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HomeMy WebLinkAboutL.I. Public Power Panel - 1986 - RE: LILCOREPORT OF THE LONG ISLAND PUBLIC POWER PANEL SUMMARY On January 30, 1986, Governor Cuomo announced the appointment of a seven-member Panel to "oversee New York's examination of the feasibility and economic viability of replacing the Long Island Lighting Company (LILCO) with a publicly owned utility" (Exhibit 1). In response to the Governor's directive, the Panel has addressed lhe following questions. 1. Can ratepayer savings be expected from either a complete or partial public takeover of LILCO? If so, under what conditions would these ratepayer savings occur? How would ratepayer savings be affected by changes in these conditions? 2. Are there feasible and preferred methods for replacing LILCO with a publicly owned utility? What are the problems and risks associated with each? The Panel was not asked to ~xpress its views concerning the public policy considerations involved in a Public takeover o£ IJLCO, and this report contains no recommendations in that regard. The Panel has reached three major conclusions. First, the replacement of LILCO with a Long Island Power Authority (LIPA) could result in ratepayer savings - in the range of 7 to 9 percent - under assumed financial and operating conditions, but the savings are quite sensilive to variations in those conditions. Second, a negotiated agreement with LILCO is the preferred alternative for a public takeover. And, finally, the negotiated acquisition of all of LILCO's generating assets or only the Shoreham nuclear plant, while offering lesser ratepayer savings, could realize some of the objectiv.~s o~ a public .takeover of the entire company. 1. Ratepayer savings are projected under certain conditions. Under assumptions the Panel regards as plausible, the replacement of LILCO with LIPA at an a~quisition cost approximately equal to the adjusted book value of LILGO equity could provide ratepa5er savings in the range of 7 to 9 percent. Electric rates on Long Island have been well above the national average for at least the last decade. During that time, ~LILCO's higher operations and maintenance costs (primarily due to a greater percentage of oil in its generation mix than other utilities have) and higher taxes (i.e., property taxes and gross receipts taxes) have been important reasons for its higher rates. In addition, LILCO's capital costs have also recently increased relative to the national average (Exhibit 2). In the future, electric rates on Long Island are likely to rise significantly under either LILCO or LIPA, if the financial and ~perating conditions that the Panel regards as plausible are realized. For example, in the case where LILCO operates Shoreharn but LIPA abandons it the Panel project~,~th,at both LILCO and LIPA rates will increase in real terms ore~,the next severa~ years, assuming that phase-in plans are utilized in both cases (Exhibit 3). The Panel compared'LIPA and LILCO rates under both Shoreharn operation and abandonment. If LIPA and LILCO would make identical decisions either to operate or to abandon Shoreham, the replacement of LILCO ~'ith LIPA could result in 8 to 9 percent ratepayer savings under a continu4ation of current State Public Service Commission (PSC) raternaking policy. If LIPA chose not to operate Shoreharn but LILCO succeeded in obtaining a commercial operating license and operated it - a comparison that the Panel believes is important to make - ratepayer savings from LIPA could fall to approximately 7 percent (Exhibit 4). The Panel cautions that the projected savings from LIPA replacement of LILCO are sensitive - in some instances quite sensitive - to changes in the specific operating and financial conditions assumed in the analysis. The projected range of savings is based on three major assumptions: (1) an acquisition price of $3.0 billion for LILCO*s common and preferred equity and a total initial LIPA financing of $3.6 billion (this initial financing is premised on a purchase price for LILCOts common stock of $18 per share, assumption of LILCO~s existing debt, and avoidance of $550 mnillion to $650 million of LILCO~s deferred Federal income tax liabiIity)i (2) an interest rate on LIPA debt (tax exempt) of 9 percent - based on market rates prevailing earlier in 1980 - and LIPA rate covenants that include a coverage requirement of 1.25 times annual debt-service obligationsl and (3) a projected economic benefit from operating Shoreham of approximately $200 million, net present value over 15 years, compared to the cost of meeting Long Islandts requirements from alternative sources of power. These projections of savings are based upon continuation of current PSC ratemaking policy, where a full recovery of and return on prudent costs would be granted even if Shoreharn were abandoned. However, the State Legislature is currently considering legislation that would bar LILCO from recovering in rates any Shoreham costs if the plant does not begin commercial operation (i.e., used and useful legislation). If such a law were enacted and Shoreharn were abandoned by LILCO, future LILCO rates would be lower than under the assumed continuation of current raternaking policy. Consequently, the price that LIPA could afford to pa)- to acquire LILCO and stil~ realize ratepayer savings would fall below LILCO~s current market value. 2. Negotiated acquisition is preferred. If the State does pursue a takeover of LILCO, a negotiated agreement that results in a friendly acquisition by LIPA is the preferred aiternati~,e. The Panel investigated three methods of public takeover: (1) condemnation of LILCO stock or assets; (2) a tender offer for LILCO*s stock~ or (3) a negotiated agreement approved by LILCO*s Board of Directors and shareholders. Because of the difficulties inherent in either condemnation or tendering for LILCO stock, a negotiated agreement is preferred. A, negotiated agreement can be consummated relatively quickly, and it can be pursued at minimal cost to the State. In addition, the Panel believes tha, t.,LILCO's management and Board of Directors should, in the ex~rcis~ o~;their fiduciary responsibility, be willing to enter into and pursue good faith negotiations for a public takeover upon receipt of an appropriate offer. Acquisition of either stock or assets by means of condemnation appears relatively unattractive because the condemnation process would be subject to leng!hy delays and its ultimate outcome cannot be predicted with certainty, even though State law can be modified in certain respects to facilitate such actions. Finally, a tender offer is preferable to condemnation, but it may be difficult to execute successfully and it would almost certainly be accompanied by substantial litigation and costs. 3. Negotiated ac-quisition of generatin~ assets could realize some obiectives. Alternatives to the complete takeover of LILCO are the negotiated acquisition of either all of LILCO's generation assets or only the Shoreham facility by a Long Island public generating authority (LIGA). Under the LIGA alternative, ratepayer savings in the range of 3 to 6 pe?cent could be realized over the 15-year horizon - again under assumed financial and operating conditions. This alternative could address at least one possible objective of a public takeover of LILC© - control of the Shoreham operation decision. In addition. LILCO management may be more willing to consider a partial acquisition alternative than :a Complete takeover. If LIGA were created, LILCO would continue as at least a transmission and distribution company and would purchase either all or part Of. its requirements from LIGA through a firm power sales contract at a price reflective of LIGA's total debt service and operations and maintenance expenses (Exhibit 5). The three chapters Of this report discuss these conclusions in detail. The results of the financial comparisons between LIPA and LILCO, from which the Panel concluded that ratepayer savings could be expected from LIPA if certain conditions hold, are presented in considerable detail. The alternative methods for achieving a public takeover of LILCO are evaluated, and the reasons why the Panel believes that a negotiated agreement is preferred are discussed. In addition, the reasons why the Panel believes that creation of a regional po~'er authority is the preferred vehicle for a public takeover are reviewed. The LIGA alternatives and their impact are examined. 4 1 - PUBLIC TAKEOVER BY LIPA COULD OFFER RATEPAYER SA'~INGS UI~DER CERTAIN CONDITIONS The Panel ahalyzed the economic consequences of a public takeover of LILCO principally from the perspective of Long Island electric ratepayers and local and State taxpayers._ The Panel's analysis assumed that Long Island property taxpayers and State taxpayers would not necessarily be penalized by s LIPA takeover. It is therefore assumed that LIPA's payments in lieu of property tax would equal LILCO's property tax - if LIPA and LILCO were to adopt identical supply plans. In addition, LIPA's payments in lieu of State gross receipts tax are as~6umed to be based on an equivalent percentage of revenues as LILCO's are. ' The Panel did not, however, introduce similar assumptions to hold harmless the Federal taxpayers. For example, the Panel projects that the public takeover of LILCO would eliminate $1.6 billion of Federal income taxes that LILCO would actually pay if it continued operations. The economic consequences of a takeover for other important constituents (e.g., the Long Island economy, LILCO long-retm debtho]ders, Long Island gas ratepayers) were not quantified. The Panel did not examine the broad issue of privatization of Federal power systems; the merits of public power takeover proposals being examined elsewhere in the country; or the p.ub!ic policy implications of a government takeover of a major, regulated corporation. In addition, in estimating the economic consequences of a LIPA takeover, the Panel has reached no conclusions about whether public power is inherently preferable to private power or vice versa on the basis of operating efficiencies, although it did conduct a financial survey of public versus investor-owned utihty systems across North America. Survey results show that public power rates are lower than the rates of investor-owned utilities, but that the nonfinancial factors (e.g., access to low-cost hydropower) explaining some of the differences may not be available' to LIPA. Conseqt:ently, the Panel assumed that operation and maintenance costs for the Long Island power system would not be significantly affected by ownership if the same supply plan were adopted - an assumption that is generally consistent with average experience in North America. The Panel has based its analyses on forecasts of many uncertain variables - these include electricity load growth on Long Island, the availability and cost of alternative ways to meet load growth, fuel prices, and interest rates, among other factors. In using these forecasts to assess the the comparative rates of LILCO and the public power alternatives, the Panel has relied on models and financial analysis developed by its staff and the Governor's Special Task Force on Public Power on Long Island (Task Force). It has validated these results, where possible, with consultants and other State agency staff members. However, there can be no absolute certainty attached to the'Panel~s fi.n. ancial projections. The Panel has pursued its analysis cognizant of the fact that future actions by the Federal government, State government, LILC, O, and the State Public Services Commission (PSC) all could materially a~fect,its, as~ump'tions and conclusions. Consequently, the Panel - where poegible - conducted sensitivity analyses to gauge the effect of future uncertainty and to provide a sense of the implications of various future actions and events. The Panel's conclusions are based primarily on the results of its rate analysis, but it is aware that projected ratepayer savings may not be the exclusive objective in deciding whether to pursue a public takeover of LILCO. Other objectives for a public takeover of LILCO could be to change the policies of LILCO*s management or to gain explicit control of the decision to operate Shoreham. While the Pane! acknowledges the possible importance of these additional objectives, its conclusions do not reflect an)- judgment on their merit. The Panel concludes that ratepayer savings in the range of 7 to 9 percent could result from the replacement of LILCO with LIPA under a range of plausible assumptions. These savings would arise primarily from the absence of Federal income taxes for LIPA, its capital structure that consists of 100 percent debt, and its assumed access to lower interest rate tax-exempt debt. The conditions necessary to realize this level of savings or obtain greater ratepayer savings may, however, be difficult to achieve. For example, longer-term savings would decrease if Ihe. purchase price for LILCO were greater than assumed or if LIPA interest rates were higher than assumed. On the other hand, savings could increase with a lower purchase price or lower interest rates for LIPA. This chapter first describes the methodology and. assum~ Panel has used to make financial project.ions under continued 1 and under LIPA. 7,,e Panel has received several studies that wide range o£ projected ratepayer advantages and 9disadvantag .~s under LIPA based on assumptions that differ from the Panelts. On balance the Panel believes that its assumptions and its analysis are objective and plausible. In any event, the Panel identifies the major differences between its assumptions and others to facilitate independent assessment by others. In the second section of this chapter, the Panel*s projections of LILCO and LIPA comparative rates and LIPA financial performance are examined. tions that the ILCO operation demonstrate a A - LILCO AND LIPA METHODOLOGY AND ASSUMPTIONS In projecting LILCO rat~.:.the Panel has relied principally on the State Energy Office's (SEO) ~fir{anc{al model for investor-owned utilities. The Panel undertook a lengthy validation process to assure the credibility of SEO's approach, including an independent projection of LILCO rates - using the Panel's assumpt{ons - by Enef~gy Management Associates. Inc. Arthur Andersen, Inc.; the DPS staff; and other staff members also conducted reviews. For projections of LIPA rates, the Panel again relied on a model developed by SEO. In this case, a review was conc]uded by other staff members and Salomon Brothers, Inc. As a result of this validation process, the Panel believes that a reasonable projection of LILCO and LIPA future rate levels has been achieved. Many important financial and operating assumptions used in the analysis significantly influence projected rate levels. FINANCIAL ASSUMPTIONS There are four major financial assumptions. 1. Rate treatment of Shoreham ~mder continued LILCO ownership. It is assumed that rates will include full recovery of and return on LILCO's prudently incurred investment in Shoreham if the'plant operates. Under abandonment, two alternative ratemaking schemes were investigated. The first assumes a continuation of PSC rate treatment, where full recovery of and return on prudent costs would be granted even if Shoreham were abandoned. The second assumes that LILCO is barred from recovering in rates any of Shoreham's cost if the plant were abandoned, either as a result of a change in PSC ratemaking policy or legislative mandate, but that the PSC - through a financial stability adjustment - maintains LILCO rates at levels sufficient to meet minimum financial performance levels.' The Panel's estimate of the cost of Shoreham is approximately 54.5 billion. Of that amount, it is assumed that the PSC's determination t~at approximately $1.4 billion was imprudently incurred (PSC Case 27563, Opinion No. 82-23, December 16, 1985) will be sustained on court review. Further, for some of the cases, it is assumed that Shoreham's total cost (i.e., $4.5 billion plus Allowance for Funds Used During Construction on costs not in rate base) will be phased in over 10 or 15 years and amortized with full return over 30 years. The PSC has recently approved a rate moderation plan for LILCO under which the remaining investment would be phased in over 15 years. The phase-in plans the Panel uses are not identical to the pL~ approved by the PSC but do produce a similar time pattern of rates. In any event, the Panel believes that these plans are sufficient to compare the abilities of LILCO and LIPA to manage near-term rates. 2. LIPA's' cost of acquiring LILCO. It is assumed that the takeover of LILCO is achieved through a stock acquisition on January 1, 1987. For purposes of the principal rate comparisons, the Panel assumes an acquisition price for LILCO Of $3.2 .billion.'f~r all of its common and preferred equity and preferred dividends in arrears. This price includes $2.0 billion for LILCO's approximately i10 million shares of common stock at a purchase price of 518 per share, $980 million for ail of the preferred stock (at par, plus accumulated deferred dividends and applicable redemption premiums), and $200 million for ITC recapture. The assumed purchase price of $18 per share approximates the projected end-of-year 1986 book value of LILCO common equity, after adjustments for Shoreham and Nine Mile Point 2 (NMP 2) imprudence disailowances. As discussed, a $1.4 billion imprudence disailo~-- ance is assumed for Shoreham. In addition, a $260 million disailowanff is assumed for I'IMP 2, reflecting LILCO's 18 percent share of the unit. Acquisition prices above or below $18 per share are possible, however, and the Panel varies this purchase price for other rate comparisons. Initial LIPA financing requirements that result from the Panel's assumptions about acquisition price are also premised on iLIPA assuming ail of LILCO's existing debt, estimated at $3.6 billion. This initial financing requirement would be sufficient to cover the purchase price, first-year debt- service obligations on the initiai debt - for establishing a debt reserve fund, and underwriting fees. The Panel recognizes that immediate refunding of the approximately $2.4 billion of General and Refunding (G&R) debt could be attractive from the perspective of LIPA ratepayers,, because of its high average coupon rate and the absence o~2cail premiums on ail but $525 million of it in the event of a public takeover. However, the Panel assumes that this debt would not be refunded, based on advice from the financial consultants that LIPA would probably improve its chances of effectively marketing the already large issue (i.e., $3.6 billion) in a short period if it could assume LILCO~s existing debt. Refunding the G&R debt would raise the amount of the required long-term financing from approximately $3.6 billion to nearly $6.0 billion and would possibly shorten the period in which such financing could be obtained. This is because of a restriction in the G&R bond covenants that requires refvnding within 120 days of completing the acquisition if the call premium is to be avoided. The PanePs initiai financing assumption thus varies from Smith Barney~s, which assumed that all of LILCO's existing debt would be refunded. The Panel acknowledges, however, that under its assumptions negotiations would be required with LILCO's banks to assume LILCO's Third Mortgage and 1984 Revolving Credit Agreement (RCA) and that it is unclear that acceptable terms could be reached. Absent such an agreement, approxi- mately $700 million of this debt would have to be refunded according to the call provisions in these indentures. 3. LIPA~s financial structure and rate covenants. A conventional municipal utility financial structure is assumed for LIPA. The Panel has been ~6,,~..~ed that ~IPAts debt could realize an A credit rating with such a structure - under a combination of favorable conditions. This rating could help LIPA market the necessary $3.6 billion initial issuance. A 9 percent interest rate on all LIPA debt is assumed~ reflecting market interest rates on comparable securities with ~[ credft,rati~.g,$.,,.earller this year. LIPA~s' ~pital structure would consist of four categories of debt: (1) the LILCO debt that is assumed and that would be senior to all LIPA debt; (2) the initial LIPA issuance to finance the purchase; (3) subsequent issues to refinance LILCO debt when it comes due and for general purposes; and (4) debt issued to finance construction of new generating plants. LIPA would collect in rates 1.0 tirn~ th~ annual interest expense on the existing LILCO debt that is assumed. With respect to the LIPA debt, a debt-reserve fund would be established for each category and a minimum balance - sufficient to fund: the following year's debt-service obligations - would be maintained in each reserve fund at all times. Revenues sufficient to cover a levelized debt-service obligation 1.25 times would be collected annually for each category of LIPA debt. Levelized debt-service obligations would consist of principal maturities and interest expense. The excess 25 percent coverage would added to the debt reserve fund throughout the year. Excesses in the debt reserve fund would be used to reduce LIPA borrowing needs. Repayment of principal on the initial issuance would begin 12 months after it is issued. The ]evelized ~ebt-service payment incorporates decreasing interest payments and increasing principal maturities. For refinancing and general purpose debt, principal maturities would begin 18 months after issuance. No revenues would be collected to service the new generating plant construction debt until the relevant asset entered service. Consequently, interest on this debt would be capitalized throughout the construction period. Principal repayment on the new generating plant construction debt would not start until 12 months after the relevant facility entered service. 4. LIPA's Federal income tax liability upon acquiring LILCO. Baseu on advice from its tax consultant, the Panel assumed that LIPA would make no payments to the Internal Revenue Service for recapture of accelerated depreciation upon acquiring LILCO, regardless of whether Shoreham is abandoned or operated. Smith Barney and the National Economic Research Associates (NERA) did not include any Federal income tax liability in their estimates either. EBASCO and others, on the other hand, have estimated approximately $600 million in tax liability. If Shoreham were abandoned, no taxes would be owed since the abandonment loss on Shoreham - estimated at $2.3 billion - would more than offset any depreciation recapture. This approach to tax avoidance could be achieved either if LILCO abandons Shoreham on its own or as part of LIPA's negotiated acquisition of LILCO. In the latter case, this could occur if LIPA required LILCO to abandon Shoreham prior to the acquisition as a condition o£ 9 the negotiatec~ agreement.. Alternatively, tax liability could be avoided if Shoreham is abandoned after LIPA acquired control of LILCO through either friendly or unfrie.ndly means but before any merger and change in LILCO's tax-exempt status~ . ' '" If, on the other hand, LIPA does not abandon Shoreham, a potential tax liability of $550 million to $650 million could arise because of depreciation recapture. This would occur if the IRS were to interpret LIPA's acquisition of LILCO as an asset purchase rather than a stock purchase. Such an interpretation could increase the effective Cost of the acquisition by apProxi- ' mately $5 to $6 per share of LILCO common equity. However, the Panel's tax consultant has presented ~4Plan thlt would probably avoid depreciation recapture in such a case. - While favorable rulings on several points would be required from the !RS to assure this result, the Panel believes that it is likely that such a ruling could be obtained. OPERATING ASSUMPTIONS In addition to the financial assumptions, there are the three major operating assumptions that significantly influence projected rate levels. 1. Shoreham operation by LILCO or LIPA. In certain financial comparisons, it is assumed that LILCO will have received an operating license from the Nuclear Regulatory Commission (NRC) for :Shoreham. LILCO has not yet received this operating license. Further, any NRC decision to issue or not issue the license will likely be subject to court review. The same uncertainties would also apply to LIPA. 2. Supply plan elements common to LILCO and LIPA. The Panel has relied primarily on the SEO's analysis of potential capacity expansion plans for Long Island. Some elements of the supply plans are independent of Shoreham's future. For example, the Far Rockaway unit x~dll be on line in 1986. A second 345 Ky transmission line under Long Island Sound, to be constructed by NYPA, is assumed to be installed by late 1991. Lon~cr term, coal plants are added in the late 1990s to meet projected demand a='o='th, net of retirements. Other supply plan elements will vary depending on whether or not Shoreham operates. If Shoreham were abandoned, 810 Mw of coal plants are slightly accelerated in the late 1990s to replace Shoreham capacity. In the nearer term (i.e., through 1991), Shoreham generation is replaced by firm purchases from other New York Power Pool (NYPP) utilities and by l~eneration from existing oil- and gas-fired units on Long Island. The Panel believes that due to possible transmission constrain{s, the Long Island power system may have some difficulty in importing sufficient power to meet its reliability targets through 1991, the year in which the NYPA 345 Ky. transmission line is assumed to be installed. As a consequence, the level of projected service reliability from the assumed supply plan with Shoreham abandoned is less than thane of the plan with Shoreham in operation - expressed in terms of the number of expected voltage reductions. In this regard, the New'York Power'P~;1 projects that the number o£ expected voltage reducti0n~s in 1991 would be approximately triple that of current conditions if Shoreham were abandoned. However, the Panel notes that this same analysis would proiect 4 incidents in the summer of 1985, but none occurred. In any event, the Panel is aware that other utilities in the country have adopted specific measures (e.g., interruptible service to commercial and industrial customers) in similar circumstances to prevent a material deterioration of service r~liabflity to their customers. These mea~l, res would also be available to the Long Island power system (Exhibit LILCO and others have asserted that if Shoreham were abandoned. combustion turbines should be built on Long Island to provide sufficient reliability through 1991, although there is disagreement over whether 200 or more Mw would be installed. In fact, the PSC has recommended that LILCO begin the process of obtaining siting permits for such turbines. The Panel believes that because of the uncertainties associated with Shoreham~s future reliability, additional combustion turbine capacity - if required at all ~6may well be justified even if Shoreham were to begin commercial operation. Consequently, the Panel does not believe that the supply plan assumptions that underly the SEO analysis materially misrepresent the relative production cost for Long Island Power systems with and wiihout Shoreham since they treat both cases similarly. 3. LIPA's access to Power Authority power. It is assumed that LIPA 4411 not have access to inexpensive hydroelectric power from NYPA's Niagara or St. Lawrence Projects. The Panel did not critically-examine whether LIPA would be entitled to Niagara t'preference' power, nor did the Panel estimate the favorable impact on LIPA production costs of a reallocation of preference power to Long Island. The Panel has incorporated the SEO assumption that LIPA w~,uld c~r,.struct and own the coal plants that are projef~ed to be required by the Long Island power system in the late 1990s. The Panel makes this same assumption for LILCO. However, NYPA could construct and operate these plants to sell power to LIPA if NYPA were granted appropriate legislative authority, the projects are economically feasible, and such construction complies with applicable fiscal requirements and tax law. I£ NYPA could construct these coal plants, LIPAts financing requirements in the mid 1990s could be substantially reduced. B - LILCO AND LIPA RATE COMPARISONS This section first ,discusses the ratepayer savings that could result from the acquisition of I4ILC0 bY LIPA'~nder plausible operating and financial conditions. It then:'eX~rnines the reasons why these savings may be d/fficult to achieve: long-term uncertainty about realizing the projected level of savings due to possible changes in operating and financial conditions and LIPA financial constraints that may limit its ability to obtain near-term rate advantages. RATEPAYER SAVINGS FROM LIPA OF 7 TO 9 PERCENT UNDER PLAUSIBLE CONDITIONS ARE PROJECTED Ratepayer savings of between 7 and 9 percent could result from the acquisition of LILCO by LIPA, assuming a purchase price of $]8 per share and a LIPA interest rate of 9 percent. Under existing PSC ratemaking policy, if both LILCO and LIPA would make an identical decision to operate or abandon Shoreham, savings on the order of 8 to 9 percent could be realized. If, on the other hand, LILCO ultimately succeeded in obtaining its commercial operating license and operated Shoreham, whereas LIP~gWere to abandon the unit, savings from LIPA could fall to about 7 percent. Projected Ratepayer Savings Of 8 to 9 Percent with Identical Supply Plans If LIPA replaces LILCO and adopts a supply plan identical to the one LILCO would have adopted (i.e., both would operate or abandon Shoreham), ratepayer savings of 8 to 9 percent would result exclusively from LIPA's inherent financial advantages. If both would operate Shoreham, ratepaver savings %'ould be slightly higher than if both were to al~andon it (Exhil~it 7). 1. LIPA rates could be 9 percent less than LILCO rates if Shoreham were operated by both. Potential ratepayer savings from LIPA could be realized because it would not pay Federal income taxes and would use a capital structure consisting entirely of tax-exempt debt. Consequently, LIPA*s capital charges would be considerably lower than' LILCO's charges from its projected capital structure and associated costs of capital. LIPA*s levelized debt service - including principal, interest, and coverage - would equal 5.8 cents per Kwh versus 7.3 cents per Kwh for LILCO - including depreciation, interest expense, income taxes~ and return on equity. The Federal income tax expense that LILCO would collect from ratepayers, which is included in the 7.3 cents per Kwh estimate, would amount to nearly $2.4 billion over the 15-year horizon, or 2.2 cents per Kwh on a levelized basis. This would be avoided if LIPA replaced LILCO. Property tax is not assumed 12 to be a source, of difference; LIPA is assumed to make payments or furnish services in lieu of such tax in amounts equal to LILCO's payments. Conse- quently, the Panel has assumed that lo. cai government revenue would be unaffected by replacement_ of LILCO. Operation and maintenance costs are also assumed to be4dentical..Finally, State gross receipt tax or payments in lieu of such tax ar,~' assu~d to be the same.proportion of revenues for LIPA as for LILCO (Exhibit 8). 