Nowhere are the failings of traditional utility regulation more evident than on Long Island. The New York Public Service Commission (PSC) has raised rates for the Long Island Lighting Co. (LILCO) 31 percent since 1989. Rates are now over twice the national average (em the highest in the continental United States. Meanwhile, Long Island's economy has been ravaged by defense cutbacks that have erased 100,000 jobs (em a 10-percent drop in employment. The high electric rates have kept new industry from moving in, and a grocery chain is now Long Island's largest employer.

The normal order has been turned upside down. While pressures for competition are sweeping the industry, New York State has floated three proposals for a public takeover of LILCO in the last 15 months. Instead of facing the ominous prospect of absorbing huge stranded costs, LILCO's investors hope to be bailed out by the state. While utilities fight public power, LILCO is quietly trying to sell itself by orchestrating a public takeover. And Gov. George Pataki, a Republican, is advocating government intervention instead of championing competition.

The Shoreham Settlement

Long Island's current electric rate problem is an outgrowth of the closing of the Shoreham nuclear plant in the late 1980s, which left LILCO in dire financial straits. At the end of 1988, LILCO had $4 billion invested in the plant and an equity ratio of 33 percent. Its cash flow from operations was only $235 million, and it needed $575 million in capital to finance debt maturities and capital spending in 1989. Without major rate relief, LILCO faced bankruptcy.

Disaster was averted by a settlement negotiated between LILCO and Gov. Mario Cuomo to return LILCO "to investment grade financial condition." The $4-billion investment in Shoreham was put into rate base as a regulatory asset, to be recovered in rates over 40 years, with a return on the unamortized balance.

The immediate impact on rates was to be mitigated by a phase-in plan involving 11 rate increases, two in 1989 followed by nine annual increases. The first three increases were provided by the settlement: 5.4 percent in February 1989, 5 percent in December 1989, and 5 percent in December 1990. None of the remaining eight annual increases was guaranteed; the settlement only provided nonbinding targets for each rate hike of 4.5 to 5 percent per year. The PSC was to administer these increases through normal ratemaking procedures. The settlement also required that "the PSC shall ensure that the future impacts on rates are to be minimized to the maximum extent practicable."

The agreement did not place any restrictions on how LILCO used the rate increases. LILCO did not have to cut costs, and it did not have to use the rate increases to strengthen its balance sheet. The job of framing specific policy to constrain LILCO and minimize the impact on rates was left to the PSC.

The settlement gave LILCO immediate credibility with the financial community. Rating agencies upgraded LILCO's bonds, and deferrals under the phase-in plan enabled LILCO to report healthy earnings. Although cash flow remained weak, LILCO initiated an aggressive dividend policy, which it financed by borrowing.

For its part, the PSC implemented the target rate increases with little concern for LILCO's aggressive dividend policy or the shrinking Long Island economy. In late 1991 the PSC approved rate increases of 4.15 percent, 4.1 percent, and 4 percent for 1992, 1993, and 1994, respectively. These increases raised LILCO's average electric rate to 15.3 cents per kilowatt-hour (¢/Kwh) in 1994.

These last three rate increases produced a marked improvement in LILCO's cash flow. Free cash flow jumped $400 million, from negative $83 million in 1991 to $321 million in 1994. However, the dividend kept the balance sheet from improving, and the equity ratio stayed below 30 percent. Indeed, until 1994 LILCO continued to finance its dividends by borrowing. Between 1989 and 1994, LILCO borrowed $583 million to pay dividends, an amount that accounted for most of its $630-million increase in debt during those years (see table below).

The continuing balance-sheet weakness had the important secondary effect of keeping the PSC worried about LILCO's financial condition, which was no doubt why LILCO pursued such an aggressive dividend policy. The larger the dividend, the weaker the balance sheet, and the more willing the PSC was to raise rates. LILCO simply outwitted the PSC, and Long Island paid the price.

The Political Leveraging

In the midst of his 1994 campaign, Cuomo proposed a takeover of LILCO by the Long Island Power Authority (LIPA), a state agency dominated by public power advocates. LIPA would acquire all of LILCO's outstanding securities at a cost of about $9 billion, and it was claimed that tax-exempt refinancings would enable rates to be cut 10 percent.

