Tennessee Valley Authority: Debt Reduction Efforts and Potential Stranded Costs
Published: 2001-02-28T00:00:00

Fast Facts:

Highlights:
section_title: What GAO Found
paragraphs: 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 three years, TVA still compares unfavorably to its likely competitors in these areas. 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.

section_title: Letter
paragraphs: 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, 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) financial condition, including debt and  fixed cost ratios, compared to that of other utilities, (3) potential stranded  costs, 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.
subsections: section_title: Background
paragraphs: 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.
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.
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 long- term 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 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.
section_title: Objectives, Scope, and Methodology
paragraphs: For each of the three objectives addressed in this report, you asked us to  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), Edison Electric  Institute (EEI), and CBO on the options other utilities have pursued to  recover stranded costs; reviewed Energy Information Administration  (EIA) 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.
section_title: TVA’s Schedule for Reducing Debt and Recovering Deferred Assets Is Slipping
paragraphs: In April 1999, we reported that capital expenditures not accounted for in  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,  TVA’s fiscal year 2000 federal budget request acknowledged that TVA would  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.
subsections: section_title: Annual Debt Reduction Is Behind Schedule and Overall Goal Is Being Revised Downward
paragraphs: To achieve the overall debt reduction goal in the original 10-year plan, TVA  established annual debt reduction goals. In the 1997 plan, the annual debt  reduction goals ranged from $476 million in 1998 to $2 billion in 2007. TVA  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  2000 and to TVA’s proposed revisions to its annual debt reduction goals for  fiscal years 2001 through 2007.
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.
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.
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 and interest expense. The net effect was  that annual expenses totaled about $122 million more than planned.
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.
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.
section_title: Plan to Recover Deferred Assets Is Being Revised Downward
paragraphs: A key element of TVA’s plan was not only to reduce the cost of its power by  reducing its debt and the corresponding interest expense, but also to  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 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. 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. 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  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.
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 remains about 6.5 percent, we estimate that TVA’s interest expense in  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, which extends through 2004, supports TVA’s  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 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.
section_title: TVA’s Financial Condition Has Improved but Key Financial Indicators Still Compare Unfavorably to Likely Competitors
paragraphs: A key objective of TVA’s 1997 plan was to alter its cost structure from a  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  marketplace. However, while TVA has made positive steps, its financial  flexibility remains below that of likely competitors, largely because its debt  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  recovery of the costs of its capital assets. Similar to improvements in  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 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) 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.
subsections: section_title: TVA’s Financial Flexibility Remains Relatively Low
paragraphs: To assess the progress TVA has made in achieving its key objective of  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 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 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, 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.
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 compared to  about 9 cents on average for its likely competitors.
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  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.
section_title: TVA’s Capital Cost Recovery Remains Relatively Low
paragraphs: Electricity providers, including TVA, generally recover their capital costs  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. 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. 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. For TVA, this consists  of construction work in progress (CWIP) and the costs of the deferred  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.
A second way to analyze the extent to which capital costs have been  recovered through rates is to compare accumulated  depreciation/amortization 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.
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; and  total cost of delivering power in relation to likely competitors,  generation capacity and mix, transmission capability, and geographic  location.
section_title: TVA’s Potential for Stranded Costs and Options for Recovery
paragraphs: Stranded costs can generally be defined as costs that become  uneconomical to recover through rates when a utility moves from a  regulated to a competitive environment. Stranded costs arise in  competitive markets as a result of uneconomic assets, the costs of which  are not recoverable at market rates. 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.
subsections: section_title: Calculating and Recovering Stranded Costs
paragraphs: Stranded costs occur when a utility moves from a regulated to a  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. 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:  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−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.
section_title: Methods of Calculating Stranded Costs
paragraphs: Two methods are commonly used to calculate the amount of allowable  stranded costs—the FERC “revenues lost” methodology and the “asset-by- asset 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  end of 2007 the costs will have been reduced to about $3.8 billion.  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. 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  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.
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 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 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. 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.
section_title: Options for Recovering Stranded Costs
paragraphs: In the states that have restructured their electricity markets, there have  been five commonly used mechanisms to recover stranded costs.  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.
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.
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.
section_title: TVA Has the Potential for Stranded Costs Because of Its Nonproducing Nuclear Plants and High Debt
paragraphs: TVA continues to operate similar to a regulated monopoly because of its  legislative protections from competition. Since regulatory changes  requiring TVA to compete with other electricity providers have not been  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, 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.
FASB 90 would apply because TVA remains in a regulated environment. 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.
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.
section_title: The Link Between TVA’s Potential Stranded Costs and Its Debt Reduction Efforts
paragraphs: A key element of TVA’s 10-year business plan is to reduce its cost of power.  TVA planned to accomplish this by reducing expenses, limiting capital  expenditures, and instituting a rate increase in 1998 to increase the cash  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  lower rates. Figure 11 illustrates the link between debt reduction and  stranded costs.
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.
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  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.
section_title: Conclusions
paragraphs: 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.
section_title: Agency Comments and Our Evaluation
paragraphs: TVA, in a letter from its Chief Financial Officer, disagreed with our findings  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 in the region in which TVA operates. EIA’s  analysis was based in part on a projected decline in coal prices 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. 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  the last 106 years. We would not predict the future on the basis of such an  anomaly.
subsections: section_title: Comparing TVA’s Financial Condition With Private Utilities
paragraphs: TVA commented that it appreciated our recognition of its progress in  improving its financial condition, but objected to our findings that TVA’s  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.
section_title: Deferred Assets and Stranded Costs
paragraphs: TVA states “the report is misleading when it implies that the historical  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.
section_title: Looking Back
paragraphs: 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.” 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.
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.
section_title: Objectives, Scope, and Methodology
paragraphs: 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.
How TVA’s financial condition, including debt and fixed cost ratios,  compares to neighboring investor-owned utilities (IOUs).
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.
subsections: section_title: Debt Reduction and Recovery of Deferred Assets
paragraphs: To identify the progress TVA has made in achieving the goals of its 10-year  business plan for reducing debt and deferred assets, we  reviewed GAO’s prior report on TVA’s 10-year Business Plan; 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  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.
section_title: Financial Condition
paragraphs: 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   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;   computed and compared key financial ratios for TVA and the other eight   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  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.
section_title: Stranded Costs
paragraphs: 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.
section_title: Organizations Contacted
paragraphs: During the course of our work, we contacted the following organizations.
subsections: section_title: Federal Agencies
paragraphs: Congressional Budget Office,  Department of Energy’s Energy Information Administration,  Federal Energy Regulatory Commission,  Office of Management and Budget, and  Tennessee Valley Authority.
section_title: Bond Rating Agencies
paragraphs: Moody’s Investors Service, New York, New York, and  Standard & Poor’s, New York, New York.
section_title: Customer Representative or Trade Group
paragraphs: Tennessee Valley Public Power Association, Chattanooga, Tennessee.
section_title: Others
paragraphs: Federal Accounting Standards Advisory Board, Washington, D.C.,  Edison Electric Institute, Washington, D.C., and  Standard & Poor’s DRI, Lexington, Massachusetts.
section_title: Mechanisms for Mitigating Stranded Costs
paragraphs: 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.
section_title: Comments From the Tennessee Valley Authority
section_title: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Acknowledgments
paragraphs: 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.
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