Electric Utility Takeover by Las Cruces Likely to Cost its Citizens

by Harry Messenheimer, Ph.D.

Senior Fellow, New Mexico Independence Research Institute, Inc.

2401 Nieve Lane, Las Cruces, NM 88005

gsaldridge@zianet.com

October 26, 1999

TABLE OF CONTENTS

EXECUTIVE SUMMARY

KEY FINDINGS

QUESTIONS FOR THE CITY

INTRODUCTION

PURPOSE

BACKGROUND

FINANCIAL ASSESSMENT

RISK ASSESSMENT

FINANCIAL RISKS ASSOCIATED WITH THE TAKEOVER

Potentially Escalating Costs

Bleak Financial Outlook

OTHER RISKS

Incentives to Account and Inform

Likelihood of New Stranded Costs

Regulatory Risk

Political Rate Setting

Administrative and Customer Costs Associated with Open Access

RISKS ASSOCIATED WITH THE NO TAKEOVER ALTERNATIVE

Regulatory Risk

ECONOMIC ANALYSIS

The Effect of Sunk Costs

The economic effect of opportunity cost

APPENDIX A: AN EXPLANATION OF "STRANDED COSTS"

APPENDIX B: REPRODUCTION OF OPERATING PRO FORMA FROM OFFICIAL STATEMENT OF 1995

APPENDIX C: REPRODUCTION OF DEBT SERVICE SCHEDULE FROM OFFICIAL STATEMENT OF 1995, PAGE 27

ABOUT THE AUTHOR

Executive Summary back to top

This study provides an independent assessment of whether or not the ongoing takeover of El Paso Electric Company's distribution system will benefit the citizens of Las Cruces. The City's goal was to reduce electric rates by at least 20 percent from those forecast in 1994 for El Paso Electric. This assessment has been hampered by the City's unwillingness to provide updated cost estimates. Therefore, this assessment is prepared using updated costs gleaned from public statements by City officials and (where nothing has been said) best-case estimates of costs not previously considered in the City's Official Statement of 1995.

Key findingsback to top

• Deregulation may lead to achievement of the City's goal without necessity of the takeover. Consumers would be able choose the lowest cost power source.
• El Paso Electric's rates are 14 percent lower than forecast by the City in 1994.
• Likely start-up costs of the takeover have increased substantially from those estimated in 1994. The following table summarizes the changes:

Start-up Costs as of September 1999 (millions)	1999 Most Likely Case	City's Official Statement of 1995
Legal and Consulting Fees	$ 14.0	$ 8.0
Stranded Costs	$ 46.3	$ 0.0
Condemnation of Distribution System	$ 42.0	$ 37.0
West Mesa Substation	$ 3.3	$ 0.0
Net Interest Charges	$ 6.1	$ 0.0
Severance Cost	$ 5.5	$ 1.5
Total as of SEP 99 (millions)	$ 117.2	$ 46.5

• Adjusting these costs downward to reflect the best possible scenario for the City leads to the conclusion that the City cannot keep its promises. In fact, rates would be at least one percent higher than El Paso Electric's current rate path.
• Using the most likely costs displayed above results in rates at least four and one-half percent higher than El Paso Electric's current rate path.
• Downside risks of the takeover in the forthcoming deregulated (open access) environment point toward even higher rates.
• The City did not provide sound economic analysis in its original studies. Economic analysis of sunk costs and opportunity costs concludes that it would take a miracle for the takeover to make economic sense. Prospective costs would have to be lowered to $71 million for the project to break even. Most likely costs will lead to rates at least 11 percent higher than what citizens would face under deregulation.
• This study provides a benchmark to challenge the City's contention that it can still lower rates relative to open access (deregulation). Perhaps the most valuable aspect of the study is the questions it raises for consideration by the City and its citizens.

