LBNL Report Number
Representatives of NUG developers have not accepted the "debt-equivalence" argument. They argue that utilities which purchase power from NUGs reduce their risk by transferring certain of the burdens associated with power plant construction to private parties. It is argued that this should improve the credit of a utility that purchases power from NUGs. The bond-rating agencies have been active participants in the discussion of debt-equivalence. Each has a different approach to calculating the balance sheet liability associated with NUG commitments. Most argue that debt-equivalence is a relative phenomenon, determined jointly by the conditions of local regulation and by the precise nature of the power purchase contract. The Standard and Poor's approach results in assigning a "risk factor" to each utility's position that discounts the nominal debt equivalence to account for important qualitative factors. Other agencies treat these issues qualitatively. In this study, we approach these questions from the perspective of the equity markets, rather than from that of the debt markets. There are several reasons for this choice. First, the debt and equity markets are linked. If NUG contracts really are equivalent to debt, then they raise the risk of the firm, and this should be observable in the equity market. Studying utility stock price performance has the advantage of avoiding some of the circularity in the prior discussion of bonds. If the bond rating agencies declare that a certain risk exists, it is a self-fulfilling prophecy. By observing the reaction of the equity markets we can see if the same assessment is made by shareholders. With regard to the basic question raised by Section 712 of EPAct, the cost of equity (and associated taxes) is the largest part of the overall cost of capital, therefore any assessment should consider this market explicitly. Finally, there is a tradition of quantitative study of the cost of equity capital, which can inform the approach taken here. Our goal is to study the debt-equivalence debate, empirically. Financial markets absorb relevant information about the risks facing firms and adjust prices to reflect these judgments. This happens whether there are explicit reactions from industry spokesmen or not. For example, secondary market prices for bonds of electric utilities which had nuclear power assets reacted to the Three Mile Island accident reacted even if there was no direct risk to credit quality. It is in this spirit therefore, that we want to study the arguments about NUG impacts on the utility cost of capital. We want to structure the arguments in a form which will potentially allow them to be confirmed or disproved. This study is organized in the following fashion. Section 2 reviews the literature on the cost of equity capital for regulated utilities. Since there is no consensus definition of the intuitive "cost of capital n notion, we will have to work with several alternative formulations. Section 3 specifies our formulation of the debate on NUGs and the utility's cost of capital. Section 4 reviews variable definitions and data sources. Section 5 discusses statistical issues and results. Conclusions are given in Section 6.