Bacon's Rebellion

Peeling Back Another Layer of the Grid Modernization Debate

A critical point has gone missing in the debate over the Grid Transformation and Improvement Act: the effect of regulatory changes on the ability of Virginia’s electric utilities to borrow money.

Electric utilities like Dominion Energy Virginia and Appalachian Power Co. are highly leveraged; that is, a high percentage of their capital base consists of debt. They enter capital markets to borrow money needed to finance big projects, and the cost of that capital — the interest rate — is charged back to rate payers. Thus, any regulatory change affecting investor confidence and, thereby, interest rates, can have a little-noticed impact on electric rates.

In repealing the rate-freeze deal that has governed Virginia’s electricity sector since 2015, Dominion has advocated an “investment” regulatory model that calls for plowing over-earnings into renewable-energy and grid-modernization projects. This model first struck me as more complicated than it needed to be. Why not stick with the regulatory system that prevailed until the rate freeze? There’s a complicated answer to that question, and it involves utility borrowing costs and interest rates.

Layers

The old regulatory model, which Dominion lobbied to put into place in 2007, divided rate adjustments into three logical categories — base rates to cover ongoing operating costs, fuel adjustments to cover fluctuations in fuel prices, and project-specific riders (or rate adjustment clauses) to cover major capital investments. The State Corporation Commission (SCC) reviewed Dominion and Apco earnings every two years, determined if they were higher or lower than the permitted rate of return, and then ordered rebates for over-earnings. Pretty straightforward.

Under the proposed changes making their way through the General Assembly, however, over-earnings could be offset by investments in legislatively favored and SCC-approved priorities such as solar power, wind power, energy efficiency, smart meters, and the burying of electric lines. For those projects, over-earnings wouldn’t be rebated directly to rate payers. Instead, they would be deducted from what the utilities would have paid had they filed for riders to recoup capital investments. And customers would benefit indirectly from lower costs passed on through riders. It sounds like a regulatory system that Rube Goldberg would contrive.

As I explained yesterday, critics accuse Dominion of “double dipping” — benefiting once from avoiding the over-charge rebates, and benefiting twice by incorporating the overcharges into their cost structure, upon which they can then earn a 9%+ return on investment. While rate payers get their money back on the back end via an offsetting reduction in rate riders, Dominion gets to generate income off that money in the meantime.

I’m not sure that the critics’ argument stands up. If the old regulatory model still applied, Dominion would finance the grid modernization priorities through rate riders, they still would be allowed to make a return on capital it invested, and that return still would be passed on to customers. Double dipping appears to be an illusion. That’s my understanding, but I’m no expert in regulatory accounting, so I’ll dish definitive answers off to the experts.

The issue I want to focus on is why Dominion wants to pay for grid modernization the Rube Goldberg way rather than the straightforward way. Why would Dominion dream up such a convoluted approach unless it had something self-serving in mind? I put that question to the company. I hereby digest and repeat what I was told.

To understand the reason behind the “investment” model, we need to know how Dominion (and by Dominion, I mean the regulated utility, not the parent company) finances projects. If the company needs to spend, say, $1 billion to build a new power station or $500 million to build a new transmission line, it doesn’t have the cash sitting around to pay for it. It must borrow the money by issuing bonds. Investors want to be assured that Dominion will generate the cash flow to pay them back on schedule. They demand predictability. They hate uncertainty.

Some unpredictability is inevitable. No one knows if a hurricane will swoop through and knock out a lot of power lines, disrupting revenues and running up costs. No one knows if the state or federal government will enact new regulations for something like coal ash clean-up — or a regional greenhouse gas initiative — that had been entirely unanticipated a couple of years before.

A recent lightning bolt out of the blue was the reduction in federal income taxes. While parent company Dominion is celebrating the tax break for its unregulated subsidiaries, Dominion Energy Virginia won’t get a windfall. The Grid Transportation Act will require Dominion and Apco to rebate all tax savings to rate payers. Moody’s Investor Service, the bond rating group, sees the tax break as a negative event, not a neutral one. According to the Wall Street Journal, Moodys has reduced the rating outlook for 24 regulated and utility holding companies, including Dominion. (A negative outlook is not a rating downgrade; it merely says that a rating downgrade is possible.)

“If [cash flow] is going to be smaller, to us, the financial risk has gone up,” the Journal quotes Toby Shea, a senior credit officer at Moody’s, as saying.

Dominion’s proposed investment model takes some of the unpredictability and risk out of the equation. When going to the bond market to finance grid modernization, the company won’t get blindsided by an SCC order to cough up several hundred million dollars in rebates to customers. Instead, the company  will offset the rebates with spending on grid-modernization spending, which it can control. Investors will be reassured that Dominion’s revenues won’t decline precipitously, and the company will be rewarded by a better credit rating and lower interest rates than it would have enjoyed otherwise. That risk reduction translates into dollars and cents for customers.

That’s Dominion’s argument. Perhaps there are countervailing arguments. Even if so, it’s a critical piece of the debate that has yet to enter the public domain.

If valid, the argument calls into question the contras’ contention that customers would lose from double dipping. The critics’ accounting of pluses and minuses to customers fails to take into account the positive impact on Dominion’s borrowing power. On the other hand, the Dominion’s argument leaves some questions unanswered. How big would the impact of the Grid Modernization Act on interest rates be? One hundredth of a percentage point? A tenth of a percentage point? Bigger? How much would that save in interest rates? Are we talking about tens of millions of dollars,  hundreds of millions of dollars, or mere millions?

If Virginians want sound energy policy, we need to give this issue closer scrutiny.

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