Why Taking Over Utilities Won’t Deliver Cheap Electricity

Renewable energy sources not only disrupt business relationships due to their low prices and rapid deployment, but they might also disrupt political movements as well, specifically efforts on the part of local governments to take over investor-owned utilities (municipalization), most prominently, recently, in San Francisco, Tucson, and the lower Hudson Valley, NY.
Proponents of municipalization hope to reduce electricity rates to local consumers. We believe that because of the advent of newer, cheaper renewable technologies, they are going about things the wrong way. By purchasing legacy utility distribution assets that are both old and expensive ( possibly at 1.7 times book value), the new owners incur risks. First, there is the classic stranded asset risk/death spiral. Existing customers (especially large C&I) may be attracted by competitors' lower prices and leave the system. (This risk is actual and not theoretical, except now it’s the renewables industry that’s beginning to cherry-pick lucrative, high-use customers.) But it’s not the main problem.
Then there is a financial risk. Let’s look at municipalization efforts financially from a balance sheet perspective. (Quick reminder: Assets are what you own, Liabilities are how you paid for them, and what combination of equity and debt.) The basic premise of municipalization is that legacy utility distribution assets are basically fine as they are. They propose to generate savings by changing the liability side of the balance sheet equation, by replacing corporate debt with lower-cost municipal debt, and by eliminating the expensive equity portion of the capital structure, which typically constitutes about half the capital structure and costs about 5-6 % more than low-risk debt. There should be no dispute. There are large savings to be realized here, but whether they will prove adequate to justify the current municipalization efforts is another matter entirely. What happens, for instance, if the takeover occurs and prices don’t come down because fuel prices escalate suddenly? Or what if the municipalization reduces the cost of each component of capital, but the municipality paid too much for the asset? Property valuation often ends up as a court decision, and courts in this country have their own ideas about value.
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Here is a simple example. The investor -owned utility has assets with a book value of $100, financed by selling $50 of debt with a 6% interest cost, and $50 of common equity with a 10% cost of capital. The property, then, has to earn $8 after all operating expenses. The local city government can sell bonds that pay 5%. It bargains with the utility to set a buyout price. The utility insists on a payment that reflects the current value of the property and goes to court for that number and prevails. (Keep in mind that the utility’s plant and property are roughly 30 years old, so prices have gone up a lot since then.) The bargaining and court actions led to a price of $170. The politicians have too much invested to back off. The city borrows the money to pay the $170 at an interest cost of $8.50. Nobody gains except for the sellers.