Tennessee Valley Authority: Debt Reduction Efforts and Potential Stranded
Costs (Letter Report, 02/28/2001, GAO/GAO-01-327).
If the Tennessee Valley Authority (TVA) were to lose its legislative
protections today, its high level of debt and corresponding high
financing costs would be a competitive challenge. This competitive
challenge would be even greater if it were at the same time attempting
to recover costs of deferred assets through rates. Despite having
reduced its debt and deferred assets over the past 3 years, TVA still
compares unfavorably to its likely competitors in these regards. In
addition, TVA is revising its goals for reducing debt and deferred
assets downward significantly. Whether or not the deferred assets will
contribute to stranded costs that are recoverable from customers depends
on the specific requirements of any legislation that might remove TVA's
legislative protections and TVA's ability to retain its current
competitive advantages in a restructured environment. In addition, the
longer that TVA has to prepare for competition, the longer it will have
to reduce debt and recover the costs of its deferred assets and position
itself more competitively. Ultimately, TVA's ability to be competitive
will depend on the future market price of power, which cannot be
predicted with any certainty.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GAO-01-327
TITLE: Tennessee Valley Authority: Debt Reduction Efforts and
Potential Stranded Costs
DATE: 02/28/2001
SUBJECT: Competition
Electric utilities
Utility rates
Energy costs
Financial management
Cost control
Debt
Strategic planning
Financial analysis
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GAO-01-327
Report to Congressional Requesters
February 2001 TENNESSEE VALLEY AUTHORITY
Debt Reduction Efforts and Potential Stranded Costs
GAO- 01- 327
Letter 3 Appendixes Appendix I: Objectives, Scope, and Methodology 54
Appendix II: Mechanisms for Mitigating Stranded Costs 60 Appendix III:
Comments From the Tennessee Valley Authority 61 Appendix IV: GAO Contact and
Staff Acknowledgments 65
Tabl es Table 1: Factors Affecting Cash Available for Debt Reduction From
1998 Through 2007 15
Figures Figure 1: Annual Debt Reduction Goals in TVA's 1997 Plan Compared to
Actual Debt Reduction for Fiscal Years 1998
Through 2000 and Proposed Goals for Fiscal Years 2001 Through 2007 11 Figure
2: Annual Outstanding Debt Goals in TVA's 1997 Plan
Compared to Actual Debt Outstanding for Fiscal Years 1998 Through 2000 and
Proposed Annual Goals for Fiscal Years 2001 Through 2007 12
Figure 3: Annual Capital Expenditure Goals in TVA's 1997 Plan Compared to
Actual Capital Expenditures for Fiscal Years 1998 Through 2000 and Proposed
Annual Goals for Fiscal Years 2001 Through 2007 14 Figure 4: Annual
Estimated Balances for Deferred Assets in TVA's
1997 Plan Compared to the Actual Deferred Asset Balances for Fiscal Years
1998 Through 2000 and to Estimated Balances for Fiscal Years 2001 Through
2007 18 Figure 5: Ratio of Total Financing Costs to Revenue for TVA and
Likely Competitors for Fiscal Years 1994 and 1999 23 Figure 6: Ratio of
Fixed Financing Costs to Revenue for TVA and
Likely Competitors for Fiscal Years 1994 and 1999 24 Figure 7: Ratio of Net
Cash From Operations to Expenditures for
PP& E and Common Stock Dividends for TVA and Likely Competitors for Fiscal
Years 1994 and 1999 26 Figure 8: Ratio of Portion of Capital Assets Not Yet
Begun to Be
Taken Into Rates Compared to Gross PP& E for TVA and Likely Competitors for
Fiscal Years 1994 and 1999 29
Figure 9: Ratio of Accumulated Depreciation/ Amortization to Gross PP& E for
TVA and Likely Competitors as of Fiscal Years 1994 and 1999 31
Figure 10: TVA's Potential Application of the FERC Methodology for
Calculating Stranded Costs 38 Figure 11: The Link Between TVA's Debt
Reduction Efforts and Its
Potential Stranded Costs 44
Abbreviations
CBO Congressional Budget Office CWIP construction work in progress EEI
Edison Electric Institute
EIA Energy Information Administration EPAct Energy Policy Act of 1992 FASB
Financial Accounting Standards Board
FERC Federal Energy Regulatory Commission IOU investor- owned utilities kWh
kilowatthour PP& E property, plant, and equipment SFAS Statement of
Financial Accounting Standards TVA Tennessee Valley Authority
Lett er
February 28, 2001 The Honorable Bob Smith Chair, Committee on Environment
and Public Works United States Senate
The Honorable Mitch McConnell United States Senate
This report responds to your request that we review several issues
pertaining to the Tennessee Valley Authority's (TVA) financial condition.
Increasing competition in electricity markets led TVA management to develop
a 10- year business plan in 1997 to position TVA to be more competitive.
Among the objectives in the plan was reducing TVA's cost of power, primarily
by cutting its $27.4 billion debt in half by 2007.
Because TVA is expected to have to compete with other utilities in the
future and, as we reported in 1999, 1 will not achieve the debt reduction
goal as laid out in its 10- year business plan, you expressed concern about
TVA's
likely financial condition and competitiveness in the years ahead. You asked
that we examine TVA's (1) progress in reducing debt and recovering the costs
of deferred assets, 2 (2) financial condition, including debt and
fixed cost ratios, compared to that of other utilities, (3) potential
stranded costs, 3 options for recovering them, and how they are linked to
TVA's debt, and (4) bond rating and its impact on TVA's interest costs. As
agreed with your offices, the first three issues are the subjects of this
report; we plan to issue a separate report on the fourth issue.
1 Tennessee Valley Authority: Assessment of the 10- Year Business Plan (GAO/
AIMD- 99- 142, April 30, 1999). 2 In this report, we use the term
“deferred assets” to jointly refer to (1) TVA's deferred nuclear
generating units (Bellefonte 1 and 2 and Watts Bar 2), and (2) unamortized
regulatory assets and certain other deferred charges. The costs of deferred
assets are costs that have been incurred but not yet recovered. In cases
where we discuss TVA's deferred nuclear generating units separately, we
refer to them as deferred nuclear units.
3 Stranded costs can generally be defined as costs that become uneconomical
to recover through rates due to regulatory changes. They arise in
competitive markets as a result of uneconomic assets, the costs of which are
not recoverable at market rates.
Results in Brief TVA has reduced its debt by about $1. 4 billion over the
first 3 years of its 1997 10- year business plan. By reducing debt, and
refinancing some debt at lower interest rates, TVA has reduced its annual
interest expense from about $2. 0 billion in fiscal year 1997 to about $1. 7
billion in fiscal year 2000.
However, TVA continues to fall behind schedule in meeting its debt reduction
goal, and consequently is revising this goal. Through the first 3 years of
the plan, TVA's debt reduction shortfall was about $1.4 billion and is
expected to be even higher by 2007. In 1997, TVA projected a debt balance of
about $13.2 billion by September 30, 2007. Currently, TVA officials estimate
that its outstanding debt by September 30, 2007, will be
between $18 billion and $24 billion, with a target of about $19.6 billion-
or about $6.4 billion higher than TVA envisioned when it issued the 1997
plan. Assuming it reaches the $19.6 billion target and its average interest
rate does not change, we estimate that TVA's interest expense in the year
2008 will be about $416 million more than if it had reduced debt to $13.2
billion. TVA is not projecting a debt reduction target beyond 2007. The
revision to the debt reduction goal is due primarily to lower revenues than
projected in
1997, and to the use of cash originally targeted for debt reduction to
instead pay for greater than anticipated annual operating expenses and
capital expenditures for new generating capacity and environmental controls.
TVA has also made progress in recovering the costs of its deferred assets.
TVA's recovery of the costs of its deferred assets, in total, is on
schedule; it has recovered about $1. 1 billion over the first 3 years, as
planned. However, since issuing its 1997 plan, TVA has added other deferred
assets totaling about $600 million, some of which will have to be recovered
through rates in the future. In addition, TVA is revising downward its goal
for deferred
asset recovery over the remaining years covered by the plan. Its proposed
revision to the 10- year plan changes the estimate for the balance of
deferred assets outstanding by September 30, 2007, to about $3. 9 billion,
up from the $500 million envisioned in the 1997 plan. Projected increases in
operating and other expenses will delay recovery of the costs of TVA's
deferred assets.
Since issuing its 10- year plan, TVA's financial condition has improved, but
still compares unfavorably to likely competitors. TVA continues to have
relatively high debt and financing costs. For example, for fiscal year 1999,
28 cents of every revenue dollar earned by TVA went to pay its fixed
financing costs compared to about 9 cents on average for its likely
competitors. Similarly, TVA's unrecovered costs associated with its deferred
capital assets are relatively high. As a result of its relatively high
financing costs associated with its high debt, and its deferred assets,
TVA's financial flexibility to respond to financial or competitive
challenges is less than that of its likely competitors. Although facing
these financial disadvantages, TVA currently enjoys certain competitive
advantages because of its ties to the federal government as a wholly owned
government corporation; these advantages may not exist in the future.
Because it has incurred costs that might not be recoverable in a competitive
environment, TVA could have stranded costs if Congress enacts legislation
that requires TVA to compete with other electricity
providers. Stranded costs could result if TVA were unable to recover all its
costs when selling power at or below market rates. TVA's potential for
stranded costs relates to its deferred assets- particularly the $6. 3
billion in costs for three nuclear units that are not operational and thus
generate no
revenue- and high debt, which totaled about $26 billion as of September 30,
2000. If TVA enters a competitive environment with relatively high debt
service costs, its ability to price its power competitively could be
jeopardized, thus increasing its potential for stranded costs. TVA's
competitive challenge would be even greater if it were at the same time
attempting to recover costs of deferred assets, including the deferred
nuclear units, through rates.
TVA, in a letter from its Chief Financial Officer, disagreed with our
findings in three areas. TVA's comments related to differing opinions about
the future market price of electricity, financial comparisons of TVA to
other utilities that are its likely competitors, and the relationship
between TVA's deferred assets and stranded costs. We continue to believe
that our findings are appropriate. Therefore, we made no substantive changes
to our report in response to TVA's comments, but did make certain changes
for clarification purposes. TVA's comment letter is reproduced in appendix
III and our detailed evaluation of TVA's comments is at the end of this
letter.
Background Under the TVA Act of 1933 (TVA Act), as amended, TVA is not
subject to most of the regulatory and oversight requirements that commercial
electric utilities must satisfy. The Act vests all authority to run and
operate TVA in its three- member board of directors. Legislation also limits
competition between TVA and other utilities. The TVA Act was amended in 1959
to establish what is commonly referred to as the TVA “fence,”
which prohibits TVA, with some exceptions, from entering into contracts to
sell power outside the service area that TVA and its distributors were
serving on
July 1, 1957.