Questions for the Cityback to top

1. What are updated start-up costs of the takeover. Specifically, what are your current estimates of legal and consulting fees, stranded costs, condemnation of the distribution system, net interest charges and severance costs?
2. How does the new, unplanned West Mesa substation affect financing requirements and revenue projections?
3. Since start-up costs are above those projected in the 1995 Official Statement and the financial outlook appears much more suspect, how do you intend to finance those additional costs? How will the City's debt position affect your ability to obtain credit at reasonable terms?
4. How much of the debt issue of 1995 has been spent on non takeover projects?
5. What is wrong with allowing deregulation to be enjoyed by your citizens? Open access would allow them to choose power sources other than El Paso Electric. Isn't that your goal?
6. You originally predicted that the takeover would be completed in 1996. Takeover is still nowhere in sight. If you insist on continuing with the takeover, what is a realistic date for its completion?

Introductionback to top

Purpose

The purpose of this study is to provide an independent assessment of whether or not the ongoing takeover (condemnation) of El Paso Electric Company's distribution system will benefit the citizens of Las Cruces.

Backgroundback to top

The City of Las Cruces ("City") and its citizens have been discontented with their high electric rates since the mid 70's. In the late 80's the City government took action to municipalize their electric service with the stated goal of reducing electric rates by at least 20 percent. The basis for the savings estimates justifying the municipalization was the City's consultants' reports of 1994 and 1991. The municipalization effort involves the takeover by condemnation ("takeover") of El Paso Electric's distribution system. Rather than actually running its own utility, the City would contract with Southwestern Public Service Company (SPS) to provide the power source and operate the system.

Based on their belief in the promised 20 percent savings, the takeover was approved by the voters in a special City election in August of 1994. In October of 1995 the City floated a bond issue in the amount of $72.5 million in order to finance as much as $54.7 million "project costs."

The takeover is still being contested vigorously by El Paso Electric in the courts, making it difficult to arrive at impartial assessments based on either City or El Paso Electric assertions. In addition, no update of the City's consultants' reports has been made available to the public.

An independent assessment of the proposed takeover was conducted by the Columbia Group in August of 1994 for Dona Ana County. That assessment suggested that the City's consultant reports were overly optimistic, raising the following red flags:

• Condemnation of the distribution system would be at significantly higher cost than the book value estimated by the City, probably "representing reproduction cost less depreciation."
• Deregulation could lower EPE's rate path relative to the forecast rate path in the City's report; Las Cruces customers might achieve the desired savings without the takeover.
• The acquisition could take longer than forecast by the City because it would be contested.
• The City's consultants did not address the risk of having to pay some portion of EPE's stranded costs. See appendix A for an explanation of stranded costs.
• The cost of standby capacity, absent from the consultants' studies, might be necessary to ensure system reliability and could be significant.

The Columbia Group's forecasts of lower El Paso Electric rate path, delays, and escalating costs have certainly been realized. The City's consultants' reports forecast El Paso Electric's residential base rates would rise by 6%. Instead those base rates have decreased by approximately 8%. The City's consultants' reports forecast that the takeover would be completed by July of 1996. Instead the City is bogged down in litigation, and the takeover is nowhere in sight.

The City's consultants' reports forecast start-up takeover costs to be in the neighborhood of $27 million. Instead those costs are at least $100 million. Although the rough magnitude of these escalating costs is known, exact estimates are somewhat uncertain. The Las Cruces Sun News has carried reports of the project's financing, while charges and counter charges regarding project costs have appeared in recent articles. Requests made to the City by me for an update of its estimated costs have been denied. Therefore, this assessment is prepared using updated costs gleaned from public statements by City officials and (where nothing has been said) best-case estimates of costs not previously considered in the City's Official Statement of 1995.

The City Manager, Jesus Nava, has recently stated that "the only thing we really don't know is what the ultimate value of the distribution system will be when the condemnation court decides,Öall the other costs are well known." He goes on: "we have double checked them with consultants" and the financial "pro forma shows that we can still achieve rate reductions." NMIRI would like to compare the results contained herein with the City's financial pro forma. Clearly there is a wide gap between the City's consultants' earlier estimates and today's realities.

Something is wrong. There seems to be no way the City can achieve any savings, even when assuming best-case costs where uncertainty now exists. In fact, the takeover appears to be a real money loser for the City and its citizens. The reader will see why in the financial assessment that follows.

Financial Assessmentback to top

This assessment uses the financial pro forma projections included in the City's 1995 Official Statement, adjusted for added debt service costs not included in that report. It compares the costs of power in the takeover scenario to the projected cost of power absent the takeover. Where there is a range of possible increased start-up costs, the assumptions made in each instance give the City the benefit of the doubt. In other words, this assessment reflects the best possible scenario for the City.

