New England Electric System (NEES) and the majority leaders of both houses of the Rhode Island Legislature have proposed legislation that would restructure the state's electric utility industry. The legislation provides for full recovery of all stranded costs, and phases in open access for all retail customers by January 2001. Although customer choice would come about relatively quickly, rates would not decline much in the near term because a transition charge shields NEES from most of the restructuring risk. Indeed, NEES may be able to earn more under the proposal than it would under traditional regulation.

Narragansett Electric, a NEES subsidiary, serves 75 percent of Rhode Island's retail load and buys power under an all-requirements contract from New England Electric Power, another NEES subsidiary.

Proposed Structure

Customers would receive the right to choose their own power supplier according to the following schedule:

s January 1998 (em Manufacturing customers with demand over 1,500 kilowatts (Kw) and all new customers with demand over 200 Kw

s January 1999 (em All manufacturing customers with demand over 200 Kw

s January 2000 (em 50 percent of remaining customers in each rate class

s January 2001 (em All remaining customers.

This schedule would accelerate if competition develops rapidly in the rest of New England. If consumers of 50 percent of the electricity in New England become eligible to choose their own power supplier at any time before January 2001, open access would be extended to all Rhode Island customers within six months.

The proposal separates generation, transmission, and distribution into distinct business entities, and requires the state's utilities to file four separate unbundled rates by January 1997: 1) a cost-of-power rate, 2) a transition charge, 3) a transmission rate, and 4) a distribution rate. The cost-of-power rate would apply only to customers that continue to purchase power from their native utility; those that choose an alternative supplier would negotiate with the supplier on price. The other three rates would apply to all customers, whether they choose an alternative supplier or not.

The transition charge collects a termination fee for NEES as compensation for releasing customers from their obligation to buy its power. The termination fee is equal to the sum of NEES's stranded investment, regulatory assets, nuclear decommissioning costs, and the present value of its uneconomic purchased power.

The stranded investment portion of the termination fee will equal the "net unrecovered capital cost of generating plants ... as of January 1, 1998," but explicitly excludes the operation and maintenance (O&M) expenses of generating facilities. Thus, all generating plant investment is treated as stranded investment, and NEES is responsible only for O&M expenses. This is tantamount to the state buying the generating facilities at book value, leasing them back to the company without charge, and paying for them with installments over 12 years, after which ownership reverts to the company.

The transition charge includes a return on the unamortized balance of the termination fee at a rate of one percentage point above the yield on long-term utility BBB-rated utility bonds, or about 8 percent. A low return offsets the residual value the generating facilities are expected to hold after 12 years, which would accrue to NEES. The transition charge is fixed at 3 cents per kilowatt-hour (¢/Kwh) for 1998 to 2000, declining to about 0.9¢/Kwh by 2010.

Rates for transmission and distribution would be governed by a price cap that holds them constant in real terms through 1999. However, the effects of extraordinary circumstances would be neutralized by a floor and ceiling. If return on equity (ROE) drops below 6 percent, a surcharge equal to the earnings shortfall would apply in the following year. Similarly, if ROE exceeds 11 percent, customers would be credited one-half the earnings in excess of 11 percent and all earnings in excess of 12.5 percent. After 1999 these rates would be subject to normal ratemaking.

Potential Financial Impact

The proposed legislation would protect NEES's earnings from most of the risks of restructuring. First, the transmission and distribution price cap would be adjusted for inflation, allowing NEES to capture all of the benefits of its productivity gains through 1999, and giving the utility incentive to innovate. Second, the transition charge provides for recovery of and a return on all nonoperating generating expense (depreciation and capital costs), albeit at a low current return of about 8 percent, as an offset to the residual value of the generating plant.

This leaves NEES at risk only for its O&M generating expense, which actually offers significant profit opportunities. Regulation would allow NEES to recover its O&M expenses without profit, no matter how high or low they were. Under the proposal, NEES would sell its power in the market, and earn a profit or sustain a loss depending on its O&M expenses. For those plants with unit O&M costs below the wholesale price, NEES would earn a profit. Where unit costs exceed the wholesale price, NEES would sustain a loss that could be limited to its fixed O&M expenses by stopping production. In the absence of fixed O&M expenses, stopping production would eliminate the loss.

NEES produces about 22 percent of its power with nuclear and hydro plants, whose combined unit O&M cost is 1.7¢/Kwh. NEES would earn a profit from these plants even at current wholesale prices of only 2.2 to 2.5¢/Kwh. Whether it would make a profit from all units combined would depend on its ability to eliminate losses from its higher-cost fossil fuel plants. However, once the current excess capacity passes, the wholesale price should firm, giving NEES excellent profit opportunities from generation.

The longer-term earnings impact of the proposal will also depend in large part on how well NEES is able to redeploy the stranded costs it recovers. On a system basis, NEES would recover about $1.2 billion in stranded investment and $0.6 billion in regulatory assets. If NEES earns a higher return on these funds than it would have earned under regulation, the redeployment would benefit earnings.

Potential Rate Impact

While the proposal's long-term impact on electric rates could be large, rates will probably not decline much for a number of years. For instance, if the wholesale price of power reaches 3¢/Kwh after 2000, the rate for those choosing an alternative supplier would only have dropped about 10 percent, to 8.5 cents, five years from now.

NEES has probably negotiated the most favorable plan it could. However, most states are unlikely to allow a utility to recover all of its stranded costs. Nor is it likely that customers will be patient enough to wait so long to reap the benefits of competition. NEES's success with this proposal derives in large part from negotiating directly with legislators who could not match its expertise.

The lesson for utilities is to seek restructuring settlements out of the public view, preferably with parties that normally do not work with utility matters. The lesson for customers is to demand open negotiations that involve evidentiary hearings and participants with as much expertise as possible. 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.

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