Mitigating "Mandated" Rate Hikes


How to develop balanced revenue-backed financing to manage the impacts of governmental mandates.

Fortnightly Magazine - May 2007

Severe upward pressure on electric rates after a decade of stability has regulators, legislators, utility executives, consumer advocates, and myriad other stakeholders searching for solutions. Often this upward pressure on rates is associated with governmental mandates ranging from market-based supply requirements to renewable energy portfolios to mandates to build base-load power plants. In some regions, rate shock is occurring or is predicted, along with harsh economic and social impacts. The mandates often are a given. The challenge is meeting these mandates without the burden of large rate increases.

Revenue-backed financing (RBF) can mitigate many of these mandate-driven rate increases significantly. RBF programs must, however, be designed to eliminate the inefficiencies and inequities that can be associated with revenue set-aside programs. Without the proper incentives, either regulatory or market-based, these RBFs unintentionally may push the critical balance among the 3Rs of risk, responsibility and reward out of kilter, causing inefficiencies that threaten the sustainability of RBF generated savings.

Revenue-backed financing commonly is provided through bankruptcy remote debt instruments often referred to as Special Purpose Vehicles (SPVs), usually supported by pledges of non-by-passable and irrevocable revenue streams set aside for a particular use. RBF is similar to what often is referred to as securitization or even asset-backed financing, but has been renamed here to focus on its particular feature of revenue pledges and how there is a need to introduce incentives that create balance and avoid losses associated with inefficiency that generally have been overlooked. Although the bonds usually are rated “AAA,” the costs of the bonds may not be that much lower than those paid by a utility for other investment-quality bonds. RBF often is done off-balance sheet to protect existing utility investors from changes in the utility’s capital structure. The bulk of the savings from RBF come from changes in the capital structure that the guaranteed revenue stream permits. For example, the cost of a 100 percent RBF program today can be about 7 percent, while the tax-adjusted cost of financing a traditional 50/50 debt-equity utility capital structure is in the neighborhood of 13 percent. On $500 million base-load generating station, the first year’s savings could be about $30 million and $600 million over the life of the asset, assuming a 40-year useful life of the plant. This translates to rate relief of similar amounts.

The set aside of revenues by regulators for specific purposes is not uncommon. The rate covenants coupled with municipal guarantees that allow a municipal utility to finance all of its external capital needs with debt shows that the market has allowed the benefits of highly leveraged capital structures in the past when the debt repayment is adequately ensured. A fairly common revenue set-aside has been fuel adjustment clauses. Stranded costs recovered through irrevocable and non-by-passable charges were fashionable in the 1990s.

Unfortunately, these examples have at times produced imbalances between risk, reward, and responsibility. Municipal utilities frequently are accused of not having enough profit incentive to encourage efficient operations. Some fuel clauses made some utilities indifferent to power-plant performance, leading to capacity factors of base-load plants that were far lower than found achievable when performance incentives exist. Some stranded-cost recovery plans were based upon long-term forecasts without reconciliation between actual and forecasted stranded costs causing inequities. This experience demonstrates that there is a need to bundle RBF with either regulatory or market-based incentives to keep the risk-reward-responsibility paradigm in balance.

Will of the State

Governmental mandates on electric utilities are being focused upon because such utility action already has been required. Sometimes an RBF takes legislative enablement to allow the regulatory commission to irrevocably pledge certain assets. Given the need for legislative support, or just the serious step a commission must take to pledge resources irrevocably for an RBF, the existence of a mandate makes the application of RBF more applicable and palatable. Some of the recent mandates by state or federal governments that can be delivered more cost-effectively through the application of a balanced RBF include:

• Base-load power-plant development;
• Default-service responsibilities;
• Transmission and distribution reliability;
• Renewable or alternative energy portfolio requirements;
• Environmental-compliance mandates; and
• Demand-side resources.

This extraordinarily diverse list is not meant to be all-inclusive, rather a sampling of how balanced RBF can address some of the many existing mandates facing electric utilities. Each of these mandates can exert enormous upward pressure on a utility’s rates. The suggested solutions are designed to mitigate this pressure through a combination of upfront financial savings and ongoing cost-effectiveness incentives, which may be applicable in jurisdictions with or without retail choice. It is important to screen and rank the many opportunities to which a balanced RBF may be applied, as there may be a limited will by regulators, legislators, and the financial market to accept these programs.