2. LIPA rates could be 8 percent lower than LILCO rates if Shoreham were abandoned by both. Under existing ratemaking policy if both LIPA and LILCO were to abandon Shoreham rather than operate it, projected ratepayer savings from LIPA would decrease from 9 percent to approximately 8 percent. LIPA's advantage coptinues to exist because of avoided Federal income taxes and a lower capital costs (Exhibit 9). This advantage is slightly diminished, however, because of the reduced need for capital in the near term if Shoreham is abandoned and the resulting diminished importance of LIPA's lower cost of capital. The reduced need for capital stems from avoid- ing the projected post-commercial capital investments in Shoreham, which are likely to be more important in net present Value terms than the need to incur capital costs for Sh6reham replacement capacity. Although the abandonment of Shoreham accelerates on-line dates for the coal units in the late 1990s, thus increasing LIPA interest expense, the impact of these interest payments does not significantly affect the rate comparison. This is because LIPA capitalizes interest until the coal plants begin operation, which is near the end of the Panel's study period. LILCO would also realize lower levelized capital charges if Shoreham were abandoned for the Same reasons and would benefit from lower financing requirements in the early years if post-commercial capital additions were not necessary. Because of LILCO's higher costs of capital, it benefits slightly more than LIPA from deferring this need for construction. Therefore, ratepayer savings from LIPA are slightly diminished in this case. Two aspects of the Panel's findings in this Shoreham abandonment case are at variance with other studies. The first relat'es to the proiected econoia~.c benefits of operating Shoreham. The Panel proiects that levelized rates would be higher for both LILCO and LIPA if Shoreham were abandoned, indicating an economic advantage to operating the unit, This advantage exists even with an oil price forecast of $19-per-barrel oil in 1986, with essentially no escalation in real terms through the end of the study period. Under the Panel's assumptions, however, operation of Shoreham results in much more modest economic benefits than have been proiected by LILCO and others recently. There are several reasons for this difference: (1) the Panel assumed the cost of power to replace Shoreham will be much lower than had been assumed in previous studies because current oil prices are much lower than has bee~, expected and are projected to increase at only a moder- ate rate; (2) the cost of post-commercial additions for the Shoreham unit is assumed to be substantially more than had been estimated; (3) Shoreham's 13 mature capacity factor is assumed to be 58 percent whereas both LILCO and the PSC have projected capacity factors well in excess of 60 percent= (4) the Panel has assumed that .replacement capacity would not be needed for Shoreham until the late 1990s; and .(5)~he. Panel's study period covers 15 years, and longer periods could hive increased the benefit of operating Shoreham. The Panel assumptions and estimates in these areas - which explain its more modest 'projection-of expected Shoreham benefits under continued LILCO operation - are depicted in Exhibit 10. Under existing ratemaking policies, the cost of the unit after adjusting for the expected imprudence disallowance is paid by ratepayers regardless of whether or not the unit operates. However, because of the. slightly accelerated tax benefits on Shoreham (net of ITC recapture) in the event of abandonment, the present value of revenue requiremer~ts On the2~xisting Shoreham investment could decrease in that case by $100 million. Property tax in the amount of $200 million could also be avoided. In addition, post-commercial investments and incremental system operation and maintenance expenses of over Sl.2 billion could be incurred if Shoreham operates. On the other hand, operation of Shoreham could result in nearly $1.3 billion in fuel savings and could avoid approximately $450 million in investments in long-term replacement capacity. These factors result in approximately .a $200 million advantage for operating Shoreham. Further, if oil prices were to return to'$27 per barrel and escalate at 2 percent in real terms and Shoreham operated at a 62 percent capacity factor, savings from operating the unit could increase by another $400 million. Higher capacity factors could produce additional saxdngs. Finally, if 200 Mw of combustion turbines - at a cost of $450 per Kw - were required to improve near-term system reliability only if Shoreham were abandoned, the total economic advantage of operating Shoreham could increase to nearly $800 million (Exhibit 10). The second Panel finding in the case of Shoreham abandonment that differs from other studies is the projection of 8 percent ratepayer savings if Shoreham were abandoned by both LILCO and LIPA. Smith Barney projects ratepayer savings from LIPA in the range of 19 percent over a 20-year horizor~ i¢ both LILCO and LIPA abandon S?,oreham. The I-ariel notes th--t if it employed a c~mbinafion of assumptions similar to those that Smith Barney used, projected ratepayer savings from LIPA could increase to over 15 percent.. Smith Barney assumes a lower purchase price, lower required coverage on LIPA debt, and the absence of State gross receipts tax (or its equivalent) for LIPA. With respect to purchase price, Smith Barney assumed $]4 per share while the Panel assumed $18 per share. At $14 per share, the Panel's projection of ratepayer savings from LIPA would increase by over 1.5 percentage points, to approximately 10 percent. Smith Barney also assumed lower coverage requirements for the LIPA debt. Rates are collected in amounts sufficient to fund annual debt service (i.e., interest and principal repayment) 1.1 times. Because of other assumptions, however, this results in actual coverage of only 1.0 times. The . 14 Panel acknowle, dges that such rate covenants are not uncommon in the municipal marketplace. However, the Panel believes that such covenants are typically employed by either established municipal distribution systems that do not face the political pressures that LIPA would face to reduce rates or by wholesalers who halve firm cont~'~s with distributors who themselves have excellent credit ra~i~s. The Panel's financial advisors have indicated that it is inappropriate to assume that LIPA would be able to obtain such a covenant. However, if the-Panel employed this coverage requirement, ratepayer savings could increase by another 2 percentage points - to approximately 12 percent - 'retaining the Smith Barney assumption of a $14-per-share purchase price. Finally, the Panel differs from Smith Barney in its treatment of LIPA's liability for State gross receipts tax or the equivalent. The Panel believes that a more neutral comparison of LILCO and LIPA from New York State's perspective can be achieved if LIPA were not assumed to have an advantage in its lack o~ liability for S, tate gross receipts tax or the equivalent. Assuming that LIPA does not make such payments, this amounts to a transfer payment of approximately $500 million to $750 mill/on from State taxpayers to Long Island ratepayers over 15 years. However, if LIPA did not make these payments, the Panel's projections of ratepayer Savings would increase by an additional 3 to 4 percentage points. This would produce a cumulative projected savings under all of the Smith ,Barney assumptions of over 15 percent. Other important factors explaining the difference between the Panel and Smith Barney could include their use of a 20-year study period: their assumption that there 'is no imprudence disallowance on N~fP 2 for LILCO~ and their assumed larger initial financing for LIPA, which included a refinancing of LILCO's G&R debt. Projected Ratepayer Savings of 7 Percent with Different Shoreham Decisions At least two rate studies reviewed by the Panel have assumed that LILCO would successfully :~erate Shoreham and that LIPA would abandon the unit if it replzccd L.~;~CO.-' The Panel believes that this comparison should be made. LILCO hag clearly stated its intention to pursue operation of Shoreham. On the other hand, a bill to create a Long Island Power Authority pending before the State Legislature (S.7784/A.9517) would expressly bar LIPA from operating Shoreham, and it appears likely :that a public power agency would abandon the unit. On the basis of the Panel's analysis of these different decisions about Shoreham, projected ratepayer savings from LIPA would fall to 7 percent. The Shoreham economics discussed in the previous section partially explain this decrease in projected savings, as evidenced by the higher operations and maintenance expenses for LIPA relative to LILCO in this case. It is also important to note that local government revenues are affected by a LIPA takeover in this instance. Property tax collections would be $200 million less under LIPA (Exhibit 11).22 The Panel's projections of ratepayer savings from these different de- cisions on Shoreham are at odds with 'NERA's analysis. NERA concludes that ratepayer savings could, be r~a]ized by LIPA only if an acquisition price of less than $202~er:~share is,obtatti~d and LIPA is given access to low-cost hydro power The Panel notes several reasons for the discrepancies between its findings and th~ NERA analysis: (1) NERA assumes the purchase price for LILCO common stock is in the range of $20 to $30 per share, while the Panel's analysis assumes $18 per sharel (2)'NERA assumes that LILCO would be able to phase in the cost of Shoreham. whereas LIPA could not (due to the effects of discounting revenue requirements over a 15-year horizon, this assumption favors LILCO over LIPA because the calculation ignores the higher LILCO rates that would prevail after the year 2000)~ (3) NERA assumes that an additional 400 Mw o~ combustion turbine capacity is added pr/or to 1991 in the Shoreham out case, whereas the Panel analysis does not assume such capacity additions are required~ (4) NERA assumes that the mature capacity factor for S~oreham is 67 percent, while the Panel uses the SEO estimate of 58 percent.-' This last NERA assumption favors LILCO, as LIPA would have to acquire additional energy (i.e.. 9 percent of Shoreham's maximum level of generation) at a relatively high cost to replace lost, Shoreham generation. PROJECTED LIPA SAVINGS MAY BE DIFFICULT TO ACHIEVE The projected ratepayer savings from LIPA under any of the Shoreham decisions may be difficult to achieve. Longer-term savings are difficult to ensure because of uncertainty about the financial and operating conditions that LILCO and LIPA would face in the future. In the nearer term, it is also uncertain to what extent LIPA can obtain rate advantages without jeopardizing its financial integrity. Lo__va~-term Savings are Uncertain With respect to the projected ratepayer savings, uncertainty surrounds the purchase price, the interest rate at'which LIPA could issue debt. the financial structure of LIPA, and LILCO's ability to refinance Shoreham with industrial development bonds (IDBs). If some of these critical financial variables turn out unfavorably (e.g.. the purchase price exceeds $18 per share or LIPA interest rates substantially exceed the Panel's 9 percent esti- mate) or if LILCO succeeds in refinancing with IDBs, longer-term ratepayer savings could be reduced or eliminated. In addition, future operating con- ditions (e.g.. oil price levels. Shoreham capacity factors, and the need for near-term capacity additions) will strongly influence the cost of replacing Shoreham generation and could thus reduce long-term savings from LIPA if different decisions on Shoreham were pursued by the two entities. On the 16 other hand, favorable variations in these financial and operating assumptions could improve ~;atepayer savings. 1. LIPA's' price for purchasin[~ LILCO - existing ratemaking policies. Substantial uncertainty Su?oun.ds,,the price at which LIPA could acquire LILCO common sto~'. The 52-week range of market value of the common equity at the time of this report was approximately $6 to $15 per share, and the current price was approximatelY $11 per share. The Panel assumed an $18-per-share price for purposes of estimating ratepayer savings. This assumption is based on the Panel's projection of the year-end 1986 book value of common equity, adjusted for expected imprudence disallowances on both Shoreham and NMP 2 and the allocatio~5of imprudent asset tax benefits between shareholders and ratepayers. The Panel believes that, depending on PSC treatment of various aspects of these disallowances under existing ratemaking practices, the LILCO adj~tsted book value could range between $17 and $19 per share. Ratepayer savings will be sensitive to purchase price. For example, at $22 per share and assuming that Shoreham would be operated by both LILCO and LIPA, ratepayer savings could fall from 9 percent to 7 percent. At $26 per share, these savings could decrease to below 6 percent. No sav- ings would be realized at prices above $38 per share (Exhibit 12). Smith Barney has used a $14-per-share price in its analysis. In the event that a $14-per-share price prevails but other Panel assumptions remain unchanged, ratepayer savings could increase to .nearly 10 percent. 2. LIPA's price for purchasing LILCO - modified ratemakin~ policies. If Shoreham were abandoned, State legislative actions to prevent recovery in rates of any costs relating to an abandoned pliant would result in lower LILCO rates than under existing ratemaking policies. While barring recovery in rates of all Shoreham-related costs would cause LILCO to become insolvent, financial stability adjustments could be employed by the PSC to permit LILCO to meet minimum financial performance levels. For purposes of illustration, the Panel has projected LILCO rate~ · ~.,.,er the assumption that the State enacts such a law to examine :he sensitivity of ratepayer savings from LIPA. The Panel assumed that the financial stability adjustment would provide LILCO with rate increases sufficient, to meet approximately a 2 times coverage of annual interest expense over the next 5 years. The Panel cannot be assured that this level of revenues would be sufficient to prevent LILCO from violating its bond indentures or would assure continued funding of LILCO operations by banks. However, this assumption of rates only sufficient to meet minimum interest coverage is not implausible, since LILCO would not need to regain access to equity capital markets to fund construction of new generating plants during that time period. Beginning in the mid-1990s, LILCO would need additional equity capital to finance the construction of new coal plants. Absent the prospect of an adequate return on this equity, it is unlikely that this capital 17 could be raised. Consequently, the Panel assumed the resumption of a normal (i.e., 13 per'cent) rate of return on LILCO's common equity in the mid-1990s. The difference in financial performance that LILCO would experience as a result of such ratemaking policies is'evident in its projected interest coverage ratios. LILCO coverage, over,,the., next 7 years would fall significantly, from an average of 3.6 times'interest under existing ratemaking policy to 2.3 times interest if such 'legislation were enacted. Because of the lower projected rate levels for LILCO if it abandoned Shoreham under this new law but was provided a financial stability adjust- ment, ratepayer savings from LIPA could fall unless the price of acquiring LILCO is lower than the Panel has assumed. The Panel's preliminary conclusion is that if LIPA paid a purchase price for LILCO's common equity that was in excess of current market value under these circumstances, an)' ratepayer savings from LIPA would be eliminated. However, enactment of such legislation is likely t0 ~ause-a drop in LILCO's market value because the company would be unable to recover the cost of Shoreham if it were abandoned. 3. Interest rates on LIPA debt. The interest rate on the debt issued by LIPA will also significantly affect ratepayer savings. LIPA. has been structured as a conventionally financed and A-rated municipal electric utility. ~¥ith this structure, the Panel believes LIPA could realize a 9 pet'cent interest rate based on market conditions that prevailed earlier in the year, or approximately 200 basis points below the cost of new LILCO issues. However, for LIPA to obtain this interest rate, investors would have to be assured that adequate rate increases would be 'forthcoming to cover debt-service require- ments. Because of the high electric rates that will exist on Long Island - regardless of ownership - and the pressure to reduce these rates, a political- ly independent governing board and assurances that debt-service require- ments can be met through rate covenants with the bond ho~ers may be necessary to realize favorable interest rates on LIPA debt. Leaving all other assumptions unchanged, ratepayer savings could fall from 9 percent to 4 percent assuming that Shoreham were operated by both if an 11 percent interest rate were required to market the initial LIPA debt. This could well happen if the market perceived that LIPA's ratemaking procedures were not secure or if t?.e transaction were executed during a period of higher general interest rates. On the other hand, if these securities received a higher 'credit rating either because the market perceived the ratemaking authority to be more independent or because of reductions in the overall market level of interest rates at the time of the transaction, additional savings could be realized. For example, at an 8 percent interest rate for LIPA and an $18 per share purcha~_§ price, ratepayer savings would increase to over 11 percent (Exhibit 13). 4. Coverage requirements in LIPA rate covenants. In employing a conventional municipal structure for LIPA that the Panel believes could be marketable at an A credit rating, the Panel has assumed rate covenants that would require collection of LIPA debt service through rates. As such, rates 18 would be charged in each year sufficient to pay interest expenses and the amount of mat~tring principal plus 25 percent of the sum of these amounts as coverage. This coverage would be invested in a debt-reserve fund and used to pay debt service in t,he event that LIPA experienced lower-than-anticipated cash flows in a giyen year, This structure for LIPA results in actual cash coverage (i.e.. cash flow from rates divided by cash needs for debt service) that averages 1.25 times all debt-service expense over the 15-year time horizon. However, based on the PanePs review of other publicly-owned utilities across North America, a wide range of actual cash coverages exists. These range from as high as 3.6 times for the Los Angeles Department of Water and Power to as low as 0.9 times for Ontario Hydro.- which relies on credit guarantees from the provincial government.. The realized cash coverages and the rate covenants that govern the rates of individual utilities will depend on many factors, including whefher or not the utility has significant construction in progress and whether the utility conducts retail or wholesale operations. The Panel believes that because of LIPAts prospective situation as a high-cost retail utility that is likely to experience pressure against necessary rate increases, a 1.25 times coverage is appropriate. However. a range of possible coverage requirements has been sug- gested in various submissions. Srrdth Barney has incorporated a LIPA struc- ture that utilizes a coverage of 1.1 times interest and principal repayment. NERA submits cases where interest 'coverage is as high as 1.4 times annual interest expense. The Panel has consequently investigated the sensitivity of ratepayer savings to coverage requirements. If Shoreham were operated by both. savings could increase to 11.8 percent at a 1.0 times coverage but could fall to 5.9 percent if a coverage ratio of 1.5 were required (Exhibit 14). 5. LILCO's use of industrial revenue bond refinancing. EBASCO evalu- ated projected ratepayer savings for LIPA under the assumption that LIPA would abandon Shoreham and LILCO would operate it and discussed the possibility that LILCO could refinance $2.5 billion of Shoreham debt with tax-e::empt industrial development bends (iDEs). The Panel acknowledges that projected savings from LIPA would be lower if LILCO could use tax- exempt financing, since the use of IDBs would remove a major source of financial advantage for LIPA (i.e.. tax-exempt debt on a very large asset). However, the Panel believes that under existing law it is unlikely that LILCO will be able to issue tax-exempt IDBs. Under Federal tax law, the Governor of the State must grant LILCO a portion of the Statets volume lin-6tation for IDEs. The State has an annuxl total volume limitation of approximately $2.5 billion. It is believed that many public authorities and agencies in the Sta*.~_ would exhaust much of this annual volume lln~tation in fulfilling their minimum annual financing needs. It is, therefore, unlikely that LILCO would ever get sufficient volume allocation within a practicable time period after securing an inducement resolution with respect to the IDBs from a statewide bond issuer prior to the date the facility is placed in service as required by Treasury Regulations. ~ Yurther, under proposed legislation, H.R. 38~8, LILCO .would' entire!~-,:lose its abil/ty to issue any IDBs as a result of the repeal of the. local furnishing of electricity and gas exemption. The Senate proposal, h6wever0 would retain an exemption similar to the one under existing law. In contrast, under existing law and under pending Federal tax legis- lation, LIPA may secure tax-exempt financing if favorable disposition of a Ruling Request to the Internal Revenue Service is obtained. 6. Costs of replacing Shoreham generation and capacity. In the case of identical supply plans, operation and maintenance costs are not a source of difference in rates. However, if LIPA would abandon Shoreham but LILCO would succeed in operating the unit. the actual cost to LIPA of replacing the generation and capacity that LILCO would obtain from Shoreham - about which there is uncertainty - will significantly affect the projected savings from LIPA. Oil price levels ~ill have a large impact. If oil prices increase to $27 per barrel in the near term and by '2 percent in real terms over the 15-year horizon, ratepayer savings would be reduced to 5 percent versus the Panel's projections of 7 percent sav~ngs with oil priced at $19 per barrel with essentially no real escalation in the future. Ratepayer savings are sensitive to oil prices because a large percentage of the generation that would replace Shoreham would be oil-based (Exhibit 15). Higher Shoreham capacity factors. if it were operated, would increase the amount of power that would have to be replaced with oil. causing further decreases in ratepayer savings from LIPA. In addition, if 200 Mw of combustion turbines are required to improve system reliability in the near term, savings could be further reduced. In a case illustrative of poor operating conditions from LIPA's perspective, ~-ith $27-per-barrel oil prices, a 67 percent Shoreham capacity factor, and 200 Mw of combustion turbine capacity req-.,i~ed in 1989 if Shoreham were abandoned. the Panel projects that ratepayer savings from LIPA would fall by approximately 3 percentage points. On the other hand, less favorable Shoreham operating conditions from LILCO's perspective could increase sav~ngs to above 7 percent. Financial Constraints will Influence LIPA's Near-Term Advantages All of the Panel's rate comparisons are based on a 15-year horizon and no phase-in of Shoreham or NMP 2 costs. However, th~ PSC has recently approved a plan for LILCO that would moderate rate increases over the next few years. Consequently, LIPA may have to adopt a similar plan to mitigate early rate disadvantages. The Panel believes that such a plan - within limits - can be consistent with the flnancia] structure it has proposed for LIPA. However, the Panel' believes that other plans that have been offered in part to alleviate this problem - including the Smith Barney approach - may not provide LIPA _with s~/£ficien~ ][inan¢ial integrity. 1. Phase-in plans malt be recluired to mitigate early rate disadvantages. Under existing ratemaking policies, rates are projected to increase from current levels, regardless of ownership form. If LILCO continues, this increase would occur if the costs of Shoreham were recovered and a return earned on this investment. If LIPA acquires LILCO at a price at or near adjusted book value, rates would increase to cover the debt service on LIPA's initial debt issue. To mitigate rate increases for LILCO, the PSC has recent- ly approved a plan that would phas~ in the costs of the Shoreham facility without, however, changinlg the present value of the revenue recovery over the life of the unit. The 10-year phase-in plan that the SEO has used for LILCO - both for operation and abandonment - differs from the PSC version. The Panel believes that the SEO plan is a conservative representation of LILCO's ability to manage its near-term rates and that it may be possible for LILCO to achieve even lower rates through a more aggressive phase-in while maintaining its financial stability. NERA claims that LIPA will have to raise rates substantially - to levels higher than LILCO rates - as soon as it acquires LILCO. IqERA bases this claim on an assertion that LILCO's current net cash flow is insufficient to cover its cash outlays, including interest. Consequently, NERA asserts that no cash is available for dividends on either preferred or common equity. Therefore, they argue that LIPA~s rates must rise if it is to service the additional debt that will be required to finance the transaction. The Panel believes that the NERA argument is deficient with respect to projections of future LILCO and LIPA rates. First, under existing ratemaking policies, LILCO will probably re- ceive rate treatment sufficient to pay preferred dividends in arrears and, possibly, resume dividends on both preferred and common equity. The Panel h~ assumed that dividends on both common and preferred are resumed by .~e, 87, and the Panel's projections of LILCO rates reflect these assumi~tions. Because of this resumption of a cash return on LILCO's equity, LIPA rates will not .necessarily be higher than LILCO rates in the near term. Further, NERA ignores the possibility that LIPA could borrow some of its early-year cash requirements and thus reduce revenue requirements. LIPA's need to adopt a phase-in plan will depend on such factors as the acquisition price, interest rate on LIPA debt, necessary coverage, LIPAts decision to operate or to abandon Shoreham, and rate treatment of the Shoreham plant if LILCO abandons it. A LIPA rate disadvantage could well be politically unacceptable on Long Island, given current concerns about high rates. Moreover, even if specific conditions that would permit LIPA~s near- 21 ~erm rates to be less than ,the rates that would be charged by LILCO were realized, there might be pressure to reduce them even further. Under thio. P'a~e!ls rate'"isrojections' if LIPA does not implement a phase-in plan, fts'?rates could be slightly higher than LILCO's in LIPA's first year of existence. Under more aggressive phase-in plans for LILCO or less- favorable financial or operating conditions for LIPA, LIPA's disadvantage could be exacerbated. However, LIPA rate increases may be mitigated by capitalizing debt service through a plan that is similar to those emp]oyed by other municipal utilities. LIPA could reduce its rates to be consistently below LILCO rates in the near term through such a phase-in plan (Exhibit 16). To manage its nearrterm rates, LIPA could capitalize debt service expenses sufficiently to reduce rates for an interim period through issuance of rate-mitigation debt. In the case of the Panel's assumed financial structure for LIPA, if the amount of rate-mitigation debt were substantial, LIPA's credit rating could be impaired. If this were the case, it could be difficult to market additional LIPA debt at attractive interest rates. This difficulty stems from the already large size of both the initial issuance and the refunding requirements on the existing LILCO debt that LIPA would as sume, LIPA would have to capitalize approximately 17 percent of its interest expense and issue an additional $1;1 billion in debt over the first 7 years of its e~:istence to reduce its rates to the levels depicted in Exhibit 16. This amount of capitalized interest is within the range ~he Panel examined in its financial survey of public power agencies elsewhere in North America. How- ever, the $1.1 billion in LIPA debt issued over 7 years would be in addition to the nearly $1.4 billion that would be required to refinance I,ILCO's matur- ing debt, including approximately $700 million that would be required to refinance the bank debt. In addition, approximately $1.4 billion would be required for construction, assuming that LIPA would abandon Shoreham. This nearly $4 billion in projected additional future financings - in part to manage its rates to the levels depirt'-d in Exhibit 16 - is not inconsequential. But the Panel cannot predict th ~. le,'el of projected financings at which b(:nd ratLug agencies would view the'creditworthiness of LIPA as being impaired. The Panel believes, however, that to ensure satisfactory bond ratings ~'hile pursuing a phase-in plan, explicit limits' on LIPA's discretion to borrow required debt set:vice may be required in LIPA's rate covenants (Exhibit 17). 2. Alternative LIPA financial structures may not provide sufficient financial integrity. The Panel has reviewed two alternative financial struc- tures for LIPA that in part could minimize the near-term rate-management challenges that LIPA may face. The PanePs financial advisor does not believe that these approaches necessarily provide LIPA with sufficient financial integrity. Smith Barney would employ rate covenants that would require only a 1.1 times coverage of interest expense and principal repayment. This plan - 22 would necessitate that 1-year's interest expense be maintained in the debt-reserve fund. Only 10 percent of the required balances in the debt-reserve fund would be funded wi~h the initial issuance of LIPA debt. In addition, provision is m~de for ra,te-mltigation debt, presumably with similar rate covenants, ~,.