more to purchased power to satisfy capacity needs, but with an increase in risk. And purchased power will become even more significant if today's vertically integrated utilities spin off the generation function. Either way (spinoffs or vertical integration), utilities must address this added risk: through fair compensation, and by correctly assessing the true cost of supply alternatives in resource planning.1

When utilities sign long-term purchased-power contracts that include a fixed-cost component, they incur financial, regulatory, market, and supply risks, as well as the risk associated with a declining rate base. Nevertheless, regulators often do not augment return on equity to compensate. This failure imposes consequences. Over the past few years, numerous companies have had bond ratings lowered, or not increased, due to purchased-power obligations.

FINANCIAL RISK

Financial theory often breaks risk down into two components (em business risk and financial risk. Business risk denotes the uncertainty associated with the level of operating earnings. Financial risk marks the additional risk a company takes on by assuming fixed-cost obligations. For example, as more debt is added to the capital structure, a company faces more fixed charges (i.e., debt payments); bondholders and stockholders both run the risk that operating revenues will fail to cover expenses and return on capital. Thus, as the share of debt rises in capital structure, bondholders and stockholders will demand a higher return to compensate for the higher leverage and financial risk.

Purchased-power contracts