Introduction

The Long Island Power Authority ("LIPA") has found numerous inaccuracies and false assertions in Rothschild Financial Consulting's ("Rothschild") review for the Citizens Advisory Panel of the Agreement and Plan of Merger among LIPA, Brooklyn Union Gas Company ("BU") and the Long Island Lighting Company ("LILCO"). Mr. Rothschild's alternative to the LIPA Plan was to "do nothing." Listed below are pertinent sections of the Rothschild report in bold faced type followed by LIPA's responses.

To begin with, it is important to note that LIPA's rate reductions of 18.2% in Nassau County and 16.4% in Suffolk County are from what rates are now. Thus, these reductions are immediate and measured against current rates. As for rate savings, because the LIPA transaction is not expected to close until sometime in 1998, the prospective information contained in LILCO's 1996 rate filing with the PSC was considered the best available information for the LIPA analysis. It is not uncommon in a rate case for several parties to propose significant reductions in the rates requested by the utility. The outcome of the deliberations of the case, however, rarely reflect a single party's view. For the reasons set forth below the rate increases shown in the rate comparison are appropriate.

First, as part of the 1989 Settlement Agreement, LILCO was ordered to refund to customers, over a ten year period beginning July 1, 1989, amounts referred to as the 1989 Settlement Credit and the Regulatory Liability Component. The annual amortization of these amounts equals $88.6 million. Once these amounts are fully refunded to rate payers in mid 1999, this annual refund credit ends and LILCO's cost of service will increase leading to higher rates.

Second, as part of the 1989 Settlement Agreement, in order to mitigate the potential rate shock of the Settlement, the Rate Moderation Component ("RMC") was created. The RMC (a balance of $402 million at December 31, 1996) represents deferred revenues that would otherwise have been collected from rate payers under the Settlement Agreement in prior years that under the Agreement were to be recovered from rate payers by December 1, 1999. Any amounts not otherwise recovered by December 1, 1999 are proposed to be recovered in rates on a straight line basis together with a return on the unrecovered amount during the period from December 1, 1999 through December 31, 2001. The projected increases in LILCO's rates through 2001 are designed to recover the projected unrecovered RMC balance.

Third, the operation of any utility involves labor, fuel, material and other costs, all of which are subject to inflation. For instance, LILCO signed a five year agreement with its unions in 1996 which provided for an average increase of approximately 3% in salaries for covered union employees. Normal increases in such costs due to inflation will ultimately be reflected in rates. To the extent such cost increases do not occur, both LIPA and LILCO rates shown in the comparison would be lower and the savings would remain the same.

Our March 19 Comprehensive Presentation clearly states that these monies were being accelerated and paid out to the rate payers immediately rather than being applied as reductions to the customers electric bills through 1999. We also clearly stated that this acceleration and the amount of such payments would have to be approved by the federal judge who awarded this verdict. The table on page 38 of the Comprehensive Presentation and page 13 of the Summary of the Agreement in Principle both of which were distributed by LIPA on March 19, explicitly excludes this accelerated payment from any savings calculations. Furthermore, absent the LIPA Plan, these monies would not be paid in one lump sum to rate payers. CAP recently sought such treatment but was denied by the Court.

LIPA will gain control of the Shoreham Phase II litigation and all other pending tax certiorari cases when the LIPA/LILCO transaction closes. There is no clear resolution of this issue, absent the LIPA Plan. The Suffolk taxing jurisdictions would likely continue to litigate for as long as possible, and the ability of the Shoreham Wading School District to pay its 39.2% share of the $1.2 billion is questionable. The LIPA Plan finally resolves this litigation and provides prompt rate relief for the overassessment. The LIPA refund checks will accelerate the payment of some of the tax certiorari monies to rate payers up-front, something not likely to occur absent the LIPA Plan.

Mr. Rothschild is wrong. The LIPA Plan provides unique benefits to the electric rate payers directly associated with the BU/LILCO merger which would not otherwise be guaranteed. As part of the Management Services Agreement ("MSA") entered into by LIPA and BU/LILCO, LIPA negotiated guaranteed synergy savings levels for electric rate payers. If synergy savings are not realized from the combination of BU/LILCO, they still must compensate LIPA for the synergy savings that were guaranteed. If BU/LILCO realize greater than expected synergy savings, rate payers will share in these savings due to the provisions of the MSA. These guarantees do not apply absent a LIPA/LILCO transaction.