~hile the Pan~t'~has not thoroughly investigated the financial characteristics of LIPA during its early years of existence under this atruc- ture, it cautions that such an approach may not be feasible or, at a minimum, might have difficulty in obtaining an A rating. The Panel bases this conclu- sion on its financial advisor's analysis of its own LIPA atructure under the assumption of reduced coverage. The second, more complex 'approach that has been suggested to the Panel involves a multitiered initial debt issue. Separate classes of debt would be created with varying coupon rates, refunding schedules, and residual claims on funds. These classes of debt would be designed to approximately reflect the different risk characteristics of LILCO's current securities. Under this approach, approximately $6.0 billion would be raised to purchase LILCO's common and preferred equity and to refund the G&R debt. Of this amount, $1.8 billion would be senior securities that would resemble the conventional LIPA debt, carrying with them a 9 percent interest rate. Another $2.5 billion would be raised from income debentures (that carry a fixed 8 percent coupon rate plus a claim on residual funds) and from low coupon (i.e., 4 percent) debt that would sell at a substantial discount to par. The remaining $500 million would be income debentures with a 6 percent interest rate plus a residual claim on funds. These 6 percent income debentures would be sold to Nassau and Suffolk counties. The purpose of plading these bonds with Nassau and Suffolk County would be to reduce the amount of debt that would have to be marketed to institutions and to shift the potential risk of bond default to those parties that could affect t~ financial integrity of LIPA by applying pressure against rate increases. While this approach somewhat matches LILCO's capital structure and the risk characteristics of its securities - or its future status if there is no resolution on the operation and cost recovery of the ShOreham unit - the Panel does not believe that such a structure would be prudent to adopt for LIPA. First, the Panel's finai~cial consultants do not believe that the munici- pal bond market would react favorably to such an offering, since no sizeable quantities of such securities have been issued in the municipal bond market in the past. In addition, while the idea of including Nassau and Suffolk County as effective equity holders has merit, it may not be feasible for these counties to issue tax-exempt debt to fund the purchase of such seeurlties. Further. issuing income debentures or other securities having ~equity' characteristics could jeopardize the tax-exempt status of LIPA and its debt. 2 - CREATION OF REGIONAL PUBLIC POWER AUTHORI~TY AND NEGOTIATED ACQUISITION OF is PREyERRED TA EOVE STRATEO¥ A regional public power authority is the preferred vehicle for imple- menting a public takeover of LILCO. To implement the public takeover, the Panel recommends that the State attempt to negotiate initially with LILCO's management and Board of Directors to acquire LILCO at a price that could provide significant ratepayer savings. If these negotiations fail, a tender offer is a feasible - but difficult and costly - follow-up strategy. Condemnation does not appear attractive. REGIONAL PUBLIC POWER AUTHORITY IS PREFERRED VEHICLE FOR PUBLIC TAKEOVER The Panel considered four vehicles for implementing a public takeover of LILCO: a new State authority w~th responsibilities for public power in the Long Island region (a regional power authority); a two-county municipal utility; NYPA; or a NYPA affiliate,i .Since NYPA is the only State authority or public benefit corporation with any related utility experience, the Panel limited its consideration of existing State authorities to NYPA. Of these four vehicles, a regional power authority is preferred. With respect to the other alternatives, a two-county municipal utility would be subject to State constitutional constraints.' NYPA would be subject to financial constraints that would limit its flexibility in accomplishing the takeover; and a NYPA affiliate (or subsidiary) appears to be feasible but is ]ess desirable because of potentially adverse effects on NYPA and the limited possibility of achieving offsetting benefits. 1. Acquisition of LiLCO by a two-county municipal utility would be subiect to severe State constitutional constraints. First, a two-county municipal utility is prohibited by the State Constitution from acquiring stock. Thus only LILCO's assets could be acquired by such an entity through nego- tiations, and a tender-offer strategy could not be employed. Second, the State Constitution requires that the debt that would be issued to finance the acquisition of LILCO's assets by such an agency be self-liquidating (i.e., that revenues from the asset provide full debt service). To demonstrate that the debt would be self-liquidating, the agency would be required to meet several stringent tests on its projected net revenues. Third, at least 25 percent of the debt of a two-county municipal utility issued to acquire LILCO's assets would be subject to the existing constitutional debt limitations on these counties. This would limit the ability of these counties to raise 24 funds for other needs. Fourth, under the State Constitution, the municipal utility would be required,to retain ownership of a11 the assets purchased ~vith such debt, thereby precluding the o~portunity to later dispose of any assets. 2. Acquisition by,NYPA is unattractive due to financial constraints. Financial const/*~ints make NYPA itself a relatively unattractive vehicle. NYPA's General Purpose Bond Resolution would, in effect, subordinate any debt issued to-acquire LILCO to debt already issued under NYPA's General Purpose Bond Resolution, thus likely increasing the interest rate and de- creasing the potential benefit o1' utilizing NYPA's established credit rating. Further, the NYPA General Purpose Bond Resolution would most probably attach as a first lien to all revenues derived from the assets acquired from LILCO. This would make it extremely difficult, if not impossible, for NYPA to assume LILCO's debt, since the assumed LILCO debt would continue to be secured, at least in part, by prior liens against the revenues and assets acquired from LILCO. The result would be conflicting first liens on the acquired properties and revenue. This problem could only be avoided if all of LILCO's debt were refunded, an option that would require marketing an additional $3 billion of debt. Further, the acquisition would .likely impair NYPA's credit rating because of the size of the undertaking and its impact on NYPA's capital structure. Finally, because of NYPA's general lack of experience in large-scale retail electric sales, the .Panel does not believe that NYPA necessarily has the appropriate management resources to improve LILCO's operations. 3. Acquisition by a NYPA subsidiary could impair NYPA. The Panel considered the possibility that NYPA might be the corporate parent of a subsidiary or affiliated authority formed to take over LILCO. It would be possible to create a NYPA subsidiary or affiliate and to statutorily and con- tractually insulate NYPA from the obligations of the new entity. However, the Panel believes that it is likely that the financial markets and the bond rating agencies' perceptions of a parent-subsidiary or affiliate relationship between NYPA and a Long Island public power authority could impair NYPA's credit rating because of concerns over the financial performance of ~ny Long Island electric operations. This could affect the cost of the projects that NYPA is already undertaking for Long Island (i.e., the transmission line due in service by late 1991). In addition, to the extent that NYPA is involved in either issuing or guaranteeing the debt, the problem of conflicting first liens on acquired properties and revenues remains. Further, there would appear to be only marginal interest rate benefits for the subsidiary from its rela- tionship with NYPA. Finally, any advantages in using NYPA personnel or expertise could be offset by any related harm to NYPA's own operations. 4. Accluisition by a stand-alone re~ional power authority would minimize t~hese problems. While the credit ratings of the State and' its various entities may be affected by a public takeover regardless of how it is structured, an independent regional power authority would minimize these problems. To assure the marketability of its securities, the authority must have autonomous 25 rate-setting power - in no way subject to PSC rate jurisdiction. The authorit¥~s governing board should be structured to provide a high level of confidence to its debtholders that the authority will be well managed and will meet its financia!~ oblighfions. In addition, genera] statutory powers of the authority should include the ability to: (1) issue bonds, notes, and other obligations not subject to the State's debt limitations, the interest on which could be either exempt from Federal and State income taxes or could b$0taxable; (2) acquire LILCO's stock by purchase, exchange~ or condemnation: (3) acquire all er a part'of LILCO's real and personal property by purchase, merger, exchange, or condemnation; (4) operate LILCO's facilities subsequent to the acquisition thereof; (5) dispose of all or part of such facilities; (6) claim an exemption from payment of State and local taxes, with the ability te enter into agreements with the State or political subdivisions for payments in lieu of taxes; (7) accept gifts or grants from the Federal or State governments; and (8) create subsidiaries with authority to exercise any or all of the parent's powers. The statute should also provide that: (1) the authority is exempt from PSC rate and financial regulation and PSC approval requirements for an)- of the actions related to the acquisition of LILCO; (2) NYPA would be au- thorized to construct or contract for generation capacity to service future electrical requirements on Long Island: (S) certain provisions of the New York Business Corporation Law (BCL), or comparable provisions set forth in the LIPA statute, apply to the transactions contemplated herein; and (4) these transactions are exempt from section 9]2 of the BCL0 which restricts mergers and imposes stock price restrictions in the absence of prior board approval by the target company. Finally, the statute should include a proce- dure for an expedited judicial determination of the constitutionality of LIPA and the related changes in State law. NEGOTIATED AGREEMENT IS PREFERRED TAKEOVER METHOD The Panel reviewed six methods for achieving a public takeover of LILCO: (1) a negotiated purchase transaction~ (2) a hostile tender offer; (3) condemnation of stock under the existing Eminent Domain Procedure Law (EDPL); (4) condemnation of assets under the ~a~isting EDPL; (5) condemnation of stock under an amended EDPL: and (6) condemnation of assets under an amended EDPL. Each of these methods is legally feasible, but each has its own problems and risks. The Panel examined these alternatives against four principal criteria. 1. Certainty of completing the takeover once the acquisition process ha~ begun. If the takeover attempt cannot be completed, any organization created to accomplish the acquisition will have lost its utility and the efforts expen, ded and costs incurred in attempting the takeover will have been wasted. Thus, a substantial risk of non- completion of hn acq~.i~ition once the process has started may make a method jhvolvin'g high transaction costs less desirable or undesirable. Contrbl of the acquisition price. Whether a takeover of LILCO will save ratepayers money is dependent (in part) on the cost of the takeover. If the price of acquisition is too high, the impact on ratepayers could be negative rather than positive. Probability of accomplishing takeover in a reasonably short period. A prompt takeover accelerates the accomplishment of the public policy objectives of the takeover. Substantial delay would continue LILCO's uncertain status and would-continue or create management, financial, and reliability concerns among ratepayers, creditors, shareholders, employees, and others who deal with LILCO. A delay in taking might deprive LIPA of the opportunity to decide whether or not Shoreham should be licensed and could otherwise change the economics of a public takeover. Absence of material litigation. Litigation could affect each of the possible acquisition methods to a greater or lesser extent by affect- ing the ability to accomplish the acquisition as well as the costs and the timing of the takeover. On the basis of this evaluation, the Panel concludes that a negotiated acquisition of LILCO at an acceptable price is clearly the preferred alterna- tive. If, for example, LILCO management refused to engage in good faith negotiation or demands unreasonable terms, a hostile tender-offer strategy might be considered. However, a hostile tender offer can be expected to generate material litigation, may be difficult to execute successfully, and could be costly to the state if unsuccessful. Condemnation, under either the existinl~ EDPL or an amended £DPL, while legally feasible, fails to meet man.v of the stated c~'iteria'. Negotiated Acquisition Can Meet All Criteria A negotiated agreement most clearly meets all of the stated criteria. If an acquisition can be successfully negotiated with LILCO at a mutually accept- able price, the transaction could be executed quickly, with substantial cer- tainty, and without material litigation. The Panel believes that LILCO's management and Board of Directors should, in the exercise of their fiduciary responsibility, be willing to enter 27 into and pursue good faith negotiations for a public takeover. WhiIe the price at which LILCO's management and Board will approve a negotiated acquisition is uncertain, if an offer is made that is viewed as attractive by shareholders, LILCO's management and Board will be obliged to give such an offer serious con~i,d~r,~tion in "thy absence of a better alternative for shareholders. :' ~,' Once preliminary approval is gained from LILCO's Board, however, there are a number of elements that should be in place to facilitate the acqui- sition. These include: (1) an appropriate IRS ruling; (2) opinions of counsel as to the authority of LIPA to acquire LILCO; (3) a rating by an appropriate bond-rating agency as. to the likely creditworthiness of long-term LIPA debt; and (4) shareholder approval of the acquisition. After these requirements are met, LIPA.could issue long-term debt supported b), LIPA revenues to purchase LILCO equity. 1. IRS Ruling. The Panel believes that it is advisable for LIPA to obtain an IRS ruling on the tax-exempt status of LIPA debt and on the tax liability of LIPA. A ruling on LIPA's tax-exempt status would be premised on, among other factors, a demonstration that the transaction will occur since the IRS will usually only rule on specific transactions. In the case of a negotiated transaction, the terms of the proposal should be submitted to the IRS as part of the ruling request. With respect to a ruling on LIPA depre- ciation-recapture liability, the Panel's tax consultant believes that there is a clear IP, S precedent for continued'tax deferral if the transaction were structured as proposed, and it is likely,, such a-ruling would be obtained. However~ the IRS could reconsider its ruling policy given the size of the transaction. 2. Opinions of counsel. Opinions of counsel will be required on a variety of matters, including an opinion supporting the authority of LIPA to execute the transaction. In the event that any litigation challenging LIPA's authority is pending, an opinion of counsel must also address such litigation in a satisfactory manner. 3. A rating by the an app;'opriate bond-fa'ting agency. In a negotiated acquisition, the most likely form of financing for the transaction would re- quire LIPA to issue long-term debt supported by LIPA's revenues at the time of acquisition in an amount at least sufficient to purchase LILCO common equity. Prior to' the issuance of the long-term debt, a rating issued by an appropriate financial-rating agency based upon its evaluation of the amount of debt to be issued and the rate covenants associated with it (e.g., coverage and permissible uses of funds) should be obtained. With the assurance of an investment grade credit, the marketability of LIPA debt could be improved and the interest rate lowered. Absent one or more such ratings, man3· financial institutions may be unable or unwilling to purchase this debt. 4. Approval by the shareholders. LILCO shareholders would be likely to approve the takeover if all of these requirements were met and they be- lieved that the price was attractive. Shareholders who did not approve the merger would~have the right ,to d~ssent and receive a court-determined ap- praisal value---for theif'-shar~,,l~ased upon fair market value. Although market value, net~'asset -,~alu~, and investment value are to be considered in determining "fair Market value," it has been held that market value can be controlling where there is a free and open market of substantial volume. However, the possibility of assertion of appraisal rights by a minority of shareholders prevents the cost of the acquisition from being completely pre- dictable, even in a nego{iated transaction. Condemnation is Unattractive Although condemnation of stock or assets is feasible, condemnation raises a series of problems that make it an unattractive option. First, there is significant uncertainty about the court's choice of a valuation theory (or theories) that could ultimately be applied to determine the condemnation award for either stock or assets. The Panel believes that the court's discretion in this area could not be materially restricted by legislation. Second, under existing law, the requirement to take title prior to valuation presents an unacceptable risk. Third, even if the law were amended so that the decision to take followed valuation, LIPA could not exercise control of LILCO opera- tions, including decisions regarding Shoreham, during the lengthy valuation proceeding. In addition, condemnation necessarily involves material litigation that ~dll take a significant amount of time to resolve. However, if condemna- tion were pursued, condemnation of stock is clearly preferable to condemnation of assets. 1. Condemnation of either stock or assets is feasible. LIPA may exer- cise the power of eminent domain to condemn any type of property for a public purpose. This power is limited only by the requirement that the condemnor pa), the owner of the property ~just compensation.~ A condemning ~.u~,horit;' thai does not have the power to tax must be'able to demonstrate tl',a: it has the resources to pay the award of just compensation. Accordingly, if vested by statute with appropriate authority to carry out a public purpose and a means to guarantee its ability ~ pay just compensation, LIPA could condemn either LILCO's stock or assets. 2. However, there is no certainty about the purchase price under either stock or asset condemnation. Control of the acquisition price, a key criterion, cannot be satisfied under condemnation. New York courts would have the discretion to apply a wide range of valuation theories to determine "just compensation." Estimates of a possible award for a LILCO asset con- demnation are as high as $16 ~llion, applying a "reproduction cost less depreciation" theory of value. Estimates for a stock asset5 condemnation are as Iow as $1.2 billion, applying a market-value theory. In addition, the court's discretion in determining just compensation cannot be restricted by legislation, and it is highly uncertain what weight would be given to legislative directives concerning valuation. Unless waivers were secured, stock condemnation would,trigger default provisions in LILCO's Third Mort- gage and 1984 RCA, thus in,teasing'the funding requirements for a stock condemnation. - - 3. Undep'~iStin~ law, the rec]uirement to take before valuation in either a stock or asset condemnation presents an unacceptable risk. Under the EDPL, the condemnor must irrevocably take title prior to a determination of ~just compensation,n Consequently, the condemnor is at risk, first, because it must initially demonstra.te that it has the ability to pay the possible awarded amount of just compensation - which may involve substantial financ- ing costs - and, second, because the condemned property cannot be returned to the prior owner if the ultimate valuation is excessive. Such risks appear to make condemnation an unacceptable strategy under existing law since a high valuation would .entail larger debt issues and could result in rates higher than those that would occur under continued LILCO operation. This risk could be eliminated, however, if there were an amended statutory provision allowing valuation to precede ~taking~ - an option available to .condemning agencies under prior State law. 4. Under an amended law, in which takin~ follows valuation, th~ lengthy valuation process could frustrate a timely takeover, offers no interim control of company operations, and could result in substantial damages. Condemnation under existing statutory procedures could take 3 to 4 years (or more). The Panel's legal consultant's indicate that modifying existing proce- dures (e.g., limiting appeals) would possibly reduce this time period to 2 years, although the litigation during that time would undoubtedly be intensive and such modifications would themselves be subject to legal challenges. Thus, another criterion - the ability to accomplish the takeover in a reasonably short time and without material litigation - cannot be satisfied ~mder condemnation. In addition, while this condemnation is being 'litigated, LIPA would have no control over LILCO's management decisions. This could include the decision to operate Shoreham. Because of uncertainty over valuation, LILCO also may be unwilling to invest in system upgrades (e.g., combustion tur- bines). Thus, continued reliable service could be impaired. Further, cause Of the uncertainty arising from the condemnation, key LILCO manage- ment and engineering personnel may not be willing to remain. The logs of these key personnel could also impair service reliability. Finally, in the event that LIPA sought to abandon the condemnation following the valuation determination, it might be subject to certain damages caused to LILCO by reason of the proceeding, such as: (1) court costs. 3O appraisal fees and attorneys' fees; (2) any diminution in the value of the property; and (3) any loss of corporate opportunity. 5. Stock condem,n~tion' is preferable to asset condemnation. Condemna- tion of stock is prefe?re,d beca~J~e it could reduce initial funding requirements and may result,itu;'a smaller award of just compensation. First, asset condem- nation would necessitate payment of recapture of. accelerated depreciation, but stock condemn~ition could avoid this payment. Stock condemnation would require only payment of "just compensation" for the equity securities taken (whose value normally reflects the amount of outstanding liabilities), while asset condemnation would require payment of "lust compensation" for the assets taken without reduction by the amount of any outstanding LILCO liabilities. Stock condemnation would not trigger redemption or default obligations under LILCO's First Indenture or G&i~ Indenture. Consequently, stock condemnation would provide LIPA with the option of assuming at least a portion of LILCO's debt and lowering the initial acquisition funding requirements versus if all LILCO's debt had to be immediately repaid. How- ever, stock condemnation would trigger default/redemption obligations under LILCO's 1984 RCA and by virtue of cross-default provisions under the Third Mortgage. Absent waivers from holders of such indebtedness, provision would have to be made for its refunding. Condemnation of stock might also result in a smaller award of "just compensation" than would condemnation of LILCO's assets. Because courts equate "iust compensation" with the "fair market value" of condemned property, the preferred valuation methodology is to examine market data from sales of comparable properties as a guide in determining lhe amount of the award. Since there is an active market for LILCO's common stock, the courts could be expected to treat its trading price as a significant - albeit not3~on- trolling - factor in ascertaining its value in a condemnation proceeding. On the other hand, because of the absence of a readily ascertainable market value for LILCO's assets, in the event those assets were condemned, the courts would rely on other valuation methods that might very well result in a higher award. Moreover, in the event of a stock condemnation, the courts might re,~ect as unfair any windfall award that would give shareholders a substantial premium above the current market price. Finally. a stock condemnation proceeding would be less costly to undertake than an asset condemnation proceeding. At least in the first instance a detailed asset description - which can be expensive to com- plete - would not be required. 6. Partial condemnation - excluding Shoreham - ma}' expose LIPA to unacceptable financial risks. If a partial, 'rather than complete, taking o£ LILCO's assets were effected (i.e., if all assets except Shoreham were con- demned), "iust compensation" would require payment for any consequential or severance damages to the property not taken that were caused by the appro- priation in addition to compensation for the value of the property taken. The measure of damages for such a partial taking would likely be based upon a comparison of the value of LILCO's assets as a whole before the taking and the value of Shoreham alone ,after th~ taking. The difference would represent njust compensation" for the value of the 'property taken and for any diminu- tion in the value:~f Shoreham"'~sed by the taking. Any effort to acquire all of LILCO's.a'S~ts except Shoreham by means of condemnation could expose LIPA to high severance and consequential damage claims if: (1) the NRC issues an operating license for Shoreham prior to condemnation and the li- cense survives legal challenge; or (2) condemnation precedes NRC action and LILCO is forced to abandon the plant. In either event, LILCO could seek to include the cost of Shoreham in its damage claim. Hostile Tender Offer-is Feasible but Difficult A hostile tender offer would be made directly to LILCO shareholders, who are free to either reject or accept the offered price. In that regard, a hostile tender offer is preferred to condemnation because it p?ovides LIPA with direct control over the price it will offer. In addition, a hostile tender offer could result in a more rapid takeover than would occur under condemnation. A tender offer is legally feasible and could be facilitated if LIPA were provided with an exemption from New York State law that restricts unfriendly tender offers. LIPA could effect the acquisitio~ through one of two options, and sufficient credit support could probably be obtained. However, the Panel cannot predict that a tender would be necessarily successful at a price that assures significant ratepayer savings. Any tender offer of this magnitude by a state public power agency for the stock of a major investor-owned utility would be unprecedented, lqhile certain questions can be answered with relative confidence, substantial uncertainty surrounds other issues. For example, the Panel cannot predict public reaction to any legislation that would exempt LIPA from the existing New York law that restricts unfriendly tender offers. In addition, the Panel cannot determine what affect a hostile tender by LIPA for LILCO might have on the general business climate of the State. The Panel does believe that an unsuccessful tender could be costly to the State. It should be recognized, however, that the availability of the tender offer strategy strengthens LIPA~s ability to negotiate with LILCO toward a mutually acceptable agreement. 1. There are two options for acquiring LILCO bT a tender offer. As in the case of a negotiated agreement, it would be advisable for LIPA to obtain an IRS ruling. In addition, opinions of counsel, an opinion by the rating agencies and, finally, shareholder approval should all be obtained. The primary difference between a negotiated acquisition and a tender offer is how the requisite shareholder approval is obtained. Under existing State law and based on the assumption that the statute creating LIPA includes provisions 32 ccmparable to those contained in the BCL, there are two options for obtaining the necessary shareholder approval and acquiring LILCO by a tender offer. The first could be achieved without ~Board approval. Under this option, LIPA would have to acquire,at least 90 percent of LILCO's stock to consummate a short-form merger.. ,' With'respect to the second option, LIPA would first acquire at least 50 percent of LILCO's common stock or 50 percent of LII3~O's preferred stock if dividends remain in arrears to elect a Board majority. With Board approval of the plan of-acquisition, LIPA could complete a merger upon meet- ing the following conditions: (1) that two-thirds of all LILCO shareholders approve the merger~ (2) that a majority of the common shareholders approve the mergers and (3) that a maiority of each series of LILCO's preferred stock approve the merger. . The Panel's legal advisors believe that the State Legislature, because of its general and statutorily reserved power, can, as part of the LIPA legislation, amend the BGL to modify the specified percentage of stock that must be obtained to effect a short-form merger so J~ng as the legislation is reasonable in light of public policy considerations. They believe that reduction of the short-form merger requirement to a two-thirds majority is possible. Such a reduction would improve the likelihood of the success of a tender offer. Further, to provide LIPA with the flexibility to rescind the tender if specific conditions were not met, LIPA could reserve the right to rescind the offer if sufficient shares were not tendered to enable prompt completion of a merger or if necessary long-term financing could not be secured. 2. Sufficient credit support could be established. Unlike the case of a negotiated acquisition, where LIPA would likely issue only long-term debt backed by its future revenues to purchase LILCO equity, in a tender offer LIPA should establish sufficient credit support prior to making a public offer for LILCO's shares. The amount of this credit suppcz:t sh2uld be sufficient to cover the anticipated price of acqv. iring LILCO. The Panel's financial advisors have said that such, credit support would not be difficult to obtain. LIPA could issue sufficient short-term tax-exempt debt to fund the transaction. Initially, these securities would be collateralized by U.S. Government securities, in which the proceeds of the issuance would be invested. Once the tender is effected, LIPA could sell the U.S. Government securities, use the proceeds to purchase LILCO equity, use any remaining proceeds to refund short-term debt, and then reissue long-term debt supported by LIPA's revenues to refund the remaining short-term debt that would no longer be collateralized. Smith Barney has proposed a bimodal, multiterm format bond (BMTF) that could efficiently roll several series of short-term securities into long-term securities - if conditions favorable to the completion of the te,nder are realized - through a format that would be familiar to m,u_nicipal markets. 