Sponsored Selby P. Jones, III, CRRA, Principal, AUS Consultants.
The authorized rate of return on common equity (ROE) for a utility is a significant issue, helping to determine what a utility earns each year. There are many factors which contribute to how the ROE is determined and which adjustments are made to it in order to reflect the various risks that a utility may, or may not, face.
One such adjustment is for acquisitions. Acquisition adjustments are listed as a “Best Practice” by both the National Association of Regulatory Utility Commissioners (NARUC) as well as the National Association of Water Companies (NAWC). These “Best Practices” apply not only to water utilities, but to the utility industry as a whole. Implementing these practices helps to enable all utilities to provide the safe and reliable service which they are obligated to provide for their ratepayers.
Utilities and regulatory commissions can utilize these “Best Practices” in order to mitigate risk – both for themselves as well as ratepayers, especially involving acquisitions. Some regulatory commissions allow adjustments to the authorized ROE in order to incentivize, or ease the concern of utilities that wish to acquire (or are being requested to acquire) another utility, while others allow adjustments to the rate base.
The general premise for state-allowed acquisition adjustments is that they provide for the difference between the depreciated original cost and the purchase price of the system being acquired (NAWC Water Policy Forum). Generally, the acquiring utility will pay slightly more than what the target utility or system may be worth, depending on the existing assets and the respective average service life of those assets. If that utility wants to add it to its rate base, the utility must file for a rate proceeding to have the new assets added to the rate base. Requesting the recognition of an acquisition adjustment before a Commission which grants it, can allow the utility to recover some of the purchase cost outside of a general rate case. That outcome can help bridge the price gap often associated with acquiring a utility or system.
Consolidation of the utility industry into fewer systems is necessary, and there are important issues which need to be considered in its performance. The most obvious issue is ratepayer impact. Rate shock can be a consequence, depending on the area in which the utility operates. Although service quality may improve, the price to provide that level of quality may not be affordable for some ratepayers. Bearing this in mind, the impact on the ratepayer is paramount.
Another concern is proximity to other systems. It makes little sense for a utility that operates exclusively in the northern part of a state to purchase a troubled system in the south (at the request of a commission) simply because it is large enough to absorb the costs of the purchase. It would be more reasonable to encourage that same request toward utilities which are in close proximity to a troubled system. In this manner, additional utility-specific costs to run the new system can be distributed more efficiently, and reduces impact on ratepayers.
The final potential complication is in the mutual agreement between larger utilities and troubled utilities. In a perfect system, there are willing buyers and sellers at all times. However, this is not always the case – there may be neither willing buyers nor willing sellers. This deserves note when considering any potential acquisition.
Incentive-Based Acquisitions – States at the Forefront
Three states are working to encourage viable utilities to acquire troubled utilities, namely, Arizona, Pennsylvania, and North Carolina.
The Arizona Corporation Commission (ACC) has begun the process of bringing large and small utilities together in order to give the smaller, or troubled, utility the ability to sell their system to a larger utility. Small utilities may be in distress and cannot fund the necessary projects in order to improve their infrastructure. This distress could be attributed to an inadequate revenue stream, or the inability to attract necessary debt or equity capital that larger utilities can access. As a result, the customers suffer. Acquisition of these troubled utilities can help all those in need – the utility as well as its customers. Getting the “right” buyer to the table is an important piece of this endeavor.
Acquisitions have also been a success in Pennsylvania, providing safe and reliable service to customers. Pennsylvania has allowed incentives for acquisitions with these adjustments being approved when a viable larger utility purchases a smaller, non-viable system. Pennsylvania’s adjustments take into account that the acquisition cost is higher than the depreciated original cost of the acquired system.
North Carolina also allows an acquisition adjustment to the rate base. When the acquirer purchases and repairs a troubled utility, one dollar of acquisition adjustment is moved to rate base for every dollar of acquisition cost and repair expended by the acquiring utility. Rate base adjustment is an alternative to an ROE adjustment, increasing the rate base rather than the authorized ROE. Increasing the rate base helps the acquiring utility by providing more assets on which to earn a return, which may prove more beneficial than receiving an increase in authorized ROE.
In conclusion, the acquisition of troubled utilities is at the forefront of the utility industry. Overall, acquisition adjustments appear to be reasonable. These adjustments will allow for the provision of safe and reliable service to customers at an affordable cost.