Start-up Costsback to top

1. At least $6 million has already been spent by the City for legal and consulting fees, and this figure likely will continue to grow. The original 1994 estimate was $8 million.
2. $52.9 million will likely be added to reimburse El Paso Electric for recovery of stranded costs as of July 1, 1999 (Source: Federal Energy Regulatory Commission ruling of 5/26/99). No assessment of this cost was included in the original 1994 estimate. The City and EPE are still appealing the FERC ruling: the City thinks it should be much lower, and EPE thinks it should be much higher. Interestingly, the FERC ruling represents about 50 percent of the book value of EPEC's stranded costs. The stranded costs are currently being amortized in the rates paid by EPEC's customers (including its Las Cruces customers). By July 1, 2000 they will be reduced to roughly $46.3 million. See appendix A for an explanation of stranded costs.
3. $3.3 million has already been spent by the City for the new substation on the West Mesa. The original estimate claimed that no additional substations would be needed. Funds were "borrowed" from the City's vehicle fund to finance the substation. The substation is currently serving industrial customers.
4. $6.1 million net interest charges have been incurred to service debt obligated by the bond issue floated in October of 1995 to finance the takeover. According to the payment schedule contained in the Official Statement (page 27) $14.1 million has been allocated to interest payments by the end of fiscal year 1999. In the meantime, the City has been earning interest at the rate of 5.4% per year on the $37 million it has invested in the New Mexico State Treasurer's short term investment fund. That investment has yielded the City almost $8 million by the end of fiscal year 1999. The difference between interest paid ($14.1 million) and interest earned ($8 million) equals net interest charges of $6.1 million.
5. $1.5 million was estimated to sever from the EPE system in the Official Statement. Severance means that the City's distribution system must be physically separated from El Paso Electric.

Table I summarizes the "absolute best case" start-up costs known at present, and compares them to the estimates contained in the Official Statement. Footnotes to each line item in Table I indicate the source of the estimate.
 

Table I  Start-up Costs as of September 1999 (millions)	1999 Absolute Best Case	City's Official Statement of 1995
Legal and Consulting Fees	$6.0	$8.0
Stranded Costs	$46.3	$0.0
Condemnation of Distribution System	$37.0	$37.0
West Mesa Substation	$3.3	$0.0
Net Interest Charges	$6.1	$0.0
Severance Cost	$1.5	$1.5
Total as of SEP 99 (millions)	$100.2	$46.5

The above estimates must be adjusted by certain assumptions for the purpose of this assessment because of two unknowns:

1. when the takeover will actually occur, and
2. the effect of the West Mesa substation.

Assumptionsback to top

1. Assume that the City's purchase of the West Mesa substation will produce additional revenues sufficient to cover its cost of $3.3 million. Under this assumption the problem of the substation is a wash, whether or not the takeover actually occurs. Thus it can be ignored in the analysis.
2. Assume that there are no more escalating up front costs. What we see above is what we will get. Those total up front costs are $96.9 million ($100.2 million less $3.3 million for the West Mesa substation by assumption 1). Of these, $12.1 million (for net interest charges and for legal and consulting fees) are sunk costs for which the taxpayer is already liable.
3. Assume that the takeover will progress smoothly in the next nine months, so that the City will be providing all its power needs by July 1, 2000.
4. Assume that the estimates of volume and costs contained in the City's Official Statement (operations and other), not including debt service, are accurate.
5. Assume that the City's annual cost of debt service will be the same proportion of debt to "project costs" as contained in the Official Statement. The debt service estimated in the Original Statement was associated with $54.7 million of "project costs." "Project costs" are now best-case $96.9 million (see assumption 2). That means that debt service costs shown in the Official Statement must be increased by 77 percent (96.9 divided by 54.7). For example, rather than incurring a debt service charge of $6.7 million in FY 2002 based on project costs of $54.7 million, the City would incur debt service charge of $11.9 million based on project costs of $96.9 million. This works just like your home mortgage. If you financed a first trust of $96.9 thousand, then principal and interest payments would be higher than a first trust of $54.7 thousand (everything else being equal).