3o But a ,t~nde~ Oirier 'will be difficult to execute successfully. Several interrelated factc~rs will make it difficult for LIPA to execute successfully a tender for LILCO equity. Because of the prospect of litigation and uncer- tainty about whether the tender can be completed, it may be more difficult in a hostile tender process to realize the conditions necessary to secure LIPA's tax-exempt credit at favorable terms than it will be under a negotiated agree- ment. In addition, signi£icant litigation, the outcome of which is uncertain, will almost certainly accompany the tender. And finally, it is uncertain whether LIPA will be able to obtain a sufficient number of shares at a price that could provide signi£i~ant ratepayer savings° First, several conditions necessary to secure a satisfactory tax-exempt credit rating for LIPA may be more difficult to realize under a hostile tender. In this situation, the terms of the proposed tender, including the price per share, should be included as part of the Ruling request submitted to the IRS. Since the IRS will require that there be a reasonable expectation that the tender will be completed, LIPA would have to indicate the basis for determining the economic feasibility of the proposed transaction. This information, if publicly available, could affect the tender process. In addition, the amount of credit support established could be an indication to the market of the range of acquisition prices that LIPA may be willing to offer. Bond rating agency opinions as to the creditworthiness of LIPA's long-term debt would depend on, among other things, determination of LIPA's rate covenants, the composition of LIPA's governing board, and the price at which LIPA would acquire LILCO stock. The price of the acquisition will influence LIPA rates in the near term, with higher acquisition prices necessi- tating higher rates. To the extent that the rating agencies believe that the price being paid for LILCO stock will produce higher electric rates in the future and result in public presslire to reduce such rates, LIPA would be given a lower credit rating, thus making its debt more expensive., Uncertainty about rate levels may make it difficult to obtain a rating and thus LIPA interest rates could remain uncertain until the outcome of the tender is clear. Second, litigation is likely to occur during all three stages of a hostile takeover - during the tender, after the tender but before formal merger, and after the formal merger. Before the formal merger, the more typical litigation in tender offers may be exacerbated because of the public status of the acquiring entity (i.e., claims relating to the quality of the disclosures made in any public statements). In addition, litigation of an unusual set of claims would be expected. For example, LILCO and others have already argued that a tender offer is an illegal attempt to circumvent condemnation, that the acquisition price will be insufficient compensation for its shareholders because 0f a long history of government actions toward LILCO that depressed the market value of its stock (e.g., opposition to Shoreham licensing), lind tha,~,.any changes in the BCL to facihtate a LIPA/LILCO me.r~er are'invalid. While the outcome of litigation is uncertain, the Panel and-itS advisors do not believe that, with properly constructed LIPA legislation, these claims are likely to prevent a tender from going for- ward. In addition, as in the case of a negotiated acquisition, shareholders objecting to the merger would have the right to litigate and receive the fair appraisal value of their shares. The cost of defending against this litigation and of any recovery of damages would increase the costs of a tender. Pending litigation could cause delay and uncertainty which, in turn, could complicate LIPA's ability to obtain the necessary long-term financing. In this regard, provision in the LIPA legislation for expedited judicial determination of such issues could be helpful. Third, the cost of the acquisition, and hence the economic feasibility of a LILCO takeover, would be in doubt until the tender was completed. Many factors will influence the price at which these shares will be tendered. Current market prices and their recent history are obvious reference points. But, typically, substantial premiums over the market price at the time an acquisition is announced are required to obtain the requisite majority of stock. Another reference point for shareholders may be book value. For electric utilities, book value is usually an appropriate measure of the under- lying value of stock since the regulators will usually grant rate increases that will provide a return on that value commensurate with the firm's cost of equity. For LILCO, if there were no dispute over Shoreham or NMP 2 costs, this value could be in excess of $25 per share. However, substantial imprudence disallowances have been made on Shoreham (and are on appeal) and have been agreed to for NMP 2. These disallowances lower LILCO's adjusted boo!: to the $17-to-$19-per share range as of year-end 1986. If abandoned utility plants contir, ue to realize the same cost recovery as plants that operate, LILCO's adjusted book value could be essentially affected by whether Shoreham operates or not. However, if ratemaking policy changed, such that if Shoreham did not operate LILCO and could not recover in rates any of $horeham's cost, adjusted book value could fall substantially below the $17-to-$19-per-share range. In the case where Shoreham costs are not recovered if the unit were abandoned, .LILCO's book value would fall to zero since the cost of the plant significantly exceeds LILCO's book value of equity. In any event, if shareholders believe that there is a reasonable probability that Shoreham will not operate and that stringent used and useful legislation will be ~nacted, the current market value will probably decline and a tender would be be more likely to succeed at lower prices than without such legislation. Finally, to the extent stockholders believe that if they refuse an offer for their stock the State will undertake condemnation with its potentially higher valuation standards, or that if they refuse an offer they can dissent from the merger and receive a higher appraisal value for their shares, or finally, that there are other alternatives that may yield a better price for them (e.g., a potential offer by priv. ate interests), they may be unwilling to accept an offer from the State. 4. In addi.t,10n,/th~~ costs o£ an unsuccessful offer could be substantial. The State could bear substantial costs because of an unsuccessful tender. Direct costs would include organization costs, litigation costs, and security issuance fees. Since the issuance fees could be expected to amount to 1 percent of the short-term credit fkcility, they could exceed $30 million, assuming an issuance in excess of $3 billion to establish credit support. Smith Barney suggests that through arbitrage - the difference between the yields on taxable government securities and the short-term tax-exempt debt outstanding - sufficient funds could be provided during the period in which short-term financing was 0titstanding but the tender was not yet completed to defray many transactions costs. Smith Barney correctly points out, however. that to ensure that these funds can be provided, both the ruling from the IRS and the transaction would have to occur before September 1, 1986. After that date, the amount of interim funds available to LIPA by this means would be governed by the new tax legislation. The Panel has been advised_that 39 under such legislation, this arbitrage would not be available to LIPA. 3 - ACQUISITION OF LILCO'S GENERATING ASSETS' PRODUCES LOWER RATEPAYER SAVINGs'BuT iCOULD MEET OTHER OBJECTIVES The acquisition of all of LILCO's gen~e~ration assets (i.e., existing fossil-fueled units, Shoreham,' and NMP 2)" by a public generating authority, LIGA, may be an acceptable alternative to a complete takeover of all of LILCO. A partial acquisition might achieve some of the desired objectives o£ public power on Long Island - somewhat lower rates and continued reliable service. Moreover, it could guarantee State control of the Shoreham operation decision. Acquisition of only the Shoreham facility could also be acceptable if the primary objective of public power were to ensure that Shoreham does not operate and if other challenges to its operation had been exhausted. Because these LIGA options would involve asset sales and the execution of a long-term take-or-pay power sales contract between LIGA and LILCO, negotiation with LILCO would be the only feasible method of acquisition. This chapter first discusses the methodology and assumptions that the Panel used to make preliminary financial projections 'for the LIGA options (i.e., full or partial acquisition of LILCO's generating assets). Second, the ratepayer savings that could result .from these options are examined in a comparison of LIGA to LILCO and to LIPA. 37 A - LIGA METHODOLOGY AND ASSUMPTIONS The principal rate savings that ~ould be realized by LIGA are based on its cost of capital advantage over LILCO on the assets that it acquires. LILCO's cost of capital ~uld bg,.based upon approximately 50 to 55 percent common and preferred eqdiiy, which requires that the ratepayer pay pretax returns on the order of 25 to 30 percent. LIGA's cost of capital, on the other hand, wor!ld consist entirely of debt with interest rates in the range of 10 to 12 percent possible. In estimating these savings the Panel has made several assumptions about the LIGA options. The most important of these assumptions relate to: (1) the steps for implementing LIGA~ (2) the resulting structure of electric operations on Long Island after implementation; (3) LIGA's cost of acquiring LILCO's generation assets~ and (4) LIGA*s financial structure. 1. Steps for implementing LIGA. Implementation of either LIGA option would follow a three-step process. First, LIGA would be created as an independent public power authority. Second, LIGA would issue sufficient debt to cover both the purchase price of the generating assets acquired and any Federal income tax liability arising from the transfer of these assets. Finally, a 'long-term take-or-pay power sales contract would be entered into between LIGA and LILCO, under which LILCO4~ould agree to purchase all or part of its electricity requirements from LIGA. The price of power in this contract would reflect the operation:and.maintenance costs that LIGA incurs to generate and/or purchase power, all of the annual expenses that LIGA would incur to service the debt issued to finance' the purchase, and expenses to serv/ce any subsequent debt that LIGA would issue to maintain or add capacity for sale to LILCO. 2. Resulting structure of Long Island electric operations. If LIGA were created and acquired LILCO's generating assets, there would be two maior electric utilities on Long Island: LIGA, a regional generating authority, and LILCO, an investor-owned utility that would continue to conduct substantially all power transmission and c!istribtition on Long Island and ;hat would purchase all or part of its generating requirements from LIGA. The Panel has assumed that LIGA would be exempt from PSC rate and financial regulation. LILCO would take actions to retain its current capital-structure ratios after the sale and would continue to be regulated by the PSC, To retain its existing capital-structure ratios, LILCO would have to refund specific series of First and G&R Indentures with the proceeds from the sale, according to the terms of the respective indentures. In addition, LILCO would probably repurchase equity. The Panel has not critically examined the specific steps that LILCO would have to take to realign its capital structure. The Panel has assumed that LJLCO's average cost of capital would be the same after LIGA acquired LILCO generating assets as it would have been in the absence of that acquisition. 3. LIGArs Cost of acquiring LILCO generation asset~. As in the case of LIPA, the Panel relied 6n adjusted ,book value as the assumed purchase price of LILCO generation assets, including Shoreham. On the basis of this assumption, the Panel e~imate.s.~.that the book value of all of LILCO's generation assets ~Wil1 be 'app~;oximately $4.4. billion at year-end 1986. previously discussed, the adjusted book value for Shoreham is S3.1 billion. LILCO's share of NMP 2 is estimated at $840 million. The book value of LILCO's other generation assets is estimated to be approximately $470 million. LIGA's liability for depreciation and ITC recapture will also influence the purchase price. In the LIPA cases, the Panel identified a possible means of avoiding accelerated depreciation recapture (i.e., a reverse triangular merger that the IRS would regard as a stock acquisition). For LIGA, the Panel has assumed that a similar transaction could occur. LILCO would first have to Spin off its generating assets into a subsidiary. LIGA subsequently would acquire the 'stock of this subsidiary and would complete the merger transaction that was described for LIPA. The Panel acknowledges that this type of transaction may be more difficult to accomplish because the IRS could very well regard the transaction as an asset sale if the spin off and the acquisition were viewed as related. Consequently, the projected level of ratepayer savings from LIGA should be considered as more uncertain than the projections for LIPA. If LILCO does not pursue a financial restructuring of this type, LIGA would clearly be acquiring assets and, as a consequence, a part of the purchase price would be a payment to the IRS fo~' these tax liabilities. If LIGA acquires all of LILCO's generating assets and is unable to avoid these liabilities, approximately $250 million would be owed for depreciation recapture. On the other hand, in the extreme case of LIGA acquiring only Shoreham, depreciation recapture consequences are minimal since LILCO has taken no tax depreciation on Shoreham. l','ith respect to-ITC recapture, LIGA would be liable for approximately $200 million, regardless of the structure of the transaction or whether it acquires all the generating assets or $horeham only. 4. LiGA's financial structure. The Panel adopted the same financial structure for LIGA as it adopted for LIPA. LIGA is assumed to retain one year's interest and principal in a debt-reserve fund at all times and collect debt service through rates of 1.25 times interest and principal due in a given year. As in LIPA, the combined interest and principal repayment would be levelized. LIGA would not itself be liable for Federal income taxes, since it would be a political subdivision of the State. The Panel assumes that LIGA would not be eligible for tax-exempt financing, however. This means that ratepayer savings would necessarily be lower than in the LIPA case because LIGA would have higher interest rates. Restrictions on tax-exempt financing for LIGA would arise because LIGA would sell all of its generation to LILCO, an investor-o~tned utility, and would thus exceed the maximum amount of generation that can be sold by a public authority to an investor-owned utility. This maximum would be no more than 25 percent of the nameplate capacity of LIGA. The .Panel does not believe that a transaction can be structured betwee~i LILCO,and,LIGA to avoid this constraint. Assuming comparable credlt ~"~tin'gs, the taxable LIGA'debt would then yield approximately 200 basis points over the tax-exempt LIPA debt. Because a percent rate is used for the LIPA projections - reflecting market conditions earlier in 1956, 11 percent is assumed for the LIGA projections. 4O B - LILCO AND LIGA RATE COMPARISONS In this section, the LIGA optior~s are compared to both LILCO and to LIPA. Ratepayer savings from L,~[GA of between 3 and 6 percent versus LILCO could be ~e~!~zed., dependmg on whether LIGA acquires all of LILCO's generating assets Or whether it acquires only Shoreham and on whether Shoreham is abandoned or operated. However, these savings could be reduced for either LIGA option if the purchase price were higher than assumed, if LIGA interest rates were higher than assumed, or if the economic benefit of operating Shoreham increased. On the other hand, these savings could increase if more favorable financial conditions were realized for LIPA or if the economic benefit of Shoreham were to decrease. LIGA ACQUISITION OF L~LCO'S GENERATING ASSETS COULD PROVIDE RATEPAYER SAVINGS Specifically, LIGA's acquisition of LILCO's existing generating assets and those under construction would entail: (1) the creation of LIGA, a regional generating authority; (2) the issuance of approximately $5.3 billion in taxable bonds to purchase the generating assets, pay ITC recapture, and establish one year's debt service in a reserve fund; (3) a transaction where LIGA acquires these generating assets for an assumed price of $4.4 billion; (4) LILCO's retirement of debt associated with Shoreham and other facilities and repurchase of equity to realign its capital structure at a debt-to-total-capital ratio of 50 percent: (5) the 'execution of a long-term power contract between LIGA and LILCO, under which LIGA agrees to provide LILCO with capacity and energy to meet all of LILCO's future needs and LILCO agrees to pay a capacity charge equal to L!GA's debt service expense plus the cost LIGA incurs to either generate or purchase the specified amount of power; and (6) an exemption of this transaction from PSC rate and financial regulation. The debt-serVice charges in this power contract would include both ir,!erest :nd principal and would be independent of whether LIGA chose to ,.;.+rate or to abandon Shoreham. If LIGA abandoned Shoreham, its generation and/or purchased power costs would be higher, since LIGA would fulfill its power obligations through least-cost power purchases from the New York Power Pool or others. LILCO would be obligated to purchase this power at its cost to LIGA. LIGA's acquisition of all of LILCO's generating assets in this manner would lead to ratepayer savings, but the amount of savings is sensitive to changes in the financial and operating conditions upon which the Panel's projections are based. 41 Projecte[d Ratepayer Savinss of 4 to 6 Percent Ratepayer s~.~ings that,vary from 5 to 6 percent could be realized purely from LIGA~s:'c0fnparative financial advantage. It is important to understand the determinants of this advantage. However, the Panel believes that the more relevant comparison for the LIGA option may be with Shoreham operating for LiLCO and abandoned by LIGA. since the state ~'ould be more likely to employ the LIGA alternative to abandon Shoreham, if other means were exhausted. If LILCO were to operate Shoreham and LIGA were to abandon it, these savings could fall to 4 percent. 1. Ratepa,ver savings[of 5 to 6 percent are proiected from identical decisions on Shoreham. If all of LILCO's generating assets were to be acquired and operated by LIGA, ratepayer savings of 6 percent are projected as compared with continued LILCO ownership and operation of the unit. These savings are smaller than the Panel's projection of 9 percent that could result from a complete public takeover by LIPA at $18 per share. Several changes would occur in the composition of total rates for Long Island ratepayers if LIGA were implemented. 'While tctal operation and maintenance expenses and property tax are assumed to be unaffected under identical supply plans, LILCO's capital charges would be reduced from ?.3 cents per Kwh to 1.8 cents per Kwh, the latter estimate reflecting only the remaining transmission and distribution assets. 'LIGA's cost of debt service on the assets that it would acquire and would have to construct would be approximately 4,5 cents per Kwh (Exhibit 18), If Shoreham were to be abandoned by LIGA, there would be no change in the debt-service portion of the power contract, but purchased power costs to be passed through to LILCO would probably be higher than the costs of Shoreham generation. Consequently, rate savings would fall to 5 percent in comparison to LILCO ownership and abandonment of Shoreham under existing ratemaking policy that would provide full recovery of and return on the unit, 2. Ratepayer savings would be 4 percent under different decisions on Shoreham. If LILCO were to operate Shoreham but LIGA were to abandon it, ratepayer savings from LIGA would fall to 4 percent. LILCO would still be bound by the power contract to compensate LIGA for all debt-service costs associated with the original asset purchase and would also be obligated to cover all purchased-power costs that LIGA incurred. This comparison rests on the economics of Shoreham. As in the case of LIPA, more favorable operating conc[itions for Shoreham could significantly reduce ratepayer savings from LIGA, The financial advantages of LIGA's capital structure and ?_bsence of Fede-al incor~.e tax liability would offset the economic disadvantag-: c.f aba.-!vning '-.oreham, Because LIGA's interest cost~ are assumed to be higher than LIPA's and its asset base would be smaller (i.e., it does not include ~ransmission, distribution, or general assets), LIGA does no, yield the same amount of savings as LIPA. In terms of the componentS.of Iota] rates, LILCO's qapital costs for transmission and distribution assets remain at 1.8 cents per Kwh, since LIGA's decision to operate or abandon Shoreham does not affect these LILCO costs, Total operation and maintenance costs increase, however, reflecting LIGA's costs of replacing Shoreham generation. LIGA debt-service costs fall because the effect of avoided post-commercial capital investments in Shoreham more than offsets increased expenditures for replacement capacity (Exhibit 19). Longer-Term Savings-Uncertain The same factors that influence ratepayer savings from LIPA would also influence savings from LIGA. The purchase price for the generating assets, LIGA*s interest rate, its necessary coverage requirements, LILCO refinancing options, and the cost of Shoreham replacement power ~ll all affect ratepayer savings from LIGA. Importantly, because LIGA would not assume any LILCO'debt. its initial financing would be greater than that of LIPA's, in acquiring all of LILCO (i.e., $5.3 billion versus $3.6 billion). As w~th LIPA, any phase-in plan for LIGA (i.e., in the power contract) would be subject to financial constraints, although the Panel did not investigate these. (All of the following sensitivity analyses assume that LILCO would operate Shoreham and LIGA would abandon it.) . 1. Purchase price. If LILCO management believes that LILCO will receive recovery of and return on its prudent cost of Shoreham in rates, whether or not it operates, they may be unwilling to sell for less than the $4.4 billion price that the Panel has assumed is the adjusted book value of LILCO's generating assets - including imprudence disallowances on Shoreham and NMP 2. At higher negotiated prices to acquire LILCOts generating assets, the savings from the LIGA option would fall; at lower prices, these savings would increase (Exhibit 20). 2. Interest rate. The strength of LILCO's payment obligations un6er its power contract with LIGA will strongly influence the interest rate that the LIGA debt will carry, since revenues from the power contract are the only source of funds for LIGA debt service. To the extent that the market perceives that this power contract is not secure and, as a result, the risk of LIGA default becomes relatively high, a higher interest rate may be required to market the debt. If interest r~tes increased to 12 percent, savings would fall below 3 percent. At a 9 percent interest rate, savings could increase to over 6 percent (Exhibit 21). 3. Coverage. The same factors affecting the interest rate may also affect required coverage on the LIGA debt. The coverage requirement may be higher than the Pane]ts assumed 1.25 times interest and principal if the :' 43 power contract is not viewed as secure or if LILCO's remaining operations continue to be viewed as apoor credit risk. At higher coverages, savings could fall. For example, at a 1.5 times coverage, savings would fall below percent. At a coverage of 1.0 times, savings would increase to nearly percent (Exhibit 32) LIGA ACQUISITION OF SHOREHAM COULD PROVIDE RATEPAYER SAVINGS AND MEET OTHER OB3ECTIVES The second possible option for a public generating authority on Long Island would be LIGA's acquisition Of only Shoreham. This option might be considerable in the event that LILCO could operate Shoreham and rejected LIGA offers to sell all the generating assets. As in case where LIGA would acquire all LILCO's generating assets, if LIGA acquired Shoreham it would first issue new bonds in the amount of $4.0 billion and would then use the proceeds of those bonds to purchase Shoreham, pay ITC recapture, and establish a debt-reserve fund. LILCO would again retire debt and equity to realign its capital structure at a debt-to-total-capital ratio of 50 percent. Finally, a long-term power contract for the estimated capacity and energy from Shoreham (i.e., 810 Mws at a 58 percent mature capacity factor) would be entered into at a price that covers LIGA's projected debt service, any changes in debt service, and any actual generation or purchased power costs. If LIGA acquires only Shoreham, ratepayer Savings from financial advantages are projected to be 4 percent versus continued LILCO ownership, if Shoreham were to be operated by LILCO and LIGA. As in the case of LIGA's acquisition of all of LILCO's generating assets, the composition of rates changes after LIGA is implemented. LILCO's capital costs fall to 3.3 cents per Kwh. reflecting all existing generating assets and future capacity additions, except Shoreham-related investments (Exhibit 23). In the more relevant comparison where LIGA abandons Shoreham but L~LCO operates it savings would fall to below 3 percent (Exhibit 24). In addition, under favorable operating conditions for Shoreham (i.e., $27-per- barrel oil, 67 percent capacity factor, and near-term capacity required for reliability), savings from LIGA would be eliminated. Finally, these savings would be sensitive to the purchase price of the generating assets, LIGA's interest rate, and coverage requirements, although the Panel has not investigated these sensitivities. summary, the Panel has concluded the following: The replacement of LILGO with a Long Island Power Authority (LIPA) eould,result.fh ratepayer savings in the range of 7 to 9 percen~ under assumed financia! and operating conditions0 but the savings are quite sensi-tive to changes in these conditions. A n~gotiated agreement with LILCO is the preferred alternative for a public takeover of LILCO, although a tender offer is a feasible but difficult alternat'lve. The negotiated acquisition of all of LILCO's generating assets or of only Shoreh~m, while offering lesser ratepayer savings, could realize some Of the objectives of a public takeover of LILCO. Fxhibit 1 PANEL MEMBERS John C. Sawhill, ChairMan . John C. Bierwirth Karen S. Burstein Kevin J. Collins William W. Hogan Alfred E. Kahn Leonard M. Rosen POSITION .Dir, ector McKinsey & Company, Inc. Chairman and Chief Executive Officer Grumman Corporation PreSident New York State Civil Service Commission Managing Director Municipal Securities Division The First Boston Corporation Director Energy and Environmental Policy Center John F. Kennedy School of Government Harvard University Robert'Julius Thorne Professor of Political Economy Cornell University Partr~er Wachtell, Lipton, Rosen & Katz Exhibit 2 COMPARISON OF~LIL¢O AND AVERAGE IOU RATES C/Kwh 1974 Interest and return ~ Incometaxes 0 1 ~[ Other taxes 0.2 ~ Depreciation ~ O&M ~ I 4¸1 2.4 ,/,~ 0.3 0.6 ;, 2.6 1.3 IOU LILCO 1984 115 · Average investor owned utility in the United States Source: LILCO annual repo~; DOE/E~A, staff analysis Exhibit 3 COMPARISON OFRATE PA'I'I'ERN$ LIL¢O* VS. LIPA** Nominal c/kwh ' 2O 15 10 1984 86 LILCO phase~in LIPA phase-in 88 9O 92 1994 · Shoreham operation '* Shoreham abandonment · .· Projected Exhibit 4 RATEPAYER SAVING5 FROM LIPA Percent LIPA vs. L/LCO Shoreham oper~t,~on LIPA vs. LILCO Shoreham abandonment LIPA - Shoreham abandonment vs.. LILCO Shoreham operation j7.8 7.1 91% COMPARISON OFLEVELIZED RATES LIGA* VS. ALTERNATIVES (OIL AT $19/BARR~L)** c/kwh SHOREHAM OPERATION SNOREHAM ABANDONMENT LILCO LIGA & LILCO ,9 1% 151 LIPA LILCO LIGA & LILCO LIPA All generating assets acquisition In 1986, with a 0.1% real increase per year Exhibit 6 COMPARISON OF LONG ISLAND SYSTEM I~ELIABILITY SHOREHAM OPERATION VS. ABANDONMENT* (700 MW's Of tie capacity)' , Projected number of~oltage reductions 2O 15 10 0 1985 Abandonment Current operating conditions % % " ........... T - - - '; Ope,at,on 86 87 88 89 90 1991 * Commencing on January 1, 1987 Source: New York POwer Pool Assessment of Future Rehability of Electric Supply on Long Island, February 18,1986; SEO analysis Exhibit 7 COMPARISON OF LEVELIZED RATES LIPA VS. LILCO (OIL AT $19/B, ARREL) c/kwh , , ' SHOREHAM OPERATION SHOREHAM ABANDONMENT 16.6 ~9.1% LILCO LiPA 15,1 16.7 ,7.8% LILC0 LIPA 154 Exhibit 8 RATE ¢OMPONENTCOMPARISON- SHOREHAM OPERATION* LIL¢O VS. LIPA Levelized c/kwh Return Income taxes Interest Depreciation GRT Property taxes O&M 16.6 1.4 2.2 2.0 1.7 2.1 66 LILCO 15.1 0.7-- 0.4 4.7 -- 06 -- 2.1 66 Coverage Principal Interest GRT Propecty taxes O&M Oil at $19/barrel Exhibit 9 RATE COMPONENT COMPARISON - SHOREHAM ABANDONED* LILCO VS, LIPA Levelized c/kwh Return Income taxes Interest Depreciation GRT Property taxes O&M 167 1.1 2.2 2.0 1.7 1.9 7.2 15.4 0.9 0.3-- 4.5 06 ~ 1.9 7.2 Coverage Principal Interest GRT Property taxes O&M LILCO LIPA · Oil at$19/barrel Exhibit 10 DETERMINANTS OF SHOREHAM ECONOMICS LIL¢O CONTINUATION $ Millions, NPVof reyenue requirements Savings from operation -800 -400 0 I I Increased revenues to recover investment Increase in property taxes Shoreham post com- mercial capital additions Increased system O&M' Reduced fuel costs ($ I9/bbl oil) Avoided costs of replacement capacity Additional savings: Oil at S27/bbl Oil at $27/bb~, capacity factor 4% h~gher 200MW of near.term capacity reclu~red for reliability Cost of operation 400 800 i ESTIMATE Range Of oote~bal savings from Shoreham 1.200 1,6~0 *Does not include fuel COSTS Exhibit 11 RATE COMPONENT COMPARISON LIL¢O* VS. LIPA'* Levelized c/kwh Deore¢iation GRT Property taxes O&M 166 1.4 2.2 2.0 1.7 21 6¸6 LILCO 15.4 O.~J 0.3-- 4.5 ~0.6 ~ 1.9 7.2 IPA Coverage Principal Interest GRT Property taxes O&M ' Shoreham '' Shoreham out i;xm D~'c 1,2 SENSITIVITY OF RATEPAYER SAVINGS TO PURCHASE PRICE* SHOREHAM OPERATION , PERCENT SAVINGS FROM LIPA 12 10 0 10 , 1 18 22 26 30 34 38 PURCHASE PRICE FOR LILCO EQUITY S/share · $19 per barrel oil prices SENSITIVITY oF RATEPAYER SAVINGS TO LIPA INTEREST RATE* SHOREHAM OPERATION PERCENT SAVINGS FROM LIPA 12 -- 8 4 2 0 ~o LIPA INTEREST R~TE Percent · $19 per barrel oil prices, $18 per share purchase price Exhibit 14 SENSITIVITY OF RATEPAYER SAVINGS TO LIPA COVERAGE* SHOREHAM OPERATION- PERCENT SAVINGS FROM LIPA . · o 1.00 LIPA COVERAGE Times ,nterest and principal 1 1 $19 per barrel oil prices. $18 per share purchase price Exhibit 15 SENSITIVITY OF RATEpAYER SAVINGS TO OIL LILCO SHOREHAM OPERATION VS. LIPA SHOREHAM ABANDONMENT ~, Percent savings Oil at $1g/barrel Oil at S271barrel 7.1% ' I ,2.85.1 Level of savings if Shoreham would operate at a 67 percent capacity factOr and if capacity were required for near-term reliability ' $18/share purchase price Exhibit 16 COMPARISON OF RATE PATTERNS LILCO* VS. LIPA** ' Nominal c/kwh ~" ' 2O Range of 10 and 15 year LILCO~ ~. ~.~ ~,, 18 -- phase-ins ~ ~2/ .. ~. ~ ~:'"'"'~"" .... " ........ I 0 1984 86'' · 88 90 92 1994 · Shoreham operation · . Shoreham abandonment · *· Projected Exhibit 17 COMPARISON OF FINANCIAL REQUIREMENTS · LIPA* 1987-94 - AVERAGE ANNUAL INTEREST CAPITALIZED Percent of total interest 17 1% I No phase in Phase ~n AVERAGE ANNUAL NEW DEBT REQUIREMENTS* $ Millions ,' 140 200 200 ".195 195 No phase in Phase ,n Rate moderation Construction Refinancing of LILCO debt Shoreham abandonment Before mnternaily available funds Exhib;t 18 RATE COMPONENT COMPARISON - SHOREHAM OPERATION LIGA* VS. ALTERNATIVES Levelized c/kwh ' , ....... ' LILCO capital recovery, return and taxes Gross receipts taxes Property taxes Operations and maintenance expenses 166 6.6 156 4.5 0.6 ' 2~1 6.6 LILCO LIGA & LILCO 5.8 · '-"-- 0,6 2.1 66 IPA LIGAJLIPA debt serv,ce Air generating assets acquired Exhibit RATE COMPONENT COMPARISON LIGA* VS. ALTERNATIVES . Levelized c/kwh LILCO capital recovery, return andtaxes Gross receipts taxes Prope~y taxes Operationsand mamtenance expenses 16.6 2.1 66 LILCO (Shoreham operation) 15.9 ~~rL6 ~ ?2 LIGA & LILCC (Shoreham abandonment) 5.8 --06-- 1.9 ~7.2 LIPA (Shoreham LIGA/LIPA debt serwce abandonment) All generating assets acquired Exhibit 20 SENSITIVITY OF RATEPAYER SAVINGS TO PURCHASE PRICE LIGA* VS. LILCO** LEVELIZED RATE SAVINGS Percent 12 10 8 6 4 2 0 3.2 3.8 4.4 5.0 ASSET PURCHASE PRICE $ Billions All generating assets, Shoreham abandoned Shoreham operated Exhibit 21 SENSITIVITY OF RATEPAYER SAVINGS TO LIGA* INTEREST RATE LIGA* VS. LILCO" LEVELIZED RATE SAVINGS Percent . . 