In addition, the Energy Policy Act of 1992 (EPAct) provides TVA with certain
protections from competition, called the “anti- cherry picking”
provisions. Under EPAct, TVA is exempt from having to allow other utilities
to use its transmission lines to transmit (“ wheel”) power to
customers within TVA's service area. This legislative framework generally
insulates TVA from direct wholesale competition. As a result, TVA remains in
a position similar to that of a regulated utility monopoly. 4
EPAct's requirement that utilities use their transmission lines to transmit
wholesale electricity for other utilities has enabled wholesale customers to
obtain electricity from a variety of competing suppliers, thus increasing
wholesale competition in the electric utility industry across the United
States. In addition, restructuring efforts in many states have created
competition at the retail level. If, as expected, retail restructuring
continues to occur on a state- by- state basis over the next several years,
then industrial, commercial, and, ultimately, residential consumers will be
able to purchase their power from one of several competitors rather than
from
one utility monopoly. Since EPAct exempts TVA from having to transmit power
from other utilities to customers within its territory, TVA has not been
directly affected by the ongoing restructuring of the electric utility
industry to the same extent as other utilities. However, if the Congress
were to eliminate TVA's exemption from the wheeling provision of EPAct, its
customers would have the option of purchasing their power from other sources
after their contracts with TVA expire. Under the Clinton administration's
proposal in April 1999 to promote retail competition in the electric power
industry, which TVA supported, TVA's exemption from the wheeling provision
of EPAct would have been eliminated after January 1, 2003. If this or a
similar proposal is enacted, TVA may be required to use its transmission
lines to transmit the power of other utilities for consumption within its
service
territory. A balancing factor is that recent proposals would have also
removed the statutory restrictions that prevent TVA from selling wholesale
power outside its service territory. 4 However, TVA is subject to some forms
of indirect competition. For example, TVA has no protection against its
industrial customers relocating outside its service area or businesses
deciding not to move to its service area for reasons related to the cost of
power. In addition, customers can decide to generate their own power.
Because of these ongoing restructuring efforts, TVA management, like many
industry experts, expects that in the future TVA may lose its legislative
protections from competition. TVA's management recognized the need to act to
better position TVA to compete in an era of increasing competition and, in
July 1997, issued a 10- year business plan with that goal in mind. TVA
established a 10- year horizon because a majority of its longterm
contracts with distributors could begin expiring at that time, and TVA could
be facing greater competitive pressures by 2007. The plan contained three
strategic objectives: reduce TVA's cost of power in order to be in a
position to offer competitively priced power by 2007, increase financial
flexibility by reducing fixed costs, and build customer allegiance.
To help meet the first two strategic objectives noted above, one of the key
goals of TVA's 10- year plan was to reduce debt from its 1997 levels by
about one- half, to about $13.2 billion. In addition, while not specifically
discussed in the published plan, TVA planned to reduce the balance (i. e.,
recover the costs through rates) of its deferred assets from about $8. 5
billion to $500 million, which TVA estimated to be the net realizable value
of its deferred nuclear units. TVA planned to generate cash that could be
used to
reduce debt by increasing rates beginning in 1998, reducing expenses, and
limiting capital expenditures; these actions would increase its financial
flexibility and future competitiveness. TVA's plan to reduce debt and
recover the costs of deferred assets while it is still legislatively
protected from competition was intended to help position TVA to achieve its
ultimate goal of offering competitively priced power by 2007. In a
competitive market, if TVA's power were priced above market because of high
debt service costs and the recovery through rates 5 of the costs of its
deferred
assets, it would be in danger of losing customers. Losing customers could
result in stranded costs if TVA is unable to sell the capacity released by
the departing customers to other customers for at least the same price.
Stranded costs, as discussed later, are costs that are uneconomical to
recover in a competitive environment due to regulatory changes.
5 As discussed later, if TVA were to be required to compete with other
utilities and it had not recovered the costs of its deferred assets, TVA
might immediately write off all or a portion of the costs to retained
earnings. To the extent that TVA instead takes the costs into future rates,
there would be upward pressure on rates that would diminish TVA's
competitive
prospects.
Objectives, Scope, and For each of the three objectives addressed in this
report, you asked us to
Methodology answer specific questions. Regarding debt and deferred assets,
you asked
us to determine what progress TVA has made in achieving the goals of its 10-
year business plan for reducing debt and deferred assets, and to what extent
TVA has used the additional revenues generated from its 1998 rate
increase to reduce debt and deferred assets. Regarding TVA's financial
condition, you asked us to compare TVA's financial condition, including debt
and fixed cost ratios, to neighboring investor- owned utilities (IOUs).
Finally, regarding stranded costs, you asked us to (1) explain the link
between TVA's debt and its potential stranded costs, (2) determine whether
TVA has calculated potential stranded costs for any of its distributors, and
if so, determine the methodology it used, and (3) determine the options for
recovering any potential stranded costs at TVA.
We evaluated the progress TVA has made in achieving the debt reduction and
recovery of deferred assets goals of its 10- year plan, and determined the
extent to which TVA is using revenue from its 1998 rate increase to
reduce debt and recover the cost of its deferred assets, by interviewing TVA
and Congressional Budget Office (CBO) officials; reviewing and analyzing
various TVA reports and documents, including annual reports, audited
financial statements, the original 10- year business plan and proposed
revisions to it; and reviewing supporting documentation (analytical
spreadsheets, etc.) and assumptions underlying TVA's 10- year plan.
To determine TVA's financial condition, we analyzed TVA's debt and fixed
costs, and then compared TVA to its likely competitors. To accomplish this,
we obtained financial data for TVA and its likely competitors from their
audited financial statements; computed and compared key financial ratios for
TVA and its likely competitors; analyzed data on the future market price
of power; interviewed TVA officials about their efforts to position
themselves competitively, including their efforts to reduce debt, recover
the cost of their deferred assets, and mitigate and/ or recover stranded
costs; and reviewed IOU annual reports to determine what steps the IOUs are
taking to financially position themselves for competition.
To assess TVA's potential stranded costs, we interviewed industry experts at
the Federal Energy Regulatory Commission (FERC), 6 Edison Electric Institute
(EEI), 7 and CBO on the options other utilities have pursued to recover
stranded costs; reviewed Energy Information Administration (EIA) 8 documents
on stranded cost recovery at the state level; questioned TVA officials on
TVA's plans for calculating and recovering potential stranded costs; and
analyzed TVA's contracts to determine whether TVA has contractually relieved
its customers of any obligation to pay for any stranded costs. Also, to
determine the link between TVA's debt and its potential stranded costs, we
analyzed the interrelationship between debt reduction and stranded cost
mitigation. Additional information on our
scope and methodology is in appendix I. We conducted our review from April
2000 through January 2001 in accordance with generally accepted government
auditing standards. To the extent practical, we used audited financial
statement data in performing our analyses, or reconciled the data we used to
audited financial statements; however, we were not able to do so in all
cases and we did not verify the accuracy of all the data we obtained and
used in our analyses. In addition, we based information on debt reduction,
deferred asset recovery,
and the future market price of power on TVA's planned revisions to its key
goals and assumptions at the time of our review. We requested written
comments from TVA on a draft of this report. TVA provided both technical
comments, which we have incorporated, as appropriate and written comments,
which are reproduced in appendix III.
6 FERC is an independent agency within the Department of Energy with broad
regulatory authority over the interstate transmission and sale of wholesale
electricity, natural gas, and oil. 7 EEI is the industry group for investor-
owned utilities.
8 EIA is a statistical and analytical agency in the Department of Energy.
TVA's Schedule for In April 1999, 9 we reported that capital expenditures
not accounted for in Reducing Debt and
the 1997 plan would negatively impact TVA's ability to achieve its plans to
reduce debt and recover the cost of deferred assets by 2007. At that time,
Recovering Deferred
TVA's fiscal year 2000 federal budget request acknowledged that TVA would
Assets Is Slipping
not achieve its goal of reducing outstanding debt by about half until 2009,
2 years later than originally planned. TVA's goal in its original plan was
to reduce debt to about $13.2 billion. Since April 1999, TVA has fallen
further
behind in meeting its debt reduction goal. TVA now has a target of reducing
debt to $19. 6 billion by 2007; it no longer is projecting a target for debt
reduction beyond 2007. For fiscal years 1998 through 2000, TVA reduced its
debt by about $1. 4 billion. However, TVA's debt reduction shortfall also
totaled about $1. 4 billion, which resulted from greater than anticipated
capital expenditures and annual operating and other expenses and lower
revenues than projected in 1997. These same factors will hamper TVA's debt
reduction efforts over the last 7 years of the plan. In addition, although
TVA reduced deferred assets to the extent planned for the first 3 years of
the plan, it is revising the amount of deferred assets it plans to recover
through 2007 downward. TVA now plans to reduce the balance of its deferred
assets to about $3. 9 billion by September 30, 2007, compared to its
original goal of $500 million. Annual Debt Reduction Is
To achieve the overall debt reduction goal in the original 10- year plan,
TVA Behind Schedule and established annual debt reduction goals. In the 1997
plan, the annual debt Overall Goal Is Being reduction goals ranged from $476
million in 1998 to $2 billion in 2007. TVA
Revised Downward has made progress in reducing debt, and in fact, exceeded
its target goal in
the first year of the plan. However, TVA fell far short in the second and
third years. Through the first 3 years of the 10- year plan, TVA reduced
debt by about $1. 4 billion, but its debt reduction shortfall also totaled
about $1. 4 billion. In addition, TVA is now planning to issue a revised
plan that would significantly reduce the goals for 2001 through 2007. Figure
1
compares the annual debt reduction goals contained in TVA's July 1997 10-
year plan to TVA's actual debt reduction for fiscal years 1998 through
9 Tennessee Valley Authority: Assessment of the 10- Year Business Plan (GAO/
AIMD- 99- 142, April 30, 1999).
2000 and to TVA's proposed revisions to its annual debt reduction goals for
fiscal years 2001 through 2007.
Figure 1: Annual Debt Reduction Goals in TVA's 1997 Plan Compared to Actual
Debt Reduction for Fiscal Years 1998 Through 2000 and Proposed Goals for
Fiscal Years 2001 Through 2007
2500 Dollars in millions 2000
1500 1000
500 0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Original Plan Actual/ Revised Plan Source: GAO analysis based on data from
TVA.
In its presidential budget submission for fiscal year 2000, TVA acknowledged
that it would not achieve its goal of reducing debt by about one- half by
2007. Instead, TVA said it would not meet the debt reduction goal until
2009, 2 years later than the goal in its original 10- year plan. TVA is in
the process of revising its goal for reducing outstanding debt again. TVA
officials now estimate that its outstanding debt by September 30, 2007, will
be between $18 billion and $24 billion, with a target of about $19.6
billion, or about $6.4 billion higher than TVA envisioned when it issued the
1997
plan. TVA is not projecting a target reduction goal beyond 2007. Figure 2
compares the annual outstanding debt goals contained in TVA's July 1997 10-
year plan to TVA's actual debt outstanding for fiscal years 1998 through
2000 and to TVA's proposed revisions to annual goals for fiscal years 2001
through 2007.
Figure 2: Annual Outstanding Debt Goals in TVA's 1997 Plan Compared to
Actual Debt Outstanding for Fiscal Years 1998 Through 2000 and Proposed
Annual Goals for Fiscal Years 2001 Through 2007
30 Dollars in billions 25 20 15 10
5 0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Debt Outstanding - Original Plan Debt Outstanding - Actual and Revised Plan
Source: GAO analysis based on data from TVA.
TVA officials attribute the $1. 4 billion debt reduction shortfall over the
first 3 years to four factors. The first factor is greater than anticipated
cash expenditures for new generating capacity. For fiscal years 1998 through
2000, TVA spent $436 million more than planned to purchase new peaking
generator units. The 1997 plan assumed that TVA would meet future increases
in demand for power by purchasing power from other utilities,
which would have used less cash through 2007 than purchasing the peaking
units. TVA officials believe that its capital expenditures for new
generating capacity will have two positive effects. First, they believe the
new generating capacity will ultimately reduce TVA's cost of power, even
though
the increased capital expenditures will use cash that could have been used
to reduce debt. Second, they believe the new generating capacity will
enhance system reliability by providing a dependable source of power. The
second factor to which TVA officials attribute the debt reduction shortfall
over the first 3 years of the plan is greater than anticipated capital
expenditures requiring cash for environmental controls to meet Clean Air Act
requirements. For fiscal years 1998 through 2000, TVA spent $276 million
more than planned on environmental controls. Meanwhile, over the 3- year
period, TVA spent about $221 million less than planned on other types of
capital items. The net effect of increased spending on new generating
capacity and
environmental controls and decreased spending on other types of capital
items is that TVA's capital expenditures have exceeded the planned amount.
