Asset or Liability?" sponsored by The Nuclear Waste Program Office of The National Association of Regulatory Utility Commissioners, Fort Myers, Florida (January 1997).

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