14 12 10 8 6 2 10 LIGA INTEREST RATE Percent 11 12 · All generating assets, Shoreham only acquisition '~ Shoreham operated Exhibit 22 SENSITIVITY OF RATEPAYER SAVINGS TO LIGA (~OVERAG£ LIGA* VS. LILCO** SAVINGS FROM LIPA Percent 14 12 10 8 6 4 2 0 1.00 1.2S LIGA COVERAGE Times interest and principal 1.50 1.75 · All generating assets. Shoreham abandoned ** Shoreham operated Exhibit 23 COMPARISON OF LEVELIZED RATES - SHOREHAM OPERATION LIGA* VS. ALTERNATIVES c/kwh ULCO capital recovery, return andtaxes Gross receipts taxes Property taxes Operations and mamtenance expenses 16.6 LILCO 15.9 m0.e' 2.1 ¸6.6 LIGA & LILCO --.._., 15.1 5.8 '_-~.;;;; '0.6 2.1 ~66 LIGA/LIPA debt serwce ' Shoreham only acquisition ULCO 7:1' IPA ~oe'eham 1 2 3 4 FOOTNOTES Governor's Pr~ Rele+ase,'January 30, 1986. As of year-end 1986 and adjusted for anticipated imprudence disallow- ances related to the construction of Shoreham and Nine Mile Point 2 nuclear power plants. All ratepayer comparisons discussed in this report are based on the Panel's projections of future rate levels for LIPA and for continued LILCO ownership. No ratepaye~ savings are projected from the current level of rates. The Panel uses levelized rates to compare long-term ratepayer savings.. These are constant annual nominal rates that, when discounted, produce a present value that is equivalent to the present value of the nominal rates that the Panel projects over the 15-year study period. These rates are useful for long-term rate comparisons since they are adjust for timing differences. The Panel assumed without critical analysis that the PSC would apply to Shoreham, if abandoned, the same rate treatment accorded abandoned utility plant in the past. PSC ratemaking policy has been to grant full cost recovery and return on the prudent investment in such plant. Application of "used and useful" without extraordinary rate relief by PSC Would result in LILCO insolvency. The adjusted book value of LILCO's common equity at the er, d of 1986 is projected to be approxi- -> mately $2 billion. Complete disallowance of an additional $3.1 billion of Shoreham's prudent cost would reduce LILCO's revenues below the level required to meet its debt service obligations. Consequently, a financial stability adjustment by the PSC would be required to allow LILCO to meet its obligations. It is not possible to precisely predict the effect of such an adiustment on L1LCO's future financial condition. Il: contrast, Sm.~th Barney's analysis for Suffolk County assumed that LIPA would not be subject to the State's gross receipts tax - which amounts to approximately 4 percent of revenues - or make payments in lieu of such tax. The Panel notes that the tax-exempt status of LIPA may be uncertain if LIPA is liable for gross receipts tax, particularly if payments are not made by other public power entities in New York. In the event that LIPA does not make these payments, ratepayer savings could increase because of a transfer Of between $500 million and $750 million in net present value over 15 years from State taxpayers to Long Island ratepayers. Net present value over 15 years. The Panel has not attempted to anticipate the possible effect that such a projected loss of revenue by the Federal Treasury could have on New York State. Two of th~ most important of these actions could be the new Federal tax bill and proposed State legislation~ barring recovery in rates of Shoreham's cost if the unit does not operate. The Pane] has not esti- mated the potantia] 'impact,,~:[-,new tax legislation on LILCO's rates, since the net effectJ~0f sUCl~'fa~tors as the lower corporate tax rate, the alternative minimum tax, ITC repeal, and taxes on unbilled revenues (i.e., AFDC) remain unclear. 10 11 12 13 14 Submission by National Economic Research Associates (March 31 and May 2, 1986) and EBASCO (December 1985' and March 1986) for LILCO, and Smith Barney for Suffolk County (May 16 and May 29, 1986). Alternative phase-in plans would produce a similar net present value of revenue requirements- i~ revenues were discounted over the entire life cycle of the plant-at the AFDC' rate. Because the 15-year period used by the Pane] does not cover tl~e life-cycle of the plant, the Panel did not use projected rates under phase-in plans to examine long-term ratepayer savings. In examining the difference in projected LILCO rates from 10- and iS-year phase-in plans and assuming Shoreham operation, the Panel found that there would be approximately 2 percent savings - in leve]ized rates - from the 15-year plan. A $1.1 billion cost is assumed for LILCO's share of NMP 2 adjusted for deferred Federal income tax benefits associated with its financing. The imprudence amount assumed is based on the proposed settlement among Niagara Mohawk, the other co-tenants, and the'PSC staff. The indentures require that all G&R debt be refunded if any is re- funded. Consequently, on the two series that were recently issued, totaling $525 million, a 9 percent call premium would apply. If LILCO's debt is assumed, LIPA debt would be subordinated and would thus receive a slightly lower credit rating than if LILCO's debt were refunded. However, the Panel believes that {he LIPA debt could siill receive .~n A rating, ~nd hence be marketable to institutions, if LIPA .dopts conventional municipal debt reserve funds and an appro- priate rate-setting mechanism is established. First, LIPA would establish a separate acquisition subsidiary. This subsidiary would purchase LILCO stock and then merge into LILCO in a taxable reverse triangular mcrger. LILCO's articles of incorporation would be amended and a special New York State statute enacted to convert LILCO into a tax-exempt entity. Under an applicable IRS ruling, the LILCO shareholders would likely be treated as having sold their LILCO stock and the assets of LILCO would be treated as not having been disposed of in the transaction. Thus, gain or loss would be recognized only by the shareholders who are exchanging their stock for cash. 15 16 In the event Shoreham were to ope?ate, the installed reserve margin fcr the Long Island system would increase to approximately 34 percent. If Shoreham ,w,,ere licefised but unavailable during any peak period prior to 1992, the Lbng Island system would be faced ,~'ith a need for alterna- tive power t.hat would be no different than if Shoreham were abandoned. 17 18 19 2O 21 22 23 Pursuant to the Niagara Development Act and conforming federal license, the Power Authority must make available to "public bodies," such as public power agencies, 'and "nonprofit cooperatives," principally in New York, at least one half of the power available from the Niagara Project. Since, howeyer; any diversion of this power would be at the direct expense of ratepayers elgewhere in the State, the Panel declined to consider this possibility in estimating the benefits of public power to Long Island. The Panel did not critically examine the siting requirements for this assumed replacement capacity. Estimates of ratepayer savings are based ~n comparisons of LIPA and LILCO levelized rates, calculated over a 1S-year periad. A 10.5 per- cent nominal discount factor is ,.used for all estimates. For the long-term comparisons, the Panel ~ssumed no phase-in plans for either LILCO or LIPA. Over Shoreham's life. the levelized rates ~Sth and without a phase-in plan would be equal ii a discount factor equal to LILCO's carrying cost is used. However, over the 15-year period that the Panel has employed for its analysis, use of the phase-in plan for LILCO but not for LIPA could have biased the results in favor of LILCO. In near-term comparisons, the Panel does examine comparative rates under the assumptions that both LILCO and LIPA employ phase-in plans. The Panel projects that LILCO will be unable to utilize completely the le:ge tax loss for several years. This diminishes the. possible ratepa)-er' savings from an abandonment. NERA and EBASCO projected ratepayer disadvantages from LIPA under this assumed difference in decisions on Shoreham. Net present va]ue over 15 years. In that case, NERA also assumed that LIPA would not replace the existing LILCO debt, that LIPA rate covenants would include a 1.15 coverage of interest, and that LILCO would not refinance its own debt with IDBs. 24 25 27 3O 31 The Panel acknowledges that capacity factors in excess of 58 percent may be achieved. In fact the PS,C has estimated capacity factors in excess of 62 percent. The Panel d~;not,~ati~mpt to independently determine what price may be required to negotiate a friendly acquisition or make a successful tender. Prices in excess of $18 per share are possible, although the Panel does not believe 'that the price under a tender offer would increase to the $30 per share that NERA suggests. Failure to realize favorable rulings from the IRS could increase the effective price that LIPA would pa)- to acquire LILCO by as much as $6 per share, although the Panel believes that favorable rulings could probably be obtained. In February, the New York State Assembly passed A.6891, which would bar recovery of costs for any nuclear plant that failed to begin commer- cial operations. Also in February, the Senate passed S.6411-A, which relates only to Shoreham. Although the bills are different, each would exclude recovery in rates of the cost of Shoreham if the unit does not operate. The Panel notes that the independence of the 15 member board of trustees proposed in S.7784/A.9517 and their discretion in setting rates will be critically important to potential investors in LIPA securities and could significantly affect LIPA's credit rating. For these sensitivities, the Panel varied interes{ rates on all categories of LIPA debt both initially and prospectively, without also varying LILCO's interest rate on new issues. If this approach were adopted, long-term ratepayer savings approxi- mating those from the Panel's projected LIPA financi'al structure could be expected. Near-term rates would initially be below the Panel's phase-in plan but would increase to higher levels wiihin the first two years of LIPA's existence. In this regard, it will be important that LIPA's deliberations on possible' acquisition prices be held in strict confidence. Because condemnation under the existing EDPL requires the taking to precede the determination of just compensation by a court, the Panel believed it advisable also to consider condemnation under a law that would permit the taking authority to determine whether to take after the court determination of the amount to. be paid for the property taken (a procedure permitted under prior condemnation law). Under the statute, the standard is "fair value" at the close of business on the day prior to the shareholders' authorization date. .~. 33 34 35 36 37 38 39 There is Some uncertainty about whether a New York court would have jurisdiction over out-of-state common and preferred shares and share- holders. See Submission of the Energy Association of New York Stat;, at pages 40-41 (April 8, 1986). The Panel's own legal consultants believe that a New ,York court would have jurisdiction over common and preferred sh~i~'es and shar~61ders. See Report'to Shea & Gould on Percent Condition Value of the Lon~ Island Lighting Company Electric and Cas Systemc, prepared for Shea & Gould by EBASCO, a{ page 6 (March 1986). Assuming $11 per share of LILCO common equity. Shea & Gould, counsel for LILCO, argue without citation that any reliance on the market value of the stock would be an unconstitutional circumvention of traditional means of valuation in a condemnation pro- ceeding. Shea & Gould, Government Takeover of the Lon~ Island _Lighting _Company: A LEg. a! Analysis, at page 59 (April 4, 1986). The Panel's legal consultants believe that because the stock's market value v~,ould serve as an important, but noncontrolling, factor in determining the amount of the award there is no constitutional pr0hibi~ion in seeking to focus the courts' attention on that market 'value. For so long as LILCO remains in default on the payment of preferred dividends, the preferred shareholders are entitled to elect a majority of the board. Under terms of LILCO's extended 1984 RCA, restrictions on payment of preferred dividends are lifted from June 30, 1986 through December 31, 1987. Thereafter, preferred dividend payments are conditioned on LILCO meeting certain internal cash requirements. The Panel's legal consultants believe that this is a determination the courts prefer to leave to the legislature. Provided it would not be so drastic as to amount to a taking, there would be no violation of the contract clause of the constitution. Similarly, due process and equal protec:ion challenges by such a statutory amendment would likely fail. It has been suggested to the Panel that it may be possible to reduce the costs of a tender, successful or unsuccessful, by beginning the tender offer without full financing in place, but rather with an investment banker,s "highly confident" letter as to its ability to obtain commitments. Using this approach, LIPA may avoid incurring significant commitment and issuance fees until success of the tender offer is more certain. At that time, LIPA could proceed with long-term financing concurrently with the purchase of shares. In this manner, it may be possible to avoid establishing a short-term credit facility. However, the Panel's financial consultant believes that such a letter may not survive a challenge. In addition, this approach may diminish the credibility of LIPA~s tender offer. 4O 41 42 In addition, LIGA would assume am obligation to meet all of LILCO's future generation re, quirements. If LIGA acqui~.~'s o~ly' Shoreham, the power sales contract would be based on the expected capacity and generation from the Shoreham unit if operated. 'l'he analysis of LIGA options is preliminary. A simple model was used to simulate the required revenues for remaining LILCO operations. This analysis is based on assumptions about capital structure. regulatory treatment of deferred taxes, and ITC, among other vari- ables, that are similar to. those used in the more sophisticated LIPA analysis. The results of the model were first benchmarked to the LILCO simulations. In subsequent analysis of LIGA, specific assets were removed (i.e., all generating assets and then Shoreham) and the require revenues on remaining LILCO assets were determined. COunty of Suffolk RECEIVED t JUN 'l 01-°8,3 R, W, Beck & Associates. Feasibility'e~tudy Regardi~ng Acquisition of ~JiLCO bY'a Public Power ~uthority Reference CaseeResults Smith Barney, Harris Upham & Co., Inc. R.W. BeCk & Associates ESRG Touche Ross & Co. Willkie Farr & Gallagher Duncan, Weinberg & Miller, P.C. 3;,, Count" of Suffolk Feasibility Study Regarding Acquisition of LILCO by. a Public Pov~er Authority Reference Case ResUlts Smith Barney, Harris Upham & Co., Inc. R.W. Beck & Associates ESRG Touche Ross & Co. Willkie Fart & Gallagher Duncan, Weinberg & Miller, P.C. June 6, 1986 SUFFOLK COUNTy LEGISLATURE POWER AND ENERGY COMMITTEE Suffolk County Legislature Legislature Building Old Willetts Path ' Hauppauge, New York 11788 Gentlemen: Several weeks ago the Suffolk County Legislature appointed a study group to evaluate the feasibility of the acquisition of LILCO by Long Island Power Authority ("LIPA"). This study group is managed by Smith Barney, and includes R. W. Beck, ESRG, Touche Ross,. Willkie Parr & Gallagher, and Duncan, Weinberg & Miller, I have attached two submissions to the Sawhill Commission by t~e study group which contain more detail 'on our findings. The study group · has completed the initial phase of the feasibility analys%s, which includes a Reference Case forecgst ~omparlng the ~=~=rmnoe case Incorporates certain assUmptions' including . =~ump=aons ~nclu=lng £oau growth, inflatIon and fuel cost. The forecast period begins i~' 1987, the 'first year of assumed ~perati)n of LIPA, and continues for 20 years. LIPA is sTeSJSn tLi= th?gh th. purohase of its commo? tock prlce anu preferred stock. The acquisition price also provides . . for repayment of LILCO,s outstanding ~ebteunes~._ T?? .cos~ .o~ acqui~ing LILCO, including providing y~ a - su~9=a~.:lal_ ~eb}...se.z~.lce reserve fund, operating un=angency zunu, an= s=a~lllza=lon fund for moderation of rates during the first several years of operation amounts to approximately $7 billion. The Conclusion of the initial phase of our analysis is that LIPA is likely to achieve rate savings when compared to LILCO of approximately 19%, in a manner described in the attached graph. The savings are relatively consistent over the entire twenty year forecast period. We have also made preliminary estimates of LIPA economics in the likely event that key assumptions vary from those utilized in this analysis. These assumptions, include the interest rate required to sell the debt, the amount of debt service coverage required, the maturity of,.~debt used to acquire LILCO, and the acquisition pri~e ~f co~on and preferred stock. While the economics of the transaction are affected by these critical assumptions, and savings'may well be less that the level indicated, substantial savings are still achieved by LIPA in virtually all cases examined. In addition, it should be noted that the assumptions used in the Reference Case are generally considered to be conservative, it is, therefore possible that savings might exceed the amount in the base case. The financial str~cture of the acquisition consists of two phases, (1) an issue Of Bi-Modal, Term Format ("BMTF") bonds in a short-term bond format initially secured solely by investment of the bOnd proceeds in highly rated investments, followed by (2) conversion of the bonds to long-term revenue bonds, whereupon the bond proceeds would become available to purchase outstanding securities of LILCO. This structure which was conceived by Smith Barney and successfully implemen~e9 in a $2 billion transaction late in 1985, improves the feasibility of implementing LIPA by (1) providing positive investmentearnings which may be available to cover issuance cost and pay certain expenses necessary in-the acquisition effort (assuming bonds are issued by September 1, 1986), and (2) securing all financing required to complete the transaction, while allowing flexibility to convert the BMTF bonds to revenue bonds of LIPA over time as required to purchase various components of the outstanding obligations of LILCO. The $7 billion issue of bonds issued by LIPA to acquire LILCO, while unprecedented in size, in our opinion is feasible, if implemented according to the BMTF structure. It is likely, however, that sale of such magnitude will require rates that are somewhat above those prevailing in the marketplace. We have therefore assumed a significant rate premium in the Reference Case. A key benef%t of the BMTF structure is that certain earnings on investments will be available through the use of the structure to defray all or a portion of the cost of issuance of the bonds and cover a portion of the significant legal and en~ineerin- costs of forming LIPA. Under current tax proposal~ in th~ Congress, this assumption is valid only if bonds are issued prior to September 1, 1986. Smith Barney believes that it is feasible to' issue the bonds prior to September 1, providing appropriate state legislation is passed in the current session. The BMTF Structure simplifies the initial structuring process, since many detailed provisions can be delayed until the time the BMTF Bonds change mode (security) and LILCO is actually acquired. While it 2 is possible that the September 1 deadline will be delayed, such delay is unlikely. The study group recommends that, following passage of legislation, of LIL¢O's Board of Directors be approached for the purpose of obt~ining~agreement to submit an acquisition plan to - be adopted b~' the shareholders, of LILCO at a special shareholders' meeting. If such a meeting were unsuccessful, the Trustees of LIPA could determine to commence a tender offer for common and preferred stock of LILCO, or any other action that the Trustees deem appropriate. If LILCO's Board of Directors were to recommend adoption of the acquisition plan to shareholders, the BMTF financing for the transaction could commence in a very short period of time. With the BMTF bonds issued and invested, acquisition plans could proceed in an orderly manner. As a next step,' the study group intends to refine its results and present the documented first phase of the study to the Suffolk County Legislature in several weeks, outlining various sensitivity analyses and detailed assumptions used in the study. If the proposed financing structure is to succeed, however, a major effort by the County and all others involved will be required in the next few weeks to lobby for passage of legislation forming LIPA. ~.n' W. Wooten ~m'~ ~al~e~,re~dr~'~st Upham& Co., $30 $28 $2o $18 $12 $10 $3 $4 ~2 $o LILCO & LIPA Requ~'ed Electric Rates · ~ I I I ' I ~ I ' I I ~ I 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 rl LILCO ELECTRIC RATE ~ LIPA ELECTRIC RATE .. $3O ~28 - $24 820 818 $1o 88 $8 $o 1987 LILCO & LIPA Stabilized Electric Rates I " I ' I ' I ' I ' I ' I I ' 1989 1991 1993 1995 1997 1999 2001 2003 2005 + LILC0 ELECTRIC RATE A LIPA ELECTRIC RATE SMITH BARNEY May 29, 1986 Mr. John C. Sawhill McKinsey and Company, Inc. 17 Pennsylvania Avenue, N.W. Washington, D:C. 20006 Dear Mr. Sawhill: In my previous letter to you dated May 16, 1986, which included preliminary conclusions of the Suffolk County Study Group (the "Group") regarding the acquisliticn of Long Island Lighting Company ("LILCO") by Long Island Power Authority ("LIPA"), I indicated that the Group'would be providing you with the results of a Reference Case analysis comparing both projected electric and gas service' costs of LILCO and LIPA. We have recently completed this Reference Case analysis, and a summary of it is enclosed herein for your consideration with the following caveats: 1) the results reflect the intensive analysis of a massive amount of new information, much of which was obtained very recently in LILCO's FERC Form 1 for the year ended December 31, 1985, 2) details of the rate moderation plan for LILCO recently approved by the New York State Public Service Commission ("PSC")are not yet available to us, 3) uncertainties exist regarding the cost of future LILCO debt financings, including opportunities to refund existing high coupon debt, as such financings depend heavily upon the speed with which the financial markets regain confidence in LILCO obligations, 4) market Judgments regarding the ability to absorb an unprecedented amount of debt from a single utility in such a short amount of time are only in the formative stages, and 5) uncertainties remain regarding a number of important factors such as the outcome of pending Federal tax legislation, future treatment of the prudent investment in the Shoreham nuclear facility, and future actions of the New York State legislature pertaining to LILCO and Shoreham. O Mr. John C. Sawhill Page Two May 29, 1986 The attached summary of the Reference Case analysis for LILCO and LIPA contains the most important of the assumptions used in developing the operating and financial forecast. Certain elements of the general financing, plan for LIPA are described in more detail below. Financin Ptan The acquisition Process of LtLCO by LIPA would commence with the passage of enabling legislation by the New York State legisla- ture, the formation of LIPA, and, finally, the approach of LILCO and its directors by representatives of LIPA regarding the submission of a purchase offer by LIPA for all LILCO common and preferred stock. If the directors Were to approveand submit LIPA's plan of purchase to LILCO shareholders, a special share- holders' meeting, could then be scheduled to vote on a merger proposal by LIPA. If the LILCO directors were not to recommend to shareholders a merger proposal with LIPA, a tender offer for LILCO shares could commence after a review of other options available to LIPA. ' In order to provide the market with some degree of confidence that the tender offer for LILCO shares was supported by adequate financing, LIPA would issue between $4. and $7 billion of Bi-Modal Multi-Term Format (BMTF) bonds. The BMTF bonds would be ini- tially secured solely by the escrow of investments purchased from bond proceeds, which would be pledged to the bondholders'. The investments would be either investment agreements with credit- worthy banks or other eligible financial institutions, or direct United States Treasury obligations with maturities matching the initial tender dates of the BMTF bonds. The BMTF bonds would preferably be issued by September 1, 1986 !or such later date subseqUently established by taX legislation) 1~ order to.permit BMTF bond proceeds to be invested without yleld restriction. The advantage of issUing ~he BMTF bongs by September 1, 1986 is clear, since the availability of arbitrage profits would insulate LIPA from potentially debilitating delays which would create continuous funding problems for legal and other consultants which may be necessary in order to proceed with the LILCO acquisition effort. As the acquisition program proceeded, various series of the BMTF bonds would be converted from a mode in which the escrow of bond proceeds is the primary security to a mode in which security is provided by LIPA revenues. These BMTF bonds would be remarketed in the marketplace much in the manner of a new issue of'revenue Mr. John C. Sawhill Page Three May 2~, 1986 bonds. There w6uld'be a number of potential remarketing oppor- tunities, ' ' ~' including i) funding the initial purchase of bonds under a tender program, ii) purchase from minority shareholders of common and preferred stock, if necessary, following a tender program, iii) purchase of the G & R bonds under the special par redemption feature in the event of a public agency acquisition of LILCO, iv) repayment of various revolving credit agreements with commercial banks and other institutions, v) repayment.of or tender for the outstanding first mortgage bonds, vi) annual remarketing of stabilization bonds for the purpose of providing a source of funds to smooth the adjustment of rates over the early years, and vii) remarketing bonds to fund capitalized interest, if necessary, should the acquisition program proceed slowly, . making access to LILCO revenues impossible to cover the cost of LIPA. The BMTF structure provides'considerable flexibility to address the inevitable uncertainties which will exist during the phase-in program as LILCO is sbsorbed into LIPA. The major advantage is that bonds can be issued without a carrying cost to LIPA prior to a remarketing to purchase LILCOsecurities, and even can provide arbitrage profits, to cover certain soft costs without requiring extensive reliance on continual appropriations. It should be noted, however, that once the acquisition.program commences with the first purchase of LILCO Common stock, the process is essen- tially irreversible, since security must exist for all BMTF bonds when converted for the purpose of funding acquisition.costs. The ability of the market to absorb $7 billionlof short-term bonds in one piece appears likely to be feasible, albeit at higher, though still attractive, rates than those for similar securities. The market has already absorbed a $2 billion dollar New Jersey Turnpike AuthorityBMTF issue, and indications for that issue at the time of sale were that the market could have absorbed a considerably larger financing. If the BMTF bonds were priced somewhat "cheap" to the market, but still at a low enough rate to provide positive arbitrage, we believe that a $7 billion BMTF issue could be done. Our forecasts assum~ no positive arbitrage at all. In addition, the possibility exists to issue the 'BMTF bonds in consecutive offerings until the total amount of finan- cing required is raised. Mr. John C. Sawhill Page Four May 29, 1986 There are slgnlficant'uD~er~alntles regarding the ability of th~ market to absorb '$7 billion of long term revenue bonds of LIPA in a short period of time. The ability to stage the transaction in several consecutive remarketings over a period of time would contribute greatly to the feasibility of the program. The maximum benefit would be received if the common stock, preferred stock, and the G & R bonds coUld be purchased in a shor~ amount of time. obviously the market must be convinced of the credit- worthiness of the LIPA entity given all of the bonding planned in the LILCO acquisition program. Flexibility might be achieved by negotiating with debtholders, particularly owners of the G&R bonds, to allow special redemptions beyond the current restric- tions provided in the G&R indenture. For planning purposes, it is better to assume that the revenue bonds are sold at a somewhat higher rate in order to attract buyers. The tax analysis of the potential recapture of tax benefits is not yet complete; however, it in any event depends upon factors such as the ultimate acquisition cost and potential introduction of ~acilitating federal tax legislation. If federal tax re- capture turns out to be a problem, a potential remedy is to devise a plan to continue the existence of LILCO until enough of the ITC and other tax attributes'have been vested to make liquidation feasible. This obviously has tremendous tradeoffs if the impact is to prevent refinancing of'the current LILCO debt. Preliminary Conclus{ons The attached graph illustrates the potentially available signifi-' cant savings from implementing a public power, program whereby LIPA acquires LILCO. This analysis is preliminary, and we expect to refine it in the coming weeks prior to the presentation of our results to the Suffolk County legislature. We recognize that the Sawhill commision is'rapidly approaching the release of a report which will be submitted to Governor Cuomo makin~ recommendations regarding the solution to problems assoc=ated with LILCO and Shoreham. We would ask that this presentation of preliminary conclusions'by the Group be kept in confidence until our final presentation to the Suffolk County legislature, and we hope that our preliminary analysis contri- butes to your efforts. JWW/ged Best re~rds, May 29, 1986 REFERENCE CASE · LILC0..ACQUISITION STUDY FOR THE SUFFOLK COUNTY LEGISLATURE Summary of Results The Reference Case, based upon the principal considerations and assumptions set forth herein, compares the projected costs of service to Long Island consumers under two LILC© Continues in business with Shoreham not if LIPA acquires LILCO and does not operate electric and gas scenarios: (1) if operating, and (2) Shoreham. The -preliminary results of the Reference Case are shown graphically 'on the attachment. The projected cost of service under LIPA ownership is based.upon the preliminary acquisition and financing plan developed by Smith Barney and the projected operating results prepared by R. W. Beck and Associates using well accepted financing techniques, including the concept of rate stabilization. These results indicate that in each year of the study period from 1987 through 2005, the cost of service under LIPA ownership on a rate stabilized basis would be materially less than under LILCO. The graph shows the potential relationship between the projected cost of electric service under LIPA and LILCO operations given the ass~nptions in the Reference Case. The bulk of the overall difference between the cost of - 1 - May 29, 1986 service has been allocated to electric service. Nonetheless, there are also lower co,ts projected for gas service, though not as large. Rate stabilization is a concept whereby through the establishment of a - special fund, the issuance of rate stabilization bonds, or a combination therof, it is possible to develop a consistent percentage differential between the projections under LILCO ~ownership and operation and under LIPA. In addition to being a practical, useful, and flexible tool in actual rate setting, this concept can and