TVA had forecast about $1. 7 billion in capital expenditures over that 3-
year period; its actual capital expenditures were almost $500 million more
(about $2.2 billion). Under current plans, TVA expects its major capital
costs for new generating capacity and environmental controls to be
completed by 2004. Figure 3 compares the annual capital expenditure goals
contained in TVA's July 1997 10- year plan to TVA's actual capital
expenditures for fiscal years 1998 through 2000 and to TVA's proposed
revisions to annual goals for fiscal years 2001 through 2007.
Figure 3: Annual Capital Expenditure Goals in TVA's 1997 Plan Compared to
Actual Capital Expenditures for Fiscal Years 1998 Through 2000 and Proposed
Annual Goals for Fiscal Years 2001 Through 2007
1400 Dollars in millions
1200 1000
800 600 400 200
0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Original Capital Expenditures Forecast Actual and Revised Capital
Expenditures Forecast Source: GAO analysis based on data from TVA.
The third factor to which TVA officials attribute the debt reduction
shortfall over the first 3 years of the plan is a net increase in annual
expenses requiring cash that could have been used for debt reduction. For
fiscal years 1998 through 2000, TVA's operating and maintenance expenses,
and
sales, general, and administrative expenses were greater than anticipated.
This increase in annual expenses was partially offset by a reduction in fuel
and purchased power expense 10 and interest expense. The net effect was that
annual expenses totaled about $122 million more than planned.
10 TVA's revised plan anticipates higher prices for natural gas and for
electricity purchased from other utilities. However, this is partially
offset by TVA's plans to buy less electricity from others.
The fourth factor to which TVA officials attribute the debt reduction
shortfall over the first 3 years of the plan is less revenue than originally
anticipated. According to TVA officials, the revenue shortfall was caused
primarily by mild winters that lessened demand for electricity. The revenue
shortfall for fiscal years 1998 through 2000 totaled about $725 million.
Our analysis confirms that the above four factors were the primary ones that
hampered TVA's debt reduction efforts for fiscal years 1998 through 2000.
These factors are also projected to limit TVA's ability to reduce debt in
fiscal years 2001 through 2007. Over this 7- year period, the primary
factors limiting TVA's debt reduction efforts are that annual revenue is
expected to be lower, and capital expenditures and cash expenses are
expected to be higher. This reduces the amount of cash that would have been
available to
repay debt. TVA now anticipates that its revenue will be about $2.2 billion
lower, and its capital expenditures and cash expenses- at about $1. 6
billion and $2. 5 billion, respectively- will be higher than planned in
1997. Table 1 shows our analysis of the factors affecting cash available to
reduce debt from 1998 through 2007.
Table 1: Factors Affecting Cash Available for Debt Reduction From 1998
Through 2007
(Dollars in Billions)
Source Amount
Decrease in revenue $( 2.2) Increase in capital expenditures (1.6) Decrease
in fuel and purchased power expense 1. 2 Increase in other operating and
maintenance expense (3.1) Increase in interest expense (1.3) Decrease in
other uses of cash 0.6
Total reduction in cash available to reduce debt $( 6.4)
Note: Figures in parentheses denote factors that reduced the amount of cash
available for debt reduction. Source: GAO analysis based on data from TVA.
In developing its 10- year plan, TVA planned to use the additional revenue
from its 1998 rate increase to reduce its debt. TVA officials attribute
about an additional $1.24 billion in revenue over the first 3 years of the
plan to the rate increase. During this period, TVA has reduced its
outstanding debt by more than a comparable amount- about $1. 4 billion.
Plan to Recover Deferred A key element of TVA's plan was not only to reduce
the cost of its power by Assets Is Being Revised reducing its debt and the
corresponding interest expense, but also to Downward
recover a substantial portion of the costs of its deferred assets. By
increasing operating revenues and reducing interest and other expenses to
generate cash flow that could be used to reduce debt, TVA would have the
opportunity 11 to use revenues in excess of expenses to recover a portion of
the costs of its deferred assets. However, as noted previously, the proposed
revision to the plan contains additional operating and other expenses over
the remainder of the 10- year period, which, absent any future rate
increases, will decrease the amount of revenue available to recover deferred
assets. TVA has also added about $600 million in deferred assets, some of
which will have to be recovered in the future. 12 Although TVA recovered the
costs of deferred assets to the extent planned over the first 3 years of the
plan, it is reducing its overall deferred asset recovery goals through 2007.
TVA has a significant amount of unrecovered capital costs associated with
three uncompleted and nonproducing deferred nuclear units- about $6. 3
billion as of September 30, 2000. 13 At that time, TVA's investment in its
deferred nuclear units represented about 26 percent of the cost of TVA's
total undepreciated generating property, plant, and equipment. The deferred
units do not generate power, and TVA has chosen not to begin to recover
their costs through rates. In contrast, the unrecovered costs of TVA's
operating nuclear plants, which produced about 31 percent of TVA's power in
2000, represented about 45 percent of the cost of TVA's total undepreciated
generating assets as of September 30, 2000. At the time TVA issued the
original 10- year business plan, the unrecovered balance of TVA's deferred
assets, including both its nuclear units and other deferred assets, was
about $8. 5 billion. TVA recovered the cost of deferred
11 The original 10- year plan called for TVA to raise rates and reduce
expenses in order to generate the cash needed to reduce debt. The TVA Act
requires TVA to generate sufficient revenues to recover all costs and allows
but does not require TVA to make a profit. Therefore, TVA could use revenues
in excess of expenses to begin recovering the costs of its deferred nuclear
units and accelerate the recovery of its other deferred charges.
12 A portion of the increase in deferred assets is attributable to an
increase in nuclear decommissioning costs. TVA believes it will recover all
of these costs through earnings on its related trust fund portfolio; to the
extent it does so, it will not have to recover these costs through rates. 13
There are two uncompleted nuclear generating units at Bellefonte and one at
Watts Bar.
assets to the extent planned for over the first 3 years of the plan. Through
September 30, 2000, $1.1 billion in other deferred assets had been recovered
through rates, but recovery of the cost of the deferred nuclear
units had not begun. However, since the original plan was issued, TVA has
also added about $600 million in other deferred assets, some of which will
have to be recovered in the future; its current total is about $8 billion.
TVA's overall plan for recovering the costs of its deferred assets through
2007 is being reduced significantly. TVA now plans to reduce the balance of
its deferred assets, including both its nuclear units and other deferred
assets, to about $3.9 billion; this represents much less deferred asset
recovery than
TVA's original estimate of $500 million. Figure 4 compares the annual
estimated remaining balances of deferred assets (both the deferred nuclear
units and other deferred assets) contained in TVA's July 1997 10- year plan
to TVA's actual deferred asset balances as of the end of fiscal years 1998
through 2000 and to TVA's estimated balances for fiscal years 2001 through
2007.
Figure 4: Annual Estimated Balances for Deferred Assets in TVA's 1997 Plan
Compared to the Actual Deferred Asset Balances for Fiscal Years 1998 Through
2000 and to Estimated Balances for Fiscal Years 2001 Through 2007 9 Dollars
in billions
8 7 6 5 4 3 2 1 0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Balance of Deferred Assets - Original Plan Balance of Deferred Assets -
Actual and Revised Plan Source: GAO analysis based on data from TVA.
Not reducing debt and recovering deferred assets to the extent planned by
2007 while still legislatively protected from competition could diminish
TVA's future competitive prospects. Specifically, not meeting these goals
could cause the price of its future power to be above market, if TVA's debt
service costs remain relatively high at the time it is required to compete
and
if TVA is at the same time attempting to recover the costs of its deferred
assets through rates. Assuming that TVA's outstanding debt balance is $19.6
billion as of September 30, 2007, and its weighted average interest rate 14
remains about 6.5 percent, we estimate that TVA's interest expense in
14 The weighted average interest rate on TVA's debt outstanding as of
September 30, 2000, was about 6.5 percent.
the year 2008 will be about $1. 27 billion, about $416 million higher than
if debt were reduced to $13.2 billion. As we stated in our April 1999
report, the more progress TVA makes in addressing these issues while it has
legislative protections, the greater its prospects for being competitive if
it loses those protections in the future. Although reducing debt and the
amount of deferred asset costs that have not yet been recovered are
important to TVA as it prepares for competition,
TVA's future competitiveness will be based to a large degree on market
conditions and how TVA will be restructured if and when TVA loses its
legislative protections. Of particular importance is the uncertainty of the
future market price of power. In our 1999 assessment of TVA's 10- year plan,
we found that TVA's projection of the future market price of wholesale power
in 2007 was somewhat lower than the projections of leading industry experts.
This lower projection prompted TVA to be aggressive in its
planning to reduce costs to position itself to offer competitively priced
power by 2007. TVA and other industry experts are continuing to revise their
projections of the future market price of power in 2007. TVA's projection is
a load- shaped forecast- i. e., its projection is based specifically on how
TVA's load varies during different hours of the day and different days of
the week. TVA officials told us that higher projections are warranted now
than when it prepared its plan in 1997 primarily due to projected increases
in the price of
natural gas, but also due to a combination of other factors, including the
extreme volatility of spot prices (in the summer months), increasing power
demands beyond what they expected 3 years ago, shortages (or at least,
shrinking surpluses) of both generating and transmission capacity, and a
better understanding of the increased costs of complying with environmental
regulations that are likely to take effect between now and 2007. TVA has
stated that the impact of these factors can be seen in higher current
trading prices, higher forward prices being offered by suppliers, higher
long- term contract prices, and higher energy prices. TVA officials are now
forecasting a market price of power in 2007 in the range of 4.0 to 5.0 cents
per kilowatthour (kWh), which would be sufficient to cover its
projected costs of about 3.8 to 3.9 cents per kWh in 2007. An analysis by
Salomon Smith Barney, 15 which extends through 2004, supports TVA's 15
Salomon Smith Barney is a financial services firm that, among other things,
conducts research on energy issues.
position that market indicators suggest that the future market price of
power will be higher during this part of the plan period.
Not all industry experts agree with TVA's belief that the price of natural
gas will necessarily drive electricity prices higher. For example, the
Energy Information Administration (EIA) projects a downward price trend (in
current dollars) between now and 2007 in the region in which TVA operates,
in part due to declining coal prices 16 that EIA projects would more than
offset increasing gas prices. EIA also projects that nuclear fuel prices
will remain stable. However, when projecting future prices by
geographic region, EIA and other industry experts generally forecast the
future market price of power on an average yearly price that includes all
peaks and valleys. Such average yearly price forecasts are not directly
comparable to TVA's load- shaped forecast. Differing forecasts by various
industry experts underscore the uncertainty of predicting the future market
price of power. The higher actual market prices are, the better positioned
TVA will be to generate revenue that could be used to pay down debt and
recover costs,
including the costs of deferred assets. However, by increasing its
projections for the future market price of power, TVA assumes it can
accommodate a higher debt level than originally planned. Because of the
uncertainly surrounding whether TVA's projections of higher market prices
in 2007 are accurate, TVA's higher debt projections increase the risk that
it will not be able to generate the revenue needed to recover all costs or
offer competitively priced power at that time. In a competitive environment,
these assumptions could increase the federal government's risk of loss due
to its financial involvement with TVA. 17
16 EIA projects declining coal prices due to improved productivity in coal
mining and growing production from lower- cost mines in the west. 17 In
September 1997 we reported on the risk of loss to the federal government as
a result of its indirect and direct financial involvement in TVA ( Federal
Electricity Activities: The Federal Government's Net Cost and Potential for
Future Losses, GAO/ AIMD- 97- 110 and 110A, September 19, 1997). The federal
government's financial involvement and risk of loss is primarily indirect.
