Financial Impacts of Nonutility Power Purchases on
Investor-Owned Electric Utilities

By purchasing power, the investor-owned utilities substitute for or postpone the requirement to build capacity.² Nonutility owners contend that this option to “buy” power enables the utilities to retain financial flexibility. Bond-rating agencies, however, treat fixed payments associated with power purchase contracts analogously with a utility’s long-term debt. When power purchases by a utility become significant, i.e., greater than 10 percent of their capacity or total sales, bond-rating agencies add some portion of the fixed payment obligations to the utility’s existing debt to compute its total long-term debt liability. This process has the potential of adversely affecting a utility’s capitalization structure and also its interest coverage ratios. These adjustments may cause its bond-ratings to be downgraded leading to an increase in its cost of capital.

Section 712 of the Energy Policy Act of 1992 (EPACT) required State regulatory authorities to consider the need to adopt four new rulemaking standards regarding the purchase of wholesale power by amending Section 111 of the PURPA regulations. The new standards include an evaluation of: (1) the effects of long-term wholesale power purchases on utility cost of capital and on retail rates, (2) the effects of leveraged capital structures on the reliability of the wholesale power sellers, (3) whether to implement procedures for the advance approval or disapproval of long-term power purchase contracts, and (4) whether to require the assurance of adequate fuel supplies before approval of power purchase contracts. EPACT further stipulated that consideration of these issues be completed by October 23, 1993.

Most State regulatory authorities have completed the required evaluations. Of the States that have completed the evaluation process, with one exception, all rejected adopting the Section 712 standards on the ground that adopting standards that would hold good for all future contingencies would be difficult to attain. The States believe that they have adequate authority under the existing legislation to look into areas of concern within the framework of either integrated resource, least-cost planning procedures, or ratemaking hearings. None of the States minimized the relevance of the issues raised but they conceded that it would be more appropriate for them to retain the flexibility to examine issues on a case-by-case basis rather than adopt ad hoc standards.

The relevance of Section 712 requirements lies in drawing attention to various issues that follow from power purchase contracts. This analysis report examines and evaluates the financial impacts of long-term power purchases by investor-owned utilities from non-utility generators. The starting point of this analysis is an overview of the financial developments affecting the investor-owned utilities during the 1980s. The analysis shows that the 1980s generally ushered in a period of financial recovery, rehabilitation, and growth for the investor-owned utilities.

Two different approaches are used to evaluate the financial issues associated with power purchases. First, two composite and comparable data sets—one comprising investor-owned utilities with significant power purchases from nonutility generators and the other without such purchases, are created by abstracting data from FERC Form 1 for the 1986-1992 period.³ Various financial ratios, derived by using composite financial data for the two groups, are compared to determine if there are performance differences between them. The intent is to assess whether there is an emerging trend in key financial and performance ratios that show differences between the two groups that can be attributed, in part, to purchased power contracts and in particular to nonutility generators.

The second approach analyzes the same problem from the perspective of equity markets. The underlying assumption is that if power purchases from nonutility generators in fact add to the riskiness of a utility and raise its cost of capital, then this phenomenon should be observable in the equity market as well. A general econometric framework in which to examine relevant determinants of the utility cost of capital is defined to perform the analysis.

The first analysis, i.e., a comparative financial analysis of two investor-owned groups with and without power purchase contracts for the period from 1986 through 1992 shows that:

• Capitalization ratios ⁴ for the two groups did not materially differ.
  
  
• The data did not support the hypothesis that utilities with significant power purchases incurred a higher cost of capital than did the utilities without such a commitment. In fact, the evidence shows that utilities with little or no power purchase commitments had to bear a slightly higher cost of capital in comparison with the cost borne by the other group.
  
  
• In the area of allocation of earnings between debt and equity, utilities with significant power purchases paid slightly more for interest expenses than those without such purchases. However, it could not be determined whether the observed minor disparity resulted from power purchases.
  
  
• Utilities without power purchases had a higher share of operating income as a percentage of operating revenues than the utilities with power purchases. Although utilities do not earn a return on power purchase expenses, difficulties exist in attributing the difference in operating income exclusively to power purchases.
  
  
• Utilities with significant power purchases charged a higher rate per kilowatthour of power sold. This disparity may be attributed to their location in high-cost generation areas (i.e., New York and California).
  
  
• Utilities with significant power purchases were found to also have more capital investments than the other group.

The results indicate that nonutility power purchases did not raise a utility’s cost of equity capital. In fact, there was more evidence to support the notion that utility construction raises the cost of capital more than nonutility power purchases do. If these results are correct, then the debate about the debt equivalence of fixed payments for power purchases reflects more on the distribution of income between debt and equity owners, rather than on the cost of capital.

Overall, based on the available financial data using two different approaches, there is no conclusive evidence that power purchases from nonutility generators raised the cost of capital to the utilities which purchase the electricity.

End Notes

Contact:

Suraj Kanhouwa

SKanhouw@eia.doe.gov

Phone: (202) 287-1919