John A. Helmuth is an Associate Professor of Finance in the Department of Accounting and Finance, College of Business Administration at Rochester Institute of Technology. Donald Kent is an Assistant Professor of Accounting at Robert Wesleyan College, Rochester, New York. Jeffrey P. Lessard is an Assistant Professor of Finance in the Department of Accounting and Finance, College of Business Administration at Rochester lnstitute of Technology

Helmuth, John A.

Kent, Donald

Lessard, Jeffrey P.

English

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Southern Business Review Volume 17 Issue 1 Article 4 April 1991 Capital Budgeting and State Approval of Power Plants John A. Helmuth Rochester Institute of Technology Donald Kent Robert Wesleyan College Jeffrey P. Lessard Rochester Institute of Technology Follow this and additional works at: https://digitalcommons.georgiasouthern.edu/sbr  Part of the Business Commons, and the Education Commons Recommended Citation Helmuth, John A.; Kent, Donald; and Lessard, Jeffrey P. (1991) "Capital Budgeting and State Approval of Power Plants," Southern Business Review: Vol. 17: Iss. 1, Article 4. Available at: https://digitalcommons.georgiasouthern.edu/sbr/vol17/iss1/4 This article is brought to you for free and open access by the Journals at Digital Commons@Georgia Southern. It has been accepted for inclusion in Southern Business Review by an authorized administrator of Digital Commons@Georgia Southern. For more information, please contact digitalcommons@georgiasouthern.edu. CAPITAL BUDGETING AND STATE APPROVAL OF POWER PLANTS John A. Helmuth Donald Kem Jeffrey P. Lessard Introduction Current issues in the electric pO\\er industry concerning excc5s capacity, escalating ne\, plant capital rnsts, and the abandonment of planb that are under construction indicate that there is a greater need to understand the power plant con~truction appro\al procedure~ used by regulatory authori-tie5. State approval procedures for plant investment arc generally referred to as either Certificates of Convenience and Necessity or Certificate5 of Need. Approximately one-half of the state\ require prior approval before an elec-tric utility can conMruct a generating plant. Hm\e and Rasmus~en ( 1982) describe the procedures required by state regulatory agencie~ when applying for either the Certificate5 of Convenience and Necessity or Certifil:ate5 of Need. Earlier survey work by both 13righam and Pettway ( 1973) and Hm,e ( 1979) provide~ significant insight into electric utility capital budgeting procedure~. This paper. in contra~c. inve~tigates the capital budgeting methods used for Certificates of Need by which the utilitie5 gain appro,al for the rnnwuction of ne\, pow er plants. Our sun ey ~uggests that, on average, c he ~tate public utility commi5~ions required that the utilitie\ · capital budgeting techniques become increasingly more rigorous. For instance, in today's regulatory environment, it is much more ..:ommon to analyze plane investments from many dimensions. These dimemions include the evaluation of plants of different s..:ale, fud type. and alternati\e technologies. However, net present \alue analysi, \Va\ not applied in any of the hearings before ~tatc commi~sion5. The lad, of the uw of net present value techniques not only can lead to a mi,allocation of rc~ourcc,. but can also impede progressi\'e methods of allocating capital co,t\ to ratepay• ers. \\hich would require more sophisticated ..:apital budgeting (Man.:us. 1986). Lit l'ratun· R('~it•\\ Brigham and Pettway ( 1973) pro\'ide th.: wminal y,ork on electric utility capital budgeting. They surveyed I I 6 electric utilitie, and received a ~6 per· ..:cnt re\pome. Brigham and Pettway found that NVP method, \\l!rl· u,ed for discretionary investment opportunitie\ (e.g., C05t savings, etc.). HO\\Cver. the ,ast majority of investment opportunities associated wi th the public util-itie~ are mandatory, thu~ not disuetionary in nature. Alternati\e capital budg-eting method, (i.e .