Robert Rosenberg in his comment on our paper makes a fundamental error regarding financial risk. (Rosenberg, "Unbundling Capital Costs: It Doesn't Add Up," Nov. 1, 1997, p. 46, responding to Maloney, McCormick, and Tyler, "The Wires Charge: Risk and Rates for the Regulated Distributor," Sept. 1, 1997, p. 26.)
Rosenberg claims that as utilities spin off into separate wires and generating businesses, risk will increase in both lines of business. He writes: "The mere act of splitting the business apart will make each of the newly formed independent segments riskier in the future¼ By disaggregating, companies will lose the benefits of intracompany diversification and vertical integration."
This statement is wrong. There are no risk-reducing benefits of integration. The fundamental theorem of finance says that all the benefits of risk reduction can be achieved by investors diversifying their portfolio of securities. There is no additional effect created when firms integrate. (See E.F. Fama and M.H. Miller, The Theory of Finance, 1972.)
Even so, it is very tempting to argue, as Rosenberg does, that because integrated firms have lower risk, risk will increase when they split. Of course, integrated firms do have lower risk, but the point is that the total is equal to the sum of the parts. That is what the weighted average cost of capital is all about. The risk of the integrated utility can be decomposed into the risk of the wires and generation. The total risk assessed by the market for the integrated company must be a composite of the two parts because if they are separated, the financial market can always put them back together in an investor's portfolio. Corporate integration does nothing that financial integration cannot.
For instance, Rosenberg claims that the disaggregated distribution company will face risk arising from the obligation to be the provider of last resort. But how is this different from the current situation? The regulated, integrated utility is the provider of last resort. The fact that the integrated utility bundles the ownership of generation assets along with this obligation to serve does not reduce the inherent risk associated with being the default provider. Moreover, to the extent that owning generation assets can somehow offset the bad things that may befall a distribution company because of its default-provider obligation, investors can rebundle by owning shares in generation enterprises along with shares in the distribution company.
The same argument can be made about the impact of performance-based regulation and the threat of distributed micro-generation. These risks are already recognized by the market; they are already priced into the value of integrated utilities and do not have a larger impact on potential cash flows when they are specifically assigned to the wires segment of the business. True, one may argue that our assignment of risk between wires and generation assets is in error, but total risk is not higher when the utility divests wires and generation.
By the way, we think the compelling reason our allocation of risk between wires and generation is right is because every case of financial distress in the industry has been associated with generation assets and not distribution (or any of the other problems Rosenberg points to). Generation assets are relatively more risky than distribution assets.
The error made by Rosenberg is all too common; it is seductively and yet falsely intuitive. Possibly this is the reason that the Nobel Prize in Economics has been awarded to several financial economists whose contributions have helped dispel this notion. We should not overlook the last 50 years of scientific inquiry by financial economists that has given us a clear understanding of the relation between financial markets and operation of the firm.
Michael T. Maloney
Professor of Economics
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