Power Plant Financing in Senate Bill 3 Shifts Risks to Customers
By John Blackburn and John Runkle
July 16, 2007
CONSTRUCTION WORK IN PROGRESS (CWIP)
Senate Bill 3 has two main sections: the first is the Renewable Energy and Energy Efficiency Portfolio Standards (REPS) and the second is the treatment of baseload financing, often called construction work in progress (CWIP). In this paper, we address the CWIP provisions in the bill and how they differ significantly from the present way rates are calculated.
WHAT IS CWIP?
CWIP is the accounting scheme used by the electric utilities to pay for the cost of capital assets, i.e. power plants or transmission lines, which need to be constructed over a period of years. The issue before the General Assembly is whether the utilities can make a profit on the costs of construction (and financing charges) before the power plant is placed in service.
HOW DO THE ELECTRIC UTILITIES CURRENTLY PAY FOR THEIR POWER PLANTS?
Electric utilities frequently have projects that take several years to complete, so that CWIP accounting is of special significance. Currently, the construction costs and financing costs associated for each project are accumulated. When the project is completed, the power plant is placed in service and becomes “used and useful.” Like the construction costs, the financing costs are not treated as expenses year by year and cannot be recovered until the plant is producing.
Utilities may use some of their own funds but often borrow funds during the construction period. They add interest on borrowed funds and a “profit” on their own funds (allowance for funds used during construction, or AFUDC) to the cost of construction, and then recover all of these sums through rates when the plant begins operating. All these calculated “profits” are reported in financial statements year by year during construction even though they have not been earned in production nor collected in cash.
The power plant will have a total booked cost composed of the sum of construction outlays, accumulated interest, and AFUDC “profits.” When the asset is finished and is producing, depreciation begins and earnings begin from the use of the asset. For the utilities, all of this goes into the rate base on which allowable returns, i.e. profits, are allowed by N.C. Utilities Commission.
WHAT WAS THE IMPACT OF THE “EARLY” CWIP PROVISIONS IN THE 1970’s and 1980’s?
In the 1970’s and 1980’s, a utility was allowed to place all of the construction and financing costs in the rate base annually, and then begin to generate profit on those costs. By allowing the utilities to make a profit on all construction costs and financing charges prior to the completion of the power plants, the utilities had a direct incentive to build as many plants as they could justify. This style of accounting and treatment of interest during construction proved to be nearly fatal to utilities in the late 1970’s and 1980’s. Vast power plant construction projects across the country were underway, project costs were rising well above budgets and long delays were common. The costs of new construction, primarily of nuclear plants, almost bankrupted the system. As a result, electric bills increased from overbuilding and canceled plants.
Utilities were, in effect, borrowing money for project costs, borrowing more for accumulating interest cost, and since much of their “profits” was AFUDC, they were borrowing money to pay dividends as well. Many projects were canceled, and their costs never recovered.
WHAT HAPPENED IN NORTH CAROLINA?
The anticipated growth in the demand for electricity did not materialize. Cost estimates for new power plants escalated rapidly, especially the nuclear power plants. (The initial estimate for the Shearon Harris plant was $1 billion for four units, and the cost of one that was actually completed came in over $4 billion). The annual cost recovery and profits from building these baseload plants caused utility rates to increase significantly. Duke Power and Progress Energy canceled nine nuclear plants after expending almost $1.5 billion. The utilities went to the N.C. Utilities Commission to decide who would pay for those canceled plants and the Commission split the costs between the stockholders and the rate payers.
In 1982, the General Assembly significantly modified this early recovery of CWIP and adopted the current regulatory rate system. Since then, there has been no construction of the costly baseload power plants.
WHY DO THE UTILITIES WANT TO CHANGE THE WAY THAT CONSTRUCTION IS PAID FOR?
The Utilities see another wave of big construction coming and they were resolved not to get caught with any of the massive costs of the nuclear plants this time. Nuclear plants are inherently risky, especially with the long construction time required. Historically, the construction delays,
risks of accidents and the unknown cost of the long-term handling of radioactive waste have made nuclear plants an unviable alternative. Hence, there is a push in state legislatures to change the regulatory accounting rules now that new plants are being considered.
