In my recent blog post, Options, I discussed the four options that will be considered as regulators and legislators deliberate over the fate of the PSNH power plants. One of these options is to compel PSNH to sell their generating assets and to complete the process of electricity deregulation in NH that was started in 1996. This would make the electricity supply market in NH a fully competitive one. In this post, I examine how this might be done, what the consequences will be for the PSNH customers, and how they will end up picking up the tab for the PSNH power plants.
As laid out in the discussion of the public utility regulatory compact in an earlier post, a State provides an electrical utility with a monopoly to provide service in a specific area so that it can make the large-scale investments it needs to provide us with safe, reliable and reasonably priced power. Once they do so, they are entitled to recover the cost of the investment and earn a guaranteed return on those investments over the life of the projects - which can some range from 20 to 30 years, and even longer in the case of nuclear power plants.
Consider the following highly simplified example by way of illustration. If an electrical utility agrees to invest $1 billion in a new power plant and receives approval from the Public Utilities Commission (PUC), they would go out and borrow the $1 billion, perhaps at a cost of 5%. Then, once the plant is built, the utility would, over time, recover the $1 billion through a depreciation charge and they would assess a return on their investment. This return would, of course, be higher than the 5% which is their cost of borrowing. Let's assume the plant has a 25-year life, so the depreciation amount would be $40 million per year ($1 billion divided by 25), which would be passed on to the ratepayers as part of the price for electricity supply. Moreover, the utility would also be entitled to earn a return on its investment. Assuming the public utility regulators agree to a 11% return (which is close to what PSNH presently earns), that first year the utility would earn $110 million (11% of $1 billion) which they would recover as a rate base charge that is a component of the all-in costs for electricity paid by their customers.
In Year 2, the depreciation from the first year is subtracted, leaving $960 million ($1000 million - $40 million) of undepreciated value which then becomes the basis for the 11% return on the rate base in the second year. In this year the return would be $960 million x 11% or $106 million. With this approach, the utility recovers its initial outlay via a depreciation charge over the life of the power plant, and it earns a return on its investment via the rate base charge.
It is important to realize that the utility's return on the rate base is not all gravy and it doesn't all go to its shareholders. The utility borrowed that $1 billion and it needs to pay its lenders their annual interest rate, which we assumed to be 5%, so the utility's net return on the invested capital will be 6%.
On top of these depreciation and rate base returns, the utility charges their customer for the cost of fuel – natural gas, coal or oil – as well as the operating and maintenance costs, the salaries for the workers, the property taxes and all other small charges associated with running an operation generating electricity. All these charges are summed and then divided by the number of kilowatt hours (kWh) of electricity produced. This yields a price per kWh for electricity which, after review and approval by the PUC, becomes the rate that the utility charges its customer for electricity supply.
In my last post, I shared a chart which showed the various costs components, including depreciation charges and rate base returns, for the 2012 electricity supply from PSNH. Electricity rate setting is an intriguing topic and it is perhaps something we could cover in a future post.
But, let's now return to the topic at hand: what will happen should PSNH be compelled to sell off their generating assets? The key numbers in this case are shown in the figure below, which breaks out the various values that will be considered in this matter. The top number, $674 million, is the total book or undepreciated value of PSNH assets as of 2012. The original value before the depreciation charges was $1.1 billion according to the Northeast Utilities 2012 balance sheet. My assessment of the book value is that it consists of $422 million associated with the mercury scrubber installed on the Merrimack power plant a few years ago and the remainder, $252 million, is the undepreciated value for the rest of the generating assets A list of these generating assets, which include coal-fired, oil-fired and hydro operations, was provided in my last post.
Step 3: PSNH sells its right to collect stranded costs from PSNH ratepayers to the SPE.
Step 4: The SPE funds the purchase of stranded cost obligations from PSNH by selling bonds to investors such as banks, insurance companies and other financial institutions. For those not financially inclined, a bond is essentially an IOU agreement that is set up between two parties. One party lends an agreed amount of money and the other commits to pay back the borrowed amount at some time in the future but also to pay a fixed interest rate every year. In this case, the security for the IOU would be the stranded costs obligations that PSNH can, by law, collect from its ratepayers.
This securitization process accomplishes two objectives: PSNH gets its money right away and it can return the funds it to its shareholders or use it for new projects, and the risk associated with the stranded costs is passed onto a new group – the bondholders in the SPE.
As laid out in the discussion of the public utility regulatory compact in an earlier post, a State provides an electrical utility with a monopoly to provide service in a specific area so that it can make the large-scale investments it needs to provide us with safe, reliable and reasonably priced power. Once they do so, they are entitled to recover the cost of the investment and earn a guaranteed return on those investments over the life of the projects - which can some range from 20 to 30 years, and even longer in the case of nuclear power plants.