will be used to demonstrate clearly the effects of the various sensitivity .analyses that will be made and compared to the Reference Case. That is, the results of each sensitivity case can be shown on the basis of a consistent percentage differential between the costs of ownership and operation under LILCO and under LIPA. The results of these analyses actual cost differentials basis. more truly and clearly represent the on both an annual and present worth - 2 - May 29, 1986 The following additional sensitivity cases will be analyzed: Sensitivity Case No. Description 2 · Load Growth Sensitivity Cases a. Higher Load Growth b. Lower Load Growth 3 Interest Rate Sensitivity Case (Higher Overall Interest Rates for LILCO and LIPA) 4 Fuel Price Sensitivity Case (Higher) 5 Cost of Acquisition sensitivity case (Higher) 6 Shoreham Costs Sensitivity Case (Lower Cost Recovery) Each of the sensitivity cases were outlined in the May 16, 1986 submittal to the Sawhill Co~mission.' - 3 - May 29, 1986 This sunu~ary of the Reference Case contains, among other things, summaries of studies and'analyses with respect to (i) the estimated finan~$~g~ progra~~ proposed for LIPA, (ii) projected power and energy requirements and bulk power supply resources for Long Island's consumers~ and (iii) projections of costs of providing power supply under continued operation by LILCO and, alternatively, LIPA. Such summaries of-our studies and analyses, including those contained in this report, are based in part upon our understanding of the LILCO system and the potential acquisition of the system by LIPA within the context of the legislation currently pending before the New York State legislature. We have used and relied upon information made available to us from Smith Barney and the other consultants on the Study Team, as well as data and information from LILCO, the State Energy Office, other utilities in New York and New England, the Federal Energy Regulatory Com~ission, the Securities and Exchange Commission, the New York State Public Service Commission, the Nuclear Regulatory Commission, and othe~ sources. While we believe these sources to be reliable, we have not independently .verified the accuracy or the validitf of the information and-cannot offer assurances with respect thereto. To the extent that actual conditions differ from information or assumptions provided to us by others, the actual results will vary from those projected herein. - 4 - May 29, 1986 PRINCIPAL CONSIDERATIONS AND ASSUMPTIONS In the preparation of these studies and analyses, we have made a number ~f assumptions with .respect to future conditions and events. Actual conditions may differ from those assumed and may have an impact on the results. While information used in the analyses is as recent as could be obtained, changes may have occurred since receipt of information on which this summary of the Reference Case has been based which, if reflected, would cause the projections to be revised. The principal considerations and assumptions made by us, and the principal information and assumptions provided to us by others for use in this report, include such items which are applicable to assumed future, operation by (1) either LIPA or LILCO, (11) LIPA only,' or (111) LILCO only, and are set forth as follows: Assumptions Common to LIPA and LILCO For the summary of the Reference Case study presented. herein, a common body Of assumptions has been employed for (1) continued operation of LILCO or (11) acquisition and subsequent operation by LIPA. With 'the exception of the financial structure of both LIPA and LILCO, the remainder of the assumptions with respect to operation and maintenance costs, new ma~or plant additions~ renewals and replacements, load forecast, dispatch of owned facilities and purchased power from others are common to both the LIPA and LILCO projections. As these assumptions and May 29, 1986 the resulting costs are the sa~e for the LIPA and LILCO analyses between the two in the Reference 'Case, ~o cost differences analyses will 5~' introduced inthis' 'comparison.' Assumptions which are common to both LIPA and LILCO in the Reference Case are as follows: · Load Forecast: Puture load growth is based upon the e with per year was used for future years' Production Costs: A stochastic methods for was used. forecast published by SEO in October 1985. Fuel Prices: FUture fuel prices are assumed to start at current market levels and -escalate at rates under the aforementioned SEO forecast. These rates vary from year-to- year, but are, gmnerally, some 2% per year for natural gas and 1%.per year for oil over the period 1984 through 2001. Both of these growth rates are in real terms. Operating ExDenses, Renewals and ReDlacemen~: A historical analysis of past expenses for both the electric and gas systems was performed and used as a basis for. projecting future costs. For major electric plant additions, expenses based upon the experience of R. W. Beck and Associates similar facilities. A general escalation rate of 5% expenses. production costing simulating operation program with of the system This program models the individual operation of the generating units and other power purchases based upon monthly load curves obtained from information derived from load data of LILCO obtained from SEO. Maintenance May 29, 1986 scheduling was assummed with a "minimum risk" criteria, as well as p~ovisions..~de for forced outages. The program uses a theoretically sound stochastic method for accounting for forced outages'and also determines certain loss of load probability ("LOLP") reliability indices. Incremental heat rates for the units are also modeled. A variety of assumed non-firm power purchases are modeled, including capacity and energy purchases and economy firm and scheduled purchases. Generation Requirements: For the period 1986 through 2005, we have made certain assumptions With respect to new plant additions and the purchase and use of additional resources from others to maintai~ -adequate resources to' serve the needs of the electric consumers on Long Island under the SEO load forecast used for this Reference Case. Under the basic assumption that the Shoreham facility is not placed in commercial service, additional resources are required to maintain adequate reserves during the study period. In addition, the use of.the ownership interest in Nine Mile Point Unit 2 to provide service on Long Island has been assumed to commence in January 1987, under both the assumed continued operation of LILC0 and under the alternative operation of LIPA. Although the proposed enabling legisIation for LIPA currently before the State Legislature provides for sale of this ownership interest to NYPA, we have assummed for the Reference Case, and for comparative purposes only, its operation under both the LIPA - 7 - May 29, 1986 e and LILCO alternatives. The' case itself of the ~Nine'Mile.p0int unit 2 by way of a separate sensitivity case. e wherein LIPA would divest ownership will be analyzed New Owned Resourcem: With respect to assumed new resources to be either Owned and opera~ed by LIPA or LILCO on Long Island, we have assumed that: 1. two 50 MW.. simple cycle combustion turbines operating on no. 2 oil would be placed in service in January 1990 for use throughout the study period; and five 400 MW coal-fired units would be placed in service beginning in January 1996 and for every other year for a total of five such units thereafter through.2004 during the study period. Purchased Resources: Based on our review of other recent reports and public statements, by LILC0, the State Energy office, and others, it is clear that without Shoreham LILCO's (or LIPA's) existing generating ~acilities will need to be supplemented by off-system capacity .purchases until such time as the additional generating facilities described personal adequate England. above could be constructed. inquiries of other surplus capacity However, the transmission lines into purchases. Based on published reports and utilities, there appears to be in upstate New York and New capacities of the current Long Island will limit these It appears that LILCO currently owns usable firm May 29, 1986 import capability of some 320 MW, consisting principally of the existing Y,-50 and Norwa!k-Northport transmission lines.' Considerab~ly -g~eater capacit~ might be available in an emergency and would be available if the emergency involved the loss of one or more Northport units, but only the 320 MW could be considered "fiz/n". A portion, 93 MW, of this capacity is required for wheeling power to NYPA's customers on Long Island, leaving approximately 227 MW for LILCO's own use. Our assumptions with respect to the future availability and use of transmission capability to Long Island are as follows: 1. LILC0 or LIPA would purchase !10 MW of transmission capacity from Consolidated Edison in 1987. This purchase would decline by 50 MW in 1988 and would continue at 69 MW until early 1991. 2. The capacity of the existing Y-50 transmission line would be upgraded by 50 MW in 1987 and again in 1988. This additional capacity is' assumed to be made available to LILC0/LIPA thereby offsetting the declines in the Consolidated Edison purchases described above. A second 345 kV transmission line into Long Island would be placed into service in early 1991, as reportedly planned by NYPA. It is assumed that the capacity of this line would be approximately 560 MW. Additional upgrades to LILCO's internal transmission May 29, 1986 system would be made as required for the assumed new generating facilities, described previously. With the assumed ..... availability of this transmission capability and;~ based upon the aforementioned reports and inquiries, we hav. e assumed the following resources would be purchased from others for the periods specified: 1. Between 1987 and 1993, LILCO's allocation of capacity from NyPA's FitzpatriCk plant would be 52 MW in 1987, declining to 36MW in 1993; 2. 200 MW would be purchased from members of the NYPP in 1991 through 1995; 3. 60 MW of NEPOOL Capacity would be purchased for use in the period 1987 through 1989; 4. On Long Island, . cogeneration would be available beginning in 1988 in the amount of 20 MW and increasing by 20 MW per year up to a total of 200 MW in 1997 and thereafter; Se In addition to t~e cogeneration assumed available, an additional 32 1988 for the Gardens; and MW would also be available beginning in resource recovery facility at Mitchell For the period from 1987 through 1991, capacity would also be purchased from municipal systems on Long Island beginning with 30 MW in 1987 and declining to 18 MW in 1991 - 10 - May 29, 1986 System Retirement,~: Based upon information obtained from reports publis,hed by LILCO, the following units are assumed to be ret~re'd from Service on Long Island as follows: Capacity Year Unit (MW) ~ East Hampton Diesels #2 - #4 Port Jefferson #1 Port Jefferson #2 Montauk Diesels #2 - #4 Glenwood #4 Far Rockaway #4 South Hampton CT Glenwood #5 Southold CT E. F. Barrett #1 Port Jeffrey CT West Babylon CT Glenwood CT Northport CT Port Jefferson #3 LIPA ASSUMPTIONS 6 1988 48 1994 48 1996 6 1997 112 1998 112 1999 11 1999 112 2000 14 2000 190 2002 16 2002 17 2002 16 2003 16 2003 190 2004 Acouisition Costs and Future CaPital ExDenditures: The costs to be paid from proceeds of bonds issued by LIPA for the acquisition of LILCO, including the retirement of all outstanding LILCO debt will be approximately $6.0 billion as provided by Smith Barney for purposes of the Reference Case. Additional amounts assumed 'to be funded from future bond proceeds for major capital expenditures have been based upon additional estimates and other information developed by R.W. Beck and Associates. e LIPA Financinq Cost~: Smith Barney has advised us to assume that: (a) to conservatively state our results the average interest rate on the initial acquisition bonds will be 9.0%; (b) to-conservatively state our results the average interest - 11 - May zg, 1986 e rate on future series of bonds issued to finance future major projects will be 9~0%; (c) the average interest rate assumed f~ collateral secured BMTF Bonds in the short term mode is 6% (This rate affects LIPA economics only to the extent it is not covered by escrow interest earnings on the collateral investments); (d) the average investment ear~ings rates on balances in funds and accounts maintained pursuant to the resolution, adopted in connection with the issuance of BMTF bonds in the short term mode is 6% and 8% for longer- term investments made with proceeds of future bond issues; (e) an allowance of 2.25% of the aggregate principal amount of the .initial series of BMTF bonds on all subsequent Series of Bonds will be sufficient to provid~ for Bond discount and expense on such Bonds; 'and (f) LIPA's future cost of long- term debt is assumed to be 90% of' LILCO's future cost of long term debt. Although 90% was assumed for conservatism, an S0% ratio is a more appropriate assumption for several reasons; a) this figure reflects a potential .spread between equivalent'credit taxable and tax-exempt, securities in 'light of the proposed Federal tax legislation, b) LIPA debt would benefit by as much as 40 to 50 basis points because of the triple tax-exemption of New York tax-exempt paper and c) LIPA will receive legislative backing and thus will likely have a higher credit rating than LILCO's debt. ~nvestment Earnings and ADDlicatton of Fun~: has advised us to assume that investment Smith Barney earnings on - 12 - May 29, 1986 e e e e unexpended moneys in all funds will negative arbitrage · Rate Sta~lization: It has' been assumed that for the purpose of this studY that a) rate stabilization bonds will be issued, b). a rate stabilization account will be maintained, or c) a combination of (a) and (b) will be used to develop a consistent annual relationship between the be invested at 0 to .5% projected cost of service under LILCO and LIPA ownership and operation. Reserve Funds: The Reserve Account Requirement, equal ~o maximum annual interest on each series of Bonds issued by LIPA, hms been assumed to 'be funded from each such series of bonds. The Reserve and 'Contingency Fund Requirement, equal to 10% of the Reserve ACcount Requirement, has been funded from proceeds of the initial series of Bonds. Estimated Initial Financing: Based on the foregoing total estimated principal amount of Bonds acquisition of LILCO is assumptions, the for the initial billion. Pavments in Lieu expenses include approximately $7~3 of Ta~e~: LIPA's estimated operating payments based upon estimated property taxes comparable to those paid by LILCO. However, no State Gross Receipts tax on revenues have been included in the LIPA projections. May 29, 1986 LILCO ASSUMPTIONS · e Shoreham Recovery Cost~: It will be assumed that LILCO receives ~'ful'l.~ ~ recovery of prudent Shoreham cost (approximately $3.2 billion). This would include the amortization of those costs,, as well as a full' return on unamortized costs. Nine Mile Point 2 - Unit IT: For purposes of the Reference Case only, in order.to make a valid comparison it has been assumed that LIPA will assume the costs of and take power equal to LILCO's share of Nine Mile Point 2. Since the legislation provides for the purchase of LILCO's Nine Mile Point 2 interest by NYPA, a. special,sensitivity case will also be analyzed wh~re the power is purchased by NYPA and O LIPA replaces that amoUnt of. capacity purchases or generation~ e and energy by Future Cost of Money and Capitalization%: For purposes of this analysis, it has been assumed that all existing LILCO debt remains outstanding to maturity. The interest on new long-term debt and the cost of new preferred stock will be 10% plus issuance costs; and that the return on common equity during the first 10 year period, during which the Rate Moderation Plan will be effective will be 13.5%, and will be 12.7% thereafter. Tax Law: For purposes of this .reference case it has been assumed that existing Federal and state tax laws apply throughout the study per~od. - 14 - 30.00 26.00 26.00 22.00 20.00 15.00 16.00 14.00 12.00 10.00 8.00 6.00 - 4.00 - 2.00 - 0.00 1967 LILCO Compared To LIPA Req-ired Rlectrlc Revenues ' I ' I ' I ' I ' I ' I ! ' I 1969 1991 1093 . 1995 1997 1999 2001 2003 2005 LILC0 Actual + v.lI~0 Stabilized LIPA Actual A LIPA Stabilized 'O. May 16, 1986 Mr. John Sawhill ' McKinsey and CompaRy, Inc. 17 Pennsylvania Avenue, N.W. Washington, D.C. 20006 Dear Mr. Sawhill: I have attached a preliminary summary of the analytical approach and certain conclusions of the consultant study commissioned by Suffolk County. The St,ldy group consists ~frSmith Barney, Harris Upham & Co. Incorporated; R. W. Beck & Associates; ESR¢; Touche Ross & Co.; Willkie Fart & Gallagher; Duncan Weinberg & Miller; and Wood Dawson Smith & Hellman as counsel to Smith Barn'ey; This study was undertaken at th~ request of the Suffolk County Legislature. Due ko the shortness of time, we unfortunately have been unable to meet with the Legislature regarding this study. We intend to share our results with the Legislature in the near future. This study, accordingly, represents solely the views of the consultant team and has not been endorsed, modified or otherwise reviewed by-the County Legislature. This summary addresses most of the questions asked by various groups regarding the acquisition of the Long Island Lighting Company by a public power authority. It does not include financial projections and analyses. These viii follow by May 27. We hope this material is useful in the proceedings of the Sawhill ¢o~isslon. If you or your staff have any questions, please do not hesitate to call. l~closure cc: Gregory Blass LII.;CiO Aequisition Study for the Suffolk CountT Legislature Introduction Smith Barney is managing a study for the Suffolk County Legislature evaluating the feasibility of the acquisition of Long Island Lighting'Company ("LILCO") by a newly created authority, Long Island Power Authority ("LIPA"). The study assumes LIPA is created in the context of legislation currently pending in the Slate Legislature. Suffolk County's objective is to obtain credible, comprehensive analyses on the options available for power supply on Long Island. Under an agreement with the Suffolk County Legislature, Smith Barney is working in conjunction with the following consultants: (1) R. Il/. Beck and Associates, (2) ESRG, (3) Touche Ross & Co., (4) Willkie Fart & Gallagher, and (5) Duncan Weinberg & Miller, P.C. In addition, the law firm of Wood Dawson Smith & Hellman is a~ting as counsel to Smith' Barney. Each consultant has been assigned work products by Smith Barney after 'appropriate discussion with the other consultants. In addition, Smith Barney is responsible for the time schedule, which includes the presentation of results to appropriate State and local authorities in a timely fashion. The study results will include forecasts of the estimated power costs to Long Island power users if (1) LILCO continues in business without operating the Shoreham facility and (2) LIPA acquires LILCO and does not operate Shoreham. From our review of prior reports of consultants engaged by others involved in this matter, this "apples to apples" comparison has not been done before. (For example the NERA report of March 31, 1986 compared projections of LILCO operations with Shoreham operating to a public power entity's operations without Shoreham operating). In generating the LIPA forecast, the stUdy group will take into account the manner in which the acquisition is accomplished, the availability and cost of financing necessary to implement the acquisition, the ability of the newly created public power authority to meet the power requirements of Long Island over the coming decades, and the variability of results if certain forecast estimates should turn out to differ from assumptions used in the reference forecast. -1- Approach to Wo/;*k' The study team's financial analyses efforts, headed R. W. Beck, involve the development and comparison of projections of the future costs of power under LILCO and LIPA operations. The projections will cover 1986 through 2005 (20 years), although 1988 will be covered only to allow a smooth transition from 1985, the last year for which complete historical data are available. In terms of analytical tools, LILCO's costs will be projected using R. W. Back's POWERCOST* system. Many of the results thus .obtained will also apply to LIPA, whose costs will be projected using other applicable.portions of R. W. Back's POWERCOST system, coupled with variOus portions of R. W. Beck's Municipal Finance System* and other applicable proprietary models which have been used extensively in connection with other R.W. Beck assignments. Alternat}ve Structures Examined The study group has studied a number of possible alternatives in connection with the establishment of LIPA, including acquisition of assets of all or a portion of LILCO, condemnation of selected assets of LILCO, condemnation of the common stock of LILCO, and acquisition of' LILCO via a voluntary purchase of common and preferred stock from current shareholders. The consultants agree that timing is a critical faetor in the formation of.,.LIPA and in the subsequent acquisition of LILCO. The consultants' examination of the alternative methods of acquisition indicates that the preferred method is an acquisition of LILCO Stock through a tender offer. Such a voluntary negotiated purchase would avoid the judicial delay and valuation uncertainty incident to a condemnation proceeding. As a consequence, th~ voluntary sale of preferred and common shares according to current market value is the primary alternative which the study group is evaluating. Our legal consultants have previously furnished to the commission legal memorandum responding to the valuation theories advanced by LILCO. We believe that the current market value of LILCO stock is the most appropriate valuation method and that any other valuation concept is an academic exercise in light of the tender offer approach. Formation of LIPA The legislation introduced to create LIPA (S. ?784{ A. 9517{ hereinafter referred to as the "Bill") provides that LIPA would be created as a corporate municipal instrumentality of the State, constituting a body corporate and politic and a political subdivision of the State (Section 1020-e). LIPA would be .governed by a board, initially consisting of seven trustees, three appointed by the Governor and two each by the Temporary President of the Senate and the Speaker of the Assembly. The Legislature is mandated, prior to Ma)' l, 1987, to establish fifteen districts in the Counties of Suffolk and Nassau and that portion of the County of Queens constituting LILCO's franchise area. Fifteen Copyrighted R. W. Beck and Associates proprietary computer models. -2- trustees, one resilient m each district, would be elected on the first Tuesday in December, 1987, to take office on Janaury l, 1988. Such trustees would be elected for staggered terms of.three years each (Section 1020-d). The Bill provides that the Public Service Commission would not have jurisdiction to approve or disapprove LIPA's abquisition of. LILCO (Section 1020-s). Upon the acquisition of LILCO's stock, all LILCO employees would be hired by LIPA subject to ali existing contracts with ]abdr unions and subject to all existing pension or other retirement plans (Section 1.020-e). LIPA would have the power to-issue tax-exempt revenue bonds, acquire assets or purchase stock and other securities of LILCO, dispose of LILCO assets, charge fees as appropriate to provide security for financing issued to acquire LILCO, operate LILCO under its existing labor arrangements and make payments in lieu of taxes. The Bill provides that the Shoreham plant be closed and decommissioned. In addition, the Bill amends the Power Authority Act by requiring the Power Authority of the State of New York tO acquire all the'right, title and interest of LILCO and LIPA in the Nine Mile Point II nuclear power facility for such price and upon such terms and conditions as the Public Service Commission shall determine (Section 2 'of the Bill, amending Sectibn 1005 Of the Public Authorities Law.) Acquisition of LILCO It is anticipated that LIPA would make an offer to purchase all of the common and preferred stock of LILCO, whether the offer is supported by LILCO management or not. If LIPA were able to acquire all of the stock of LILCO pursuant to a voluntary tender offer, LILCO would become a wholly-owned subsidiary of LIPA. LIPA would, by virtue of its stock ownership in LILCO, have the right to elect all of LILCO's directors. As a result, LIPA would have total control of LILCO which would,, in substance, become a "public" entity. In addition, LILCO may be liquidated or merged into LIPA if the magnitude of LILCO's previous tax benefits which would be "recaptured" as a result of the liquidation or merger did not result in serious adverse tax consequences. The tender offer would be conditioned upon receipt of a certain minimum required number of shares, generally envisioned as the amount ~necessary to take control of LILCO and freeze out minority shareholders. In New York this amount is at least 66 2/3% of the outstanding amount of the stock. If LIPA were able to. acquire at least 66 2/3% of LILCO's stock pursuant to a voluntary tender offer, the LILCO stock acquired by LIPA would be contributed to a new wholly-owned subsidiary of LIPA. LILCO would then be merged with the subsidiary pursuant to the Provisions of the Business Corporation Law. LIPA would then have total control of the merged company by virtue of its 100% stock ownership~ To m{nim{ze the tax cost of a merger of LILCO with a subsidiary of LIPA, it may be desirable to'merge the subsidiary into LILCO rather than merging LILCO into the subsidiary. -3- Purchase of the ~ei~uity in LILCO of course means that all assets and liabilities of LILCO would be acquired by LIPA. There would be no need for individual condem- nation or acquisition of assets, or comdemnation of common stock or debt securities. Acquisition Tax Considerations Any bonds issued by LIPA to acquire the stock of LILCO pursuant to a tender offer would not be IDB's for Federal income tax purposes and would thus not require an allocation of New York State's IDB volume cap. Moreover, if LILCO were merged into LIPA or a wholly-owned subsidiary of LIPA, any additional bonds issued by LIPA to finance future capital improvements would also not be IDB's and thus not require an allocation of the State's IDB volume cap. However, if LILCO were not merged into LIPA or a LIPA subsidiary, any bonds issued by LIPA to finance future capital improvements for LILCO would be IDB's and thus require an allocation of a portion of the State's volume.cap. Any bonds issued by LIPA to finance the acquisition of LILCO stock would be tax- exempt and. would not require an allocation Of the,State's volume cap. Any additional LIPA bonds issued to finance future capital improvements would also be tax-exempt under current law whether or not LILCO were merged into LIPA or a subsidiary of LIPA. However, any s~Ch-bonds would require a cap allocation in the event that LILCO were not merged into LIPA or a LIPA subsidiary. Neither H.R. 3838, as passed by the United States House of Representatives on December 17, 1985, nor the proposals approved by the Senate Finance Committee on May ?, 1986 would impair the ability of LIPA to issue tax-exempt bonds to finance the acquisition of LILCO stock. However, H.R. 3838 would prohibit the Issuance of tax-exempt IDB's to finance future capital improvements if LILCO were not merged into LIPA or a LIPA subsidiary. Moreover, even though the Senate Finance Committee proposal would allow the issuance of tax-exempt IDEI's to finance capital improvements in the event that LILCQwere not merged into LIPA or a LIPA subsidiary, such bonds would be counted against the State's IDB volume cap. H.R. 3838, but not the Senate Finance Committee proposal, would tax all gains (gains,. for this purpose, being generally defined as an amount equal to the difference between the purchase price of the liquidated company and the liquidated company's tax basis for its assets) realized on most corporate liquidations (including a liquidation by merger). By contrast, present law subjects such a liquidation only to certain recapture taxes. Adoption of the H.R. 3838 liquidation gains tax provisions could make it preferable to merge a LIPA subsidiary into LILCO rather than having LILCO merge into a subsidiary of LIPA. If LILCO were merged into LIPA or a LIPA subsidiary, certain previous tax benefits realized by LILCO would be "recaptured". However, LILCO may have sufficient net operating loss carryforwards to wholly or partially offset any such recapture with the result that there would be little or no additional Federal income tax liability realized by LILCO as a result of the merger. --4-¸ O If Shoreham does[not operate, .I~II~CO would realize a deductible Federal income tax loss only if 6horehsm were sold at a price less than LILCO's tax basis in Shoreham or, in the alternative, if Shoreham were viewed as being "abandoned" for tax purposes. Due to the difficulty of establishing a true "abandonment" .'or tax purposes (as well as the legal and practical restraints on any such attempted abandonment by LILCO), it would appear that a sale of Shoreham by LILCO would probably be required in order to establish a tax lossL If LILCO were able to establish a tax loss in this manner, it could be' used to offset any "recapture" gain LILCO'would realize as a result of a liquidation or a merger into LIPA or a subsidiary of LIPA. Use of any such loss deduction would, therefore, ultimately inure to the benefit of LIPA,. If LILCO were merged into LIPA or a wholly-owned subsidiary of LIPA, LIPA (or the subsidiary) would have no Federal income tax liability (except for any recapture that was not offset.by LILCO net operating loss carryt'orwards) and would not be required to file Federal income tax returns. However, if LILCO remained in corporate existence, it would still have to file Federal corporate income tax returns despite the fact that it was wholly owned by LIPA or a LIPA subsidiary. In such case, however, LILCO would probably not be liable for any substantial Federal income taxes by virtue of SeCtion 115 of the Internal Revenue Code which provides that income realized by utilities Which are wholly owned by a political subdivision (such as LIPA. or a LIPA subsidiary) are not subject to taxation if it is paid over to the political subdivision. No I.R.S. tax ruling will be necessary in order for this financing to proceed. Aequlsition Financing It is anticipated that LIPA would issue approximately $7 billion of tax-exempt financing to fund the acquisition of LILCO. This financing ~would likely be issued initially on a short-term basis, secured by U.S. Treasury bond investments or other "AAA" rated securities with provision to change mode to a fixed rate or other rate-setting meehanlsm at specified times. The cost of issuing this financing would be low for the first phase and, under current law, th'e investment proceeds could be invested without restriction. A portion of the bond proceeds would be used to finance the purchase of the eommon~ stock end preferred stock tendered pursuant to a tender or merger offer. As the offer takes place and merger activities proceed, presentations to rating agencies and negotiations with various interested parties would also go forward. Upon closing of the acquisition of the common and preferred stock, and potentially redemption of certain debt securities of LILCO, portions of the short- term acquisition financing would change mode to a fixed rate structure secured by LIPA revenues, and would be priced according to current market conditions. This ehanglng of mode would trigger a mandatory tender of the bonds by short-term bondholders and a remarketing of bonds similar to a new issue of bonds. The existence of the initial borrowing would likely give some confidence to the market that the requisite amount of financing could be obtained for the acquisition -5- .N\ll'I'I I \KNI-' '0 financing. This..S~tYue{ur'e will also allow investment earnings in excess of the short-term bond rate if issued prior to September 1988. Positive arbitrage earnings would mitigate the impact of acquisition costs and insulate LIPA from delay tactics of LILCO or others. Following change of the security from the initial eollateralized form of credit support to th~ long-term LIPA revenue-based Credit support, portions of the bonds would be remarketed at fixed rates as appropriate. The bi-modal, multi-term format bond ("B.