These assumptions result in the following amended start-up cost estimates in Table II and recurring cost estimates in Table III. Table II displays the same start-up costs as Table I except that 3.3 million substation cost has been omitted by assumption 1.
 
 
 

Table II Start-up Costs as of September 1999 without new Substation (millions)	1999 Absolute Best Case
Legal and Consulting Fees	$6.0
Stranded Costs	$46.3
Condemnation of Distribution System	$37.0
Net Interest Charges	$6.1
Severance Cost	$1.5
Total as of SEP 99 (millions)	$96.9

Table III  Recurring Costs for FY 2002 (millions) Because of Increased Debt ServiceCurrent Absolute Best Case	City's Original Estimate
Debt Service Charge	$ 11.9	$ 6.7

The best-case conclusion of this takeover assessment is: the City might possibly save its power consumers a little before full debt service charges kick in. But from July 1, 2001 they will suffer losses as far as the eye can see. This conclusion follows from the City's best-case assumptions and is displayed in Table IV below. The first two columns of Table IV reproduce the projections from the City's Official Statement of 1995 for fiscal years 2001 and 2002. The second two columns amend those projections for updated best-case debt service costs (see row highlighted in boldface). The only difference between the first two columns and second two columns is the updated debt service charge calculated in this assessment. The results of Table IV are highlighted in the bottom two rows, which compare average rates per KWh without gross receipts tax. In FY2001 the City would charge 8.47 cents per KWh versus 8.98 cents per KWh for El Paso Electric. In FY2002 the City would charge 9.07 cents per KWh versus 8.98 cents per KWh for El Paso Electric. The gap could be wider, since competition may push the benchmark rate below 8.98 cents per KWh.

 

	1995 Official Statement (page C-18)			Current Best-Case Scenario
Year:	FY 2001	FY 2002		FY 2001	FY 2002
Statistics
Peak Capacity (MW)	96	98		96	98
Energy Sales	503	514		503	514
Total Revenue Requirement	$40,967	$44,395		$45,326	$49,573
Operating Costs ($000's) Purchased Power and Transmission:
Fixed	6,484	7,046		6,484	7,046
Variable	14,223	15,214		14,223	15,214
Transmission Wheeling	2,429	2,528		2,429	2,528
Operation and Maintenance	2,716	2,834		2,716	2,834
Admin. & General	2,459	2,545		2,459	2,545
Cust. Service Expense	604	625		604	625
Gross Receipts Tax	2,612	2,830		2,612	2,830
Interest Earnings	(382)	(382)		(382)	(382)
Total Operating Costs	31,145	33,240		31,145	33,240
Other Costs
Debt Service	5,661	6,725		10,020	11,903
PILOT	368	397		368	397
Franchise Tax	1,024	1,110		1,024	1,110
Improvements and Additions	2,769	2,923		2,769	2,923
Net Revenues	0	0		0	0
Average Rate (cents/KWh)
Without Gross Receipts Tax	7.66	8.12		8.47	9.07
Compare above to EPE Rate without Gross Receipts Tax	8.98	8.98		8.98	8.98

It is important to remember that this represents best-case for the City. But the City is unlikely to approach this best-case. The reasons are discussed below in the Financial Risk Assessment.

Risk Assessmentback to top

The takeover and no takeover alternatives each entail risk. However, in my view risk is much greater for the City and its citizens should the takeover occur.

Financial Risks Associated with the Takeoverback to top

Potentially Escalating Costsback to top

As much as $35 million may be needed for backup power and ancillary services to ensure reliable service. This is particularly crucial if service from SPS via the "Eddy Tie" is knocked out or taken off line for service. Alternatively, the City may have to contract for a backup power source from PNM or EPEC in the amount of roughly $4 to $7 million per year.

Costs to sever the distribution system from El Paso Electric may be higher than the $1.5 million projected in the Official Statement. Newspaper articles and statements by EPEC's CEO indicate that this cost may be more on the order of $4 to $5.5 million. In addition, the Columbia Group finds that the range of $8.3 to $11.3 million to be somewhat more persuasive than the City's projection.