Consider the following highly simplified example by way of illustration. If an electrical utility agrees to invest $1 billion in a new power plant and receives approval from the Public Utilities Commission (PUC), they would go out and borrow the $1 billion, perhaps at a cost of 5%. Then, once the plant is built, the utility would, over time, recover the $1 billion through a depreciation charge and they would assess a return on their investment. This return would, of course, be higher than the 5% which is their cost of borrowing. Let's assume the plant has a 25-year life, so the depreciation amount would be $40 million per year ($1 billion divided by 25), which would be passed on to the ratepayers as part of the price for electricity supply. Moreover, the utility would also be entitled to earn a return on its investment. Assuming the public utility regulators agree to a 11% return (which is close to what PSNH presently earns), that first year the utility would earn $110 million (11% of $1 billion) which they would recover as a rate base charge that is a component of the all-in costs for electricity paid by their customers.
In Year 2, the depreciation from the first year is subtracted, leaving $960 million ($1000 million - $40 million) of undepreciated value which then becomes the basis for the 11% return on the rate base in the second year. In this year the return would be $960 million x 11% or $106 million. With this approach, the utility recovers its initial outlay via a depreciation charge over the life of the power plant, and it earns a return on its investment via the rate base charge.
It is important to realize that the utility's return on the rate base is not all gravy and it doesn't all go to its shareholders. The utility borrowed that $1 billion and it needs to pay its lenders their annual interest rate, which we assumed to be 5%, so the utility's net return on the invested capital will be 6%.
On top of these depreciation and rate base returns, the utility charges their customer for the cost of fuel – natural gas, coal or oil – as well as the operating and maintenance costs, the salaries for the workers, the property taxes and all other small charges associated with running an operation generating electricity. All these charges are summed and then divided by the number of kilowatt hours (kWh) of electricity produced. This yields a price per kWh for electricity which, after review and approval by the PUC, becomes the rate that the utility charges its customer for electricity supply.
In my last post, I shared a chart which showed the various costs components, including depreciation charges and rate base returns, for the 2012 electricity supply from PSNH. Electricity rate setting is an intriguing topic and it is perhaps something we could cover in a future post.
But, let's now return to the topic at hand: what will happen should PSNH be compelled to sell off their generating assets? The key numbers in this case are shown in the figure below, which breaks out the various values that will be considered in this matter. The top number, $674 million, is the total book or undepreciated value of PSNH assets as of 2012. The original value before the depreciation charges was $1.1 billion according to the Northeast Utilities 2012 balance sheet. My assessment of the book value is that it consists of $422 million associated with the mercury scrubber installed on the Merrimack power plant a few years ago and the remainder, $252 million, is the undepreciated value for the rest of the generating assets A list of these generating assets, which include coal-fired, oil-fired and hydro operations, was provided in my last post.
From the book value of $674 million, I have subtracted the value that PSNH might realize from the sale of their various power plants. I have optimistically assumed a value of $200 million - which leaves us with approximately $474 million of what are termed "stranded costs".
These costs are termed "stranded" as they represent the value of the assets on which PSNH can no longer earn a return nor can they recover their investment via depreciation charges due to utility regulation changes. Nevertheless, PSNH is still responsible for interest payments and paying down the debt they incurred when they purchased and installed the assets many years ago.
These costs are termed "stranded" as they represent the value of the assets on which PSNH can no longer earn a return nor can they recover their investment via depreciation charges due to utility regulation changes. Nevertheless, PSNH is still responsible for interest payments and paying down the debt they incurred when they purchased and installed the assets many years ago.
I had also noted previously that there is presently a prudency review underway that will determine if PSNH should have spent $422 million on the mercury scrubber at the Merrimack plant when the original budget was $250 million. If it is determined that PSNH was unwise in spending that amount of money, the New Hampshire PUC will make a determination that only part of those costs should be part of the book value for PSNH generating assets and the stranded costs will decrease commensurately.
It is unlikely that PSNH would agree with such a decision. We should not forget that PSNH, through its parent, Northeast Utilities, is a for-profit publically traded company that has an obligation to its shareholders to ensure steady dividend returns and an increasing share value and it is only to be expected that they will mount a legal challenge to the NHPUC scrubber value determinations as any write-off of assets would have a significant effect on their profits and lead to a bunch of unhappy shareholders. In the legal battle will that will ensue, the NH Courts may end up determining the final value of the Merrimack scrubber project. In the process, millions will be spent on lawyers, consultants and expert witnesses, time will drag on, rates for PSNH energy supply customers will continue to be high and the value of the coal-fired power plants will continue to diminish. From my perspective, this seems rather inefficient compared to getting everybody involved around a table for a few days to hammer out a compromise: things might get done faster, a great deal of money would be saved and the PSNH ratepayers would be better served.