For indirect involvement, the federal government is at risk of loss for
unreimbursed costs because of any actions it might take to prevent default
on the debt service requirements on TVA's outstanding public debt. Although
the federal government explicitly does not guarantee TVA's publicly issued
debt, the major credit rating agencies rate this debt as if it has an
implicit federal guarantee.
TVA's Financial A key objective of TVA's 1997 plan was to alter its cost
structure from a Condition Has rigid, high fixed- to- variable cost
relationship to a cost structure with more financial flexibility that is
better able to adjust to a more volatile Improved but Key marketplace.
However, while TVA has made positive steps, its financial Financial
Indicators flexibility remains below that of likely competitors, largely
because its debt Still Compare remains relatively high. Another key
objective of TVA's 1997 plan was to reduce its cost of power. One of the
components of the cost of power is the
Unfavorably to Likely recovery of the costs of its capital assets. Similar
to improvements in Competitors
flexibility, while TVA has made some progress in recovering the costs of its
capital assets, financial indicators show that TVA has recovered fewer of
these costs than its likely competitors. In 1995 18 we reported that one
option available for TVA to improve its financial condition was to raise
rates while it is still legislatively protected from competition and use the
proceeds to reduce its debt. In 1998, TVA implemented its first rate
increase in 10 years. For the previous 10 years, TVA had chosen to keep
rates as low as possible rather than generate
additional revenue that could have been used to reduce debt. Revenue from
TVA's 1998 rate increase has reduced debt (and corresponding interest
expense) 19 and recovered some of the costs of deferred assets over the
first
3 years of its 10- year plan. From September 30, 1997, through September 30,
2000, TVA reduced its debt from about $27.4 billion to about $26.0 billion.
This debt reduction, along with the refinancing of debt at lower interest
rates, enabled TVA to reduce its annual interest expense
from about $2.0 billion in fiscal year 1997 to about $1. 7 billion in fiscal
year 2000. In addition, TVA has recovered about $1. 1 billion of its
deferred assets through rates. While not reducing debt and recovering the
costs of deferred assets to the extent anticipated in its original plan,
these actions are important because they are a step toward giving TVA more
financial flexibility to adjust its rates in a competitive environment. 18
Tennessee Valley Authority: Financial Problems Raise Questions About Long-
term Viability (GAO/ AIMD/ RCED- 95- 134, August 17, 1995).
19 TVA has reduced its interest expense not only by repaying debt but also
by refinancing debt at lower interest rates. In fiscal year 1999, TVA
obtained authority from the Congress to prepay, without penalty, the $3. 2
billion that TVA then owed the Federal Financing Bank; it
then refinanced that debt at lower interest rates. In our 1999 report, we
estimated that the interest savings from this refinancing would provide an
average annual savings of about $116 million. TVA has also refinanced other
debt.
TVA's Financial Flexibility To assess the progress TVA has made in achieving
its key objective of Remains Relatively Low
altering its cost structure from a rigid, high fixed- to- variable cost
relationship to a cost structure with more financial flexibility, and to put
TVA's financial condition in perspective, we compared TVA to likely
competitors 20 in terms of (1) total financing costs, (2) fixed financing
costs, and (3) net cash generated from operations as a percentage of
expenditures
for property, plant, and equipment and common stock dividends. These ratios
are indicators of TVA's flexibility to withstand competitive or financial
challenges. To assess TVA's financing costs 21 compared to these
competitors, we computed the total financing costs to revenue ratio, which
is the percentage of an entity's operating revenue that is needed to cover
all of its financing costs. A lower percentage indicates greater flexibility
to respond to financial or competitive challenges. Financing costs for TVA,
which consist of the interest expense on its outstanding debt and payments
made to the federal government as returns on past appropriations, 22 are
fixed costs in the short term that must be paid even in times of financial
or competitive difficulty. In contrast, for the IOUs, financing costs
include preferred and common stock dividends in addition to interest
expense,
because part of the IOUs' capital is derived from preferred and common stock
and dividends represent the cost of this equity capital. Figure 5 shows that
TVA's total financing costs, although improved since 1994, remain high when
compared to those of likely competitors.
20 According to industry experts, TVA's competition is most likely to come
from nearby entities because of the high cost of transmitting power. Our
analysis used seven utilities that border on TVA's service territory that
are used by analysts to compare TVA to other electric utilities, and one
large independent power producer; we refer to these entities generically as
IOUs. TVA could face competition from other sources, including utilities
that do not border
on TVA's service area, power marketers, and other independent power
producers. 21 Differences in financing structures between TVA and likely
private sector competitors make direct comparisons somewhat difficult.
Specifically, financing costs include (1) interest expense on short- term
and long- term debt (both TVA and IOUs), (2) returns on
appropriation investment (TVA only), and (3) preferred and common stock
dividends (IOUs only). In addition, IOUs are organized as tax- paying
businesses and are usually financed by the sale of securities in the free
market and by issuing debt, while TVA's capital is derived primarily from
debt. The requirement that TVA obtain financing by issuing debt could be
considered a competitive disadvantage because of the corresponding fixed
financing costs which reduce TVA's financial flexibility. We performed
analyses which take into effect these differences in financial structure.
22 The 1959 amendments to the TVA Act require TVA to make annual principal
payments to Treasury from net power proceeds plus a market rate of return on
the balance of this debt. The latter is the payment on appropriations.
Figure 5: Ratio of Total Financing Costs to Revenue for TVA and Likely
Competitors for Fiscal Years 1994 and 1999 40
Percentage 35 30 25 20 15 10
5 0
American Carolina
Dominion Duke Entergy LG& E Southern
AES TVA Electric
Power and Resources,
Power Energy Company
Power Light
Inc. Corporation
1994 1999
Source: GAO analysis based on entity annual reports.
Next, we computed the fixed financing costs to revenue ratio, which
indicates the percentage of operating revenues needed to cover the fixed
portion of the financing costs. For this ratio, we excluded the common stock
dividends paid by IOUs because these are not contractual obligations that
must be paid. They can be reduced- or even suspended in extreme cases- to
allow an entity to respond to financial or competitive challenges. As with
the total financing costs to revenue ratio, the lower the percentage
of the fixed financing costs to revenue, the greater the financial
flexibility of the entity. Figure 6 shows that, while TVA has made progress
since 1994, its fixed financing costs remain high compared to those of
likely competitors. For example, for fiscal year 1999, 28 cents of every
revenue
dollar earned by TVA went to pay for fixed financing costs 23 compared to
about 9 cents on average for its likely competitors.
Figure 6: Ratio of Fixed Financing Costs to Revenue for TVA and Likely
Competitors for Fiscal Years 1994 and 1999 40 Percentage
35 30 25 20 15 10
5 0
American Carolina
Dominion Duke Entergy LG& E Southern
AES TVA Electric
Power and Resources,
Power Energy
Company Power Light
Inc. Corporation
1994 1999
Source: GAO analysis based on entity annual reports.
Another key indicator of financial flexibility is the ratio of net cash from
operations (i. e., cash in excess of operating and interest expenses) to
expenditures for property, plant, and equipment (PP& E) and common 23 TVA
has further reduced this to about 26 cents of every revenue dollar for
fiscal year 2000.
stock dividends. This net cash in effect represents the amount available for
management's discretionary use. A percentage of 100 would indicate
sufficient net cash provided by operations to pay for 100 percent of annual
PP& E expenditures and common stock dividends. By necessity, utilities that
are unable to pay for capital expenditures from net cash are forced to pay
for them through retained earnings or by borrowing funds or issuing
stock. Issuing debt to cover capital expenditures increases a utility's cost
of power by requiring annual interest payments, and issuing stock could also
increase the cost of power through the payment of dividends. Since TVA does
not pay dividends, its ratio only includes expenditures for PP& E. A higher
percentage indicates greater flexibility. Because of increased revenue from
TVA's recent rate increase, a significant reduction in annual capital
expenditures for its nuclear power program, and cost control measures that
reduced certain expenses, TVA's ratio has improved
significantly and now compares favorably to those of likely competitors.
Figure 7 illustrates the improvement TVA has made to date compared to likely
competitors.
Figure 7: Ratio of Net Cash From Operations to Expenditures for PP& E and
Common Stock Dividends for TVA and Likely Competitors a for Fiscal Years
1994 and 1999 200
Percentage 180 160 140 120 100
80 60 40 20
0 American
Carolina Dominion
Duke Entergy LG& E Southern AES TVA
Electric Power and
Resources, Power
Energy Company
Power Light
Inc. Corporation
1994 1999
a We did not include the 1994 ratio for AES in figure 7 because this ratio
was significantly higher than the other utilities (about 1,700 percent) and
the scale that would have been needed to include it would have visually
distorted the differences among the other utilities; AES's ratio has
decreased considerably since 1994 due to capital expenditures for generating
equipment.
Source: GAO analysis based on entity annual reports.
TVA's Capital Cost Recovery Electricity providers, including TVA, generally
recover their capital costs
Remains Relatively Low once the capital assets have been placed in service
by spreading these costs
over future periods for recovery through rates. This way, customers
“pay” for the capital assets over time as the assets provide
benefits. When a decision is made not to complete a capital asset, it
becomes “abandoned.” Accounting standards require that abandoned
assets be classified as
regulatory assets and amortized into operating expense; therefore, they
would be included in rates over time. 24 Thus, even though abandoned assets
are nonproductive, the costs may still be recovered.
TVA's three uncompleted deferred nuclear power units have not been
classified as abandoned, even though no construction work has been done in
the last 12 to 15 years. In 1995 and 1997, we reported that TVA should
classify them as regulatory assets and begin to recover the costs
immediately. However, TVA continues to assert that there is a possibility
the units will be completed in the future and has not classified them as
regulatory assets and begun to recover their costs. As of September 30,
2000, the deferred cost of the three uncompleted nuclear generating units
was about $6. 3 billion. If TVA is required to compete with other
electricity providers, depending on the market price of power and TVA's cost
of providing power, recovery of these deferred assets could be difficult.
Effective for 1999, TVA began emphasizing the
accelerated recovery of certain of its other deferred assets in its planning
and adopted accounting policies that would enable it to recover more of
these costs earlier. 25 However, as the following analysis indicates, TVA's
continued deferral of the $6.3 billion related to the three nuclear units
would hinder its ability to compete in a restructured environment, if TVA
tries to recover the costs through rates. This would increase the risk of
loss to the federal government from its financial involvement in TVA. The
extent to which the costs of deferred capital assets have not been
recovered by TVA compared to its likely competitors can be shown by two
analyses. The first analysis compares the amount of capital assets that have
not yet begun to be taken into rates to gross PP& E. 26 For TVA, this
consists of construction work in progress (CWIP) 27 and the costs of the
deferred 24 Financial Accounting Standards Board (FASB) Statement of
Financial Accounting Standards (SFAS) No. 90, Regulated Enterprises-
Accounting for Abandonments and Disallowances of Plant Costs.
25 As of September 30, 2000, TVA had recovered about $1. 1 billion of the
costs of its unamortized regulatory assets and other deferred charges. None
of the $1. 1 billion related to TVA's deferred nuclear units. 26 For this
analysis, we only include those deferred assets that TVA and its competitors
include in PP& E; thus, we excluded other deferred assets. 27 CWIP
represents the cost of PP& E projects under construction that have not been
placed into service.
nuclear units; for the other entities this consists of CWIP only. A lower
ratio indicates fewer capital costs to be recovered through future rates,
and therefore more flexibility to adjust rates to meet future competition.
TVA's ratio improved- dropping by more than half- when it brought two
nuclear plants on line in 1996 and began to recover their costs. However, as
figure 8 shows, the portion of TVA's capital assets that has not yet begun
to be taken
into rates remains significantly higher than that of likely competitors.
