When an electric utility invests in a resource to serve its customers, it does so with the belief that the asset underlying the investment can be pledged as collateral to secure debt capital. But what happens if the asset is not owned by the company and, therefore, provides no collateral? The following situations illustrate:

Situation A

Electric utility "A" chooses to build a small generating plant to meet the future needs of its growing customer base. It secures project financing for the new plant. Once the unit becomes operational, utility A pledges the asset as collateral to obtain permanent, lower-cost financing.

Situation B

Electric utility "B" also enjoys a growing customer base, but chooses to meet part of its future needs by suppressing electric usage through investment in a demand-side management (DSM) energy-conservation program. Unlike utility A, utility B does not own the asset underlying its investment (em its customers do, through grants to install energy-conservation measures in their homes and businesses. Since the utility does not own the asset, there is no collateral to support lower-cost financing.

In the not-so-distant past, situation B would have posed little concern. State regulators would have conducted a prudence review for the conservation investment. Following approval, they would have added costs to the rate base and allowed amortization over the appropriate time period, giving the utility an opportunity to recover its investment. But in today's environment, lack of ownership of a DSM asset raises concerns not present in construction of a generating plant.

With a DSM investment equal to approximately 7 percent of its assets, Puget Sound Power & Light Co. qualified as utility B. How could it finance an asset it did not own? How could it ease the financial community's increasing concern about the ultimate recovery of $240 million in DSM investment? Three years ago, the company began to grapple with these issues. At the time, no attractive solution lay in sight.

Then Puget Power went to the Washington State Legislature with an idea: Since the legislature had consistently supported DSM as a resource solution, would the state now legislate statutory recovery of conservation? With such support, utilities could finance DSM investment in a manner similar to municipal financing, which is supported by statutory taxing authority.

In June 1994, a new statute was signed into law after winning near-unanimous support in the state legislature (see sidebar, From the Legislature). Puget Power then began working with Salomon Brothers, Inc. and Chemical Securities to structure a transaction, and sought the support of the Utilities and Transportation Commission (UTC) staff and the Public Counsel Section of the State Attorney General's Office. On May 1, 1995, the UTC issued an order giving its approval of the transaction (see sidebar, From the Commission).

The Transaction

The statute enacted by the Washington legislature created a new property right, known as "bondable conservation investment." Under the new law,

customer rates must be allowed to recover DSM-related expenditures (em along with the costs of financing (em once they are approved by the UTC. Essentially, the new law allows electric utilities to convert a regulatory promise of cost recovery into a statutory right to recovery. Most important, this secured revenue stream may be sold, pledged, or assigned as the basis for issuing securities.

On June 8 of this year, Puget Power completed the first-of-its-kind transaction under the statute. Specifically, the transaction established the Puget Power Conservation Grantor Trust, involving a true sale and transfer to the trust of $202 million of its $240 million in DSM investment assets, and the sale by the trust of certificates to outside investors. The proceeds from the sale provided an infusion of cash to repay existing securities.

Because of the statutory right to recovery and other protections, the trust certificates were rated AAA by Duff & Phelps, Fitch, and Standard & Poor's. Moody's rated the issue Aa-2. These credit ratings and favorable capital market conditions led to a 6.45-percent certificate rate, taxable to investors. The transaction reduced the cost of conservation by more than $36 million when compared to financing at the utility's authorized overall cost of capital.

Investment bankers and analysts familiar with the financing arrangement think there may be other benefits down the road. Salomon Brothers, the lead manager for the financial transaction, noted in a June 1995 informational release:

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"We believe that this approach is a timely one given the industrywide discussion of stranded assets and accelerated depreciation of selected assets. Puget [Power's] ability to monetize its largest regulatory asset through this transaction has been very favorably received by the rating agencies and by equity analysts."The Groundwork

The history of this unique trust fund began modestly in 1978, with the installation of energy-saving devices on customers' property. After nearly two decades of dramatic customer growth, Puget Power found itself in a resource-deficit position, and residents of the Pacific Northwest widely agreed that energy-conservation measures made plain good sense. Indeed, the Pacific Northwest Electric Power Planning and Conservation Act of 1980 designated cost-effective conservation as the resource of choice for the region.

Puget Power's commitment to energy conservation meant that the building of new generating plants could be deferred. The UTC demonstrated its support by allowing the company to recover and earn a return on its conservation investment under a theory Benjamin Franklin would have approved: A kilowatt-hour saved is a kilowatt-hour earned.