• non-NPY techniques) are applied to these non-discretionary investment opportunit ie~ by the public utility commissions. The mo\t common method of evaluation (69 percent of respo nses) was to 12 ... ... select the project with the lowest present value of annual costs. Ninety-four percent of the companies indicated that the present value least cost method is used to analyze some of their capital projects. Second, the cost of capital used for discounting to present value was overwhelmingly the current cost of capital rather than the embedded rnst of capital. Third, sophisticated tech-niques were not used to evaluate risk. The method\ used to evaluate risl. gener-ally incorporated either a sen~itivity analysis or arbitrarily decreasing the expected life of a project. Finally, only 60 percent of the companic~ con-ducted post-audits of their capital budgeting decisions. The Howe telephone survey of May 1978 included 51 privately owned elec-tric utilities. Howe \\a~ primarily intere~ted in the amount of resources devot-ed to the capital budgeting process. He found that the average capital budget was greater than S200 million. Further, Howe found that, on average, more than twenty employees wen: engaged in the capital budgeting process. Near-ly 67 percent of the capital buuget was de,oted to generation, anu 50 per-cent of the staff'~ t imc was engaged in analyzing generation expenuitures. The above-mentioned two artide~ comprise the major wor(.. on electric util-ity capital budgeting practices. Incidental article\ often have capital budget-ing implications. For instance, Chao, Gilbert and Peel. ( 1984) referred to a corporate strategy of "capital minimiLation" that has been adopted by util-ity executi\es. Thi5 strategy occur, \\hen 1he rate of return allowed by the slate is lc,s than 1hc utililics' co, t of capital. Thus, the , hareholder would be better off withoul the capital expenlliture. The "capital minimization" slrategy attempl5 to minimi.-e the negative impact on the value of the share-holder', equity position if the allcmabk ra1e of rc1urn becomes lower than the utilitie5' co,t of capital. Such a strategy appear5 as if "capital minimiza-tion" ha, a5 its basis the internal rate of return. Thus, Chao, Gilbert and Peck imply that utility excculive, an: primarily concerned \\ ith shareholder wealth maximilation. In summary, bccau,e of the \\Ork by Brigham and Pett,\ay, Howe, and Chao, Gilbert and Pe,(.., \\C ha\c a good idea of the capital budge! proce-dures and the re~ource, employeu by the cl.::..:1ric utilitic, . The nex1 ,ection of the paper indude5 an imc,tigation of the capital budgeting techniques that are used before ~tate utility ..:ommi,,iom in gaining approval for ne,\ po11er plants. Sune~ Rc!>ults The plan for surwying , tate public ,ervice commis~ions (or d.::,ignatcd regulatory boclie~ for Certificate, of Need) wa, to i111estigate the extent to which rigorous capital budgeting procedures were followeu in light of recent issues that face the utility induqry. Accordingly, our survey audr<.'ssed the following: I. Does your ~late have a formal Certificate, of Need procedure for new power plant inve5t111ent? 13 2. What capital budgeting procedures are used by utilities in applying for Certificates of Need? 3. Are alternative capital projects analyzed for: a. Different fud sources? b. Different scales of plant? c. Purchased power (from other sources)? d. Alternative tcchnologie~ (solar, wind, etc.)? 4. Are the certification procedure, different for peak load J)O\\er plants as compared with base load power plant,? 5. Docs tht' ,tate mandate the capital budgeting techniques that will be used in applying for certification? Our sample consisted of twenty-five \late public utility commissions, list-ed in Appendix A. Five state, had no prior approval process or Certificates of Need procedure, and two states did not respond. Thus, our sample con-sists of eighteen of the approximately twenty-five states that have formal cer-tification requirements.' The survey proi.:edure v. as to first initiate the questionnaire over the telephone during Spring, 1989. This\\ a, practical since the survey proi.:css often required talking to se,cral people per commbsion before v.e v.ere directed to the individual supervising the Ccrtifi<.:ates of Need procedures. Second, after the telephone interview, a questionnaire was rnm-plctcd and then mailed to the de,ignatcd indi,idual ,o that he or she could make any corrections or amplifications to the initial an,,,er,. Additionally, ,,e asJ..ed that the mo t recent certification case be mailed to us. The remit, presented herein are a compilation of this information. A v.ord of warning is advisable pertaining to the nature of the utility