Electric Utility Deregulation Creates Winners & Losers Whats the Effect on Utilities Financial Statements

<p>In 1996, the Federal Energy Regulatory Commission (FERC) issued orders for open access for electric
transmission, triggering a structural change unprecedented in the history of the U.S. power industry. Today, most
utilities are facing an evolving business and regulatory environment that is changing from a regulated monopoly to
a competitive marketplace for electricity. The characteristics of this transitional period have also affected the
regulatory accounting rules that govern the reporting requirements for electric utilities. As in any transition to open
markets, there will be winners and losers in the process.

</p><p>A reader of an electric utility's financial statements will be required to understand the impact of deregulation on the
entity's business and the changes in the financial reporting rules to fully assess the financial condition of the
reporting entity. This article will introduce the reader to the deregulation of the electric utility industry and provide
an overview of the underlying concepts and regulatory accounting requirements governing electric utility financial
statements.

</p><h3>From Deregulation to Competitive Electricity Markets</h3>

<p>Historically, U.S. electric utilities operated in a regulated electricity market that combined and controlled all three
separable components of the electricity industry: power generation, transmission and distribution. The utilities'
revenue, calculated on a rate of return on deployed assets and incurred cost, was determined through tariffs. These
tariffs were regulated through rate filings by the utility and granted during hearings by the state's Public Utility
Commissions (PUC) or similar entity. The utility's assets (and, in fact, liabilities) were determined by regulatory
accounting rules and requirements rather than market-driven valuations. The operational paradigm for an electric
utility was to provide a reliable source of electricity overriding a focus on cost efficiency. Financial performance was
measured in the recovery of incurred cost through customer charges and an additional artificially determined
stakeholder rate of return.

</p><p>The FERC's open-access transmission orders caused states to begin the debate on deregulation, passing laws and
regulatory plans mapping out the electric industry transition to competition. These laws generally have called for the
separation of the three historical business units, divestiture of a majority of the generating assets and the hand-over
of operational control of the transmission system to independent system operators (ISOs) or other forms of a
company's controlling electric transmission lines.

</p><p>The immediate results of deregulation became apparent with the entry of new participants responding to the new
competitive forces in the market. This change also caused many existing utilities to restructure their operations and
balance sheets to meet the new competition. Most participants are adopting one of several business models currently
considered viable to succeed in this new market.

</p><p>Because the primary regulatory control has been exercised by the state commissions for the electric utilities,
deregulation has been location-based in the United States. The shift to true competition is in a transitional phase
with most state regulatory commissions providing temporary financial "protection" for the incumbent utilities
through a variety of mechanisms. The most notable mechanism is the provision giving utilities the opportunity to
recover their costs of service and allow stranded costs through non-bypassable transmissions and/or distribution
charges, sometimes referred to as a Competitive Transition Charge (CTC). Allowed stranded costs may include
regulatory assets, the diminished value of generating plant assets, above-market purchase power contracts and costs
required to renegotiate or buy out certain contracts. These plans facilitate the advent of competition in the generating
segment of the electric industry while continuing to provide for traditional cost-based regulation of the utility's
transmission and distribution segments (wires). Many of these costs were incurred in excess of the market levels for
recovery because of various programs required by state regulators, cost overruns on nuclear plant construction or
changes in the forecast price of power.

</p><p>However, upon completion of this transition period, all existing and new market participants will be measured
against a new competitive paradigm. This new open market will shift the consumer's demand considerations to
lower-cost providers and allow those suppliers to succeed. In addition, successful market participants will be defined
by management skills including product innovation, customer service and effective risk management. Existing
utilities will face the yardstick of true financial profitability and will need to strive for increasing shareholder value
in an environment of intense and ample competition for their customer base.

</p><p>The success of well-adapted market participants will undoubtedly result in the failure of others. Early potential
warning signals that may indicate a propensity for future business failure will materialize in electric utilities'
financial statements over the next years. To properly assess the ramifications of these financial disclosures, the
reader will need to have an understanding of the underlying accounting requirements governing this transitional
period to open market competition.

</p><h3>Accounting Rules Prior to and During Deregulation</h3>

<p><b><i>FASB Statement No. 71.</i></b> Prior to the implementation of deregulation, regulatory accounting was governed by the
Financial Accounting Standards Board (FASB). Statement No. 71, <i>Accounting for the Effects of Certain Types of
Regulation</i> (FAS 71). Issued in 1982, FAS 71 specified how the effects of different types of regulation should be
reported in the financial statements of regulated enterprises.

</p><p>The specialized accounting prescribed in FAS 71 requires a regulated enterprise to recognize assets (and liabilities)
that enterprises in general would not record. Specifically, the FASB noted that a regulator's direction to include the
recovery of a specific cost in future revenues can require a regulated enterprise to capitalize certain costs that
enterprises in general would expense as regulatory assets.

</p><p>FAS 71, as amended, further requires the enterprise to assess at each reporting date the likelihood of recovering its
regulatory assets in future rates and, if it determines the likelihood of recovering these assets is less than probable,
to write them off.

</p><p><b><i>FASB Statement No. 101.</i></b> In December 1988, the FASB issued FAS No. 101, <i>Regulated
Enterprises—Accounting for the Discontinuation of FASB Statement No. 71</i> (FAS 101). The FASB decided that FAS 101 would not provide detailed guidance about when a regulated
enterprise ceases to meet the criteria for the application of FAS 71, but would focus on the accounting once such a
determination is made.

