PowerFacts
EPSA PowerFact: Demystifying Debt Equivalency to Better Serve Consumers
“We share the concerns of EPSA on this issue. We are highly skeptical that this phenomenon is real, and believe that it tends to promote the interests of bondholders and utility shareholders over the interests of ratepayers. … The debt-equivalency argument provides the utility with a win-win situation at ratepayer expense, either freezing out competition to its profit or increasing expensive equity to its profit.” (Reply Comments of the Attorney General, In the Matter of Resource Planning Guidelines for Electric Utilities and Consideration of SEC 111(d)(12) of the Energy Policy Act of 2005, Before the Arkansas Public Service Commission, Docket No. 06-028-R, May 5, 1006)
What is “Debt Equivalency?”
Consumers get the best deal when electricity is procured on a competitive basis. With demand for electricity rising, utilities in many regions face a choice of buying from among multiple wholesale bidders or building their own power plants. Competitive procurement is undermined when utility’s use the technical issue of “debt equivalency” to artificially inflate a competitive supplier’s bid. When a utility buys power rather than builds its own generation, it enters into a power purchase agreement (PPA) with the competitive supplier.
“Debt equivalency” is inferred debt, the treatment of a long-term non-debt obligation, such as a PPA, as debt on a balance sheet. Historically, contracts between an electric supplier and a utility have been viewed by credit rating agencies as the equivalent to debt on a utility’s balance sheet. A number of utilities have cited this issue as a reason to pursue utility-owned and operated power plants, which are reflected as assets. In fact, building a power plant generally has a negative impact on a utility’s cash flow, which according to S&P “is the single most critical aspect of all credit rating decisions.”
How It Is Used… Or Misused
The issue and use of debt equivalency first emerged in 1990, when the credit rating firm Standard & Poor’s (S&P) proposed to apply a “debt-equivalence” risk factor to utility balance sheets for power contracts from third-parties, such as competitive suppliers. Some form of debt equivalency is used today by the three major credit rating agencies (S&P, Moody’s and Fitch Ratings), although their specific approaches differ.
Debt equivalency can be misused by utilities to artificially raise the price of a competitive bid to the detriment and expense of its captive ratepayers – typically when a utility favors constructing and owning its own power plant rather than purchasing less expensive power from the market. Utilities have sought to use this discriminating tactic as a factor in evaluating resource options and it has recently been made the subject of regulatory proceedings in a number of states across the country.
Who is at Risk?
A determination by a utility to self-build a costly power plant ignores the benefit to consumers of power supply available from the wholesale electric market that provides power from a variety of fuel sources. Power purchases from the market provide a strong measure of protection for utility customers and shareholders alike, because neither assumes various risks – those risks are transferred to the competitive power supplier. On the other hand, when a utility builds, owns and operates a plant, its customers risk having to absorb construction cost over-runs, delays in completion, and the cost of finding and purchasing replacement power should the plant not be online when expected.
A Fair Application to Better Serve Consumers
While it is difficult to attribute a utility’s credit rating to a single factor, if the use of debt equivalency is deemed necessary, a comparable assessment of all risks and costs of both competitive market proposals and any proposed utility self-build alternative must be undertaken. S&P has recognized that, if a utility’s cost recovery of power purchased from the market is complete, automatic and timely, the debt equivalency risk factor can be decreased. Nonetheless, the application of any debt equivalency risk, without taking all risks into account, unfairly penalizes competitive power purchases – to the detriment of consumers.
In the absence of a comprehensive evaluative framework, debt equivalency should be a component of the utility cost-of-capital proceeding, not part of a resource procurement program, when competitive bids are considered.
The most effective and secure way to meet the nation’s future power needs is to ensure that the full benefits and protections offered by competitive electric markets are utilized in all states, including those served by vertically-integrated traditional utilities.
Additional Resources Available at www.epsa.org:
• In-depth report on debt equivalency conducted by GF Energy, LLC (July 2005)
• Prepared remarks from EPSA President and CEO John E. Shelk at the Western Power Supply Forum (May 9, 2006)
Electric Utility Resource Planning: The Role of Competitive Procurement and Debt Equivalency (GF Energy LLC)
CONTACT: JOHN SHELK
(202) 349-0154or 703-472-8660
EPSA is the national trade association representing competitive power suppliers, including generators and marketers. These suppliers, who account for nearly 40 percent of the installed generating capacity in the United States, provide reliable and competitively priced electricity from environmentally responsible facilities serving global power markets. EPSA seeks to bring the benefits of competition to all power customers.