in-dustry. Man) states have not had nev. Certificates of Need applications for O\er ten year,. This reflects the ex.:e~s generating capacit) of the 198O's. Thus. the certification procedures reported in some cases arc aged. furthermore. state trends arc such that portions of cost overrun,, especially those associate~ with nuclear plants, arc nor being admitted 10 the rare ba,e. Some stares, with no prior approval for plant5, will add power plant~ to the rate base only on an ad hoc basis. Also, ,ome state, have indicated that they intend to revie\\ their certificates of need procedures. Thus, both the procedure5 \\C di\cus\ and the industry en, ironment arc far from static. lme,tment Criteria E,hibit I indicate, thar the mo\! common capital budgeting criterion (770/o) is the present value least cmt met hod. Thi, method results in the executive selecting inve~tment opportunities that provide the least co5t pre5ent value of annual costs. The present value least cost method of capita l budgeting i~ also referred to, within the utilit y industry, as the present value rc\enuc requirement.' In contrast to the present value least cost technique, one state employs a least co,1 approach with no associated present value analysis, and one state allows the u,e of any method thar applies time value of money con-14 1 -cepts. No state employ, the NPY approach to capital budgeting. Addition-ally, we inquired to the extent that payback, present value payback, average return, and internal rates of return 1>.cre used in the capital budgeting process, and there was no such rcspome. Method Present Value Least Cost Fxhibit lmC'~trncnt Criteria Any Time Value of Money Method Least Co~t Various• Responses Percentage 1-1 77.7QO-/o I 5.55 010 5.55% 2 11.1 l lro *Indicates that no particular ,tam.lard for rnpital budgeting is applied. It is intcrc,ting to note that the moo;t common ,apital budgeting technique identific-d by the Brigham and Pettway study \\a, also the prc-,cnt value least cost method. Thu,, ~ixteen years later, "c qifl find the pre~ent value kast cost method a, the mo,1 commonly employed capital budgeling technique in use. Brigham and Pettway cxplainec.l the ,ta tic rea,oning in adopting ,uch a technique. They po,ited that if a utility accepted positive NPV projects, the utility believed that it \vOulc.l be penalized if thl' allowable rate of return decrcascc.l. Thu,, the (caq .:o~c method is adopted. Brigham and Pettv.ay raised ob\ iou, exception\ to thi, rea,oning from a c.lynami, setting and ar-gued for the u,c of NP\' analysis. It is ,urpri\ing that, given the growing sophi,tication of rate of return hearing, ~incc I 973, .:apital budgeting tech-niques arc ~till antiquated. Comparison ol" AlkrnatiH· lllll",lmC'nh Sixteen of the eighteen ,tate, re,pondcd chat they required a comparison of diffcrclll invc,trnenl altcrnati\es before granting Cc:rtifi,atc<i of Ne..:d. Ex-hibit 2 indi,ate\ that !he \a~t majority of state utility corrnni,~ions ill\e,tigated both different fuel type, (e.g., rnal vs. oil) and s.:alc of plant. These two factors can be important 111 that they inhibit the ability of the utility to ar-bitrarily induce input sub,titution~ that may not be efficient. Further, thir-teen ,tate, con5idcred the purcha,c of power a, an altcrnati\e to capital construction. A ,urpri5ingly large number (nine) of u1ilicy commi~sions con-sidered the evaluation of alternative technologies. The general impression is that, over time, there ha~ been more rigor associated with the analy,is of appropriatc- capital budgeting pro.:edures, (i.e., looking at alternative invest-men1s). Further, ,ome sta tes have just begun to incorporate present \aluc analysis in their capital budgeting decision making. The trend toward great-er rigor in capital budgeting is ,Kcounted for by industry problems sud1 a, excess capadty and cost overruns for new plant,. I 5 Exhibit 2 Comparison or Alternathe lm•e,;lments Alternative Response Yes No No Fuel Type 15 0 Sile 13 2 Alternative Technologies (Wind, Solar, etc.) 9 6 Conservat ion 11 Purchase Po\\ er 13 :? Finally, se, cnteen state~ indicated that they do not differentiate or change the certification procedure associated with a peak load plant , er5us a base load plant. However, several utility commissions indicated that ir the capac-ity of the plant wa, extremely ~mall. the certification procedure would be less rigorous. Thb could be an efficient U')C of re~ources on a marginal benefit -co~t relationship. A, far as the choice of the imc5tment criteria, sixteen 5tate5 indicated that they did not mandate the u~c of .