Issuing Bonds to Finance Utility Fuel Costs: A Bad Idea Courtesy of Appalachian Power

Charleston Gazette
February 23, 2012

‘Just Say No’ to AEP’s Coal Addiction
Leslee McCarty

A bill passed by the West Virginia legislature and awaiting Governor Tomblin’s signature (SB 584 and HB 4350) would allow Appalachian Power to issue bonds to cover its higher power costs, rather than increasing current utility rates to recover these costs. Appalachian Power is currently facing an under-recovery in power costs of about $350 million. In other words, its electricity rates are set a level that fails to recover the costs it is currently paying to generate electricity. Why have electric rates gone up so much over the past few years? Coal prices have doubled over the past decade, and Appalachian Power has foolishly – “fuelishly” is more accurate – failed to diversify its resource portfolio, and is nearly 100% dependent on coal-fired electricity. While that might have made sense when coal prices were cheap – and in fact it produced rates for West Virginians that historically have been far below the national average – it no longer makes sense. Prudent utility management – i.e., one that engages in a rigorous long-term resource planning process – would have figured that out long ago and diversified its energy resource portfolio (and included, for example, natural gas, renewables, energy efficiency) rather than merely sticking utility ratepayers with ever-increasing electricity prices from coal-fired generation. Coal is an international commodity, and the prices will continue to surge with the industrialization of China, India and other developing nations.

What is Appalachian Power doing about it? Rather than managing its power supply costs and engaging in a meaningful least-cost planning process to try to hold utility rates down, it has come up with a creative way of trying to ease the pain of its higher power costs by “securitizing” them through issuance of bonds. The bill passed by the West Virginia legislature would allow Appalachian Power to issue $350 million of bonds, which ratepayers would pay off over a number of years, rather than raising rates immediately to cover these costs. A rate increase of this magnitude is simply unacceptable, both to Appalachian Power and to the Public Service Commission (PSC), so the idea is to spread it out over a number of years to avoid rate shock. Securitizing the debt would reduce the financing costs by having the PSC issue an order virtually guaranteeing repayment of the bonds regardless of subsequent events. This order, in turn, results in a more favorable credit rating on the bonds from the rating agencies, thereby lowering the financing costs.

What’s the problem with this approach? Where to begin. First, it deals with the symptom, not the cause. Appalachian Power has failed to control its power costs through its failure to engage in a rigorous long-term resource acquisition process, and this bill does absolutely nothing to address this issue. Instead, it gives Appalachian Power a pass, and leaves the ratepayers holding the bag, albeit spread over more years to ease the pain. To compound the insult, Appalachian Power opposed another bill (SB 162), introduced by Senator Dan Foster, that would have required the utility to engage in a least-cost planning process. Had Appalachian Power engaged in such a process a decade ago – like virtually all other utilities in the country – we likely would not be looking at the prospects of a $350 million rate increase, as Appalachian Power long ago would have seen the fuelishness of continuing to rely so heavily on coal rather than diversify its fuel supply. A rigorous least cost planning process – also known as “integrated resource planning” – would require sophisticated modeling of various resource scenarios, using a variety of assumptions, in order to determine a portfolio of resources that results in the lowest cost, over time, to utility customers. Such modeling would have included, for example, different coal price scenarios that would have highlighted the risk of heavy, and virtually exclusive, dependence upon coal-fired generation. A “high” coal price scenario, for example, would have shown natural gas-fired resources to be cost effective, and likely would have shown energy efficiency and conservation to be the most cost-effective means for Appalachian Power to meet its obligation to serve.

Appalachian Power has resisted implementation of least-cost planning in West Virginia, and has opposed Senator Foster’s bill, SB 162. The basis for its opposition: Appalachian Power does not want the term “least cost” to appear in the legislation. In other words, it does not want to be obligated to defend its resource acquisition strategy to the PSC (and other stakeholders) against a “least cost” requirement. This, in and of itself, provides some explanation of why Appalachian Power finds itself with a $350 million shortfall. If a utility denies any obligation to manage its power supply costs in a manner that results in reasonable electricity rates for its customers, we should hardly be surprised that its power costs are out of control. Rather than prudently managing its power costs, Appalachian Power is using its creativity to hire lawyers to draft a bill that sticks the consequences of its imprudence to customers, through issuance of bonds. As a matter of federal law, utilities are required to engage in integrated resource planning – the requirement was included as part of the Energy Policy Act of 1992 – and the process is geared to produce “the lowest system cost” for utility ratepayers. Why is Appalachian Power so strongly resisting the type of rigorous long-term utility planning that virtually all other utilities in the country are following? And why are West Virginia utility customers being asked to bear the consequences for this mismanagement?