$42 million may be needed for condemnation of El Paso Electric's distribution system. This is the likely outcome of the dispute between EPE and the City in which the City appraiser estimated $37 million and EPE appraiser estimated $46 million. An independent appraisal estimated the value at about $42 million.

Legal and Consulting fees are a continuing burden to the City. So far, according to official statements published in the press, the City has spent $6 million. Outside observers estimate that this burden may be $10 million or more. Further delays in the takeover will only increase this burden.

The new West Mesa substation may create an extra cost burden on the entire system. Where are the revenues that justify the expenditure of $3.3 million? How does the demand for power delivered by this substation affect the overall estimates of demand set forth in the Official Statement?

The City must come up with at least another $42.2 million, and the only way to do that is debt financing. But the City may have to pay proportionally more for additional financing than it did for the original debt issue. In other words, when the additional best-case $42.2 million is financed there may be added a risk or legal premium to the consultants' estimated debt service-to-debt ratio. Moreover, the City's Official Statement of 1995 (page 28) discloses that the City has previously incurred additional debt of $22.5 million from its Series 1992 bond issue. In addition, the City has obligated some of the money it borrowed in 1995 for non-takeover related infrastructure improvements, so its needs will actually be that much greater than $42.2 million. Given the bleak financial outlook for the takeover and the existing debt burden, how can the City possibly hope to finance a new bond issue on the same terms as it did in 1995?

Bleak Financial Outlookback to top

Just how bleak is the financial outlook for the takeover? Just to break even relative to El Paso Electric's current rate path (8.98 cents per KWh on average), project start-up costs for the City would have to be reduced by roughly $3.8 million from the $96.9 million best-case scenario laid out above. How can the City possibly find additional start-up reductions?

Given the financial risks associated with the best case scenario, what is the likely case scenario? The reader's conjecture about that may be as good or better than mine. Using conservative estimates the condemnation of the distribution system will add $5 million, additional legal and consulting fees will add $8 million and additional severance costs will add $4 million. Other costs associated with additional finance charges and backup power may very well add to the start-up burden. That brings the likely case scenario to roughly $110 million in start-up costs (rounding down to the nearest $10 million).

Chart 1 below illustrates the relationship between start-up costs and average price per KWh in FY2002. The average price per KWh increases by 0.024 cents for every extra million dollars of start-up costs incurred (using the best case assumption 5 above for debt service charges). Notice that the break even point occurs, relative to EPEC'S average rate of 8.98 cents per KWh, when start-up investment is $93.1 million. The best case scenario occurs when start-up investment is $96.9 million, and average rates are 0.09 cents higher than EPEC. The likely case scenario occurs when start-up investment is $110.0 million, and average rates are 0.40 cents higher than EPEC. Viewed another way, the average household consumer will pay about $25 more per year for electricity should the takeover occur under the likely case scenario.

Chart 1back to top

Other Risksback to top

The takeover also entails nonquantifiable risks that should be considered. Although these risks of the takeover are not subject to precise financial estimating, they will nonetheless increase the cost burden to the citizens of Las Cruces.

Incentives to Account and Informback to top

Incentives in the public and private sectors are quite different. That these incentives matter has led to a widely accepted doctrine within the economics of public choice: Those who administer the government apparatus, in their roles as politicians and bureaucrats, have less incentive to provide accurate information to consumers of public services than do their counterparts in the private sector. The main propositions for this are threefold. First, private sector consumers have much greater choice. Alternatives exist. If a consumer does not like product A, then he or she can decline to purchase product A and purchase product B. Electricity consumers in Las Cruces, particularly households, will have more choice under forthcoming open access (deregulation) than they will under the proposed takeover.

Second, each consumer cannot influence public sector choices without great individual effort on his or her part. Unless they decide to "vote with their feet," consumers accept political decisions as a state of nature. Their choices in the private sector, on the other hand, are quite different. Individuals therein personally bear the costs and consequences of their own decisions. In the private sector, therefore, individuals have greater incentive to acquire information about prospective choices. The implication of this proposition, combined with proposition one above, is that information will be much more forthcoming in the private sector than in the public sector. There is no way in the private sector, for example, that the prospective "owners" of the municipalized utility would have as much trouble as I have had in obtaining information about its prospective costs. In fact, withholding information the way the City has done would result in legal sanctions in the private sector. Where is the prospectus for the prospective "owners" of the municipalized utility?