~pecific capital budgeting tech-niques hut rather allo\\ed the utility to pre,ent capital budgeting techniques of their 0,1 n choosing. Also, external rate con~ultants provide much of the analysis. !\lO\I state\, ho\\ever, indicated that they revie,~ed, critiqued, and often a~'-ed for, additional analy~is. This study included a 5Uney of twenty-five state public 5ervice commis-sions with regard to their pre-approval certificate procedure5 for po,\er plant~. The overwhelming majority of state, accept the present value lea,t cost method of capital budgeting. Thi, method ,,a, also dominant in the Brigham and Pettway (197)) survey of utilities. Further, ,rate utility commission5 do not mandate the capital budgeting techniques, but accept those method, provided by the utilitie5. No \late neith.:r required nor reported accepting the NPV analysb. 1 he resulting inefficiencies in plant choice, and possible aggrc:gation of such a misallocation at the indu5try level. can be exces\ive and may lead to new industry problems as the era of exec,, capacity in the I 980's is nearly over. Our study did find, however, that there b a growing trend toward~ an in-crca~ed rigor in the approval procc:s\ . Thi, can be seen in that mo~t , tate\ no\\ u,e <,ome method of present value analysis. Further, there is no\, ntcn-sive analysi~ of alternative investments (i.e., c,tended evaluation by plant scale, type of fuel, alternative technologies and purchased power). The capi-tal budgeting procedure, currently employed arc far from static and are likel> to be greatly refined during the next round of power plant con~truction. It appears equally likely that there will be greater public attention to the front 16 end of the regulatory process given both the sheer magnitude o f the public ";' utilities' investment opportunities and the choice of nuclear versu~ alterna-tive fuels. Mo reo, er. some states, such as Ma~sachusetts, have a lready de-bated the relative merit of the pre-approval certificates versus no pre-approval before public utility commissiom. ---I. Arizona* z. California** 3. Conne(·ticut 4. Florida 5. Illinois 6. Indiana 7. Kansas 8. Kenlu{'k) 9. Louisiana 10. Maine 11. Massachusetts 12. Michigan* 13. Minnc,ota 14. el\ Jcr!>e~ 15. Ne\\ York 16. North Carolina 17. Ohio 18. Oklahoma* 19. Pcnn!>}hania* 20. South Carolina 21. Texas** 22. Virginia 23. Wa,hington* 24. West Virginia 25. Wisron!,in Appl•ndi, A Statr, Included in thl' Sune~ * State, not requiring crrtificak ** Information not rl•rl'iH·d Endnote!> ' New Yor~ ,,a, reported a, a l·ertifkate, of nerd ,tale. Ho11,e,er. it~ law governing the certification proces~ expired in 1988. 'See Brigham and Pettway (1973) for a more deta iled explanat io n . 17 References Brigham, E.F., and R.H. Pettway, "Capital Budgeting by Utilities," Finan-cial Management (Autumn 1973), pp. 11-22. Chao, H.P., R.J. Gilbert, and S.C. Peck, "Customer anJ Investor Evalua-tions of Power Technologies: Conflicts and Common Grounds." Public Utilities Fortnightly (April 26, 1984), pp. 36-40. Howe, K.M. and E.F. Rasmussen , Public Utilit} Economic, and Finance, En-glewood Cliffs, NJ, Prentice-Hall Inc., 1982. Ho'-'e, K. r-.t. ·•Capital Budgeting and Search in Electric Utilities," paper presented at the FMA meetings, Boston (October 1979) a\ de,cribed above in Ho'-'e and Rasmussen (pp. 246-249). r-.tarcus, A.J. "Depreciation Rules and Rate Shocl-- in Rate of Return Regu-lation," Financia l M anagement (Winter 1986), pp. 61-68. John A. Helmuth is an Associate Profe\SOr of Finance in the Department of Accounting and Finance, College of Business Admini,tration at Rochester Institute of Technology. Donald 11:ent is an As~istant Professor of Account -ing at Ro bert Wesleyan College, Rochester, Ne\\ York. Jeffrey P . Lessard is an A,sistant Professor of Finance in the Department of Accounting and Finance, College of Bu,iness Administral ion at Roche,ter lmtitutc of Tech-nology. 18 

Capital Budgeting and State Approval of Power Plants

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Capital Budgeting and State Approval of Power Plants

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