This is due largely to the deferral of TVA's three uncompleted nuclear
units. For example, about 19 percent of the total cost of TVA's PP& E as of
September 30, 1999, was not in rates, while the highest percentage for TVA's
likely competitors was only 10 percent.
Figure 8: Ratio of Portion of Capital Assets Not Yet Begun to Be Taken Into
Rates Compared to Gross PP& E for TVA and Likely Competitors for Fiscal
Years 1994 and 1999 50 Percentage
45 40 35 30 25 20 15 10
5 0
American Carolina
Dominion Duke Entergy LG& E Southern
AES TVA Electric
Power and Resources,
Power Energy
Company Power
Light Inc.
Corporation
1994 1999
Source: GAO analysis based on entity annual reports.
A second way to analyze the extent to which capital costs have been
recovered through rates is to compare accumulated depreciation/ amortization
28 to gross PP& E. A higher ratio indicates that a greater percentage of the
cost of PP& E has been recovered through rates. A utility that has already
recovered a greater portion of its capital costs could be in a better
financial condition going into an increasingly
competitive environment because it would not have to include those costs in
future rates. TVA has also made progress in this area since 1994, as have,
in general, its likely competitors. However, figure 9 shows that as of
September 30, 1999, TVA had recovered a substantially smaller portion of its
capital costs than most of its likely competitors, again, largely due to the
deferred nuclear units. 28 Depreciation is the process of recovering the
cost of PP& E by allocating the expenses associated with it to each period
benefited by the asset. Amortization is the allocation of expenses
associated with intangible and other assets, such as abandoned plant costs,
to each period benefited.
Figure 9: Ratio of Accumulated Depreciation/ Amortization to Gross PP& E for
TVA and Likely Competitors as of Fiscal Years 1994 and 1999 45
Percentage 40 35 30 25 20 15 10
5 0
American Carolina
Dominion Duke Entergy LG& E Southern
AES TVA Electric
Power and Resources,
Power Energy
Company Power
Light Inc.
Corporation
1994 1999
Source: GAO analysis based on entity annual reports.
When considering its financing costs and unrecovered deferred assets, TVA's
financial condition compares unfavorably to its likely competitors. Although
TVA's ratio of net cash from operations to expenditures for PP& E
and common stock dividends is better than its likely competitors, this
advantage is negated by TVA's relatively higher financing costs, including
fixed financing costs, and relatively higher deferred asset costs. These
factors reduce TVA's financial flexibility to respond to future financial or
competitive pressures, a key objective of TVA's 10- year plan.
Bond analysts with experience rating TVA's bonds confirmed our assessment by
stating that if forced to compete today, TVA's financial condition would
pose a serious challenge. The analysts further stated that their Aaa rating
of TVA bonds is based on TVA's ties to the federal
government and the belief that any restructuring legislation would give TVA
sufficient time to prepare for competition. According to the analysts, their
bond rating of TVA was not based on the same financial criteria applied to
the other entities rated. When assessing the progress TVA has made in
achieving the key objectives of its 1997 plan, TVA's financial condition
remains unfavorable compared to its likely competitors in the current
environment. However, TVA also has certain competitive advantages.
Specifically, it ? remains its own regulator;
? is not subject to antitrust laws and regulations; ? enjoys a high bond
rating, and associated lower interest costs, based on its ties to the
federal government; ? is a government entity that is not required to
generate the level of net
income that would be needed by a private corporation to provide an expected
rate of return; ? is not required to pay federal and state income taxes and
various local
taxes, but is required to make payments in lieu of taxes to state and local
governments equal to 5 percent of gross revenue from sales of power in areas
where its power operations are conducted; in addition,
TVA's distributors are also required to pay various state and local taxes;
and ? has relatively more low- cost hydroelectric power than neighboring
utilities.
Although TVA enjoys these competitive advantages, its high debt and
unrecovered costs would present challenges in a competitive environment.
However, it is not possible to predict TVA's future competitive position. In
addition to uncertainties over the future market price of power, TVA's
future competitive position will be affected by a number of issues,
including
? the specific requirements of any legislation that might remove TVA's
legislative protections, including whether it would be able to retain some
or all of the competitive advantages described previously;
? actions being taken by TVA to prepare for competition in relation to those
being taken by TVA's competitors; ? the amount of time before TVA might lose
its protections from competition and is required to compete with other
utilities- the longer TVA is legislatively protected from competition, the
longer it will have to
reduce its debt and related financing costs and recover deferred costs
through rates; ? the extent to which TVA would write off all or a portion of
the cost of its
deferred nuclear units to retained earnings should it go from a regulated to
a restructured, competitive environment. To the extent retained earnings is
sufficient to cover the cost of the write- offs, any costs written off
directly to retained earnings would not have to be recovered through future
rates; 29 and
? total cost of delivering power in relation to likely competitors,
generation capacity and mix, transmission capability, and geographic
location.
29 TVA follows FASB standards on regulated enterprises, including SFAS No.
71, Accounting for the Effects of Certain Types of Regulation. Unless
otherwise prescribed by restructuring legislation, TVA would be required to
apply other FASB accounting standards in a nonregulated environment,
including FASB 101, Regulated Enterprises- Accounting for the
Discontinuation of Application of FASB Statement No. 71; and FASB 121,
Accounting for the Impairment of Long- Lived Assets and for Long- Lived
Assets to Be Disposed of. Under these standards, TVA would be required to
mark certain of its capital assets up/ down to market value. If the book
value of those capital assets exceeds market value, TVA would be required to
recognize the difference as a period loss and write it off to retained
earnings. However, restructuring legislation could allow the recovery of
certain capital assets that otherwise would be required to be written off in
accordance with accounting standards.
TVA's Potential for Stranded costs can generally be defined as costs that
become
Stranded Costs and uneconomical to recover through rates when a utility
moves from a
regulated to a competitive environment. Stranded costs arise in Options for
Recovery
competitive markets as a result of uneconomic assets, the costs of which are
not recoverable at market rates. 30 There are two commonly used methods for
calculating stranded costs, and various mechanisms have been used to recover
them in the states that have restructured their electricity markets. TVA's
potential for stranded costs arises mainly from its uneconomic assets-
primarily its three nonproducing nuclear units with unrecovered costs
totaling about $6. 3 billion- and the fixed costs associated with its high
debt. The mechanism( s) that would be available to
TVA to recover stranded costs would determine which customer group would pay
for them.
Calculating and Recovering Stranded costs occur when a utility moves from a
regulated to a Stranded Costs
competitive environment and is unable to recover certain costs because the
market price of power will not allow it to generate revenue at a level
sufficient to recover these costs. Such costs result from past decisions
that were considered prudent when they were made, and the costs would have
been recoverable in a cost- based, regulated environment. 31 However, in a
competitive environment, recovery of these costs would force a utility's
price above market, and it consequently could not recover them by charging
market- based rates. As discussed below and in appendix II, states that have
restructured their electricity markets have addressed the issue of
mitigating and recovering potential stranded costs in various ways. Stranded
costs can be the result of, among other things:
30 TVA's deferred nuclear units would be uneconomic in either a regulated or
a competitive market, but the recovery of the costs associated with them
would be different. In a regulated market in which there is little price
competition, TVA, acting as its own regulator, would have a better chance of
recovering these costs through future rates; in a competitive market,
assuming competition had decreased prices, there would be less chance of
recovery through rates.
31 In the regulated environment, utilities are required to meet demand for
electricity within their service territories and to make investments in
generating assets to do so. The utilities' investment decisions are approved
in advance by regulators and the costs are approved to go into the
utilities' rate bases. When the regulatory structure is changed, the
utilities may no longer be guaranteed the right to recover these costs. If
the costs are not recoverable at market rates after regulatory
restructuring, they may be considered stranded costs.
? investment in generation assets that may not be able to produce
competitively priced power in a restructured environment, even though the
investments were considered prudent at the time they were made; ? power
purchase contracts made in anticipation of future needs that
would become uneconomical should market prices for power in a competitive
market become lower; ? regulatory assets, such as deferred income taxes that
regulators would
have eventually allowed utilities to collect but may not be recoverable in a
competitive market; ? future decommissioning costs for nuclear facilities;
and ? social programs where public utility commissions mandated spending for
programs such as demand side management 32 such costs would typically be
capitalized and amortized in a regulated environment, but,
since the costs are not part of generating power, the market price for
electricity under competition may not allow recovery of them.
Methods of Calculating Two methods are commonly used to calculate the amount
of allowable
Stranded Costs stranded costs- the FERC “revenues lost”
methodology and the “asset- byasset
approach.” FERC has jurisdiction over stranded cost recovery related
to wholesale power sales and power transmission and uses the revenues lost
method in determining allowable stranded costs for these activities. If
legislation is enacted providing for TVA to compete in a restructured
environment, TVA would likely fall under FERC jurisdiction for stranded cost
recovery for its wholesale customers. TVA's wholesale sales to its 158
distributors were about $6 billion in fiscal year 2000, or about 88 percent
of TVA's total operating revenues.
Under the FERC methodology, whether a utility's plants are nonproducing or
productive is immaterial to the stranded cost calculation, as long as the
costs associated with the plants are included in rates at the time a
customer departs TVA's system. According to FERC officials, stranded cost
recovery assumes the costs are already in the rate base; if not, FERC
officials told us they would likely not consider them in a stranded cost
recovery claim. The three deferred nuclear units, with costs of about $6. 3
billion as of September 30, 2000, that TVA has not yet begun recovering, are
a primary
reason for TVA's potential exposure to stranded costs. However, TVA's
projections through 2007, using its current power rates, show that by the
32 Demand side management programs offer incentives to consumers to modify
patterns of electricity usage.
end of 2007 the costs will have been reduced to about $3. 8 billion. 33
Depending on the timing of any restructuring legislation affecting TVA and
assuming that FERC would have jurisdiction over TVA, it is unclear whether
FERC would consider these costs to be in TVA's rate base and, thus, allow
TVA to include some or all of these costs in a stranded cost recovery claim.
In the past when TVA calculated its stranded costs, it used the FERC
“revenues lost” methodology. When the 4- County Electric Power
Association (near Columbus, Mississippi) and the city of Bristol, Virginia,
threatened to find other sources of power, TVA used the FERC methodology to
calculate stranded costs, and TVA officials told us that they would continue
to use the FERC methodology to calculate stranded costs in the future. TVA's
calculations of stranded costs for the 4- County Electric
Power Association ranged from $57 million to $133 million. 34 The 4- County
Electric Power Association ultimately decided not to leave the TVA system
and therefore no stranded costs were assessed. In contrast, Bristol did
leave the TVA system. TVA again calculated stranded costs using the FERC
methodology and initially attempted to assess Bristol for $54 million for
stranded costs. However, TVA and the city of Bristol ultimately negotiated a
settlement that included an agreement under which Bristol would not be
assessed for stranded costs, but would purchase transmission and certain
ancillary services from TVA.
According to a FERC official, under the revenues lost method, when a
customer leaves a utility's system, stranded costs are calculated by
? first taking the revenue stream that the utility could have expected to
recover if the customer had not left, then
33 The underlying spreadsheets provided by TVA show that it will begin
recovering these costs in 2005. However, in February 2001, TVA officials
told us that based on revenue projections for fiscal year 2001, it is
possible that TVA could begin recovering these costs as early as fiscal year
2002. 34 To determine stranded costs in the case of the 4- County Electric
Power Association, TVA performed a study in which it evaluated four
scenarios using different capacity alternatives. According to TVA officials,
under all four scenarios, TVA would have been forced to sell the freed up
capacity at a lower price than it would have received under the existing
contract with the 4- County Electric Power Association due to a limited
wholesale market for the released capacity.
? subtracting the competitive market value of the electricity capacity
released by the departing customer (that the utility will sell to other
customers), then ? multiplying the result by the length of time the utility
could have reasonably expected to continue to serve the departing customer.