Finally, the City has the power to tax, and private enterprise does not. Taxation as a source of revenue, combined with the first and second propositions above, reduces incentives to ensure that only electricity sales are used to cover electric utility costs. For example, City officials could "borrow" $3.3 million to construct a substation without having to worry about whether sufficient revenue would be generated to cover the cost.

Likelihood of New Stranded Costsback to top

There is an irony associated with the takeover attempt. In an attempt to escape stranded costs associated with a traditional monopoly electric utility, the City is taking on new, inescapable stranded costs by its overextended attempt to takeover the electric utility. As discussed above, the City has already spent at least $12.1 million for legal and consulting fees and for net interest charges on its debt. The City's taxpayers have no means to escape these sunk costs. There is not much hope that sufficient revenue by its sale of electricity will be sufficient to cover them. Therefore, they are just like stranded costs. Moreover, these costs are growing day-by-day.

Regulatory Riskback to top

Regulatory risk is the risk that the regulatory process will lead to monopoly protection of the owners of distribution systems similar to the outcomes when utilities were entirely regulated. Regulated monopolies led to less choice and higher rates for consumers. Under open access, uncertainty will still exist with respect to the regulation of distribution systems. Distribution systems in New Mexico are under the jurisdiction of the Public Regulatory Commission. In that sense the traditional regulated monopoly utility is alive and well, and the associated regulatory risk could lead to potential disruption of power rates. One possible advantage, therefore, of the takeover is that it may reduce this risk for the citizens of Las Cruces. Reduction of regulatory risk is the only potential upside to the takeover attempt.

On the other hand, the City will own an unregulated monopoly distribution system after the takeover. And it could very well set rates for use of its system that are so high as to effectively give its consumers no choice of power provider.

Political Rate Settingback to top

The takeover would result in electric rates being set by the City Council. The incentives of politicians to make rate decisions may not lead to efficient rate setting. Public choice economics recognizes that well organized interest groups may be able to obtain differential benefits through the political process. That differential benefit may manifest itself in more favorable rates for those with differential influence.

Administrative and Customer Costs Associated with Open Accessback to top

The City's consultants may have underestimated the operating costs associated with tracking and billing customers. They assumed the City would be doing business as usual, like in the days of regulated monopolies. Those days are over. The unregulated "open access" environment will be much more volatile, requiring administrators to give more emphasis to keeping up with changes in customer accounts.

Risks Associated with the No Takeover Alternativeback to top

Regulatory Riskback to top

As mentioned above, the potential exists for disruption of power rates by continued regulation of monopoly utilities' distribution systems. This risk is the only potential downside to the no takeover alternative. But it may be more than offset by the risk of high distribution system fees charged by the City.

Economic Analysisback to top

The financial assessment and discussion of risk so far is essentially an assessment of political accounting. It is directed to the question of whether or not the City will be able to abide by its promises of lower rates that are still sufficient to cover the accounting costs incurred in the takeover. It has little to do with real economic analysis; it is far from the complete picture. To complete the economic picture sunk costs and citizens' opportunity costs must be considered.

The Effect of Sunk Costsback to top

So far the City has spent at least $12.1 million on legal and consulting fees and net interest charges. That $12.1 million (perhaps more) is what is known as a "sunk cost." The $3.3 million spent for the new substation is not entirely a sunk cost, since it has a value in the market. In fact EPE has offered the City $3.3 million for purchase of the substation, if the City will abandon the takeover attempt.

Economists ignore sunk costs. They have no relevance for future decisions, since they cannot be undone. Economic analysis is entirely prospective. The citizens of Las Cruces are stuck with a bill for at least $12.1 million. The real economic question is whether or not the takeover makes economic sense (e.g. whether or not the City is doing the best it can) from here on out.