Second, securitization is the wrong remedy for this problem. The tool itself is financially sound, and one cannot argue with the numbers, and the fact that the mechanism will result in lower costs for customers by being able to finance the shortfall at a lower interest rate due to the advantageous credit rating the bonds will receive. (Of course, the reason the bonds are so attractive to Wall Street is that ratepayers are on the hook to repay the bonds, regardless of any changes in circumstances down the road. In fact, even if Appalachian stops delivering power, ratepayers will still have to pay. If a large industry tries to drop off the grid and self-generate, it will still have to pay. The boilerplate in this bill is so one-sided in favor of the utility and against the customers as to shock the conscience. And, in the electricity business, the correct word is indeed “shocking.”) I am quite familiar with the concept of securitization in the electric utility business. A former client of mine, Puget Sound Energy (PSE), invented it back in the mid-1990s, and it has all the advantages that Appalachian describes. The trouble is, the tool does not fit with these circumstances.

Securitization should never be used to finance ongoing, routine operating expenses. That’s what Appalachian Power is trying to do here: its fuel costs (and revenues from wholesale sales) are out of whack with what it expected, and it needs to raise rates to cover the shortfall. It is a misuse of securitization, however, to finance normal operating expenses through issuance of bonds. It has never been done before, with good reason. It is financially irresponsible. When PSE first used securitization, for example, the tool was to spread out over time PSE’s investment in energy efficiency measures. These investments (insulation, windows, HVAC, high-efficiency furnaces, etc.) have useful lives that extend many years. Securitization allows the repayment of these investments to be refinanced at lower interest rates over a time period that corresponds to the useful life of the underlying asset. Securitization has not been, and should not be, used to finance normal operating expenses. Appalachian Power refers to these fuel costs as “extraordinary” in the fact sheet it distributed to legislators. Yes, they are extraordinarily high, due to Appalachian Power’s mismanagement, but they are normal, routine operating expenses that need to be paid by current customers, not spread out over some future period. It is a violation of fundamental financial management principles to finance operating costs through long-term debt. Yet that is what Appalachian Power seeks to do with its “consumer rate relief bonds.” American Electric Power (AEP), Appalachian’s parent company, includes a discussion of securitization on its website, and virtually all the examples it cites where securitization has been used involve long-term assets (transition and stranded costs associated with above-market generating assets; costs of environmental control equipment; and financing utility system infrastructure). AEP cannot cite an example where securitization has been used to finance fuel costs. Long-term debt simply cannot be used to cover ordinary, routine operating expenses. The same folks who brought you the Wall Street meltdown must love this stuff, as it is exactly the sort of financial gimmickry that can wreak havoc on the marketplace if misapplied in the manner proposed by Appalachian Power.

Third, it is a violation of fundamental ratemaking principles to force future ratepayers to bear the costs that are being incurred by current customers. This is known as the “matching principle”: those who cause the costs, bear the costs. Under Appalachian Power’s proposed misuse of securitization, current ratepayers would not have to bear the costs incurred by Appalachian Power to serve them. Rather, securitization allows the costs to be shifted to future customers. There is a complete mismatch between costs incurred and revenue received when the bonds are paid back in future years. Current ratepayers get subsidized; future ratepayers get burdened with costs not associated with the costs incurred by Appalachian Power to serve them at the time. It’s great if you’re an Appalachian ratepayer in 2012, since you are dodging the bullet of paying the actual costs of serving you. It’s not so great if you’re an Appalachian Power ratepayer in 2017, when you are paying utility rates completely unrelated to the costs incurred by the utility in serving you in 2017. It’s a mismatch. It’s not fair. And utility commissioners abhor such practices in setting rates. Yet Appalachian Power’s securitization bill embraces this mismatch, as it avoids the current pain of the $350 million under-recovery caused by its mismanagement.

Other utility industry veterans are reaching the same conclusion. The Power Line contains a similar analysis (When Half Truth = No Truth), and Keryn Newman provides an excellent commentary (HB 4530: We Need a Solution, Not a Band-Aid). Stop the madness. This bill needs to be rejected, and the next legislature should enact the least-cost planning bill proposed by Senator Foster. It’s time to deal with the cause, not the symptom.