Base-Load Mandates

Developing new base-load generation has been encouraged or mandated in certain jurisdictions. For simplicity, assume that the utility will own and build this plant. Some of these mandates have been supported by upfront guarantees of revenues, similar to the assurances necessary to support an RBF. The decision already has been made by the appropriate governmental authorities that this is the type of plant that should be constructed. The challenge is to get this asset built as inexpensively as possible while having that plant operated efficiently.

As noted above, financing a $500 million base-load generating plant at 100 percent debt of “AAA” RBF can produce first-year savings of $30 million (a reduction in revenue requirement associated with financing costs from $65 million to $35 million) and a 40-year life-cycle savings of $600 million compared with traditional utility financing. As there is no equity component in this example or any opportunity to revisit prudence in the future, the risks associated with the plant’s construction have been placed on the utility’s customers in exchange for the significant cost savings.

The creation of the RBF may create a balance between the risk and reward from the customer’s perspective, but what about the responsibility of the utility to build this project on budget and operate the plant efficiently? A construction incentive could be established by setting a cost cap where the utility and consumer share in all savings below an established target.

On the operating side, if the customer gets all the benefits, the responsibility-reward paradigm is seriously unbalanced. Customers may be getting all the benefits produced by the project, but are all the benefits being produced? Based upon decades of experience with fuel-adjustment clauses that produced massive disincentives to power-plant efficiency, the answer is an unambiguous “no.” The loss of 10 percentage points in capacity factor at a 500-MW unit could increase the cost of electricity by $10 million/year. The enormous savings of RBF must be coupled with an operating incentive. The exact nature of the incentive will depend upon many factors, including the facility being discussed, the overall risk-reward balance, wholesale- and retail-market structure, and jurisdictional restrictions. Potential approaches could include establishing benchmarks for capacity factor, heat rate, fuel prices, or market management and then allowing some level of a sharing if these benchmarks are exceeded. By balancing RBF with operating incentives, great financing savings can be achieved without sacrificing operational efficiency.

Meeting Green Expectations

Renewable energy or alternative energy requirements are being mandated in a growing number of states. Utilities and other load-serving entities are being required to meet an increasing portion of the retail electricity load that they serve with renewable (e.g., wind and solar) or other alternative resources (e.g., waste products as fuels such as waste wood or culm, or specific technologies such as ICCG). Sometimes load management and conservation and other demand-side resources (DSR) are included in these portfolios. Because of the vast variety of programs and potential business structures, one type of balanced RBF may not be universally applicable to all situations. When the utility owns the renewable or alternative resource being developed and the technology is a typical boiler plant, the paradigm set forth for base-load generation may be applicable.

But what type of an RBF can be used when the resource is owned by a third party and when the facility is powered by the sun or wind? Using RBF to fund a project like a wind farm owned by someone other than a regulated utility might start by the utility entering into a long-term contract with the developer for the project’s output, even before construction has started. At completion, using the utility’s pledge as collateral, the developer could refinance the project using RBF. The purchased-power agreement could require that a certain amount of power be delivered to the utility, with a portion of the revenues being set aside to repay the bond. The power would be priced to reflect the enormous savings in financing costs.

Advocates for renewable and alternative resources often cite the importance of long-term contracts with utilities to get attractive financing. The use of RBF just takes the concept to its logical conclusion, not only reducing the cost of capital, but improving leverage as well. Typically, the overall tax-adjusted cost of capital of merchant-generating plants is in the percentage of low to mid-20s. RBF can reduce this cost to about 7 percent at 100-percent debt financing and 10 percent if 20-percent equity still is retained in capital structure. In either case, the cost of the mandated project significantly is reduced by RBF.

Wires and POLRs

Default service responsibility is another mandate being placed on utilities in retail-choice states that may be implicit in other states. This mandate requires the utility, often with no generating facilities of its own, to meet electricity needs for customers not served by other load-serving entities. Regulators, wanting to protect the customers that are not active in the competitive market from volatile prices have at times further mandated that this electricity be provided at a known price.