We can use the break even analysis discussed above to show the effect of ignoring sunk costs. To at least break even, prospective project costs must not exceed $93.1 million (see Chart 1). What are prospective project cost estimates? Table V provides (somewhat conservatively) a most likely scenario (for explanation see prior discussion of financial risks):
 

Table V Prospective Start-up Costs as of September 1999 (millions)		1999 Most likely prospective costs
Legal and Consulting Fees		$ 8.0
Stranded Costs		$ 46.3
Condemnation of Distribution System		$ 42.0
Net Interest Charges		$ 3.2
Severance Cost		$ 5.5
Total as of SEP 99 (millions)		$ 105.0

For the purpose of projecting legal and consulting fees and net interest charges, I am assuming that the takeover will occur on July 1, 2000. Some of the prospective net interest charges may actually be a sunk cost, since the City is obligated to its repayment schedule whether or not the takeover happens. The City may be able to undertake some revenue raising activities to reduce net interest charges, or it may retire the debt early with penalty.

In any event, prospective costs now exceed the break even threshold by more than 10 percent. Unless the City can make credible estimates of prospective costs lower than those shown in Table V, the takeover does not make economic sense.

The economic analysis is still incomplete, however. To complete the economic picture, we must also consider the opportunity cost of the takeover for the citizens of Las Cruces.

The economic effect of opportunity costback to top

The City refers its municipalized utility as a "citizen-owned system." But the utility will not be owned by any of its citizens in any meaningful sense of the word "owned." Real ownership conveys certain rights. Among those rights is the right to purchase or sell. In particular, if a citizen does not think ownership of the municipalized utility makes sense, he or she would have the right to sell it. But in the case of a municipalized utility, the citizen is coerced into participating in the project. The citizen has no freedom of choice.

No freedom of choice is undesirable in its own right. But it also masks the true opportunities forgone because of the takeover. If citizens really did have a choice, opportunities forgone would be transparent. And opportunities forgone are a prime consideration in any assessment of the economic viability of the takeover.

Assume that risk is equal for all alternative investments and consider the following hypothetical example: Suppose that citizens actually did have the right to buy and sell shares in the municipalized utility. The prospective return to investment in those shares would have to be competitive with alternatives faced by the citizen-investor. That means that the municipalized utility would have to provide a prospective return competitive with alternative opportunities available to the citizen-investor. Say that alternative opportunities yield a prospective return net-of-taxes of 6 percent. In that case, investment in the municipalized utility would also have to yield a prospective return net-of-taxes of 6 percent.

The hypothetical example brings into focus the forgone opportunities that must be considered. If the "citizen-owners" of the municipalized utility are to obtain a normal return on their "investment," then the only way that return can manifest itself is by rates that are lowered by enough to be competitive with forgone opportunities. If the competitive opportunities offer a prospective return net-of-taxes of 6 percent, then rates charged by the municipalized utility must be 6 percent lower than the alternative open access alternative. Since EPE is offering an average rate of 8.98 cents per KWh without GRT, then the actual break even rate for the municipalized utility without GRT is 6 percent less than that, or 8.44 cents per KWh without GRT.

You can see from Chart 1 above that consideration of opportunities forgone is nontrivial. The prospective start-up cost that would just allow the City to break even is in the neighborhood of $71 million. Compare that to the likely case, prospective start-up cost of $105 million discussed in the preceding section. Short of a miracle, there is no way that the takeover project can make economic sense for the citizens of Las Cruces.

APPENDIX A: An explanation of "stranded costs"back to top

The construction of nuclear power plants and high fossil-fuel prices during the "energy crisis" of the 1970s have had the net effect of placing high-cost obligations on many traditional monopoly electric utilities. These high cost obligations have led them to charge rates higher than current market prices of electricity. El Paso Electric Company is one such utility, suffering high-cost obligation especially for its investment in the Palo Verde Nuclear Generating Plant.

Market participants have incentive to avoid these costs. One reason that the takeover initially appeared attractive to the City is that it implicitly assumed it could avoid these costs for its citizens. In unregulated markets the City would have had no such worry and no need to takeover the utility. Falling energy prices would have resulted in the bankruptcy of the high-cost generation technologies used by the traditional utilities. Or projects, such as Palo Verde, would not have been undertaken in the first place. In the regulated electricity market, however, such uneconomic plants, independent power supply contracts and other required regulatory assets are termed "stranded costs" (costs that utilities will not be able to recover if they are forced to compete for business). The frequently staggering nature of those uneconomic assets and contracts have produced demands for compensation by traditional utilities like El Paso Electric. In return for that compensation, traditional utilities have agreed to accept mandatory retail wheeling of power, produced by low-cost alternative generators, to traditional utility customers.