Let's assume, for the sake of illustration, that a determination is made that the scrubber project is only worth the original $250 million. PSNH would have to take a haircut of $172 million and write down the value of the assets. In this case, the numbers would be those shown in the diagram below.
Now the total book or accounting value would be $502 million, which would consist of $250 million for the value of the scrubber and $252 million of undepreciated value for the rest of the generating assets. From this, we subtract the $200 million that PSNH might realize from the sale of the assets which leaves us with approximately $302 million. This will be the amount due to PSNH for their stranded costs. The question now becomes: Who writes that check? As it turns out, the unpleasant answer is that all PSNH customers will end up paying for the stranded costs, as will become clear in the explanation that follows.
PSNH has approximately 500,000 customers and, for the purposes of simplification and illustration, let's assume they are all equal. That means each rate payer would have to send PSNH a check for $604 to cover their portion of the stranded costs. PSNH will want that money as soon as possible so that they can invest the $302 million into another project to start earning a return or return the money to its shareholders. It is unlikely that PSNH customers are going to be rushing for their check books to write a $604 check payable to PSNH. One alternative would be for PSNH customers to pay down this amount over time through their electricity charges and also pay PSNH their expected 11% interest. Essentially PSNH would be lending the $604 to each of their rate payers, and they would expect to earn a return on that loan. If we assume the payments are spread over 10 years, this means that each rate payer would be paying an extra $8.32 per month to PSNH for the next 10 years to cover the stranded costs. In kilowatt hour terms, and taking into account that PSNH distributed 7821 Gigawatt hours of electricity in 2012, this would equate to surcharge of ~0.6 cents for every kWh of electricity distributed by PSNH.
In these days of low, single-figure interest rates, 11% is a very high interest rate to pay on a loan. Many of you might be asking whether is it not possible to refinance this amount at a lower interest rate, just as we would do on our home mortgages?
Well, this is exactly what would happen should the regulators and legislators steer PSNH ratepayers down this road. There are many financial institutions that would be willing to lend PSNH customers the $302 million at a lower interest rate, especially if they can be assured, by law, that PSNH ratepayers are obligated to pay down the debt over a fixed time period and that there is no way to avoid the obligation.
This refinancing of the stranded costs is done through a process called securitization, which is a series of financial deals in which debt obligations, such as mortgages, are sold to another party and are pooled with similar obligations. This pool of obligations is then sliced and diced and sold to a new set of investors who pay for the pieces in order to earn a return on their investment that would, in this example, come from principle and interest payments that each homeowner with a mortgage makes every month.
The key aspects of securitization are
- The transference of risk from the original party that held the obligation to a new group of investors.
- The original party gets their money back right away so they can invest it in new projects.
The way that securitization would work with stranded costs is via the following steps:
Step 1: The regulators, with legislative approval, would establish a financing order which will give PSNH the right to impose, bill and collect stranded costs from its ratepayers. The stranded costs become an asset on the PSNH balance sheet which replaces the $674 million for the generating assets.
Step 2: A new financial company, called a special purpose enterprise (SPE), is set up.
Step 5: Using the revenue from selling these bonds, the SPE will pay PSNH for the stranded costs so PSNH gets a cash payment, it no longer has the asset on its books and it can take the money and return it to its investors.
Step 6: Every month the stranded costs payments from the individual rate payers will be passed through PSNH to the SPE, which will use these payments to pay the interest on the bonds and eventually the principal amount back to the bond holders.
This securitization process accomplishes two objectives: PSNH gets its money right away and it can return the funds it to its shareholders or use it for new projects, and the risk associated with the stranded costs is passed onto a new group – the bondholders in the SPE.
The risk issue is an important one and, quite frankly, this is not a very risky investment for the bond holders. PSNH customers will be mandated by law to pay for the stranded costs so the risk of 500,000 ratepayers not paying up is low. (There is, however, the possibility that future lawmakers in NH would not feel constrained by these obligations and could choose to overturn them, but this is little different from the risks that lenders to public utilities are presently exposed to.)
With a steady stream of monthly payments from a large group of customers that are mandated by law to pay for the stranded costs through their electricity rates, this is indeed a low risk investment and, as a result, the bond investors would be willing to accept a much lower interest rate than the 11% PSNH would expect. In our present low-interest environment, I believe investors in these bonds would be willing to accept interests rates of 5% or perhaps even lower. Costs for funding would also be significantly reduced by the fact that interest on debt is tax deductible, exactly like your mortgage, which further reduces the cost of borrowing.
