Long-term ratepayer obligation charge of rate reduction bonds may provide answers

March/April 2011

Grid modernization monetization
Long-term ratepayer obligation charge of rate reduction bonds may provide answers

By Joseph Fichera

MODERNIZATION OF THE NORTH AMERICAN ELECTRIC power grids is crucial to grid security, reliability and efficiency. Doing so will provide economic, competitive and environmental benefits for the United States. However, it is also expensive. Methods must be found to easily and economically fund the investment. Fortunately, there is a time-tested, efficient way to raise funds that has survived the recent credit crisis. It is favored by respected credit agencies, investors and others as a powerful tool to lower electricity costs to consumers.

In the November/December 2010 issue of Intelligent Utility (http://www.intelligentutility.com/magazine/article/172975/securing-grid), we made the basic arguments for long-term Ratepayer Obligation Charge of Rate Reduction Bonds (ROCs/RRBs) and thus will not repeat the fundamentals. This article covers specific measures necessary to develop and bring to market well- structured ROCs/RRBs for grid modernization.

Lowest-cost financing method

Utilizing ROC/RRBs for grid modernization offers many advantages over more traditional cost-recovery financing options and more closely aligns with the longer-term benefits. It’s quicker and cheaper to raise small or large amounts of funds from the capital markets. ROC/RRB bonds are a lowest-cost financing method because, properly structured, they present the least risk to investors and more affordable monthly costs to ratepayers. Nationally recognized credit rating agencies give them top (AAA) ratings. They are purchased by investors in the public bond markets and thus result in the lowest possible cost to ratepayers.

Solely applying a monthly surcharge to the consumer utility bill provides a source of capital that merely trickles in. Public utilities benefit because the sale of ROC/RRBs results in quick and inexpensive capital almost immediately without using the balance sheet or credit of the utility. Consumers also benefit in the end because the costs of large, capital-intensive grid modernization projects are spread over many years.

Our emphasis on properly and well-structured is intended. In most states and their public service commissions (PSCs), with rapid turnover of commissioners and thin expert staff, coupled with the desire for most investor-owned utilities to invest only in assets that earn quick returns for shareholders, there is comparatively little or no experience with ROCs/RRBs. A review of the 50 states indicates that only 15 have experience in the use of utility tariff bonds; we know of no instance in which securitization has been chosen to finance smart grid.

If ROC/RRB bonds potentially have the benefits that the rating agencies and many other independent observers claim, why is this so?

Mostly, it is simply a lack of specific state statutes that provide the legal authorities for PSCs to have the option of ROC/RRB financing, and expert knowledge of how to do this so that a PSC does not rely solely on utilities or Wall Street.

Specific state authority needed

The first and most important step in well-structured ROCs/RRBs for grid modernization is for states to enact specific authorities for their PSCs, which provide the procedures for a transparent public process to determine whether securitization provides the least costs.

This state statutory authority establishes the legal framework for creation of a new type of intangible property right and grants the PSC authority to issue an irrevocable regulatory guarantee to investors by ensuring timely repayment via automatic true-up/down adjustment processes. Like any other utility property, this new property can be pledged as collateral. The property created is the right to bill and collect a specific charge on some or all retail electricity purchased by consumers in a given distribution service territory.

A well-structured statute also authorizes the utility to sell this property to a bankruptcy-remote special purpose entity (SPE), authorizes the SPE to issue debt instruments, and requires the utility to use net proceeds from the ROC/RRB bond sale for specified purposes. Bankruptcy-remote means that the assets of the SPE are separate from the utility in case the utility has credit problems.

Pursuant to a special financing order, a charge is imposed on each customer, which is collected by the utility, and given to the SPE. The collection solely supports the payment of the ROC/RRB bonds; expenses cannot be used for any other purpose.

Given the historical regulatory uncertainty regarding changes to laws and regulations, the statute must include a state pledge of non-impairment; the statute must stipulate that if a PSC financing order is issued for a specific project, it must be final and irrevocable, and “non-bypassable,” meaning that, irrespective of future changes in the regulatory environment or the business organization of the utility, the charge must continue to be collected from customers by the utility and/or any successor entity. For example, self-generation cannot dilute the charge.

PSC actions required in statutes

To be most effective, state statutes require certain actions from the PSC, including certifying that ROC/RRB financing is the “least cost alternative” and achieves “lowest cost of funds.” This means an important degree of PSC involvement and oversight facilitated by expert financial advisors after the final order through actual ROC/RRB bond offerings.

Special care has to be taken to ensure compliance with federal income tax rules. To avoid being taxed, securitization regimes must meet the new six-part test found in Federal Internal Revenue Service (IRS) Revenue Procedure 2005-62, 2005-37 IRB 507-collectively, the “Revenue Procedure”-issued September 12, 2005. The Revenue Procedure has the effect of opening up securitization to grid modernization and a range of other rate-reduction purposes, including grid modernization.

How an ROC/RRB bond is structured and sold could result in it being classified solely as an asset-backed security (ABS) and sold primarily to ABS investors who demand higher yields to invest. This must be avoided.

If ROC/RRB bonds are deemed to be ABS, the bonds would need to follow the SEC Regulation AB rules, which govern the issuance and sale of ABS securities, and investors might treat them as riskier than they are.

Thinking like Amazon

Thinking outside the box, securitization could balance the current gross imbalance between utility and customer benefits. Tangible smart grid consumer benefits occur more quickly. The utility establishes an online “Amazon-esque” portal, including consumer education and ratings, where energy modernization goods and services are purchased in a competitive market and with charges sent to the utility. The set aside has transparent and separate accounting, but the “grid modernization” charge and the itemized “home energy modernization” charge that appear on the customer’s bill is paid to the utility, with the two charges immediately transferred to the SPE.

Issues of creditworthiness and equity in customer access to the set aside are not difficult to establish. Securitization pools buying power while providing default protection. Sale of a home or building, technological obsolescence, upgrading, etc., are facilitated by securitization’s automatic true-up/true- down attributes.

A defining and common feature of securitization is that it is made possible by state legislation that not only specifically enables it, but that establishes a legal framework for the creation of a new type of intangible property right under law.

ROC/RRB bonds, as securitized debt instruments, do not burden the assets or revenues of the sponsoring utility.

ROC/RRB securitized financing is unlike any of the utility’s other financial obligations: it is effectively off- balance-sheet for credit purposes with no recourse to the utility, which is, thus, fully protected. Shareholders get an improved balance sheet and more headroom in rates for other financings that may earn an equity return. This means the utility can finance grid modernization with nearly 100 percent debt rather than its normal capital mix of about 50 percent debt and 50 percent equity, without any impairment of its credit structure.