~IT¥") approach allows the flexibility to secure all financing requirements for LIPA, giving credence to tender offers, and, in addition, allow low rates of interest and positive investment earnings should any phase of the acquisition be delayed.' The BMTF structure, by initially limiting the amount of bonds directly supported by LIPA revenues, may take some marketing pressure off the initial financing. Nevertheless, the bulk of the financing would be required to be.remarketed as bonds supported by LIPA revenues 'in a relatively short period following eonsumation of the contract acquisition of. LILCO to purchase the common and preferred shares, and repay the accelerated G&R bonds, Other portions of the takeover acquisition financing would be used to fund out the first mortgage bonds, bank debt, and fund a stabilization fund designed to phase in rates during the early years of LIPA. Transition Phase of Transaction Immediately following the closing and purchase of stock by LIPA, proceedings would take place to freeze out minority shareholders and value their shares. Tax considerations described above may require that LILCO remain as a corporate entity for a period of time. Those G&R bonds containing acceleration provisions pertaining to public 'ownership of LILCO by a public authority would be redeemed at par as provided in the G&R bond resolutions. Purchase of the remaining LILCO securities, the first mortgage bonds, and various short-term bank facilities would take place as appropriate following negotiations with various bank participants, and as required under the first mortgage bond indentures. The amount of Iow rate first mortgage bond debt outstanding below the interest rate of 8% assumed for a LIPA financing amounts to approximately S370 million with an average life of approximately 6 to ? years. While the benefits of leaving this financing outsianding to achieve rate savings below that of tax-exempt debt are substantial, they are not of overwhelming significance in the context of a financing to take over all of LILCO. Therefore, the provisions required to leave this debt outstanding must be weighed against the adverse impact of a small amount of senior debt upon LIPA debt, making the LIPA debt, in effect, subordinated. Financing techniques such as constructive defeasance .could mitigate the problem, but this is a secondary issue to be addressed in the detailed financial plan. -6- 8eetttity for the l~ontls The fundamental security for the bonds would be the obligation of LIPA, under the Bill, to charge rates sufficient to cover all of its obligations including debt service with a pre-determined coverage ratio. LIPA would also be required to charge rates sufficient to cover debt service vnder the bond indentures. The power and gas rates of LIPA would not be subject to review by any regulatory athhority, bowater, ~.~ previo,Jsly noted, the board of LIPA would be comprised of officials sub}ecL to election following terms of initial interim appointments. Bondholders would also have a security interest in the facilities of LIPA. It is expected that, once the financial issues regarding Shoreham are resolved, the bond ratings of LIPA should reflect the overall economic conditions in Long Island, and should ultimately allow a rating in the WA" category. The challenge for the financing team with the rating agencies is to give effect to the long-term security of LIPA upon its formation to avoid a rating in the "BBB" category initially. The strategy would be to make certain that the formation of a pUblic power authority would dispose of the Shoreham issue and establish rate setting mechanisms that are accevtable to the Long Island rate payers and wquld constitute a permanent solution to the Shoreham problem. Legal Issues Federal tax con.sequences have been discussed above.' It is anticipated that the Bill governing the purchase of LILCO by LIPA would allow LIPA to avoid payment of gross receipts or other taxes of LILCO, other than payments in lieu of local taxes. Since the securities issued by LIPA would be backed by LIPA's independent-credit ability, namely its powers to charge rates and fees for service to its customers, it is anticipated that the securities would not be subject to the federal reserve restrictions regarding the use of "junk bonds" for takeovers secured solely by the assets of the organization to be taken over. No restrictions of the Federal Reserve Board would impose any limitation on the amount of debt which the LIPA could issue in connection with the acquisition of the stock or assets of LILCO. Specifically, Federal Reserve Regulation G, which imposes restrictions on the use of "junk bonds" in corporate takeovers, is inapplicable both to public entities and to debt sold in a bona fide public offering (Section 12 CFR 207.112). Cases and Scenarios Projections'and forecasts of soeio-eeonomic systems are always surrounded by considerable uncertainty. Actual future conditions that vary from original assumptions can have a significant effect on the results of a study. It is important, therefore, that decision makers be provided with a range of possible results that could issue froma variety of possible future conditions. However, it is obviously impossible to anticipate all future turns of events or combinations thereof. With the foregoing,eonsideratiofis and cautions in hand, the study team is of the opinion that the'following key issues and elam&nfs could have a significant enough effect on the results of this study to warrant special attention: 0 0 0 0 0 Load Growth, Interest Rates Fuel Prices Costs of Acquisition of LILCO, and Recovery of Shoreham-Costs. In general, two or three scenarios for each of the foregoing elements are being considered. However, it Will not be possible or necessary to consider all possible combinations of all of the scenarios to be considered. Rather, a manageable series of "sensitivity eases" will be developed for comparison to a "Reference Case". Each sensitivity ease will be based on an assumed change in one of the key elements as compared to the corresponding assumption for that element in the Reference Case. More specifically, the following individual analyses (eases) are being considered. -8- Case No. 3 4 5 6 Description Reference Case Load Growth Sensitivity Cases a. Higher Load Growth b. Lower Load Growth Interest Rate Sensitivity Case (Higher Overall Interest Rates for LILCO and LIPA) Fuel Price Sensitivity Case (Higher) Cost of Acquisition Sensitivity Case (Higher) Shoreham Costs Sensitivity Case (Lower Cost Recovery) Each of these cases is detailed further below. Case 1: Reference Case The Reference Case will, generally, represent a mid-point or median against whioh other eases may be compared. It will include mid-point or baseline 'assumptions w}th respect to all of the key eleme'nts described above. In some eases, current conditions are assumed to continue into th..e future (for example, the current tax laws continuing into the future). In other eases, the Reference Case will include assumptions that correspond to mid-point forecasts of certain factors estimated by reputable expert sources. The Reference Case is intended to represent an adequate basis for analysis of the various assumptions which may impact the feasibility of a public authority acquisition of LILCO. Thus, on the basis of the Reference Case and the sensitivity analyses (Cases 2 through 6) sufficient information should be available to assist Suffolk County and other public entities in making public policy decisions. The Reference ~'aSe eoni~iinS'the following assumptions-' Load Forecast: Future load growth will be based upon the forecast published by the New York State Energy Office ("SEC") in October 1985. Interest Rates: Assumptions will be developed in the Reference Case for the following costs of borrowed and invested capital in the near term and for the long term. LILCO: Long-Term Debt Preferred Stock Common Equity LIPA: Short-Term and Long-Term Debt Assumed investment earning rates will be based initially on current market rates. Fuel Prices: Costs of Acquisition: Future fuel prices will be assumed to start at. current market levels and escalate at rates underlying the aforementioned SEC load forecast.. These rates vary from year- to-year but are, generally, some 2% per year for natural gas and 1% per year for oil over the period 191{4 through 2001. Both of these growth rates .are in real terms. The cost of LIPA's a~quiring LILCO will be based on the current market prices of that stock. Shoreham Cost Recovery: It Will be assumed that LILCO receives full recovery of prudent Shoreham cost (approximately $3.2 billion). This 'would include the amortizat{on of those costs, as well as a full return on unamortized costs. Nine .Mile Point II: For purposes of the Reference Case only, in order to make a valid comparison, it will be assumed that LIPA will assume the costs of and take power equal to LILCO's share of Nine Mile Poin-t II. Since the Bill provides the purchase of LILCO's Nine Mile Point 1I interest by NYPA, a special sensitivity case will also be analyzed where the power is purchased by. NYPA and LIPA replaces that amount of capae{ty and energy by purehases or generation. -10- Cases 2a ~nd 2b-' ~eti~Gr~Wth Sensitivity Cases These cases will be used to estimate the variability in the study's results with respect to varying Icad growth assumptions. Case 2a will be based on a forecast which is 1096 higher in 2001 than the Reference Case forecast; Case 2b will be 1096 lower iN 2001. Serious consideration has been given to. using LILCO's own load forecast, but that does not appear warranted at this point. From what we have seen , ii appears that LILCO's most recent offieinl load forecasts, presented by LILCO in rebuttal m. es'.imony in the reopened RMP ease before the NYPSC in October 1985, appears higheu than the SEC October 1985 forecast, but not 1096 higher. Thus, our ease 2~ will adequately encompass LILCO's forecast. Case 3: Interest Rate Sensitivity Case This sensitivity case will consider the variablility in interest rates and, for LILCO, the eosts of equity capital. Case 3 will be based on 25% higher Overall costs of money for both LILCO and LIPA, while maintaining the same relationship between those eosts as included in the Reference Case. Since current interest rates are at the lowest level of the last several years, no separate ease involving even lower rates will be analyzed. Case 4: Fuel P~ice Sensitivity The ease will address the variability in future fuel prices and will include higher rates of escalation than the Reference Case. More specifically, this ease will be based on 2% higher annual escalation rates for fossil fuel prices compared to the Referenee Case. Case 5: Cost of Acquisition Sensitivity Case This case will be based on assumed acquisition costs of common stock being 25% higher than the.eorresponding costs used .in the Reference Case. A complete case in which these costs would be lower, independent of other assumptions, will not be analyzed. However, Case 6 will reflect, potentially lower acquisition costs re- covery. · C-~e 6: Shoreham Cost Sensitivity Case The full cost recovery treatment described above for the Reference Case is, in general, the same treatment afforded Con Ed by the New York Court of Appeals, March 25, 1986, Cornwall decision. That decision pertained to a particular aban- doned facility, Con Ed's Cornwall Pump Storage Facility. However, Cornwall and other New York decisions make it clear that no precise formula for cost recovery of abandoned property is mandated by New York law. Rather, the particular facts of each case must be considered. This sensitivity case will, thus, consider less than full recovery of such costs, in particular, this analysis will be based on .the -11- recovery ease studied previously by I/:SRG on behalf of the Consumer Protection Board. It provides for the amortization of the full $3.2 billion, but a return on an investment of some $2.0 billion only. It is believed that this would likely result in a lower market value of LILCO's stock and, therefore, a correspondingly lower acquisition cost wil also be reflected in this ease. 1 OTHER ISgUES AND ASSUMPTIONS The project team is of the Opinion that the following assumptions should be made with respect to the remaining key issues of the study: LIPA Taxes It is assumed that LIPA will make payments in lieu of taxes equal to the property taxes that would be paid by LILCO, including the special provisions in the pro- posed legislation for property taxes on Shoreham. It is also assumed that LIPA would not be. subject to gross receipts taxes. LIPA Financlal Structure~ '. The following assumptions as to to the proposed auth0rity's financial structure will be used: that it will have a d~bt service reserve requirement equal to its max- i~um annual interest expenses: that it will -have a 1.10 coverage of debt service from which normal .renewal and replacements and capital additions will be paid to the extent required; and that renewals and replacements and future capital additions in excess of l.]0 will be funded from future bond issues. With respect to the acquisition itself, it will be assumed that an initial bohd issue will fund the acquisition of LILCO's common and preferred stock and outstanding debt issues. Subsequent takedowns of bond proceL'ds to retire LILCO~s debt will be assumed tO-be made over a short period. The precise timing of such subsequent issues will be considered during the course of the work. -12- Future Power Supply Alternatives . Without Shorehanl',. LILCO (ahd LIPA) may require some additional sources of generation at some point in the future. The amounts and nature of such resources will be investigated as part of the study, but these investigations cannot and will not take the form of a e_omprehensive long-range power supply study. Rather, these investigations will be based on the following criteria and assumptions: 1. The need for new resources will be based on the NYPP requirement of 18% after tax target reserve-~ with consideration given to reliability levels measured by a static capacity LOLP (~loss-of-load" probability) analysis. 2. Readily available and reasonably .economical sources of purchased power from other utilities will be considered to the extent'consistent with LILCO's transmission capacity (including transmission capacity that might be constructed in the near future). e Other capacity require.meats will be assumed to be met' by new fossil- fueled generating facility constructed on Long Island. In the short- term, combustion turbines will. be used; coal-fired steam facilities are assumed for the longer term. Load management conservation, eogeneratton, and alternative-fuel resources will be considered only to the extent that such resources have been included in SEO's "Starting Point Scenario" for its December 1985 report entitled "Meeting the Challenge: An Analysis of Electricity Supply Options for New York State." No "life-extension" programs for existing generating facilities will be considered, except to the extent that such programs have already been evaluated and planned by LILCO. In general, it will be assumed that LIPA will not gain access to existing deliveries to preference customers. While LIPA would likely have access to new allocations of hydro power in the State, it is not assumed in the foreeasts, but will be dis- cussed in the study. By adopting the foregoing assumptions and limiting the focus of the study, the study team neither endorses nor rejects the future potential of power supply options that might otherwise be considered. It is quite likely, for example, that a public power authority on Long Island would have the motivation to pursue co- generation, renewable fuels, conservation, and other demand side options more vigorously than LILCO. The analysis of such other options is simply outside the scope of the present study. -13- Operating Characteristics ..... The operating characteristics of LILCO's existing generating facilities (i.e., capacities, heat rates, maintenance requirements, outage rates, etc.) have been obtained from such sources as are currently available. These include certain of LILCO's own production Costing computer runs, some New York Power Pool data, and other published information. To the extent such available information appears unrealistic or unreliable, or the otherwise needs to be supplemented, the necessary data are being estimated based on the typleal characteristics of similar facilities. Load Characterlsties LILCO's load characteristics (i.e., weekly, daily, hourly load patterns) will be taken from available historical data. These currently include two recent years' worth of hourly system load data obtained for SEC). These historical load patterns will be adjusted so as to be consistent with the annual load forecasts discussed previously. One may note that none of those load forecasts contemplate' drastic changes in 1:ILCO's annual load factor, and we would not, therefore, expect any major changes in load patterns. C Operation and Maintenance Expenses, LILCO's operation and maintenance expenses for its existing facilities, ather than fuel expenses, will be based on the historical levels of those expenses, as reported by LILCO to the NYPSC and FERC. Future levels of these costs will reflect a 5% annual inflation rate. Estimates of operating expenses for new facilities will be based on R.W. Beck and Associates' experience with similar facilities. No poten- tial differences in efficiencies as between LILCO and LIPA will be assumed. Future Construction Costs 'the capital costs (excluding AFUDC) of future facilities (and renewals and re- placements) will be based on LILCO's own estimates thereof, to the extent such' estimates are available. Otherwise, such estim.ates will be developed by R.W. Beel: and Associates based on th& firm's experience with similar facilities. Here again, no direct capital cost difference between LILCO and LIPA will be assumed.- Shoreham Decommss{oning/Abandor, ment Costs For purposes of the initial study authorized by Suffolk County it will be assumed that Shoreham never goes into commercial operation and that decommissioning/abandonment formally begins January l, 1987. R. W. Beck and Associates will utilize estimates of the costs of the decommissioning based on available information on what such costs are projected to be. -14- Ratemaking ~. , It will not be possible to develop projections of the future cost components of specific rate schedules. Rather, the projections developed will be of LILCO's and LIPA's projected future annual revenue requirements, in total and on an overall cents per kilowatt hour basis. While avoiding projected cost allocations between customer class and potential rate design questions, the projected LILCO revenue requirements to be developed will be based on &pplieabl~ New York Public Service Commission ratemaking practices, and otherwise generally accepted ratemaking principles. Estimates of LIPA's revenue requirements will be developed in a manner consistent with its proposed financial structure and the proposed legislation. Following coordination meetings with the other consultants, R.W. Beck and Associates is now conducting a study of the Reference Case. The results will be reviewed with the other eonsultants and Smith Barney. It is expected that the preliminary results to the Reference Case 'w~ll be available bY May 27, 1986. -15- COMMENTS ON THE NERA STUDY This section reviews the March 1986 study performed by National Economic Research Associates, Inc. ("NERA") on behalf of LILCO. The objective of the NERA study is to estimate the likely electric rates on Long Island to the year 2000 unOer two scenarios. In the first scenario, NERA assumes LILCO continues to provide service with the Shoreham nuclear facility in operation and, in the second scenario, a Long Islsnd Power Authority ("LIPA") replaces LILCO without Shoreham in operation. NERA concludes that its LIPA takeover scenario would likely result in sub- stantially higher electric rates than its LILCO continuation scenario. According to NERA, LIPA rates will exceed LILCO rates by over 50% on average over the 1987-2000 timeframe if it is assumed that LILCO is obtained through condem- nation of its assets. Further, rate increases would still be considerable under LIPA if it is assumed that LII'.CO is acquired through a stock purchase (average increases of 3% to 17% depending on the .assuinptio~ns used for, load forecast, stock purchase price, coverage ratio, ere.). NERA Assumptions Regarding Operati0.~ of Shoreham The NERA analysis assumes that LILCO will operate Shoreham and that LIPA will not. Consistent with the Bill the study comparing LILCO to LIPA being prepared by Suffolk County's consultants assumes that the Shoreham nuclear facility will not go into operation in either case. This assumption is based upon actions taken by the State and Suffolk. County, and Kirkpatrick & Lockhart's assessment of issues surrounding Shoreham's licensing whieh indicates that neither LILCO nor · LIPA is likely to be able to operate Shoreham. The bases for counsel's view that it is appropriate to assume nonoperation of Shoreham are set forth below. Shoreham cannot be operated at commercial power levels unless It~ satisfies the Nuclear Regulatory Commission's ("NRC") regulatory requirements. One such regulatory requirement is set forth in l0 CFR Section 50.47 and requires that there be "reasonable assurance that adequate protective measures can and will be taken in the event of a radiologieal emergency". LILCO has been unable ~o satisfy the foregoing regulatory requirement because it lacks legal authority to implement its offsite emergency plan. The New York State Supreme Court ruled on February 20, 1985, that LILCO would usurp the State's police powers if it were to implement its plan. Cuomo v. LILCO, (February 20, 1985). The NRC's Licensing and Appeal Boards have accepted the Cuomo v. LILCO decision and have ruled, in addition, that Federal law does not operate to remove the bar to LILCO's inability to implement its plan. in view of LILCO's failure to satisfy NRC regulations, the NRC Boards have denied LILCO a commercial operating license. -16- The Cuomo v. L'ILCO and the NRC Board's decisions are under appeal by LILCO. However. absent a reversal, these decisions make clear that the current status of Shoreham is that it will not be operated by any entity. It is reasonable for the study group to assume for analyses purposes that the current legal status will be upheld on appeal, and thus, that Shoreham cannot be operated, and to perform the necessary comparisons on that basis; 'O The Condemnation Scenario Condemnation of LILCO'S assets would be based; according to NERA, on the reproduction cost new'less depreciation (RCNLD) valuation procedure. Quoting LILCO's RCNLD figure of :$16 billion (developed for them by LILCO), NERA deduces that LIPA would need to raise rates to support interest on the debt incurred to pay this amount. Since the condemnation approach is not under consideration in our investigation, a detailed critique of NERA's findings is not necessary. However, several factors should be considered. ' ' NERA's description of their findings is misleading. For example, on Page 9, they compare the interest requirements of LIPA after a takeover to that of LILCO in 1985. NERA concludes, based on this &omparison, that rates would increase by 15% to ?5% for condemnation payments ranging from $6.4 billion (NERA's estimate of book value less the Shoreham imprudence allowance) to Ebasco's $16 billion figure, respectively. This is improper since much of LILCO's paper earnings in 1985 were in the form of the Allowance for Funds Used During Construction which are not flowed through to rates. But such AFUDC would be capitalized with return once Shoreham enters rate base (in NERA's LILCO continuation scenario). Consequdntly, the comparison of LIPA 'rates in which Shoreham is purchased through a condemnation (at $5 billion) to 1985 LILCO rates which do not yet reflect Shoreham costs is misleading. The EBASCO figure itself makes assumptions on thb value of LILCO's prop- erty which may be on the high side since it uses a "percent condition" es- timate of depreciation of electric plant rather than, e.g., physical age. NERA's basic study design -- comparing LILCO scenarios with Shoreham to LIPA scenarios without Shoreham ~ combined with the use of LILCO as- sumptions on likely Shoreham operations and costs of alternatives, means that much of the resultant superiority of. LILCO rates is simply a reflection of LILCO's Shoreham assumptions at the onset. The Sto~k Pm'eh~,~e Scenario NERA then considers the rate impacts of LIPA taking over LILCO through a purchase of its stocks. Focusing on the rate comparison issues, ~there are again a number of factors in the analysis which consistently bias the results toward building the case that preserving LILCO keeps rates lower. Some of these prob- lems are: -17- LILCO's 1986'rates 'do not reflect the full impact of the Shoreham plant, which according to NERA, LIPA's would -- they assume the buying price at something approaching $30 per share. The rate eomparlson is dependent on the assumptions NERA makes on Shoreham power costs, on the one hand, and replacement energy and power costs for Shoreham, on the other hand. The former are charged to LILCO and the lat:er are charged to LIPA. NERA's assumptions here, drawn from LILCO, reflect extreme optimism on the costs of Shoreham and extreme pessimism on the costs of replacement power. Consequently, given such assumptions and the Scenario design -- LILCO with Shoreham, LIPA without Shoreham -- the finding that LILCO rates would be lower is predefined. There are thus two simultaneous effects confounded in their findings: (1) the economics of Shoreham and (2) the economics of LIPA. It is very difficult to disentangle these impacts. Remaining unanswered in the NERA study is the very question we are asking: What are the relative rates between the two institutional forms assuming the same power plan. There aJr'e a number of questions regarding NERA's technical assumptions which tend to bias the results toward findings favorable to LILCO. For example,'LIPA's revenue requirements are set unnecessarily high in the early years, bonds rates at 9% are ..[~robably a point too high, stock acquisition prices of $20 to $30 per share are pessimistic (common stock is selling for half that now), oil prices forecasts are too high, ere, NERA Treatment of Shoreham InveStment ~'he NERA report also references advice of counsel "that LILCO may be comp- ensated for a taking of Shoreham even if an operating license is denied -- e.g., if the denial of the operating license results from State or County refusal to par- ticipate in the testing of an evacuation plan." Counsel has advised that the NERA statement fails to take into account legal decisions which support the view that no taking would occur if LILCO were denied an operating license due to LILCO's inability, absent State or County participation, to satisfy the NRC's regulations. First, neither the State nor Suffolk County have any obligation under Federal law · to assist LILCO to obtain a license from the NRC or otherwise to participate in LILCO's emergency plan. Citizens for an Orderly Energy Policy v. County of Suffolk~ 604 F. Supp. ]984 (E.D.N.Y. ]985). Indeed, in the Citizens decisions, Judge Altimari specifically upheld certain Suffolk County resolutions whereby the County, in the exercise of its police powers, decided not to adopt or implement any emergency plan for Shoreham. Second, the New York County of Appeals m New York's highest court -- ruled in Prospect v. Cohalan, 65 N.Y. 2d 867, 49:{ N.Y.S. 2d 293 (1985), that under New York State law, "the partieipat}on of County plans is optional, not mandatory". The study group has been'advise~by Kirkpatriek & Loekhart that since Suffolk County under Federal and NeW'yo'rk State law was not required to prepare a plan for Shoreham, the?-e is no basis for LILCO's assertion that the County could be liable for a "taking" when it declines to do that which it is not required to do. Therefore, the LILCO's "taking" assertions should be disregarded and analyses should focus on a comparison of the required revenues for LIPA and LILCO under the assumption that neither operates Shoreham~ SMITH BARNEY THE BMTF STRUCTURE ~O A Financing' Technique For Large ConStruction Programs ~ BMTF b · service n~uk of Smith Barney, Hah'is Uptmm &'Co. incorpenued. ~'riff~l © 1985~ Smith Barney Han'u~ Upham & Co. lncoq~:mued PREFACE The BMTF Structure allows tax-exempt bond issuers maximum flexibility in the management of the capital funding of large construction programs and generates significant debt service savings over traditional financing structures. BMTF also redUces an issuer's exposure to the risks of changes in the marketplace and changes in Federal tax law. This is achieved Without requiring credit support or the payment of credit support fees, BMTF is the ideal choice for structuring the fi- nancing of large construction programs and results in lower costs of operation for public entities and their consumers. SM1TH BARNEY CONTENTS Introduction . Financing Large Construction Programs ......................... BMTF vs Traditional Financing Structures ........................ The BMTF Structure ................................. Bond Security ................................................ The Escrow Mode ' Changing Modes,.., Revenue/Construction Mode ................... ~C?mpadson of Borrowing Rates ............................... ~,~3wBMTFProducesSavings i.' i! ""ii ii: i'ii i The BMTF Structure Saves Money What BMTF Savings Mean to An Issuer.. ........................................ Structural Advantages of BMTF ........................... Appendix 1. Review of the $2,000,000,000 New Jersey Turnpike Authority Financing Using the BM'IF Structure ........ 2. BMTF and Traditional Financ .......... 