What we would then have done through securitization is refinanced that $302 million obligation to PSNH, which carried an interest rate of 11%, to one with a 5% interest rate. In the process, the monthly payments for PSNH ratepayers will drop from $8.37/month to $6.41, or from 0.6 to 0.5 cents per kWh, which is a 23% reduction in the monthly stranded cost obligation for all PSNH ratepayers. So by issuing lower interest rate bonds through the SPE, stranded cost recovery amounts charged to PSNH ratepayers will have decreased – hence the name: rate reduction bonds. In reality, these rate reduction bonds will actually result in additional tariffs on all PSNH ratepayers, but the amount is lower due to refinancing. It is important to note that the numbers I have calculated are presented for illustration of these concepts only and that the final numbers could be quite different depending on the outcome of the prudency review, the final stranded costs tally and the market for securitization of these costs in a year or two.
Now some readers might be thinking that this is pretty wild and crazy financial stuff and that we are clearly walking on the wild side*, financially speaking. Well, that would not be correct. Securitization is a long standing tool that is used extensively in the mortgage industry, and it is, in fact, one of the reasons we have such a robust home lending market in the US. It very likely that after receiving your mortgage for your home, your obligation was sold to another party who pooled your mortgage together with several thousand similar mortgages via a SPE. Bonds in the SPE were sold and bond holders were promised regular interest payments based on the monthly payments from that pool of mortgages. As my Financial Management students in the Energy and Sustainability MBA program at Franklin Pierce University learn, securitization and the unchecked transference of risk played a large role in the 2008/2009 housing crisis and recession. Moreover, securitization for stranded costs payments has been done before here in New Hampshire: PSNH ratepayers are presently assessed a stranded cost recovery charges associated with the Seabrook power plant as part of their monthly electricity rates.
Now some readers might be thinking that this is pretty wild and crazy financial stuff and that we are clearly walking on the wild side*, financially speaking. Well, that would not be correct. Securitization is a long standing tool that is used extensively in the mortgage industry, and it is, in fact, one of the reasons we have such a robust home lending market in the US. It very likely that after receiving your mortgage for your home, your obligation was sold to another party who pooled your mortgage together with several thousand similar mortgages via a SPE. Bonds in the SPE were sold and bond holders were promised regular interest payments based on the monthly payments from that pool of mortgages. As my Financial Management students in the Energy and Sustainability MBA program at Franklin Pierce University learn, securitization and the unchecked transference of risk played a large role in the 2008/2009 housing crisis and recession. Moreover, securitization for stranded costs payments has been done before here in New Hampshire: PSNH ratepayers are presently assessed a stranded cost recovery charges associated with the Seabrook power plant as part of their monthly electricity rates.
One of the questions we should be asking ourselves with respect to stranded cost recovery is - which customers of PSNH will be obligated to pay these charges? The answer – I believe – is that all PSNH distribution customers will be assessed these charges, including those getting their electricity provided by competitive suppliers. The key to stranded costs recovery is the establishment of the financing order by the NH PUC that will give PSNH the right to impose and collect stranded costs from its customers. However one of the most critical aspects of this financing order will be that these charges are non-bypassable. In other words, PSNH customers will not be able to avoid them by going to other electricity suppliers. Without this provision, the issuance of rate reduction bonds is unlikely to happen as bond investors would view it a particularly risky investment if ratepayers could escape their obligations.
Now, if you live in the PSNH franchise area and are buying your electricity from a competitive supplier, you are likely whipping yourself up into a froth of indignation at the unfairness that you should be assessed charges related to PSNH's generating operations. However, do take into account that many of these obligations were likely incurred when you were a PSNH electricity supply customer and present PSNH customers might consider it unfair that you could walk away from your obligations. A greater unfairness probably occurs when someone new moves from out of state into the PSNH franchise area and is assessed stranded costs recovery charges they had absolutely nothing to do with.
There is, of course, the possibility that things will play out differently in the legislative and legal deliberations that will occur over the next year or two, but this is where I am placing my bet. If you are angry with stranded cost recovery charges that might be assessed, the very best way for you to show your indignation and to challenge PSNH is remarkably simple - use less electricity. Show PSNH that you mean business by investing in energy savings projects. Put in more insulation, upgrade your windows and heating systems and install low-energy lighting and solar heating systems.
And, of course, remember to turn off the lights when you leave the room.
Mike Mooiman
Franklin Pierce University
Mike Mooiman
Franklin Pierce University
mooimanm@franklinpierce.edu
11/17/13
11/17/13
(*Walk on the Wild Side – Probably the best known song by the late and very great Lou Reed who just passed away last month at the age of 71. I remember listening to this song as a young teenager and having very little idea at that time what I was singing about as I accompanied Lou Reed on vocals. Fortunately, neither did my mom. Even if I didn't understand the lyrics, the arrangement, the "Doo, doo, doo" chorus and the very prominent bass line appealed to me.)
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