In North Carolina, the utilities wish to be reimbursed year by year for interest on construction, rather than adding these costs to projects and then recovering them later as the assets go into service. Moreover, they seek to insure against losing their partial investments in new plants should they be canceled. They want to shift as much risk for plant construction onto the ratepayers as possible.
WOULD THE CWIP PROVISIONS IN SENATE BILL 3 RETURN RISKS TO THE CUSTOMERS?
The CWIP provisions in Senate Bill 3 allow construction costs to go into the rate base, so that the utility gets cost recovery plus a rate of return on the money. This makes CWIP both a direct subsidy by the ratepayers for new plant construction and a strong incentive for the utilities to build those plants. We, and not the stockholders, would pay even if the plants are abandoned.
The CWIP provisions in Senate Bill 3 shift much of the risk for plant construction back onto the ratepayers. Once the N.C. Utilities Commission were to approve a plant, there would be an annual review of construction costs and financing charges. At the next rate case point, those costs and AFUDC would go into the rate base and the utilities would make profit on them. Given the costs of the plants, we would expect rate cases to happen more frequently, if not annually.
WHAT HAPPENS WHEN A POWER PLANT IS CANCELED?
Another major change sought by utilities in Senate Bill 3 seeks to limit their losses in the event of canceled projects. Construction costs would be reviewed annually, and if found by the N.C. Utilities Commission to be reasonable and prudent, those costs would be recouped by amortization charges “over a reasonable period” should the project be canceled.
HOW MUCH NEW BASELOAD CONSTRUCTION ARE THE UTILITIES EXPECTING IN THE NEXT DECADE?
Duke Energy is planning to construct the 800 MW Cliffside coal plant in Rutherford County by 2011 and two 1170 MW nuclear units at its Lee Station site in Cherokee County, South Carolina. Progress Energy is considering construction of two 1117 MW units at its Shearon Harris site in Wake County, and two more nuclear plants in its Florida service area. Both utilities have plans for natural gas and combined cycle plants, although these are generally used for intermediate and peak loads. These plants are less expensive to construct and have far shorter construction times than coal and nuclear units.
HOW MUCH WOULD THESE NEW PLANTS COST?
It is difficult to guess at this time. The latest cost projection for Duke’s Cliffside unit are $1.8 billion with another $600 million for the AFUDC financing charges. The utilities have not presented any reliable estimates for the nuclear units, although given the $3000/kW for the Cliffside unit, the nuclear units would cost at a minimum $3.5 billion each. Given the long construction time for the nuclear units they could easily be $4.5 billion each. As a result, the total cost for the four nuclear units, and the Cliffside coal unit easily approaches $20 billion. And this would be over the next decade.
WOULD THE NORTH CAROLINA RATEPAYERS HAVE TO BEAR ALL OF THIS $20 BILLION?
No. Because the service areas of both Duke and Progress include parts of South Carolina, the North Carolina ratepayer’s share is about 70% or about $14 billion.
HOW MUCH WOULD THIS COST RATEPAYERS?
Averaged over the next decade, the new plant construction would be an increase in bills of $1.4 billion per year, more than 10 percent of the current gross revenues of the utilities annually.
Under the baseload financing provisions in Senate Bill 3, the utilities get our money for construction costs, financing costs and profits and our rates would go up to cover all of these costs.
WHAT IS THE BASIC PROBLEM WITH THE CWIP PROVISIONS IN SENATE BILL 3?
For electricity customers, the changes proposed in Senate Bill 3 mean that rates would go up sooner than would be the case under the current rate structure, since interest charges on construction projects would be allowed as a current expense in determining rates immediately rather than later when the plants are completed and become used and useful. Moreover, profits would be allowed in rates right away on CWIP and AFUDC.
Once the costs went into the rate base, the utility would get its current 12% rate of return on the money. If the utilities get the opportunity to recover all of the costs for constructing baseload plants, it would become much easier and economical for utilities to build new plants. The utilities would bear very little of the risk. The costs to ratepayers would increase considerably while the plants were being built and even if the plants were abandoned, we would still pay for them.
John O. Blackburn, Ph.D. is former Chair of the Economics Department and Professor Emeritus, Duke University.
John Runkle is General Counsel of the Conservation Council of North Carolina and attorney for NC WARN.