Figure 10 illustrates TVA's potential application of the FERC methodology.
Figure 10: TVA's Potential Application of the FERC Methodology for
Calculating Stranded Costs
Note: As discussed previously, TVA could still have uneconomic assets even
if it has no stranded costs. Restructuring changes the character of
uneconomic assets from costs that might be recoverable in a
regulatory environment to stranded costs that may not be recoverable in a
competitive environment. Source: GAO analysis based on information from TVA
and FERC.
The second commonly used method to calculate stranded costs is the
“asset- by- asset” or “bottoms up” approach. This
method has been used by the states when they restructure their retail
markets. In this method, the market value 35 of a utility's generating
assets is determined and compared to the amount at which those assets are
currently recorded on the utility's
books (book value). The difference would be reflected on the income
statement as a gain or loss and recorded in the retained earnings of the
organization. If the total book value of a utility's generating assets
exceeds their total market value, the utility would have stranded costs
equal to the difference between book and market values.
Because TVA is a unique 36 self- regulator that crosses state borders and is
not currently subject to FERC regulation, it is unclear what entity would
have jurisdiction over any stranded cost recovery at the retail level. 37
Sales to TVA's direct service industrial customers and other
nondistributors, which we consider retail sales because they are sales to
final users, were about $0. 7 billion in fiscal year 2000, or about 10.4
percent of TVA's total operating revenues. Options for Recovering In the
states that have restructured their electricity markets, there have
Stranded Costs been five commonly used mechanisms to recover stranded costs.
38 Depending on the approval of state regulators, utilities have the
following
options; the choice of option affects which customer group pays. ? Exit fees
fees charged to departing customers, either via a lump sum
or over a set number of years. 35 Market value is the amount a willing buyer
would pay and a willing seller would accept in an arms- length transaction.
36 TVA is the only federal government corporation supplying electricity and
is specifically excluded from the wheeling provisions of EPAct; other
federal entities involved in the electricity industry are not government
corporations but include entities under the
departments of Defense, Agriculture, Energy, Interior, and State. 37 In its
published discussion to the April 1999 Clinton administration's plan for
restructuring the electricity industry, officials state that “since no
State would have jurisdiction over TVA, there must be a federal arbiter
[FERC] to provide for the Authority's [TVA's] recovery of its stranded
costs;” however, this was only a proposal.
38 In addition, the states that have restructured have generally used three
mechanisms for mitigating the amount of stranded costs. These mechanisms
were employed either before or during the restructuring. See appendix II for
a discussion of the mitigation mechanisms.
? Competitive transition charge (or competitive transition assessment)
either (1) a one time charge applied to all customers at the time the state
initiates restructuring, or (2) charges based on kilowatthour (kWh) usage,
usually charged to remaining customers over a set number of years.
? Wires charge (also called transmission surcharge) a predetermined
surcharge that is not based on kWh usage, which is added to remaining
customers' power bills during a set period of time; sometimes considered a
subset of competitive transition charges. ? Rate freeze or cap regulators
set a cap on the total amount a utility
can charge; however, under the cap, the regulator would allow the utility to
recover stranded costs by charging higher prices for the two components of
the market that are still regulated (distribution and transmission). The cap
is usually frozen for the estimated length of time needed to recover the
stranded costs. Remaining customers bear the burden. 39 ? Write off to
retained earnings In the case where a utility moves from a regulated to a
competitive environment and has assets whose
book value is in excess of market value, it would mark its assets to market
value, and recognize any excess of book value over market value as a loss on
the income statement, which would flow through to retained earnings.
Retained earnings represent cumulative net profit from past operations that
can be used to benefit either stockholders or current
and future customers, by keeping profits in the company for future use. In
addition, the change to a competitive environment, with overvalued assets,
could result in stranded costs. However, the legislation that caused the
change to a competitive environment could give utilities the option of
recovering the amount of overvalued assets over time, rather than charging
all the cost to retained earnings immediately. Writing off the costs of the
overvalued assets to retained earnings immediately
would mitigate potential stranded costs and eliminate the need to recover
the cost of these assets from future ratepayers, making a utility's power
rates potentially more competitive. 39 It should be noted that not all
entities consider competitive transition charges, wires charges, or rate
caps to be true stranded cost recovery mechanisms. For example, the Edison
Electric Institute (EEI), the industry group for investor- owned utilities,
considers only that portion of costs associated with the change to
competition that is paid by departing customers to be stranded costs; other
mechanisms that involve recovery from remaining customers or other groups is
considered cost shifting. Therefore, EEI believes
only exit fees are an appropriate stranded cost recovery mechanism. The
option( s) available to TVA to recover potential stranded costs would depend
upon the final makeup of any restructuring legislation passed by Congress.
TVA Has the Potential for TVA continues to operate similar to a regulated
monopoly because of its Stranded Costs Because of
legislative protections from competition. Since regulatory changes Its
Nonproducing Nuclear
requiring TVA to compete with other electricity providers have not been
Plants and High Debt
made, TVA does not currently have stranded costs. However, as discussed
previously, TVA has uneconomic assets- primarily its three nonproducing
nuclear units with unrecovered costs totaling about $6. 3 billion that do
not generate revenue. In 1998, TVA estimated the net realizable value of
these assets to be about $500 million.
TVA has not made a final decision on whether to abandon these three units or
complete them and place them into service. If it abandons them, under
current accounting standards, 40 TVA would be required to mark them to
market value, begin amortizing the revalued plants on a yearly basis over a
set number of years, and recognize any excess of book value over market
value that it deems unrecoverable as a loss on the income statement of the
year in which the decision is made. However, according to the proposed
revision to its 10- year plan, to the extent there is sufficient revenue,
TVA
plans to begin recovering the full costs of these assets by 2005. 41 This
action would require approval of TVA's Board. If its retained earnings are
not sufficient to cover any losses arising from revaluation of these units,
TVA
could find itself with stranded costs if legislation were enacted that would
require TVA to compete with other electricity providers before it completes
these units and brings them into operation. TVA's ability to recover costs
that could ultimately become stranded is compounded by TVA's high debt and
corresponding financing costs.
If legislation is enacted subjecting TVA to FERC authority, subject to FERC
approval, TVA officials envision using exit fees, wires charges, or
competitive transition charges to recover any allowable stranded costs.
FERC's guidance specifies that the recovery mechanism would be exit fees
from departing customers. However, TVA could have difficulty recovering
any stranded costs because of existing contracts entered into with 97 of its
158 distributors. These contracts would prevent TVA from collecting stranded
costs after 2007 from these distributors if they agreed to purchase all
their power requirements from TVA through 2007. Proposed
40 FASB 90 would apply because TVA remains in a regulated environment. 41 As
mentioned earlier, TVA officials told us they could begin recovering the
costs of these deferred nuclear units as early as fiscal year 2002.
restructuring legislation would have required these contracts to be
renegotiated; however, it is possible that this clause will remain in
effect. Thus, if TVA enters a competitive environment with stranded costs,
it may be unable to collect them from certain departing customers after
2007, and the burden for recovering these costs may fall on remaining
customers or retained earnings from prior customers. 42 According to TVA
officials, if TVA were unable to collect any stranded costs
from departing customers under its contracts, remaining customers would bear
the burden of stranded cost recovery. To the extent stranded cost recovery
is spread among remaining customers, it would become more difficult for TVA
to price its power competitively. The Link Between TVA's
A key element of TVA's 10- year business plan is to reduce its cost of
power. Potential Stranded Costs
TVA planned to accomplish this by reducing expenses, limiting capital and
Its Debt Reduction expenditures, and instituting a rate increase in 1998 to
increase the cash
Efforts flow available to pay down debt. Reducing debt, in turn, reduces the
corresponding annual interest expense. By reducing interest expense, TVA
frees up cash that can be used to further reduce debt. In addition, these
actions increase the portion of revenue that would be available to recover
the costs of its deferred assets. To the extent that TVA reduces costs, it
will be able to offer more competitively priced power and its distributors
will be less likely to leave TVA's system for alternate suppliers. At the
wholesale
level, under current FERC rules, if its distributors do not leave, TVA does
not have the option of recovering stranded costs. If its distributors decide
to leave, TVA would have potential stranded costs if TVA is either unable to
sell the power released by the departing distributor or is forced to sell
the
power that would have been purchased by the departing distributor for 42
Depending on the magnitude of TVA's potential stranded costs, its retained
earnings may not be sufficient to cover them. For example, TVA's main
uneconomic assets- its three nonproducing nuclear plants- have a book value
of about $6. 3 billion, some or all of which could contribute to potential
stranded costs- while its retained earnings as of September 30, 2000 are
about $3. 7 billion.
lower rates. 43 Figure 11 illustrates the link between debt reduction and
stranded costs. 43 This discussion applies to TVA's wholesale distributors
because, as noted in our report,
they account for about 88 percent of TVA's sales, and it is unclear who
would have jurisdiction over any stranded costs at the nondistributor level.
The main difference between stranded cost recovery at the wholesale and
retail levels is that the options available for retail stranded cost
recovery do not necessarily presuppose that a customer leaves. However, the
link between TVA's potential stranded costs and debt reduction remains the
same.
Figure 11: The Link Between TVA's Debt Reduction Efforts and Its Potential
Stranded Costs
TVA institutes rate increase and reduces expenses to increase cash flow and
revenue
TVA uses cash TVA uses additional to pay down revenue to recover debt
deferred assets Paying down Reducing interest debt reduces
expense increases interest expense cash flow
Reducing expenses and recovering the cost of deferred assets enhances TVA's
ability to offer competitively priced power If TVA offers competitively
priced power, distributors are
less likely to leave If distributors do not
leave, TVA has no wholesale stranded
costs Source: GAO analysis.
This circular relationship is key to understanding how TVA's 10- year plan
links to potential stranded costs. In its original 10- year plan, a key
element of TVA's plan was to reduce its cost of power by cutting its debt in
half by September 30, 2007. By reducing debt, TVA would also reduce future
interest expense, which would free up additional cash that could be used to
further reduce debt. However, not explained in the published plan was how
the revenue generated from its 1998 rate increase would give TVA the
opportunity to recover the cost of its deferred assets. By increasing
revenue and reducing expenses, TVA would free up revenue that could be used
to recover the cost of its deferred assets and cash that could be used to
pay down debt.
As discussed previously, TVA estimates the additional revenue from the rate
increase over the first 3 years of the plan to be about $1. 24 billion. TVA
had the option to use that revenue for any authorized purpose, such as
adding any excess revenue to retained earnings, accelerating depreciation,
or amortizing its deferred assets, including writing down its deferred
nuclear units. TVA planned to first amortize some of its other deferred
assets before writing down its deferred nuclear units. To accomplish this,
TVA's Board of Directors approved a resolution to begin accelerating
amortization of these other deferred assets. This means that in any given
year in which TVA has revenue sufficient to meet all of its legal
requirements to recover all costs and comply with all laws and regulations
regarding revenue levels, any excess revenue can be used to accelerate the
write- down of a portion of the costs of its deferred assets; this would
result in TVA recovering these costs over time. 44 In relation to its
deferred nuclear units, TVA's original plan was to recover all but $500
million of these $6.3 billion costs by September 30, 2007, at which time TVA
officials believed it could be subject to a competitive environment through
legislative changes and expiring customer contracts. Its proposed revision
to the 10- year plan now calls for a balance of about $3. 8 billion by 2007,
or about $3.3 billion more than originally planned. To the extent TVA
recovers the costs of the deferred nuclear units before such
time as the Congress may remove its legislative protections, it would no
longer have to recover these costs through future rates, potentially making
44 As previously noted, TVA is allowed to but is not required to make a
profit. The supporting schedules to TVA's 10- year plan indicate that TVA
plans to manage its earnings so that in general, its net income will be
about $100 million per year, and any net income in excess of $100 million
can be used to accelerate amortization or write off its deferred nuclear
units.
its power more competitive, and giving it more flexibility to operate in a
competitive environment. And, as noted above, if TVA is able to offer
competitively priced power by 2007, its distributors would be less likely to
leave and TVA would be less likely to have stranded costs.