1 2 3 5 6 7 8 9 10 11 12 13 14 16 ,( .. INTRODUCTION The Bi-Modal MUlti;T~rrn Format ("BMTF") StrUcture was .developed by Smith Barney to aid municipalities and other tax-exempt issuers in the financing of large scale construction programs. The BMTF Structure can save an issuer 3% to 8% (on a present value basis) of the debt service cost of a given projc~ when compared to more traditional construCtiOn program financings. The BMTF Structure is unique in that it allows an issuer access to the tax-exempt bond market much like a line of credit allows a pdvate corporation to borrow from a commercial bank; however, the BMTF Structure creates no costs to the issuer until funds are frcccl for construction. Under the BMTF Structure, an issuer will issue all the bonds needed to finance estimated construction costs at one time, but the debt service burden associated with the borrowing will not be paid from revenues until funds are freed for construction and capitalized interest is extinguished. Initially, proceeds of the bond sale will be invested in Eligible Investment Securities and deposited into an Escrow Fund. The interest earnings on the investments cover the interest ex- pense of the bonds. As monies are needed for construction, the required amount will be transferred from the Escrow Fundto the Construction Fund. The BMTF StrUcture allows an issuer the flexibility to. determine when and to what extent it desires funds to be available for constrUction purposes. That flexibility also allows an issuer the ability to determine the timing of the growing debt service burden associated with 'the constrUction and operation of the project. Through the use of the BMI'F Structure, an issuei' is able to-lower its borrowing rate during the construction period by offedng investors instru- ments priced as short-term AAA-rated securities. This lowered borrowing rate, in turn, creates the opportunity for substantial net investment earnings dudng the construction pedod. These earnings result from investments in taxable securities that bear a rate of interest higher than the initial borrowing rate of the short-term tax-exempt bonds (although such investments may yield less than the long-term average borrowing rate of the tax-exempt bonds). As a result, fewer bonds will be needed to fund a construction program and correspondingly, debt service on these bonds will be less than that of a traditional financing. The lower long-term debt service requirements resulting from the use of the BMTF Structure reduce the cost of such construction to an issuer and to the ultimate users of the project. ...... SMITH BARNEY FINANCING LARGE~ONSTRUCTION PROGRAMS Traditionally, large municipai"bOnstruction programs have been financed with tax-exempt bonds on a borrow-when-needed basis. TOTAL BORROWINGS VS CUMULATIVE CONSTRUCTION EXPENDITURES (TRADITIONAL STrUCTUrE) / Begin ("~:'Jsing the BMTF Structure, '~'-fion program upfront. an issuer borrows all the monies neeossary to finance the construc- TOTAL BORROWINGS vs CUMULATIVE CONSTRUCTION EXPENDITURES (BMTF STRUCTURE) -a- SMITH BARNEY BMTF vs TRADITIONAL" FINANCING STRUCTURES With a traditional structure, all bonds are issued as long-term tax-exempt debt. Bond proceeds are invested in short-term taxable securities until the monies are needed for construction. Thus, under a traditional financing structure, the issuer must immediately begin to bear the burden of borrowing at the relatively high interest rates associa;.~J with long-term debt. TAXABLE AND TAX--EXEMPT YIELDS '"~'~[/ith the BMTF Structure, bonds are initially issued as short-term tax-exempt securities. Until bond proceeds are used for construction, interest eamings on the investments will cover the borrowing cost of the short-term debt. By raising all of the monies needed for construction upfront and taking advantage of the relatively Iow short-term rates, an issuer is able to minimize the overall borrowing cost of its construction program. TAXAeLE AND TAX--EXEMPT YIELDS SMITH BARNEY THE BMTF STRUCTURE The BMTF Structure was de~i~'~l t(~ enable an issuer to' maximize the advantage of short-term debt without incurring the cost or loss of flexibility associated with conventional short-term st~'uctures. With a BMTF Structure, bond proceeds are ih't"~l,y deposited into an Escrow Fund and invested in Eligible Investment Securities. As funds are needed for construction, monies are transferred from the Escrow Fund to the Construction Fund. MONIES- I'N THE ESCROW FUND MONIES T~ANSFERRED TO THE CONSTRUCTION FUND The BMTF Structure creates flexibility by giving the issuer access to the full amount of monies nccded for construction, but requires that debt service be incurred only as funds are used for construction purposes. .... -.4- SM1TH BARNEY 'BONQ~sECURITY The BMTF Structure has two distinct security modes: · Initially, all 'bonds are in the Escrow ~udu, in wt)ich bonds are supported by the Eligible Investment Securities in the Escrow Fund. The interest earnings of this fund are used to pay the borrowing cost of the Escrow Mode Bonds. Escrow Mode bonds have Mandatory Tender Dates during the construction period and carr~ the short-term interest rates asso- ciated with each'of these tender dates. Because the Eligible Investment Securities have a AAA rating tlt~ Escrow Mode Bonds will also be rated AAA. Escrow Fund Security Escrow Mode Bonds 100% of Bonds · As monies are needed for construction and funds are transferred out of the Escrow Fund into the Construction Fund, bonds in ~the Escrow Mode are converted to the Revenue/Construction Mode. For example, after half of the bond proceeds have been spent on construction, half of the ,'. b0nds will have been converted to the Revenue/Construction Mode. ': Escrow Fund Escrow Mode Bonds 50% of Bonds I Project/System I Security Revenue/Construction Revenue ~_ Mode Bonds- 50% of Bonds · Bonds in the Revenue/Construction Mode are supported by project or system reven~es. Thus, Revenue/Construction Mode Bonds are rated on the basis of the project or system crediL Capitalized interest may be used to support the bonds during the construction pedod. Project/System Revenue Revenue/Construction Mode Bonds- 100% of Bonds SM1TH BARNEY THE ESCROW MODE Escrow Mode Bonds are issued with Mandatory Tender Dates at vadous times during the' con- 'ruction pedod. The selection of Mandatory Tender Dates and the amount of bonds with a ,~articular Mandatory Tender Date ii based on. (1) expected construction draws, (2) the need for flexibility and (3) market factor:." ' ~ ' · Mandatory Tender Dates are selected to ensure that monies are available to fund construc- tion expenditures when needed. CUMULATIVE MANDATORY TEN~RS VS CUMULATIVE CONSTRUCTION EXPENDITURES O · To the extent that the construction draw sChedule is uncertain and flexibility is needed, the average tenor of the Mandatory Tender Dates would be shortened, so that monies are made available sooner than the established draw schedule. · If Mandatory Tender Dates are shorter than the established draw schedule, additional flexibility is created, allowing for potential conversions to a Iong-term fixed rate if market conditions are favorable. CUMULATIVE MANDATORY TENDERS CUMULATIVE CON$*i'RUCTION EXPENDITURES · Once the aVerage life o7 the Escrow Mode bonds has been determined, Mandatory Tender D. ates will be selected to match where market demand is strongest with consideration being given to the yield differential between taxable and tax-exe-~ rates for alternative tender/maturity dates. This ensures that the issuer maximizes savings. CHANGING MoDES-..REVENUE/CONSTRUCTiON MODE Initially, all bonds are in the Escrow Mode. As monies are transferred out of the Escrow Fund to pay for the costs of construction, bonds in the Escrow Mode are converted to the Revenue/Construction Mode, ESCROW MODE: E~ONDS AND REVENUE/CONSTRUCTION MODE BONDS Begin Mode ~onstruction Mode Bo~ds : End Construction Period Monies are freed to pay for construction expenditures only when Escrow Mode bonds are con- verted to the Revenue/Construction Mode. Bonds can change modes only on a Mandatory Tender Date. When Escrow Mode bonds are converted to the Revenue/Construction Mode, the issuer has a choice of converting the bonds to a long-term fixed rote or to a vadable rate type of instrument, The conversion to long-term fixed rate is automatic. The option to convert to one or more vadable rate structures may be dependent upon Bond Counsel opinions. -?- SM1TH BARNEY COMPARISON OF BORROWING RATES The average borrowing rate or,traditional borrow-when-needed financings varies according to the borrowing rate of each bond issue that is a component of the total financing. The borrowing rate will change depending on both credit and market conditions. AVERAGE BORROWING RATE (TRADITIONAL STRUCTURE) x Begin End Construction Period C:- ._~e BMTF Structure lowers the aVerage borrowing rate dudng the construction period because ~e Escrow Mode bonds carry short-term AAA interest rates. AVERAGE BORROWING RATE (BMTF' STRUCTURE:) SMITHB HOW BMTF PRODUCES SAVINGS ~ pdmary advantage of the BMTF Structure ove[ traditional financing techniques is that the ,ssuer is able to reduce its overa, l! borrowing cost by taking advantage of the use of Iow short-term AAA interest rateson Escrow Mode Bonds and investing money in the Escrow Fund at rates substantially higher.titan that'0f the initial borrowings. The Escrow Fund earns sufficient interest income to cover the interest expense on all the Escrow Mode bonds. CUMULATIVE INTEREST INCOME vs CUMULATIVE INTEREST EXPENSE The net interest income reduces the total cost of the construction program to the issuer. TOTAL DEBT SERVICE FROM REVENUES SMITH BARNEY THE BMTF STRUCTURE SAVES MONEY Another way to examine an issuer's, b0¢rowing cost is to compare the debt service that the issuer must pay 'frOm revenues to the coSt of constructing the project. The BMTF Structure saves money compared to a traditional financing: · When interest rates are.steady over time: · When interest rates dse over time: EF'F'EC~IV~ BORROWING COST · When interest rates fall over time: .. SMITH BARNEY WHAT BMTF SAVINGS MEAN TO AN ISSUER · Lower borrowing-level§~ '' ." NI-I-ET BONDS OUTSTANDING UPON COMPLETION OF' CONSTRUCTION · Lower debt service. · Lower revenue requirements. -11- SMITH BARNEY STRUCTURAL ADVANTAGES OF BMTF addition to significant debt seCvice savings, the issuer obtains many structural advan- tages with the BMTF StructiJre. Flexibility With complete access to,funds, an issuer can alter construction schedules to meet changing conditions and can modify its capital program in resPonse to changing market conditions; · Minimize or Eliminate Fees BMTF minimizes-or eliminates many of the fees traditionally associated with flexibility and access to funds---including credit support fees. · Protection Against Future Tax Law Changes By issuing bonds to fund the construction costs in full at one time, issuers will be protected against future changes in Federal tax law. Use of AAA Rated Debt By utilizing debt of the highest credit rating, initial market acceptance of bonds is assured, thereby creating market .access. · Demand in Marketplace The BMTF Structure has demonstrated marketplace acceptance and market demand. Use of Low Coupon Short-Term Debt By utilizing the mandatory tender date concept, BMTF Escrow Mode Bonds bear Iow initial interest rates. · Control of Construction Program An issuer retains COntrol over its construction program and its funding base without the interference and cost of a third party credit provider. CONCLUSION The BMTF Structure offers unpb.,ralleled,flexibility in the financing of a major construc- 'don program and mitigateS'the uncertainty surrounding potential tax law changes that could affect market access for future financings. By issuing bonds at one time to fund the full costs of a construction program, issuers of BMTF bonds are protected against ta~ law changes that may take effect after the initial issuance date. The BMTF Struc- tu~'e succeeds in providing tax law protection and flexibility in capital management without yielding control to a credit facility provider and without requiring an issuer to bear the costs of such a credit facility. BMTF's chief attributes are greater flexibility in the management of the capital program used to fund a large construction program corabined with significant net' debt service savings. BMTF also allows an issuer to retain control over the construction program and its funding base without the inter- ference and cost of a third party credit provider. These attributes have made the BMTF Structure the ideal cornerstone of creative financing plans for large municipal con- ~,~c'don programs. SM1THB APPENDIX , SMITH BARNEY i NEW JERSEY TURNPIKE AUTHORITY $2,000,000,000 TURNPIKE REVENUE B,ONDS, 1985 SERIES BI-MODAL MULTI-TERM FORMAT (BMTF)sM ~, C', Review of the Financing On November 21. 1985, the New Jersey Turnpike Authori .ty issued $2 billion of its Turnpike Revenue Bonds. 1985 Series (the "1985 Bonds") to finance tJi,ui,,~d coa~h'ucdvu costs of $1.7 billion for its 1985-90 Widening Program and to provide for the necessary debt service reserve fund. capitalized interest and other incidental costs required by such a financing. The 1985 bonds issued by the Turnpike introduced the Bi-Modal Multi-Term Format I"BMTF') Sa"ncmre developed by Smith Barney to aid municipalities in the financing of large scale construction programs. Through its use of the B MT~ Structure, the Turnpike saved over $100 million on a present value basis when compared to a more traditional construction program financing. More than $200 million will be saved over the life'of the bond issue. The BMTF Structure allows an issuer to access the tax. exempt bond market much like a line of credit allows a private corporation to access borrowings from a commercial bank. but the BMTF Structure uses tax-exempt bonds with mx. exempt interest rates and creates no costs to the issuer until funds are freed for construction. Under the BMTF Structure, the Turnpike issued all the bonds needed to finance the 1985-90 Widening Program at one time. but will not begin, tO. pay from revenues the debt service burden associated with the borrowing until funds are freed to be used for com/truction. Initially· proceeds of the bond sale were invested in Government Securities and deposited into an Escrow Account within the Construction Fund. As funds am needed for construction; monies will be transferred out of the Escrow Account and into the Widening Program Constructibn Account· Prior to being available for construction, the borrowed funds in the Escrow Account will secure t:[~e AAA rated portion of the 1985 Bonds. This AAA rated portion wilt be carried with no cost to the Turnpike. As the Turnpike needs money for construction costs, the AAA rated escrow supported portion of the t985 Bonds will be converted to revenue supported 1985 Bonds. The Turnpike will pay debt service only on the revenue supported portion of the 1985 Bonds. The BMTF Structure allows the Turnpike the flexibility to determine when and to what extent it desires funds to be freed for construction puq~ses. That flexibility also allows the Turnpike the ability m determine the timing of its growing debt service burden associated with the 1985-90 Widening Program. The Turnpike does not, however, need to be concerned with its ability to access the tax- ~empt marketplace at future times. The 1985 Bonds have two medes while they are outstanding: Mode I and Mode A. The modes differ with regard to primary security and with regant to format. All bonds were issued in Mode I. During the construction period, as funds are freed for construction purposes, 1985 Bonds will be c~nverted from Mode I to Mode A. In the fit~t mode ("Mode I Bonds''), the bondholder is totally secured as to principal and interest payments by monies held in the Escrow Account. These monieg the proceeds of the initial offering-- we~ invested with the Federal National Mortgage Association ("Fannie Mae") under a Parallel Debt Facility ("PDF'), developed by Smith Barney. By segregating monies in the-Escrow Account from the s~e ~ is a s~.rvi~ mark of Smith Barney, Hat'tis Upham & Co. In~. The BM'i'F Stm~tu~ is a financing vehicle developed by and p*o~ to Smith Bat'ney. monies available to pay construction costs and by pledging the segregated monies as security for a matched portion of the 1985 Bond issue, the Turnpike is able to sell Mode I Bonds as AAA-rated securities. The Mode I Bonds are entirety backed by monies in the Escrow Account and will not be dependent upon the Turnpike's revenue stream. Thi~ structure achieves the highest municipal bond ratin,,, which allows the Turnpike tominimiz? its borrowing cost. The PDF creates a Gov~ment Securities portfolio that exactly parallels the payment and cash flow needs of the Mode I Bonds, both initially and at each succeeding Tender Date throughout the construc- tion period. Mode I Bonds are subject to Mandatory Tender on specified dates, and the segregated Escrow Account of the Construction Fund is pledged as security for, and provides liquidity to cover. such tenders. As the Turnpike desires funds to be made available for construction expenditures, a portion of the Escrow Account portfolio will mature and be made available as cash. This cash is first pledged as liquidity .to cover the remarketing of 1985 Bonds and is available for that purpose until sufficient remarketing proceeds have been received: The monies from the Escrow Account will ultimately be reinvested in the Widening Program Cbnsirocti6n Account and spent for construction and related purposes. As 1985 Bond proceeds are transferred to the Widening Pro~m'am Construction Account. a matching portion of Mode I Bonds will be converted to the second security mode ("IVlode A Bonds"). Mode A Bonds are directly supported by Turnpike revenues. The current Financing Plan contemplates that Mode A Bonds will be structured in the form of traditional long-term fixed rate bonds, although tender format options are available. Through its use or' the BMTF Structure. tbe Turnpike is able to lower its cost of borrowing during the construction period by offering bondholders instruments priced as short-term AAA-rated securities. The lowered borrowing cost. in turn, creates the 0ppormnity for substantial net investment earnings during the construction period. These earnings res~tt from investments in taxable securities under the PDF that bear a rate of interest higher than the borrowing cost of the tax-exempt bonds. As a result. fewer bonds will be needed to fund the 1985-90 Widening Program, the lower debt service requirements of which will reduce the cost of the 1985-90 Widening Program to the Turnpike and to the citizens ~Jf New Jersey. BMTF AND TRADITIONAL FINANCING STRUCTURES During the past two years, the tax. exempt marketplace has been dramatically affected by two ~owina forces: the spectre of tax reform and~ an increasing preferenc~ for liquidity among investors. These two forces have comb?.ed to create many changes and innovations in the marketplace, includina an increase in the use of Shoi't-term and variable rate tax-exempt instruments and .the use of "escrow" financings which secure market access prior to an issuer actually needing funds for a particular project. The mx-exempt marketplace has experienced a startling increase in the use of letters of credit and other credit facilities (including bond insurance) as a result of the financing structures adopted in response to the pressures discussed above. The use of such credit instruments transfers many of the risks associated with a financing to the third party credit provider, but that transfer legitimizes a claim for control 'of the financing process by the third party. As a result, many creditworthy issuers have felt compelled to yield this control in order to obtain the interest cost benefits of credit enhanced financings. The BIVlTF Structure was developed t° enable large scale and creditworthy entities to avoid an unnec- essary dependence on third party ci'edit providers and to obtain many, if not all, of the benefits of third party credit enhancement. The Deficit Reduction Act of 1984 limited the ability of many municipal issuers tO issue tax.exempt debt and eliminated the ability of these same issuers to invest bond proceeds at a rate higher than their borrowing cost. With an effective date of January 1, 1985. many of the affected issuers rushed to the market in an attempt to preserve the benefits of the then current tax .law. This year. in an atmosphere of desperation over the budget deficits, additional tax reform proposals have been introduced into Congress. These reforms seek to further restrict the ability of municipal issuers to raise funds in the tax-exempt marketplace,. The legislation currently proposed by the House Ways and Means Committee has an effective date of January 1, 1986. Thus. similar to what occurred in 1984. many issuers issued bonds in the last quarter of 1985 in anticipation of further restrictions that could have been imposed upon them if they had waited until 1986. The volatile capital market over the last few years has made capital budgeting difficult, and has increased the cost of financing for many issuers. The upsurge in the preference for liquidity has heralded aa unprecedented growth in variable rate (and short-term) securities, which traditionally carry lower interest costs but which also are traditionally dependent upon a third party to guarantee the availability of funds due a bondholder. Such tax. exempt instruments have become more of a commodity with regard to features offered to the bondholder, but have altered the traditional interaction between borrower and issuer that governed the flexibility and credit strength of the tax. exempt borrowing. The dynamics of the market have made the financing of large, multi-year projects especially difficult. Reacting to these conditions, many issuers have sought alternative approaches to financing iarg~ projects in order to avoid an unfavorable financing environment. The financing of large public sector construction programs has traditionally focused on the timing of the need for funds. Three approaches to this timing need have been dominant in the tax. exempt marketplace: { 1) By issuing long,term fixed rate bonds on a borrow-as-you-need basis, issuers have min- imized the debt burden associated with a project throughout its consU'uction period and thus maintained f'~scal control. Such conu'ol is meaningful, however, only in an environment of stable interest rams and few external shocks to the marketplace (such as tax law changes). In the current market environment, issuers are exposed to the risk of rising interest costs and potentially adverse tax law changes. Unlike in prior .yeats, these risks a~ viewed as significant and may be inap- propriate for governmental bodies to take. (2) When long-term market access is seen as creating an unacceptable risk for borrowers that need funds, the traditional response has been to issue construction notes to finance the costs of the }~,,~.; .... 2.,~,.h i,otes would have a duration that approximately equalled the construction period and weald ~e fallowed by a long-term financing. This approach can result in a significantly lower debt service burden due to the lower interest rates associated with short-term borrowings, but it fails to overcome the risk of tax law changes that could restrict the issuer's access to long-term financing when the interim construction fl6tes (3) Alternatively. d~ uS~ 0f'~ letter of credit can provide significant advantages in terms flexibility and security structures. The letter of credit provides liquidity to support short-term and variable rate features, credit support to ease the burden of transition during the construction period m,d a coniinuatio~i of security provisions during facility operation, thus providing an effective transition to permanent financing and protection from risks of tax law changes. Letters of credit and other credit facilities, however, are expensive. Issuers can expect to pay between ~ and 200 basis points per year over and above their direct borrowing cost while a letter of credit/liquidity facility is in place. The use of a letter of credit or other credit facility also introduces an important third party into the financing process--.qhe credit facility provider. That financial institution will demand some control over the financing program and the msolting loss of control is another direct cost to the issuer, a cost that can mean a loss of flexibility and of the ability to react to changing public needs and conditions. The development of the BMTF Structure reflects the need for innovative solutions to mitigate the limitations and concerns inherent in the financing structures noted above; The BM'rF Structure elimi- nates many of the cost disadvantages of these other techniques and provides issuers with greater control of the financing and funding processes than offered by alternative techniques a'ied in the past. Large scale construction programs create their own demands and require flexibility and control in order to achieve their objectives. When formulating BMTF, Smith Barney included features that directly focus on such construction program capital management concerns as: (1) Projected timing of construction expenditures; (2) Available spreads between tax-exempt borrowing rates and taxable investment rates; (3) Long-term tax-exempt inte~st rates available during the construction period; (4) Market conditions, including competing demand and supply of compm'able tax-exempt securities: (.5) Structural flexibility to respond to changes in the factors above'as they occur throughout the construction period. Each of these concerns can have a major impact on the ultimate cost of a large capital program and therefore on the cost of the service to be provided. Prior to the inn'oduction of BIvlTF by Smith Barney, financing structures available in the market- place that dealt with the sensitivities of large scale construction programs focused on attaining better coordination between the use of a credit facility and the use of the escrow financings noted above. The traditional belief has been that only a credit facility could address the several goals of an issuer. (1) Minimizing risks during the construction period; (2) Avoiding the uncertainty associated with tax reform; and (3) Most importantly, minimizing the borrowing costs of the construction program. --17- Yet for large creditworthy issuers, the use of letters of credit and other credit facilities itself raises .-concerns fundamental to the capital management process: · Can an issuer obtain the lowest interest cost without yielding significant control? · Is it necessary to pay the costs of a credit facility? · Is there sufficient credit facility availability in,the marketplace? · Is it necessary m expose an ~issuer to the risks of short-term financing vehicles during the construction period.~.~ ~an ~those risks'l~ mitigated? · Can flexibility regarding short-term and variable rate features be provided without a credit facility? · Can flexibility regarding construction expenditures be provided without a credit facility'? · How can an issuer best mitigate interest rate risks? Only the BMTF Structure answers these concerns without being dependent upon the use of a credit facility and Without a loss of flexibility or control. The BM'IF Structure is unique in that through the segregation of the construction fund as a self-supporting escrow account with liquidity features, monies can be made available as the issuer desires rather-than in accordance with set conditions of scheduled dates. Central to the BMTF Structure is that the escrow account eliminates the need for a credit facility by requiring the availability of cash at tender dates, thus providing its own liquidity support. Access to funds for construction purposes is thus free from restrictions external to the issuer's own month-to- month planning, and access to the long-team sector of the marketplace is similarly unencumbered. The BMTF Structure leaves control of the financing process with the issuer and fmstee rather than yielding control to a credit facility provider, and it removes the cost of credit facility fees from a construction financing. Thus, the BMTF Slmcture is a means of maximizing flexibility and minimizing bon'owing cost while at the same time retaining the elements of control to mitigate interest rate risks. By eliminating the need for a credit facility, the BMTF Structure overcomes the limitations of more u2aditional approaches to the financing of large construction programs. By providing significant savings in the financing of a construction program, BMTF can be an important financial tool for state and local government. New Issue $2,000,000,000 New jersey TUrnpike Authority Turnpike Revenue Bonds, 1985 Series, Bi-Modal Multi-Term Format (BMTF)sM Mode 1 Bonds The Bonds ate dated ~be date of delivery., due January 1.2018 and are subject to t~dempcion as described in the Official Statement. The 1985 Bonds are being ,issued for the purpose of financing in full the e~imated co~t of the 1985-90 Widening Program of the Authority de~crihed in the Official Statement. The 1985 Bonds a~e being issued with a BMTF Str~cture wherein the 1985 Bonds will be in either of two Modas. The 1985 Bonds will be~r interest initially either at a Mode 1 Weekly Rate or at fLxed ragas of inter~t until their respective lnitla] Tender Dates, subject to the ocou-rence of a. Dr?p-Lock Conversion as described in the Official Statement. On the Initial Tender Date applicable to a 1985 Bond bearing interest at a fixed rate, such Bond will be sub,.ct to mandatory tender for pur~ha.~, subject to.the right of a bondholder to provide notice of an eleczion to retain his Bond. A 1985 Bond bearing interest at a Mode 1 Weekly Rate ~s sub,ct to tender ~or purr..lmse at the option of the bondholder and to mandatory tender for purcha.~, sub~zt to the right of a bondholder to provide notice of an election to retain his Bgnd. all as more fully described in.the Official Statement. The 1985 Bomts are revenu~ obligatlo~ o/the New Jersey Turapli~e Auth~t~ ~be 19B5 B~ a~ ~t a ~bt or I~lity of the Sm~ of Ne~ Je~ey ~ of a~ ~t~al su~ tbe~o/ ~ a pledge of tbe fMtb, ~dit or ~g ~r o/t~ Sm~ o/ N~ Je~ey ~ o/any s~h s~i~ The A~ty ~ ~ ~g ~ the op~nlon o/Bomt Coussel and Sp~clal Ta~ ¢o~se~ in.rest o~ the 1985 Bonds is ~#mpt f~om Fed~nd i~come t~zati~ The 1985 Bonds ara ssdajec~ to the appmml of legality ~. Kraft ,~ Hssgbes, Nemrrk, New Jars~, Bo~d Coumd. C.~nam will be pa~sed upon I~ Wood Da~$on Smith ~ Hedlmas, New York, blew York. Special Tax Co~msd. C~rtain ~rs ~ cos~ctio~ w~zh the 1985 Bo~ wig he t~ved ulma for the Und-~,.~writem by Wood Dawson Smith & Hellman. New York. New York. Counsel to the U~te~. Smith Barney, Harris Upham & Co. Ryan, Beck & Co. Shearson Lehman Brothers Inc. Goldman, S~chs & Co. Dillon, Read & Co. Inc. Ehrlich-Bober & Co., Inc. Merrill Lynch Capital Markets PaineWebber Prudential-Bache Salomon Brothers Inc November 14. 1985 THE BI-MODAL MULTI-TERM FORMAT STRUCTURE The Bi-Modal Multi-Term Format ("BMTF") Structure is a financing vehicle developed by and proprietary to Smith Barney, Harris Upham & Co. Incorporated. The BMTF Structure provides that the proceeds of a bond issue (the "Bonds") are to be deposited into an Escrow Fund and invested in Eligible Investment Securities that will fully secure the payment of the Purchase Pdce of and the interest on such Bonds while in the Escrow Mode. Upon each transfer of funds from the Escrow Fund to the Construction FUnd established for each such issue, a related. portion of Bonds will convert from the Escrow Mode to the Revenue/Construction Mode and be secured principally by the Capitalized Interest Fund and the Net Revenues .of the Project, System~ or Issuer, as appropriate. Unique to the BMTF Structure s the use of an Escrow Fund to provide both security and liquidity for Bonds in the Escrow Mode without the use of or need for a credit facility, in conjunction with the flexibility to convert Bonds ~..~'from the Escrow Mode to the Revenue/Construction 'Mode as needed to meet the construction expenditure . schedule of the financed project or projects. Financing Plans incorporating the. BMTF concept are considered to be proprietary to Smith Barney, Harris UPham & Co. Incorporated. Such financing plans are available through the services of Smith Bamey's Public Finance Division. 'BMTF~ is a service mark of ~;mith Bameyl Harris Upham & Co. Incorporated.