How risky are utility investments today? Regulators have always faced this question when setting the return component of rates under traditional rate base/rate of return regulation. With major industry restructuring looming, risk issues have become proportionately more important and complex. California regulators, for example, have increased the return for the state's electric utilities to account for investor worries over the pace of restructuring in the "Blue Book" proceeding. Performance-based regulatory (PBR) reform efforts, new environmental regulations, and swings in interest rate trends have also been cited to support utility risk bonuses. Yet, in many cases, regulators have refused to award bonus adjustments, finding such changes to be well known and reflected in the standard financial models used in setting return on equity (ROE) (see box on page 44).

Nevertheless, regulators have acknowledged that restructuring might increase utilities' cost of capital. While finding that consumers might benefit from restructuring and competition at the retail level, the Connecticut Department of Public Utility Control (DPUC) advised careful consideration of "downside risks." In particular, the DPUC cited the potential for escalating financing costs and an increased risk of financial failure.

The possibility that shareholders might be left to cover high-cost investment stranded as a result of increased competition in the electric market has also figured in the ROE debate. At the same time, the question of whether investors assume the risk of paying for uneconomic utility investments has become a focal point in the policy debate over stranded costs.

Just What California Needed?

Over the past several years, the California Public Utilities Commission's (CPUC's) annual ROE proceeding has served as a forum for debate on the newest issues affecting the utility industry. Most recently, debate focused on added financial risk stemming from electric utility reliance on purchased power. This year, falling interest rates and electric industry restructuring took center stage. Specifically: Do utility investors deserve an increased return now that regulators intend to expose monopoly companies to increasing levels of competition? The CPUC added a bonus to its ROE award, finding that investors had not expected the restructuring to be pushed along at such a fast pace. Citing rising interest rates, the CPUC also increased ROE for the state's major energy utilities 70 to 120 basis points above the 1994 baseline ROE of 11 percent. (It had reduced ROE in 1993 based on predictions that interest rates would stay low.)

The risk associated with industry restructuring proved a more contentious issue. Utilities argued in favor of an investor bonus for risk, claiming that the "Blue Book" restructuring might 1) make recovery of economic assets uncertain; 2) prohibit cost-shifting among customer classes, resulting in rate and revenue concessions; 3) eliminate current balancing account protections; and 4) emphasize incentive ratemaking. As evidence of the rulemaking's financial downside, the utilities noted that 1) stock prices for California electric utilities had declined, and 2) credit-rating agencies and brokerage firms predicted increased risks. (In fact, after the CPUC approved the ROE increase, Moody's Investors Service downgraded the senior debt of California's three largest investor-owned electric utilities, citing intensifying competitive pressures in the state's electric industry.)

The CPUC rejected the utilities' analysis, finding the decline in stock prices unacceptable in estimating compensable risk for ratemaking purposes. It noted that prices rebounded after the initial reaction, and called the market's bumpy reaction a biased response to the investigation's "wake-up call." The CPUC concluded that the "Blue Book" proceedings changed the timing of investor risks but not their magnitude: Investors should have fully understood the scope and importance of competitive risks; however, they apparently believed the impact lay far in the future. The CPUC, therefore, found a separate upward adjustment of 0 to 20 basis points adequate to fairly compensate investors for possible but uncertain nondiversifiable risks.

The debate is far from over, however. CPUC president Daniel Fessler issued an artfully worded separate opinion that points out several areas of concern. First and foremost, approval of the increased ROEs would translate into higher rates for energy services. Quoting the CPUC's own statements in its restructuring proposal, Fessler emphasized that "a major goal of the restructuring" is to "lower the cost of electric service to California's residential and business customers." While not denying increased risks, Fessler said:

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"Commission decisions which translate into rate increases exacerbate rather than resolve this disparity. In addition to their damaging impact upon California's economy, rate increases, like a prescription of laudanum to one afflicted with dropsy, may well kill the utility patient with kindness."

Fessler added that care should be taken to avoid the impression that the CPUC might automatically roll over the increased ROE figures into PBR departure points. Fessler said such a move would "avail California nothing" if the starting point for measuring utility efficiency is "larded with excess exactions on our electric and gas service customers."

A Key to Stranded Investment?

Southern California Edison Co. (Edison) had argued that a separate ROE premium was needed because investor risks are "asymmetric" (em that is, the potential for investor losses is not balanced by a equivalent opportunity for investor gains. Under the traditional regulatory compact, a utility trades its ability to raise prices to market levels in exchange for the obligation to serve all consumers at a rate pegged to cost of service. However, if the cost of stranded investment is allocated solely to shareholders, the risk of doing business becomes asymmetric (em investors must pay if things turn bad, but cannot reap rewards if market position turns out better than expected. In addition, Edison argued that the CPUC's restructuring proposal imposes several other asymmetric risks: 1) increased competition will undercut rates and returns, 2) California utilities could offer retail wheeling before utilities in neighboring states, and 3) ongoing obligations to serve customers that leave the system may force utilities to build uneconomic assets.

The CPUC said that asymmetric risks did not warrant a bonus in the current proceeding, noting that share prices should drop if the opportunity for losses exceeds the opportunity for gains. The CPUC also said that Edison had failed to account for terms in the restructuring proposal that might offset the added risk of losses, such as the reduced exposure to reasonableness reviews. It added that Edison had overlooked its past willingness to account for asymmetry when justified, as it did while authorizing incentive ratemaking for telephone utilities. The CPUC concluded that "any asymmetries brought to utilities by competition in electricity markets are not new since the last cost of capital, but have long been incorporated into share prices."

This debate about balance and fairness has also surfaced as a key to whether regulators will shield ratepayers from responsibility for the cost of stranded investment. An Edison Electric Institute study argues that shareholders should not be held responsible for the cost of plant rendered uneconomic by a competitive market because utilities have not been able to raise rates to market-clearing levels when investment decisions turn out better than expected.1 On the other hand, a study prepared for the National Association of Utility Regulatory Commissioners (NARUC) argues that the answer is not so clear.2 The authors of the NARUC report suggest a review of past decisions to determine whether the "compact" between regulators and the utilities truly calls on ratepayers to shoulder all such costs. The study suggests that pre-investment decisions by regulators or post-investment requests by utilities might serve as evidence that the risk of market failure was known and assumed by the utilities and their shareholders. The NARUC study maintains that if no risk of loss were assigned to shareholders, regulators would set ROE at the level of a highly rated bond. t

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