Securing the Grid

December 7, 2010 by: Joseph S. Fichera

Intelligent financing creates new options for grid modernization

By Michael Ebert and Joseph Fichera

— Improving the delivery of electricity over the existing strained electric power grid through grid modernization-”smart grid”-is a national priority, but it is in danger of becoming another victim of the financial crisis. Federal economic stimulus funds from the American Recovery and Reinvestment Act (ARRA) directed toward the goal of smart grid will soon be depleted. The recent burst of investments and implementations will likely slow once the 50/50 federal-to-private sector cost-sharing comes to an end.

Yet from the financial crisis, certain lessons have been learned about raising private capital at a low cost to electricity consumers. Smarter financing techniques have been developed and proven that could be applied to securing the smart grid. Utility financing for hurricane and storm recovery in the South and environmental upgrades in the Midwest have saved hundreds of millions for ratepayers versus traditional financing methods. A new application of this financing technique-smart grid cost mitigation bonds, or SGBs-has a number of potential benefits.

Smart grid implementation an expensive undertaking

Because our economic recovery has been anemic, proposals to increase investment in smart grid technologies-indeed, most infrastructure investments not considered “urgent”-have met opposition due to concerns about increasing costs to already burdened consumers. Smart grid implementation is an expensive initial undertaking designed to pay for itself over time through energy cost savings and greenhouse gas (GHG) reductions, whether or not the U.S. puts a price on carbon. Much of the costs will be incurred in the more complex distribution segment of the grid’s three-legged stool of distribution, generation and transmission.

In rate-regulated environments, utilities and other smart grid industries must gain approval for investments made in grid modernization from state public service commissions (PSCs) if they want cost recovery for investments from rate-paying customers. Even with ARRA-financed 50/50 federal cost sharing for smart grid implementations, cost recovery from consumers has not been easy; in fact, in many cases there has been pushback from consumers in all customer classes, from powerful consumer advocacy groups and from PSCs.

The current fragmented U.S. regulatory paradigm will not undergo radical change anytime soon. Nor should we expect shareholders to volunteer to bear the entire cost of improving the grid. Ratepayers will continue to pay for PSC-approved smart grid investments, meaning higher electricity prices at a time of high unemployment, flat incomes and increasingly risk-averse investors.

Electric power utilities will, for most jurisdictions, continue to be rate-regulated entities, which at the state jurisdictional retail level may only recover grid modernization costs when PSCs deem that the investments meet the classic tests of reasonable and prudent, used and useful. In the context of smart grid, meeting these tests-especially used and useful-has been difficult for utilities because utilities and commissions struggle to qualify and quantify consumer benefits and any potential savings, particularly for the residential customers.

Proven financial techniques can reduce consumer burden

Investments in smart grid can continue, if not accelerate, even without another round of economic stimulus aid from the federal government. What can drive the pace of private investment is the use of proven financing techniques that can reduce the burdens on consumers while still attracting large sums of increasingly risk-averse private investment.

This option emerged from the mega-hurricanes of 2004 and 2005. Electric power infrastructures in Gulf Coast states from Florida to Texas incurred catastrophic damages. Operating under a grant from the U.S. Department of Energy, the Center for Infrastructure Protection at George Mason University studied how the states confronted cost recovery for storm losses that ran into billions of dollars.

The traditional approach would be for utilities to recover the costs of restoration and recovery through customer surcharges that recouped losses over 24 to 36 months. But in this instance, the losses were so substantial, and the underlying state and regional economies so devastated and frail after being hit hard by back-to-back storms, that traditional cost-recovery approaches were not economically or politically feasible.

Several Gulf Coast states responded by passing legislation that specifically authorized the option of “securitization” of storm-related utility costs. Securitization means that new or amended state authorities are created where a specially authorized charge is placed on electric consumption that creates a specific cash flow that can be packaged and sold as a security to private investors.

The special class of utility tariff bonds (UTBs)-in this case called storm recovery or hurricane bonds-would be sold to private investors. UTBs more generally are called ratepayer obligation charge (ROC) bonds. The laws created a unique and powerful form of credit enhancement for the new bonds to achieve the highest credit rating (AAA) and to be sold at the lowest interest rate. This combination significantly mitigated increases in customers’ electricity rates by using a long-term approach.

Securitization has great potential to finance grid modernization costs at an accelerated rate because this approach-carefully and correctly implemented-has many benefits for consumers and utilities. It imposes the smallest possible price increases for electricity for all ratepayers while not imposing any additional risk on utility shareholders or using the utility balance sheet.
,br> Benefits are clear

The benefits of SGBs are the same as those found in the research project conducted four years ago in which states provided cost-recovery options for storm bonds. These are:

Lowest-Cost Financing. Special state statutes or PSC financing orders based on the statute required ROC bonds provide the lowest customer cost through the sale of AAA-rated bonds to private investors.

Credit Enhancement thru Bond Charge True-ups and True-Downs are reduced from cumbersome commission procedures to simple, mathematical calculations.

Accelerated financing for long-term investments. Using traditional approaches such as short-term surcharges, utilities must wait two to three years after PSC approval of allowable, recoverable costs to recover investments; storm bonds provided more immediate infusions of cash. SGBs have the same potential.

A more logical cost recovery strategy. The transformation to smarter, greener and more resilient power grids will occur over decades. Spreading the costs of state jurisdictional electric utility investments using SGBs with maturities (for example, 10 to 20 years or longer) is more logical, matched to life cycles of assets, and less onerous to the consumer than trying to recover such investments in a few years.

Some might argue that making analogies between storm bonds in the financial markets of 2006-2007 and SGBs in the context of today’s financial markets is a stretch. The facts are contrary. ROC bonds have been one of the few successful financial innovations of the past decade. A recent study by Standard & Poor’s entitled “The Recession Hasn’t Been Hard On `Ratepayer Obligation Charge’ Bonds” substantiates this. Despite the upheavals of the recent past, not one of these types of bonds ever was downgraded or even considered at risk of a downgrade.

SGBs make even more sense in today’s economy-that is, in the contexts of the credit crisis and costs of raising capital. Today’s cost of AAA debt capital (between 3 and 6 percent) versus the 10- to 12-percent cost of a mix of debt and equity in normal economic times makes the use of these new financial instruments even more attractive. If utilities are willing to accept less than a full return to shareholders as part of a political and technological balance since the consumer benefits in the near term for smart grid, investments seem difficult to quantify. The savings to all parties can be substantial.

But will investors have sufficient appetite for smart grid bonds in our current and likely near-term future economic and policy environments? Yes, provided that policymakers carefully create environments that allow SGBs to be implemented correctly to achieve the greatest financial benefits for investors, consumers and utilities alike.

Published In: Intelligent Utility Magazine November/December 2010

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