Conclusions If TVA were to lose its legislative protections today, its high
level of debt and corresponding high financing costs would be a competitive
challenge.
This competitive challenge would be even greater if it were at the same time
attempting to recover costs of deferred assets through rates. Despite having
reduced its debt and deferred assets over the past 3 years, TVA still
compares unfavorably to its likely competitors in these regards. In
addition, TVA is revising its goals for reducing debt and deferred assets
downward significantly. Whether or not the deferred assets will contribute
to stranded costs that are recoverable from customers depends on the
specific requirements of any legislation that might remove TVA's legislative
protections and TVA's ability to retain its current competitive advantages
in a restructured environment. In addition, the longer that TVA has to
prepare for competition, the longer it will have to reduce debt and recover
the costs of its deferred assets and position itself more competitively.
Ultimately, TVA's ability to be competitive will depend on the future market
price of power, which cannot be predicted with any certainty.
Agency Comments and TVA, in a letter from its Chief Financial Officer,
disagreed with our findings Our Evaluation
in three areas- the future market price of electricity, TVA's financial
condition compared to other utilities, and the relationship between TVA's
deferred assets and potential stranded costs. TVA's comments are
reproduced in appendix III and discussed below. In addition, TVA officials
provided technical comments on the draft report, which we have incorporated
as appropriate. TVA also took the opportunity to comment, in a section
called “Looking Back,” on progress it has made since issuing its
10- year plan in 1997, including reducing debt and recovering the costs of
certain deferred assets, and its goals and strategies for the future. We
discuss these comments at the end of this section.
Market Prices for Electricity TVA agreed that the future market price of
electricity is a key factor in assessing the likelihood of success in a
competitive environment and that
the price cannot be predicted with any certainty, but disagreed on the
general direction of prices. TVA and its consultants are projecting higher
future market prices. As evidence of projected increases in market prices,
TVA cites higher trading prices, higher “forward” prices offered
by suppliers, higher long- term contract price offerings, and higher prices
for fuel sources such as natural gas. Our report discusses TVA's views in
this regard; however, we underscore the uncertainty of projections of the
future
price of power by citing a knowledgeable source that projects lower prices.
In the draft we provided to TVA for comment, we included point estimates
from various sources for the future market price of power. Considering TVA's
comments, we agree that point estimates imply more certainty about future
prices than we intended or is warranted. As a result, we revised our report
by removing those estimates. However, to underscore the
uncertainty of future market prices, we have included the Energy Information
Administration's (EIA) projection of a downward trend in the future market
price of power 45 in the region in which TVA operates. EIA's
analysis was based in part on a projected decline in coal prices 46 that,
according to EIA, would more than offset projected increases in gas prices.
EIA is also projecting that nuclear fuel prices will remain steady. We
believe these are relevant points to consider since, in the year 2000, TVA's
power generation fuel mix was about 63 percent coal, 31 percent nuclear, 6
percent hydropower (which has no fuel cost), and less than 1 percent natural
gas. 47 Our main point is that the future market price of power
“cannot be predicted with any certainty.” TVA cites prices for
electricity and natural gas for December 2000 as an
example of market direction and volatility to support their projection of
future higher prices. We agree that the market has shown volatility at
certain times. In fact, this volatility strengthens our view that future
prices are uncertain. In addition, according to data from the National
Oceanic and Atmospheric Administration, in the entire region in which TVA
markets power, December 2000 was one of the 10 coolest periods on record
over 45 Prices from EIA are in current dollars.
46 EIA projects prices for coal to decline due to improved productivity in
coal mining and growing production from lower- cost mines in the west. 47
Since 1999, TVA has added 680 megawatts (mw) of new gas- fired peaking
capacity and plans to add up to another 1360 mw of gas- fired peaking
capacity over the next 2 years. However, based on the usage patterns of
peaking units, the percent of total generation from natural gas units should
not significantly increase.
the last 106 years. We would not predict the future on the basis of such an
anomaly. Comparing TVA's Financial TVA commented that it appreciated our
recognition of its progress in Condition With Private
improving its financial condition, but objected to our findings that TVA's
Utilities
financial condition compares unfavorably to likely competitors. In
particular, TVA questioned our choice of financial ratios in comparing it to
other utilities. TVA noted that most of our ratios ignore total cost and
merely reflect the differences between the capital structure of TVA and that
of IOUs. We disagree with TVA in this regard. Our choice of ratios was
appropriate because they result in meaningful information regarding the
relative financial conditions of the entities. To assess the financial
condition of the entities, we selected two types of ratios. The first type
indicates an entity's financial flexibility to successfully respond to
competitive and financial challenges. In this regard, we compared TVA to
other utilities in terms of (1) total financing costs, (2) fixed financing
costs, and (3) the ability of an entity to pay for capital expenditures and
common stock dividends from net cash generated from operations. Each of
these ratios is an indicator of an entity's ability to withstand stressful
financial conditions. Interest costs are particularly
important to consider because they are fixed costs that must be paid even in
times of competitive or financial pressures. Contrary to TVA's comment
letter, we recognize the differences between
TVA's financial structure and those of IOUs and accounted for those
differences in performing our analyses. As our report notes, TVA's financing
(except for internally generated cash, as with all entities we assessed) is
obtained by issuing debt, while IOUs also have the option of equity
financing. The requirement that TVA obtain financing only by issuing debt
could be considered a competitive disadvantage because of the corresponding
fixed financing costs which affect TVA's financial flexibility. The ratio of
total financing cost to revenue compares TVA interest costs, as a percent of
revenue, to the IOUs' costs of (1) interest, (2) preferred stock
dividends, and (3) common stock dividends as a percent of revenue. The ratio
of fixed financing costs to revenue compares TVA interest costs, as a
percent of revenue, to the fixed portion of the IOUs' financing costs (i.
e., their interest costs and preferred stock dividends) as a percent of
revenue. These analyses appropriately adjust for the different financing
structures of the entities in assessing financing costs, and assessing the
extent to which
entities have fixed costs that limit their financial flexibility is a valid
means by which to consider their respective financial conditions. The second
type of financial ratio we used indicates the extent to which capital costs,
including the costs of deferred assets, have been recovered. In this regard,
we compared TVA to other utilities in terms of the (1) portion of capital
assets that has not begun to be included in rates and (2) the portion of
gross property, plant, and equipment that has already been recovered. These
indicators are important because a high level of unrecovered capital costs
could compound an entity's challenges as it enters a competitive market. In
the case of TVA, if it enters a competitive
environment with the relatively high debt service costs it now carries, its
ability to price its power competitively could be jeopardized, thus
increasing its potential for stranded costs. Our report notes that TVA's
competitive challenges would be even greater if it were at the same time
attempting to recover the costs of deferred assets through rates. We
disagree with TVA's statement that a single statistic- the residential price
of electricity in TVA's region- best reflects TVA's competitiveness. While
we agree that selling price is a function of cost, we note that TVA has
a large amount of unrecovered costs. Since TVA remains in a regulated
environment, with the ability to set its own rates and to recover or defer
recovering the costs of some of its capital assets, this single statistic
does
not provide a complete picture of TVA's costs nor its ability to operate in
a competitive environment. In addition, TVA's current cost of delivering
power does not provide a complete picture of the competitive environment TVA
would likely be subject to if its legislative protections and the benefits
of being a wholly owned government corporation were removed.
We also disagree with TVA's statement that our ratios are distorted because
they do not recognize the uniqueness of TVA's business compared to others.
According to TVA, a distortion results when TVA, which has predominantly
wholesale sales, is compared to other entities that have predominantly
retail sales. However, these other entities also sell at wholesale and would
be competing with TVA at that level. Regardless, an entity's fixed costs and
portion of capital assets that have not been recovered are relevant and
important considerations as one considers an entity's prospects in a
competitive market, be it wholesale or retail. We also note that, in its
comment letter, TVA compared its total production costs to those of the 50
largest power producers in the United States, which for the most part are
providers of retail power, but objected to our comparing TVA to some of the
same utilities.
Deferred Assets and TVA states “the report is misleading when it
implies that the historical Stranded Costs
accounting value of any particular set of assets determines the potential
for stranded costs,” and that it is the net market value of all assets
combined that is germane to the determination of stranded costs, and only if
their amortization drives total cost above market. While we do not disagree
with TVA's interpretation of stranded costs, we do disagree that historical
accounting value plays no part in determining stranded costs. Historical
accounting value, less accumulated depreciation and/ or amortization,
shows the amount of remaining capital costs to be recovered in the future.
If TVA is attempting to recover more of these costs than other utilities in
a competitive market and, as a result, its rates are above market, it could
have stranded costs. TVA also implies that we consider its deferred assets
to be a proxy for stranded costs. On the contrary, our report clearly states
that TVA could have stranded costs if it were unable to recover all its
costs when selling power at or below market rates. In addition, we state
that TVA's potential for stranded costs relates to its high debt and
deferred assets, which as of September 30, 2000, totaled about $26 billion
and $8 billion, respectively. Recovery of these costs could drive the price
of TVA's power above market,
leading to stranded costs. This is consistent with TVA's definition of
stranded costs.
Our report reaches no conclusion on whether TVA will have stranded costs; it
merely points out that if TVA is unable to price its power competitively
because it is attempting to recover costs it incurred in the past, it could
have potential stranded costs, depending on market conditions at the time.
As noted above, due to the uncertainty of the future market price of power,
we also do not conclude on whether TVA will be competitive in the future.
Looking Back TVA notes that it has made progress in reducing debt, and
corresponding interest expense, and recovering the costs of deferred assets
since it released its 1997 plan. For example, by the end of fiscal year
2001, TVA expects to have reduced its debt by about $2. 2 billion and its
annual interest expense by about $300 million, and expects to have recovered
about $2 billion in costs associated with its deferred assets. While we
agree that TVA is moving in the right direction, TVA's current proposed
revisions to its 10- year plan project significantly less progress than
envisioned in 1997 and these changes are not without consequence.
As our report states, TVA's current revisions to the plan estimate that debt
outstanding at the end of fiscal year 2007 will be about $19. 6 billion
versus the $13.2 level anticipated when TVA issued its 1997 plan. TVA notes
that since issuing the plan in 1997, it changed its strategy by investing
cash in new generating capacity that otherwise would have been used for debt
reduction. However, in our report we correctly point out that, while TVA
has made this change, the cash it has invested in new capacity is far less
than its debt reduction shortfall. TVA's current projections show its debt
reduction through 2007 being about $6.4 billion less than planned in 1997,
and its investment in new generating capacity about $1. 3 billion more. As a
consequence of this debt reduction shortfall, we estimate that TVA's
interest expense in 2008 will be about $416 million greater than if it had
reduced debt to $13.2 billion. In the 1997 plan, one of TVA's key stated
objectives was to “alter its cost structure from its currently rigid,
high fixed- to- variable cost relationship to a structure that is more
flexible and
better able to adjust to a volatile marketplace.” 48 TVA's 1997 plan
further stated that interest expense is the cost component that, more than
any other, challenges TVA's ability to provide power at projected market
rates in the future. This situation continues to be true today. However, as
we state in our report, ultimately, TVA's ability to be competitive will
depend on the
future market price of power, which cannot be predicted with any certainty.
To the extent TVA is able to improve the financial ratios set out in our
report, the better positioned it will be to deal with this future
uncertainty.
