The next step in the reform process involves optimizing the capital structure for each newly unbundled entity. Importantly, unbundling enables a more precise targeting of cost of capital determinations for the newly formed entities operating in each segment of the electric sector value chain.
There are relative levels of risk associated with the various segments of the value chain, from generation, transmission, and distribution – a vertically integrated utility can be considered to have a weighted average risk of all these businesses. In contrast, unbundling allows for a more precise targeting of cost of capital determinations, which can be targeted to each of the three business functions independently.
- Generally speaking, the unbundled generation business will have greater risks than the vertically integrated utility, as generators are exposed to price volatility and are not guaranteed to recoup their costs, in particular their investment costs.
- Competition increases risks to shareholders, and as a result of this transformation, the engineering component of the generation business becomes less dominant, while the economic, financial, and legal components become increasingly important.
- On the other hand, the basic fundamentals of estimating the appropriate level of returns on equity for transmission and distribution remain similar under both unbundled and vertically integrated structures. As such, the transmission and distribution businesses will typically have lower risks than the vertically integrated utility.
- The higher risk businesses should expect to see higher returns.
- Debt levels for wires companies (transmission and distribution) can approach or in some cases exceed 60% of total capitalization.