The reason that Southwest Public Service Company (SPS) can offer lower rates than EPE is because of the stranded costs issue. SPS did not undertake uneconomic investments. By contracting with SPS, the City had hoped to avoid payment of stranded costs by its citizens.

It was the political-regulatory process that led to the uneconomic investments known as "stranded costs." Now, as open access is emerging, it is the political-regulatory process that is determining their disposition. Economists are in dispute about the validity of competing claims to these costs. I, for one, am persuaded by the argument that formerly regulated monopolies have no claim to these costs. But the arguments for or against the collection of stranded costs by formerly regulated monopolies are irrelevant for the purposes of this assessment.

What is relevant is the direction in which the political-regulatory process is evolving toward resolution of the issue. And that is where the FERC order of 6/26/99 comes into play. The most likely scenario is that El Paso Electric will collect roughly $52.9 million in stranded costs beginning July 1, 1999. This is the reality that must be considered in assessing whether or not the takeover by the City of Las Cruces makes financial sense.

APPENDIX B: Reproduction of Operating pro forma from Official Statement of 1995back to top

 
 
 

	Fiscal Year Ending June 30
Year1	1997	1998	1999	2000	2001	2002
Statistics2
Peak Capacity (MOO)	87	89	91	93	96	98
Energy Sales	229	469	480	491	503	514
Total Revenue Requirement3	$14,960	$30,251	$36,210	$39,433	$40,966	$44,396
Operating Costs ($000's)
Purchased Power 4
Fixed	$ 2,857	$ 5,847	$ 5,982	$ 6,120	$ 6,484	$ 7,046
Variable	5,988	11,750	13,074	13,677	14,223	15,214
Transmission Wheeling5	1,034	2,153	2,241	2,333	2,429	2,528
Operations ant Maintenance6	1,161	2,413	2,519	2,604	2,716	2,834
Administration and General7	1,071	2,217	2,295	2,375	2,459	2,545
Customer Service7	268	545	564	584	604	625
Gross Receipts Tax8	954	1,928	2,308	2,514	2,612	2,830
Interest Earnings9	(0)	(0)	(382)	(382)	(382)	(382)
Total Operating Costs	$13,333	$26,852	$28,600	$29,824	$31,144	$33,240
Net Operating Revenues	$ 1,627	$ 3,398	$ 7,609	$ 9,609	$ 9,822	$11,156
Debt Service10	$ 0	$ 0	$ 3,906	$ 5,661	$ 5,661	$ 6,725
Pilot11	139	289	314	340	368	397
Franchise Tax12	374	756	905	986	1,024	1,110
Improvements and Additions13	1,115	2,353	2,484	2,623	2,769	2,923
Net Revenues	$ 0	$ 0	$ 0	$ 0	$ 0	$ 0
Average Rate (cents/kWh)14
With Gross Receipts	6.5	6.4	7.5	8.0	8.2	8.6
Without Gross Receipts	6.1	6.0	7.1	7.5	7.6	8.1
Debt Service Coverage15	ó	ó	1.95	1.70	1.73	1.66

___________

APPENDIX C: Reproduction of Debt Service Schedule from Official Statement of 1995, page 27back to top

The following table shows the estimated debt service requirements for the Series 1995 Bonds for each Fiscal Year ending June 30:

Source: Underwriters.
 
 

About the Authorback to top

Professor Harold C. "Harry" Messenheimer: Dr. Messenheimer received his MA from Virginia Tech in 1980 and his Ph.D. from George Mason University in 1989. He is president of Southwest Political Economy (an economics consulting firm in the Albuquerque, New Mexico area) and a Senior Fellow at the New Mexico Independence Research Institute (a free market think-tank for New Mexico). He is also research associate at the Center for Study of Public Choice, George Mason University. He has taught at the University of Richmond and George Mason University, specializing in microeconomics, macroeconomics, econometrics, the economics of taxes and production of public policy. From 1991 through 1993 he served as economic advisor to Commissioner William P. Albrecht (acting Chairman) at the Commodity Futures Trading Commission. Dr. Messenheimer has written on applications of economics to collective decisions.

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