As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this letter until 7 days from
its date. At that time, we will send copies of this report to appropriate
House and Senate Committees; interested Members of Congress; Craven Crowell,
Chairman, TVA's Board of Directors; The Honorable Spencer Abraham, Secretary
of Energy; The Honorable Mitchell E. Daniels, Jr., Director, Office of
Management and Budget; and other interested parties. The letter will also be
available on GAO's home page at http:// www. gao. gov. We will also make
copies available to others upon request.
48 TVA Ten Year Business Outlook, July 22, 1997.
Please call me at (202) 512- 9508 if you or your staffs have any questions.
Major contributors to this report are listed in appendix IV.
Linda M. Calbom Director Financial Management and Assurance
Appendi Appendi xes x I
Objectives, Scope, and Methodology We were asked to answer specific
questions regarding TVA's (1) debt and deferred assets, (2) financial
condition, (3) potential stranded costs, and (4) bond rating and its impact
on TVA's interest costs. As agreed with your offices, this report addresses
the first three questions. We plan to issue a separate report to address the
fourth question. Specifically, for each of
these three areas, you asked us to determine: 1. Debt and deferred assets
? The progress TVA has made in achieving the goals of its 10- year business
plan for reducing debt and deferred assets. ? The extent to which TVA has
used the additional revenues generated from its 1998 rate increase to reduce
debt and deferred and regulatory assets.
2. Financial condition
? How TVA's financial condition, including debt and fixed cost ratios,
compares to neighboring investor- owned utilities (IOUs).
3. Stranded costs
? The link between TVA's debt and its potential stranded costs. ? Whether
TVA has calculated potential stranded costs for any of its distributors, and
if so, what methodology they used.
? TVA's options for recovering any potential stranded costs. Debt Reduction
and
To identify the progress TVA has made in achieving the goals of its 10- year
Recovery of Deferred
business plan for reducing debt and deferred assets, we Assets
? reviewed GAO's prior report on TVA's 10- year Business Plan; 1 ?
interviewed TVA and Congressional Budget Office (CBO) officials; ? reviewed
and analyzed various TVA reports and documents, including
annual reports, audited financial statements, TVA's 10- year business plan,
and proposed updates to the plan; and
1 Tennessee Valley Authority: Assessment of the 10- Year Business Plan (GAO/
AIMD- 99- 142, April 30, 1999).
? analyzed supporting documentation (analytical spreadsheets, etc.) and
assumptions underlying TVA's 10- year plan and proposed updates to the plan.
To identify the extent to which TVA has used the additional revenues
generated from its 1998 rate increase to reduce debt and deferred and
regulatory assets, we ? obtained an estimate from TVA of the amount of
additional revenue generated from its 1998 rate increase; ? analyzed sales
and revenue data in the supporting schedules to the
proposed revision to the 10- year plan to determine whether TVA's estimate
was reasonable; and ? compared the estimate of the amount of additional
revenue generated from the 1998 rate increase to the reduction in debt and
deferred assets over the first 3 years of the plan.
Financial Condition To determine how TVA's financial condition, including
debt and fixed ratios, compares to its likely competitors, we
? reviewed prior GAO reports on TVA that analyzed its financial condition; 2
? determined likely competitors by analyzing prior GAO reports and other
reports by industry experts; ? obtained and analyzed financial data from the
audited financial statements of TVA, seven IOUs, and one independent power
producer; 3 ? computed and compared key financial ratios for TVA and the
other eight
entities; ? reviewed the annual reports of the eight entities to determine
what steps
they have taken to financially prepare themselves for competition; ?
interviewed TVA officials about their efforts to position themselves
competitively, including their efforts to reduce debt, recover the costs of
their capital assets, and recover stranded costs, and
2 Tennessee Valley Authority: Financial Problems Raise Questions About Long-
term Viability (GAO/ AIMD/ RCED- 95- 134, August 17, 1995) and Federal
Electricity Activities: The Federal Government's Net Cost and Potential for
Future Losses (GAO/ AIMD- 97- 110 and 110A, September 19, 1997). 3 The
latest available data for TVA and the other entities was for fiscal years
2000 and 1999, respectively; for consistency, we used 1999 data for all our
comparisons.
? analyzed data on the future market price of power. The ratios we used in
our comparison were computed as follows: ? The ratio of financing costs to
revenue was calculated by dividing
financing costs by operating revenue for the fiscal year. The financing
costs include interest expense on short- term and long- term debt, payments
on appropriations (TVA only), and preferred and common stock dividends (IOUs
only). Note that preferred and common stock dividends were included in the
IOUs' financing costs to reflect the difference in the capital structure of
these entities and TVA. ? The ratio of fixed financing costs to revenue was
calculated by dividing financing costs less common stock dividends by
operating revenue for
the fiscal year. Common stock dividends were excluded from the IOUs'
financing costs because, since they are not contractual obligations that
must be paid, they are not fixed costs. ? The ratio of net cash from
operations to expenditures for PP& E and
common stock dividends was calculated by dividing net cash from operations
by expenditures for PP& E and common stock dividends for the fiscal year.
Net cash from operations represents the cash received
from customers minus the cash paid for operating expenses. Thus, net cash
from operations represents the cash available for expenditures for PP& E,
common stock dividends (IOUs only), and other investing and
financing transactions. Again, we included common stock dividends in the
IOUs ratios to reflect the difference in cash flow requirements for these
entities and TVA. Preferred stock dividends were not included because they
come out of operating revenues and thus are already reflected in the net
cash figure. Because these data were not available for all entities, we
excluded the effect of capital assets acquired through acquisition. ? The
ratio of accumulated depreciation and amortization to gross PP& E
was calculated by dividing accumulated depreciation and amortization by
gross PP& E at fiscal year- end. ? The ratio of deferred assets to gross PP&
E was calculated by dividing
deferred assets by gross PP& E at fiscal year- end. Deferred assets include
construction in progress and for TVA only, its deferred nuclear units.
Deferred nuclear units are included for TVA because TVA treats them as
construction in progress (i. e., not depreciated).
For comparison purposes, we selected the major IOUs that border on TVA's
service area because industry experts told us that due to the high cost of
transmitting electricity, TVA's competition would most likely come from
IOUs located close to its service area. However, to represent the changing
structure of the electricity industry, we included one large independent
power producer. We did not include any publicly owned utilities in our
analysis because the publicly owned utilities that provide electricity in
the
states served by our IOU comparison group generally only distribute but do
not generate electricity. The IOUs used in our comparisons include (1)
American Electric Power, (2) Carolina Power & Light, (3) Dominion Resources,
(4) Duke Power, (5) Entergy, (6) LG& E Energy Corporation, and (7) Southern
Company. The independent power producer was AES
Corporation. To obtain information on various issues facing utilities in a
restructuring industry, we reviewed documents from the Energy Information
Administration (EIA) and the annual reports of TVA and the IOUs. We also
spoke with the organization that represents TVA's distributors to understand
their concerns about TVA's future competitiveness. In addition, we contacted
financial analysts to identify the criteria they use to evaluate the
financial condition of electric utilities. Stranded Costs To identify the
link between TVA's debt and its potential stranded costs, we
? interviewed industry experts at the Federal Energy Regulatory Commission,
Edison Electric Institute (EEI), and CBO on the options other utilities have
pursued to recover stranded costs; ? reviewed EIA documents pertaining to
how stranded costs have been
dealt with in the states that have restructured; ? questioned TVA officials
on TVA's plans for mitigating, calculating, and
recovering potential stranded costs; and ? analyzed TVA's contracts to
determine whether TVA has contractually
relieved its customers of any obligation to pay for stranded costs. To
determine whether TVA has calculated stranded costs that could potentially
be assessed against it distributors, and if so, the methodology used, we
? questioned TVA officials on whether they had calculated potential stranded
costs for any of its distributors and ? obtained information on the
methodology TVA used to calculate potential stranded costs for the two
distributors who informed TVA of their intent to leave its system.
To identify the options for recovering any potential stranded costs at TVA,
we
? obtained and analyzed information from EIA, EEI, and CBO regarding the
mechanisms for stranded cost recovery that have been used in states that
have restructured their electricity industries and ? interviewed FERC
officials and reviewed FERC documents pertaining
to stranded cost recovery. We conducted our review from April 2000 through
January 2001 in accordance with generally accepted government auditing
standards. To the extent practical, we used audited financial statement data
in performing our analyses, or reconciled the data we used to audited
financial statements; however, we were not able to do so in all cases and we
did not verify the accuracy of all the data we obtained and used in our
analyses. Information on TVA's debt reduction, deferred asset recovery and
projection of the future market price of power was based on TVA's
anticipated changes to the 10- year plan at the time of our review.
Organizations During the course of our work, we contacted the following
organizations.
Contacted Federal Agencies ? Congressional Budget Office,
? Department of Energy's Energy Information Administration, ? Federal Energy
Regulatory Commission, ? Office of Management and Budget, and ? Tennessee
Valley Authority.
Bond Rating Agencies ? Moody's Investors Service, New York, New York, and ?
Standard & Poor's, New York, New York.
Customer Representative or ? Tennessee Valley Public Power Association,
Chattanooga, Tennessee. Trade Group
Others ? Federal Accounting Standards Advisory Board, Washington, D. C., ?
Edison Electric Institute, Washington, D. C., and
? Standard & Poor's DRI, Lexington, Massachusetts.
Appendi x II
Mechanisms for Mitigating Stranded Costs In the states that have
restructured their electricity industries, there have been three commonly
used mechanisms to mitigate stranded costs. These mitigation measures can be
employed either before or during restructuring. Depending on the approval of
state regulators, utilities have the following options:
? Securitization Under securitization, state restructuring legislation
authorizes a utility to receive the right to a stream of income from
ratepayers, such as a competitive transition charge. The utility turns
over that right to a state bank for cash, thus effectively refinancing
present debt and trading a regulated income stream for a lump sum of money.
The state bank issues debt (i. e., sells bonds) secured by future customer
payments or the competitive transition charge on customers' bills. The
benefits from securitization stem from lower financing costs the state bonds
generally are free from state tax and have a higher rating
than the utility, thus reducing interest expense. Therefore, the customer
surcharge required to pay off the bonds is less than the charge that would
be necessary to produce the same amount of money had the utility issued the
bonds itself. ? Mitigation before restructuring With this option, regulators
allow a utility to take steps to reduce potential stranded costs before full
restructuring is implemented, including allowing accelerated
depreciation. To the extent a utility is permitted to mitigate potential
stranded costs, customers benefit. ? Mandatory asset divestiture Requiring a
utility to divest itself of generating assets produces revenue that can be
used to recover
potential stranded costs, potentially benefiting all customers. When a
utility sells its assets, it can use the cash to reduce debt. At the same
time, it no longer has to recover the cost of those assets, making its power
potentially more competitive. However, it also must now purchase power and
is thereby subject to market risk. In addition,
proceeds from the sale are assumed to cover the book value of the asset; if
not, potential stranded costs remain. Also, asset divestiture affects
stockholders; to the extent a utility receives cash in excess of book value,
stockholders benefit.
Comments From the Tennessee Valley
Appendi x II I Authority
Appendi x V I GAO Contact and Staff Acknowledgments GAO Contact Rob Martin,
(202) 512- 4063 Acknowledgments In addition to the individual named above,
Richard Cambosos, Jeff Jacobson, Joseph D. Kile, Mary Merrill, Donald R.
Neff, Patricia B. Petersen, and Maria Zacharias made key contributions to
this report.
(913904) Lett er
GAO United States General Accounting Office
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Appendix I
Appendix I Objectives, Scope, and Methodology
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Appendix I Objectives, Scope, and Methodology
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Appendix II
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Appendix III
Appendix III Comments From the Tennessee Valley Authority
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Appendix III Comments From the Tennessee Valley Authority
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Appendix III Comments From the Tennessee Valley Authority
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