The takeover was opposed by Cuomo's opponent Pataki, who championed competition as a means of reducing electric rates and labeled the takeover "corporate welfare." Pataki won the election, which killed Cuomo's takeover proposal. However, Pataki had committed himself to a rate reduction,which could have been accomplished in a pending rate case in which LILCO was requesting a rate freeze for 1995 and 1996, and a 4-percent increase for 1997. A rate reduction of 10 percent would have discharged Pataki's campaign promise and diffused any future takeover attempts by LIPA's public power advocates.

Pataki quickly remade the PSC. He elevated Republican Harold Jerry to the chairmanship and appointed a Republican colleague, John O'Mara, to the Commission. The term of Democrat Lisa Rosenblum expired in February, and Pataki allowed her to continue, but held the authority to replace her at any time. Pataki had put his stamp on the PSC.

Inexplicably, however, Pataki's PSC froze base rates for 1995 as LILCO had requested, but deferred its decision on rates for 1996 and 1997. The PSC's decision was driven by the continuing weakness of LILCO's balance sheet and a desire to ensure that LILCO had access to capital markets.

The PSC failed to consider the strength of LILCO's free cash flow, which was financed by $410 million that LILCO was allowed to collect from ratepayers

as a return on its Shoreham

intangibles. That same amount could have financed a 17-percent rate reduction.

The PSC completely ignored its obligation to minimize the settlement's impact on rates.

The LIPA Proposals

Cuomo's takeover plan would have provided investors with a windfall from a takeover, a point not lost on LILCO's management. LIPA would have bought LILCO's $4.3 billion of worthless Shoreham intangibles at book value. Investors would have been bailed out, and Long island residents would have been left holding the bag.

LILCO, of course, could not openly promote a takeover. Publicly it had to appear a cooperative bystander, but behind the scenes LILCO began to do whatever it could to induce major players to support a takeover. It has been very successful.

In June 1995, LIPA came forward with a second takeover proposal (em a somewhat more palatable version of the original proposal. This proposal marked a last-ditch effort by a lame-duck board of public power advocates. The state legislature had restructured LIPA, and in August a new 15-member board was to take over, with 9 members appointed by Governor Pataki, and 6 by the leaders of the State Senate and Assembly.

Pataki also opposed this takeover, and it appeared the proposal would pass quietly into oblivion. In July, however, LILCO won a key tax judgment that renewed the turmoil. Suffolk County and the Town of Brookhaven, where the Shoreham plant was located, had collected property taxes from LILCO on Shoreham while it was being built. Since the plant never operated commercially, the court found that these taxes had to be refunded to LILCO with interest. The judgment was for $78 million and covered 1976 to 1984. A pending case for later years threatens to bring the total refund to about $400 million.

LILCO was only the conduit for these taxes; the judgment represents a debt that some parts of Long Island owe to others. The obvious way to satisfy this debt is to reverse the original collection process by placing a tax on electricity sold in the areas that benefited from the original Shoreham taxes, and crediting the proceeds to the bills of all ratepayers. LILCO cleverly kept the politicians from focusing on the obvious solution.

LILCO now had the political weapon it needed to create sympathy for a takeover. LILCO played the villain by pressing for immediate payment of the judgment, which was seen as an attack on the town and county. The politicians were anxious to counterattack, and LIPA said it would not collect the refund if it took over LILCO. LIPA's promise of forgiveness was strongly endorsed by Brookhaven and Suffolk, and the wilting takeover bid took on new life.Candidates of both parties vied to take the strongest position in favor of the takeover.

Pataki's Intervention

While campaigning for Republican hopefuls on Long Island in early September, Pataki declared that any solution to "high electric rates on Long Island must include the end of LILCO." He went on

to say there would have to be "double-digit rate reductions for Long Islanders. . . . Right away." The Governor had unnecessarily taken direct responsibility for Long Island's electric rate problem. He had also committed himself to dismembering LILCO, which made little sense since the company provides satisfactory service, just at too high a price. Only a rate cut was needed, but Pataki apparently had a hidden agenda.

The Governor instructed the new LIPA board, appointed in August, to develop a plan to reduce electric rates. The PSC had effectively been taken out of the loop. Gone also was its expertise. The members of the new LIPA board had no appreciable professional experience in the electric power industry, though several had strong ties with the financial community. Not surprisingly, LIPA hired investment banker Bear Stearns as its consultant. Control of LIPA had shifted from public power advocates to financial dealmakers.

LIPA's plan, which Pataki announced and strongly endorsed, makes good on the Governor's promises for a double-digit rate reduction and a break-up of LILCO. Unfortunately, it makes little economic sense. It was prepared by investment bankers for the benefit of investment bankers.