</p><p>FAS 101 indicates that when a regulated enterprise determines that it no longer meets the criteria for applying FAS
71 to all or a separable portion of its operations, it should eliminate from its financial statements the effects of any
actions of regulators that have been recognized as assets and liabilities pursuant to Statement 71 that would not have
been recognized as assets and liabilities by enterprises in general, regardless of the potential recoverability of those
assets through future revenues.

</p><p>Thus, the likelihood of recovering a regulatory asset is no longer the relevant test for retaining regulatory assets
when a utility has discontinued the use of FAS 71. FAS 101 required the write-off of all assets recognized solely
due to the actions of the regulator, irrespective of their potential realization. FAS 101 also required that regulatory
assets and liabilities be written off unless the right to receive payment or the obligation to pay exists as a result of
past events or transactions and regardless of future transactions.

</p><p><b><i>EITF Issue No. 97-4.</i></b> To address the regulatory accounting issues caused by the deregulation of the electric utility
industry, the FASB's Emerging Issues Task Force (EITF) released Issue No. 97-4.<small>^{<a href="#1" name="1a">1</a>}</small>

</p><p>It acknowledges that previous regulatory accounting pronouncements did not consider circumstances where there
was to be an orderly transition to competition, generally providing for full recovery of potentially stranded costs,
and that this change in circumstances necessitated a change in the relevant accounting rules. It provides guidance for
the following questions:

</p><ul>
<li>When should a utility subject to a deregulation plan discontinue the application of FAS 71 for the generation
portion of its business?
</li><li>How should that utility implement FAS 101?
</li><li>Which costs should be considered during the implementation of FAS 101?
</li></ul>

<p><b><i>Financial Statements Reflecting Discontinuation of FAS 71.</i></b> With regard to when a utility should discontinue
FAS 71, the EITF reached a consensus that a utility subject to a deregulation plan for its generation business should
stop applying FAS 71 to the generating portion of its business <i>no later</i> than the date when a plan with <i>sufficient detail</i> of the plan's effects is known. Additionally, the EITF observed that once FAS 71 is no longer applied to a
separable portion of an enterprise's business, the financial statements should segregate, via financial statement
displays or footnote disclosures, the amounts contained in the financial statements that relate to that separable
portion.

</p><p><b><i>Financial Statements Reflecting Adoption of FAS 101.</i></b> The EITF reached a consensus that when FAS 101 is
being applied to an electric utility subject to a deregulation plan, the recoverability of that utility's regulatory assets
that originated in its generation segment should be evaluated based on what segment will receive the cash flows to
realize them. That is, a utility implementing FAS 101 would not be required to write off regulatory assets that
originated in the generation segment that are probable for recovery through a wires-based CTC. At each balance
sheet date, however, management must continue to assess the recovery of these regulatory assets through the CTC
as probable to avoid their write-off. In addition, if in the future the wires segment of the business were to fail to
qualify for the continued application of FAS 71, these regulatory assets would be written off at that time, even if
their future collection remained probable.

</p><p><b><i>Which Costs Should Be Considered?</i></b> With respect to which costs should be considered during the implementation
of FAS 71, the Task Force reached a consensus that the "source of the cash flow" approach adopted in the consensus
to question (b) above should be used to determine the accounting for all costs (not just those deferred as regulatory
assets) for which regulated cash flows are specifically provided in the deregulatory legislation or rate order. The
result of this consensus is that all generation-related costs that are probably recoverable through the CTC, even those
incurred subsequent to the discontinuation of FAS 71, may be deferred and recognized as regulatory assets.
Examples of these types of costs might include the loss on the sale of generating assets or costs associated with the
buy-out of uneconomic purchase power contracts incurred subsequent to the implementation of a deregulation plan,
but which will be recovered through the CTC.

</p><h3>Conclusion</h3>

<p>The current transitional phase of the electric utility industry is anticipated to continue for some years. However, a
utility's abandonment of FAS 71 and adoption of FAS 101 under the guidance of EITF Issue No. 97-4 will yield
valuable information about the financial state of the entity. The evolving competitive electricity market continues to
affect valuations for non-economic assets. The remaining regulatory valuation basis utilizing a cross-segment cost
recovery approach may result in utilities' incurring an economic loss in the market value of their generating plant
assets, with no financial statement effect because of a peculiarity in the relevant accounting standards. Becoming
aware of these remaining regulatory accounting rules and the significance of the adoption of FAS 101 will enable
the reader to properly assess an entity's current and future financial performance in electric utilities.

</p><hr>
<h3>Footnotes</h3>

<p><small>^{<a name="1">1</a>}</small> <i>Deregulation of the Pricing of Electricity—Issues Related to the Application of FASB Statements No. 71, Accounting for the Effects of Certain Types of Regulation,</i> and No. 101,

<i>Regulated Enterprises—Accounting for the Discontinuation of Application of FASB Statement No. 71</i> (EITF 97-4). <a href="#1a">Return to article</a>

</p><hr>

<br>

<!-- Source Code Copyright © 2003 Active Matter, Inc. www.activematter.com -->

</td>
<td valign="top" width="125">

<table border="0" cellpadding="0" cellspacing="0" width="125">
<tbody><tr>
<td width="5"><img src="/AM/graphics/spacer.gif" alt="" height="1" width="5"></td>
<td align="center" width="120">
</td>
<td width="5"><img src="/AM/graphics/spacer.gif" alt="" height="1" width="5">