Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 68 APPENDIX A: CAPITAL ADEQUACY ISSUES FOR REGULATED UTILITIES Not all utilities are regulated in the same manner, and the extent of regulatory recovery allowed by or expected from a regulator defines whether a utility needs to hold economic capital to cover its risk exposures, and if so, to what extent. In addition, the source of regulatory authority can take different forms depending on the type of entity. Most investor-owned utilities are regulated by governmental authorities. Public power entities and consumer-owned energy cooperatives are typically self-regulated within their own governance structure (e.g., boards of directors, boards of trustees, utility service boards, city councils) in some cases, these self-regulated entities are also regulated by governmental authorities. Under any of these sources of regulation, the regulatory authority may provide for certain types of cost recovery mechanisms that can mitigate the full impact of exposure to market, credit, or operative risks. There is a broad spectrum of degrees to which regulated utilities are afforded cost recovery by various regulators. On one end of the spectrum are regulated utilities that, if all expenditures are “prudent,” may recover all costs via a regulatory recovery mechanism plus a predetermined rate of return or a margin. Toward the middle of the spectrum are utilities that are authorized to hedge for their customers, passing the costs of “hedge losses” to the customer while sharing in some of the “hedge gains.” In the middle of the spectrum are regulated energy utilities that have “incentive- based regulation” that exposes a part of their business to market, credit, and operative risk either completely or in a shared loss/gain situation with its ratepayers. Finally, on the opposite end of the spectrum from the first category are utilities that may have a large segment of their business exposed to risks with no regulatory recovery mechanism available. An example would be when the energy price component of a utility’s regulated load obligation is fixed by the regulator and at least a portion of its regulated business is left exposed to market prices for procuring its power because of regulatory design or deregulation compliance with a regulatory authority. The first category of companies described above has the most complete regulatory recovery mechanism, and therefore significant regulated business risks have been transformed from market, credit, and operative risks into regulatory and liquidity risks. The liquidity risk arises from the delay in the recovery from actual expense. This risk can be large but is often manageable via the capital markets, either through borrowing or securitization or by means of maintaining ample cash reserves. If none of these options are feasible, then economic capital may be necessary. The regulatory risk is difficult to quantify, but unfortunately it may be positively associated with market, credit, and operative risk since its regulator is more likely to find large losses imprudent. Perversely, the holding of economic capital for this possibility may increase the probability of a regulatory loss because the regulator may be more likely to assign such a loss to the utility rather than the ratepayer because the utility is viewed as having the financial ability to pay. The companies in the two middle categories should make sure they have adequate economic capital available for market, credit, and operative risks. However, if these risks are small enough, it may be determined that adequate capital is available through the ordinary course of business and an ongoing economic capital calculation would be an unnecessary burden.