A common approach being used to meet this mandate is annual or bi-annual supply auctions. Unfortunately, this requires that the utility buy power through the short-term futures market for electricity. Even in the well-organized PJM marketplace, research has found these markets to be extremely inefficient, charging huge risk premiums in the annual range of 10 to 15 percent over the spot market price, possibly a 5 to 7.5 percent increase in overall rates.

A relatively simple solution is for regulators to do away with these inefficient auctions and instead require or allow utilities to purchase all or most of their default-service power needs on the spot market. To protect customers from price volatility often associated with the wholesale electric spot market, these utilities should be allowed or required to establish an annual or bi-annual set of rates for these customers (or at least smaller customers) based upon forecasted spot prices and create a volatility protection fund.

The volatility protection fund (VPF) is a pot of money used to smooth out the costs experienced in the wholesale spot market. It is a self-insurance product that is much cheaper than the premiums for market-offered price hedges. The VPF can be created by issuing revenue-backed financing for the amount that is needed to smooth out volatility. The interest on the VPF would need to be secured by a dedicated revenue stream. Conservatively, the initial VPF might be 20 percent of the projected annual default service electricity purchase. When rates are higher than the actual cost, deposit the extra proceeds in the fund. When rates are lower than actual costs, take money from the VPF and pay the wholesale electricity bill. Balances in the fund could earn interest to reduce the cost of maintaining the VPF.

The cost savings can be enormous. Rather than paying an enormous premium for a short-term price hedge of around 10 to 15 percent, the cost of price stability could be less than 1 percent of the commodity cost of electricity. The efficiency of the marketplace is blended with an RBF to create balance. Both the utility and the customer are protected from market volatility and the customer gets the stable price that is desired at a much lower price than offered through short-term price hedges on the market. Unnecessary upward pressure on rates caused by the enormous insurance premiums associated with short-term future contracts is eliminated while still protecting selected customers from market-price volatility.

Meanwhile, transmission and distribution reliability have become an increasing concern in the wake of large-scale outages caused by relatively small mishaps and the threat to our nation’s infrastructure from terrorism. But how do we spend more on T&D reliability mandates without causing upward pressure on rates? One answer is T&D ring fencing, another RBF application. T&D ring fencing functionally separates the T&D assets and operations from the rest of the holding company and funds these assets entirely or nearly entirely with an RBF. The potential savings may be about one third of the revenue requirement needed to support the wires portion of a customer’s bill. This potential 15-plus percent decrease in overall electric rates can be used to temper the mandate-driven rate cases, whose impacts are being mitigated but not eliminated by these other strategies or used to fund or offset the cost of mandated T&D projects.

RBF of T&D assets can make the financing of new T&D reliability mandates cheaper and provide a large cushion for customers from the impact of associated rate increases. But as with other applications of RBF, this can strip the utility of the proper incentives to perform. To avoid this long-term pitfall, it may be necessary to insert some performance incentives into the risk-reward-responsibility balancing act. A loss of load or outage benchmarks would be possible approaches where the utility gets extra revenues when it surpasses a performance benchmark. As the structure here is not based upon the sharing of explicit savings, a cap on incentives earned should be considered.

Other Applications of Balanced RBF

Applications other than the ones mentioned above also should be considered, keeping in the mind the following principals.

Single Critical Purpose: The program should meet a critical need that is easy to understand.

Dedicated Revenues: A key element to RBF is that there be an irrevocable, non-by-passable revenue stream supporting it.

Lower Retail Rates: Financial strategies that don’t deliver rate relief are tough to sell.

Balance: Create balance among risks, rewards, and responsibility. Any regulatory structure that is significantly out of balance eventually will collapse.

Reconcilable: This has been the norm in many dedicated-funding applications and provides the consumer and regulator with additional comfort.

Benchmarks: The benchmarks used in any IBR should be reasonably achievable and changed slowly over time, unless found to be greatly out of kilter.

Balanced RBF can save a utility and its customers tens if not hundreds of millions of dollars as it moves to comply with governmental mandates. Achieving balanced RBF takes discipline and careful assessments of the mandates, the structure of RBF and the incentives that are supposed to keep it in balance. When successfully achieved, balanced RBF respects investors and customers and is good for all concerned—not just a grab-bag that helps someone at the expense of someone else. All stakeholders must work together to modify existing paradigms and secure the savings that balanced RBF can produce and that are within our reach.