8

procurement. (This change would seem to be a logical

outgrowth of the concept of integrated resource or least
cost planning.)

allow the utility to take advantage of leveraging by forming
a NUG which would sell power back to the utility under cost-
of-service regulation (and thus mitigate any problem of self-
dealing).

Finally, a utility that finds its rate base declining can simply use the cash flow generated by depreciation to buy back its own common stock and debt.6/ This practice has the effect of shrinking the size of the utility, but it maintains the amount of earnings per share. Buy-back is apparently a common practice for utilities today when cash flow from depreciation is not needed to finance new capital investment.

In summary, the declining rate base problem is neither likely to occur, nor insoluble if it does.

6/ Utilities recover depreciation in their rates as an expense.

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Attach
Pa

ANALYSIS OF DEBT LEVERAGING BY IPPS

One key issue in the debate over PUHCA reform involves d leveraging by Independent Power Producers (IPPs). Some oppon of PUHCA reform argue that debt leveraging creates an unfair advantage for a IPP when it competes with a utility to build capacity. They argue that debt leveraging gives an IPP a low cost of capital than a utility, and that the utility cannot u debt leveraging to match this. They argue that this advantag will allow IPPs to build much of the new capacity needed to demand, even though IPP power may be more costly.

This paper examines this argument and reviews the eviden The analysis approaches the question from the perspective of financial theory and from two empirical perspectives: 1) by comparing a range of actual costs of capital for utilities an NUGS, and 2) by simulating a competitive bid between a utilit and a NUG. The analysis indicates that leveraging may confer cost advantage to the NUG in some instances, but that the advantage is neither consistent nor inherent. In some cases, IPPs have a higher cost of capital than utilities.

This analysis indicates that one cannot argue against PU reform on the basis that debt leveraging gives a IPPs an unfa competitive advantage.

Financial Theory and Leveraging

Electric utilities typically have capital structures of about 50% debt and 50% equity. IPPS use debt in the 80 90 percent range or even higher. Because interest on debt is ta deductible, some have argued that debt leveraging lowers the IPP's cost of capital, and creates an unfair advantage over a utility. The question can be stated as follows: If an IPP ca build a plant for the same cost as a utility (under cost-of-service regulation), will the IPP be able to bid unde the utility's avoided cost solely because of it can use highe debt leverage?

Financial theory is ambiguous on whether leveraging increases the value and profitability of a firm. One school d thought maintains that the value of a firm is quite independer of its capital structure. This school would argue that a firm cannot simply swap debt for equity and thus benefit from the t deductibility of interest. Instead, the cost of both equity a debt rise as leveraging increases. Another school maintains t debt is always cheaper than equity. Firms should borrow as lo as lenders view the loans as "low risk". According to this vi there are optimal capital structures for different types of firms. Optimal capital structures would be determined by the

E

A

relative certainty of a firm's earnings and the tangibility of its assets.

Evidence: Weighted Average Cost of Capital

One empirical approach to the question at hand is to compare the Weighted Average Cost of Capital (WACC) for a utility and an IPP. WACC is a shorthand way of measuring how much it costs a firm to raise money for investment. It accounts for the mix of debt and equity, the profits that equity holders demand, the interest that debt holders demand, and the tax-deductibility of that interest.

13

Currently, utility stockholders require a return of 12 percent on their investment; bondholders require interest rates of about 9 - 10 percent. A plausible range for a utility's WACC is 9.3 to 9.5 percent. Given that IPPs are unregulated firms facing higher risks, stockholders require higher returns on the order of 15 - 20 percent. IPP bondholders also require higher interest rates in the 10 to 11 percent range. A plausible range for an IPP's WACC is 7.4 to 9.8 percent. These numbers are derived in detail in Table 1.

The comparison of WACCS indicates that some IPP's may have a cost of capital advantage over utilities, but that this advantage is not consistent or inherent. Moreover, a simple comparison of WACCS can be misleading. First of all, the WACC does not reflect the length of the loans to the two types of firms. Utilities can borrow for up to 30 years; IPPs typically borrow for 15-20 years. The fact that IPPs must repay debt over a shorter period makes them less competitive, holding all else constant. Second, the 80-90 percent debt financing of the IPP may underestimate the equity committed to the project. For example, equipment vendors may be forced to pay for construction cost overruns or make compensation if performance falls below specifications.

Evidence: Cash Flow Model

Given the simplicity and drawbacks of a simple WACC comparison, a more sophisticated analytic approach to the debt leverage question is needed. Committee staff developed a cash flow model that can simulate, in effect, a competitive bid between a utility and an IPP, while accounting for the fact that IPPS borrow for shorter terms. Tables and 3 gives a sample output from the model.

revenue

The model begins by calculating a utility's requirement for a plant costing $1000 (Table 2). An IPP attempts to compete with this plant. The IPP has the same fuel and O&M costs as the utility and bids a price component perfectly indexed to these costs. The IPP can build the identical plant for $1000

with its leveraged capital structure. The utility pays its "avoided capital cost" to the IPP in the form of any of severa payment streams with a present value equal to the present valu of the revenue requirement for the same plant. The model calculates the IPP's cash flows, coverage ratios, and return o equity for the payment streams (Table 3). If the IPP earns a return on equity higher than it's 15 20 percent minimum, the one can conclude that the IPP can underbid the utility (i.e., offer a price lower than avoided cost).

As was the case with WACC calculations, there is no one s of correct inputs for the this model, thus, various plausible sets of inputs have been used. The model indicates that in so cases the IPP could underbid the utility, but once again, this not a consistent or inherent result. The model also shows tha leveraging can increase an IPP's return on equity, but often t IPP would have trouble obtaining financing in the face of negative cash flow and poor coverage ratios (i.e., the ratio o revenue to loan payment).

TABLE 1

COMPARISON OF UTILITY AND IPP WEIGHTED COST OF CAPITAL (WACC)

Corp Tax Rate

=

348

==== WACC =====

PRE

COST OF EQUITY COST OF PREF'D COST OF
EQUITY SHARE PREF'D

DEBT

PRE- AFTER

TAX

SHARE

DEBT

SHARE

TAX

TAX

RETURN