Over time, Puget Power's DSM program became more ambitious and sophisticated. Organizations such as the Northwest Conservation Act Coalition and the Natural Resources Defense Council recognized the company's efforts as exemplary. Energy-conservation grants by Puget Power to its customers expanded well beyond the earlier residential measures of water-heater wraps and insulation. By 1988, Puget Power had shifted its focus to new construction markets, offering technical assistance, training, and financial incentives to builders of new residential structures that incorporated energy-efficiency measures and designs. Puget Power also

targeted commercial and industrial projects, energy-efficient lighting, building insulation, and electrical energy-efficiency improvements, such as HVAC (heating, ventilation, and air conditioning) equipment and energy-management controls upgrades, heat pumps, heat recovery, refrigeration, variable speed motor drives, lighting system modifications, and process efficiency improvements. All combined to benefit the company, its customers, and the region.

The DSM program also effectively suppressed the kilowatt-hour sales from which the company normally derived its revenues. The disincentive associated with lost margins was recognized by the UTC, which in 1991 approved an annual adjustment mechanism that permitted dollar-for-dollar recovery for approved DSM investment in addition to recovery of fluctuations in power costs. The periodic rate adjustment mechanism (PRAM) replaced kilowatt-hour-based revenues with revenues based on the number of customers served. This decoupling was critical since Puget Power was spending $50 million and more annually on conservation.

Blue Book Fallout

As annual investment in DSM grew, so did Puget Power's regulatory asset (em an asset that could not be pledged as collateral for the issuance of securities. In principle at least, one could say that the company's DSM program had been funded entirely with equity. However, under traditional cost-of-service regulation, DSM was included in rate base and recovered through rates as if financed at the utility's authorized weighted average cost of capital.

When the California Public Utilities Commission issued its "Blue Book" in early 1994, proposing to allow customers to choose their electricity provider, major credit rating agencies and equities analysts changed their views about the pace of increasing competition and deregulation. As Moody's

Investors Service noted in an April 1994 special research report:

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"Beyond California, we anticipate that industrial customers, in anticipation of the spread of retail wheeling, will increase their leverage in their negotiations with their own electricity providers for lower prices. In addition, other state regulators may feel pressured by the increased pace of deregulation."Because independent power producers, wholesale power marketers, and other nonutility providers do not bear costs associated with public-policy objectives, utility regulatory assets quickly attracted the scrutiny of the capital market. Puget Power as quickly turned a weather eye to its credit rating.

Puget Power's solution was to secure legislation that would provide a statutory basis for recovery of its largest regulatory asset, easing financial community concerns regarding ultimate recovery of its DSM investment. In turn, the cost to customers of financing the outstanding DSM investment was dramatically reduced.

The book on Puget Power's ability to recover rate-based DSM investment is thus closed. But, for other utilities with regulatory assets or more serious stranded-investment concerns, a new chapter may be unfolding. t

Andrea L. Kelly is a policy research specialist on the staff of the Washington Utilities and Transportation Commission in Olympia, WA. Donald E. Gaines is the treasurer for Puget Sound Power & Light Co. in its Bellevue, WA, headquarters.From the Legislature The 1994 Washington state law creates new classes of property known as "conservation investment assets," "bondable conservation investment" (BCI) and "conservation bonds." When an electric, gas, or water utility incurs specific expenditures under a "conservation service tariff," the law provides a statutory guarantee of rate-base inclusion (investment and carrying costs) and revenue recovery ("sufficient to recover BCI and the costs of equity and debt capital associated with it"). BCI includes all expenditures for conservation measures that improve efficiency of energy or water consumption if:

(1) the utility could not otherwise mortgage the conservation assets

(b) the utility incurs the expenditures under a conservation tariff, and the UTC finds the costs prudent

(c) a prior rate order added the costs to rate base--not current expense

(d) no proof was required of a given level of energy savings.Source: Wash. Rev. Code. Ann., secs. 80.28.005, 80.28,303, 80.28.309.From the Commission This is a case of first impression and we appreciate the thoughtful work of each party....

"The amount of the Company's unamortized conservation investment being recovered in rates... can be designated as bondable conservation investment ... [if] the commission had determined these expenditures to be prudently incurred ... in prior general rate increase proceedings....

"The Company is authorized to defer the actual transaction costs....

"Transaction costs... shall be subject to review in the Company's next general rate proceeding; provided, however, that any adjustment shall be prospective only,--i.e., shall be effective only as to the unamortized balance of such transaction costs at such time." Source: Re Puget Sound Power & Light Co., Dkt. No. UE-950195, May 1, 1995, 162 PUR4th 635, 637, 640 (Wash.UTC).

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