The plan promises to cut rates 12 percent and then freeze them for five years. The cut rests solely on LIPA's ability to finance with tax-exempt bonds. To get the 12-percent rate reduction, however, LILCO would sell all of its assets to various parties.

LILCO would sell its $1.15-billion transmission and distribution system to LIPA for $6.7 billion, and would be operated under contract by a third party. This arrangement raises questions about service quality, since a contractor whose risk is limited to losing the contract would not have as much incentive to provide good service as a company whose equity is at stake.

LILCO's five steam generating plants would be sold to five power producers that would sell power to LIPA under five- or 10-year

contracts. These plants are expected to compete with each other eventually, but transmission constraints would no doubt give the plant owners too much market power for competition to be effective. Moreover, these plants are old and inefficient. LILCO has curtailed their operation in recent years, reducing their capacity factor from 55 to 35 percent in the last five years. These plants should be phased out; extending their lives with long-term contracts can only keep rates high.

Finally, the plan defers treatment of LILCO's investment in the Nine Mile Point 2 nuclear plant, whose overcapitalization could lead to a write-off of $3.50 per share. How much LILCO would be paid for its assets is thus unclear, and the possibility that LIPA's offer will prove unacceptably low has made LILCO apprehensive. However, a compromise is likely: LILCO has a minimum price it wants for

investors, and LIPA wants to make a deal to generate fees.

Meanwhile, the people of Long Island are being ignored, as LIPA has released precious few details. The takeover has garnered little support on Long Island, which makes its fate uncertain. Local organizations and people writing letters to the editor overwhelmingly oppose the proposal. Nevertheless, LIPA has threatened to start condemnation proceeding to get things moving. LIPA claims it has Pataki's "all-out support."

The Simple Solution

Long Island's main task is to find the most efficient way to provide high-quality electric service. Unfortunately the wrong questions are being posed. LIPA's proposals have been compared to arbitrary criteria such as Pataki's goals of a double-digit rate cut and the dismantling of LILCO. Instead, all viable alternatives should be considered, including the rates and service that would exist if LILCO remains independent, is efficiently managed, and is properly regulated.

The solution is not so hard to find: Long Island would be best served by an energetically managed LILCO, because electric rates can be cut more if LILCO remains independent than if it is taken over. LILCO can no doubt cut costs more than LIPA could, and would undoubtedly be able to take better advantage of the rapid technological change that is sweeping the industry. Moreover, it is easier to require investors to share the Shoreham burden if LILCO remains independent than if there is a takeover. Indeed, where LIPA could cut rates

12 percent, LILCO could cut rates 30 percent over three years without its viability being threatened.

Finding a way to keep LILCO independent may not be so easy, however. First, LILCO does not want to remain independent and is discreetly doing all it can to facilitate a takeover. It does not want to appear too efficient, has done little to prepare for competition, and offers no visible long-term plan. Although its chairman, William Catacosinos, is 66 years old, LILCO has announced no management succession plan. LILCO's stodgy image and high costs undermine the case for its independence by obscuring what a dynamic LILCO could accomplish.

Second, investment bankers and takeover specialists have entered the fray, and with huge fees at stake, Wall Street interests are lobbying strongly for a takeover. Third, Pataki has publicly

demanded the breakup of LILCO and endorsed LIPA's takeover plan. It may be his intention to curry Wall Street's favor by implementing a takeover, if possible.

On the other side, Pataki has good political reasons to avoid a takeover. LIPA's ability to provide good service is questionable, and its ability to cut rates limited. In fact, LIPA may not be able to cut rates on Long Island as much as competitive forces cut them elsewhere. Democrats in the state Assembly are introducing a bill on utility competition they say will cut upstate rates by 25 percent. If LIPA cuts rates 12 percent on Long Island and competition cuts them 25 percent upstate, the political fallout would be disastrous for Pataki.

One possible solution would be for Pataki to have the PSC reassert itself. The PSC still has not rendered a decision on LILCO's 1996 rates, which were left in abeyance by the 1995 rate order. If the PSC cut rates for 1996 by, say, 10 percent, it would show that it could cut rates more than LIPA, giving Pataki a convenient excuse to jettison the takeover. Otherwise the struggle will continue. Time will pass, rates will remain high, and Long Island will suffer. t

Charles M. Studness is a contributing editor of PUBLIC UTILITIES FORTNIGHTLY. Dr. Studness has a PhD in economics from Columbia University, and specializes in economics and financial research on electric utilities. He lives and works on Long Island.

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