The Studness report referenced by Mr. Rothschild is flawed for a number of reasons including its failure to properly treat future T&D capital additions. LIPA and its consultants have provided an analysis in response to the Studness report which compares the capital costs under LIPA's Public Power Utility approach and the LILCO status quo. For this analysis LIPA has included future capital expenditures. The chart below summarizes the results assuming LIPA sells its acquisition bonds at its assumed interest rate of 6.7% (0.7% higher than current market borrowing costs) versus LILCO's cost of capital maintained at its current rate of 9.5%. The analysis was calculated over forty years to show the impact of fully amortizing LIPA's acquisition bonds (2032) and LILCO's regulatory asset (2029). As shown in the chart below, LIPA's capital costs are less than LILCO's for the first 25 years, equal for one year, slightly higher for the next nine years and dramatically lower thereafter. Over the 40 year period LIPA's capital costs are $5.5 billion lower than LILCO's. On a present value basis, LIPA's capital costs are $2.7 billion lower than LILCO's.

Mr. Rothschild fails to understand the benefits of the Power Supply Agreement. LIPA is only obligated to purchase capacity from LILCO, not energy. The cost of LILCO's on-island capacity is less than $200 per kilowatt, as compared to $500 to $600 per kilowatt for the lowest cost new generation that could be developed on-island. This is not a burden to the rate payer -- it is protection against cost increases. If the power supply market was immediately opened to competition and LILCO were allowed to charge what "the market will bear", LILCO could charge the cost of a new power plant for its existing base load steam units. Absent cost increase protection, open competition would likely increase, not decrease rates. The LIPA transaction protects against competition bidding rates up due to the lack of ability to access lower cost power supply markets off-island.

Mr. Rothschild is wrong. The fixed and variable cost of generation will be established in a budget subject to LIPA's approval. The budgeted costs will be established in a formula rate filing with the Federal Energy Regulatory Commission ("FERC"). Upon approval by the FERC of the rate, costs reflected in rates can not rise above the approved rate formula. Actual generation costs in excess of the rate formula will not be borne by the rate payers. This approval was selected specificially to avoid the risks associated with operating costs.

The purchase price paid by LIPA to acquire LILCO was the result of a negotiation and as part of the negotiation, it was agreed that the price to be paid for the generation assets if exercised after the third year by LIPA will be fair market value ("FMV"). As the utility industry moves toward deregulation, generating assets are being bought and sold based on FMV. LIPA does not know at this time whether the value of the generating assets in the future will be above or below book value. However, LIPA believes the terms of the Power Supply Agreement which are based on the historic costs of the generating assets and are renewable, will largely determine the FMV of the assets. LIPA decided it was not cost effective to purchase land now, but rather negotiated a 99-year right to purchase sufficient land in the future to promote and foster competition.

The Management Services Agreement includes a $10 million fee for managing the T&D System. However, it also contains provisions that are designed to protect LIPA's customers from excessive costs. The contract requires that the Manager absorbs the first $15 million of annual cost overruns thereby creating a significant incentive for the Manager to operate within the budget. In addition, the contract provides a further incentive for the Manager to operate more efficiently. The Manager will retain the first $5 million of cost savings and share with the customers 50% of savings in excess of that up to a cap. If cost savings exceed the cap, customers will receive 100% of the benefit of such savings. Because LIPA will be approving the budgets annually, it will be able to ensure that the combined budgets are realistic and that the customer is benefiting from the most efficient operation of the system possible. In fact, LIPA's plan is very much like the incentive regulation plans adopted by recently privatized utilities around the world.

It is in the rate payers' interest to have BU/LILCO agree to a hypothetical capital structure. BU/LILCO's capital structure will be a combination of debt and equity. Equity returns are higher than debt returns which means that LIPA would want to limit the equity return it pays to BU/LILCO. Without a hypothetical capital structure, BU/LILCO could capitalize its generation subsidiary ("GENCO") entirely with equity and try to pass that higher cost on to LIPA.

The Agreement and Plan of Merger specifies how LILCO will charge LIPA for its costs. LIPA and LILCO will agree to an annual budget prior to the closing of the LIPA/LILCO transaction. This budget will be based on LILCO's historical costs which are reported to the PSC.

The LILCO shareholders have already absorbed approximately $1.3 billion of disallowed costs for the Shoreham plant. To equal the rate savings from the LIPA plan, shareholders would need to pay for an additional $2.7 billion of the Shoreham costs. The prospect of achieving any meaningful rate reductions through litigation to force shareholders to absorb a portion of the Shoreham Regulatory Asset is highly speculative. There is no assurance that any additional Shoreham costs will be required to be absorbed by the shareholders. In fact, both California and Pennsylvania, the two states that have adopted deregulation legislation, have provided the opportunity for full recovery of stranded assets.

LIPA represented the interests of rate payers by purchasing the stock of LILCO at slightly less than net book value of the assets it is acquiring. As shown in the chart on the following page, LILCO's stock has traded in an narrow range since its merger with BU was announced at the end of 1996.

Mr. Rothschild has grossly mischaracterized the situation here. First he assumes that LIPA would be able to purchase the gas business and the fossil fuel generating business from LILCO at net book value. This is clearly not the case based on the premiums paid in other merger and acquisitions in the industry as well as the premium paid by BU for the very same assets. Even if you accept this assumption, Mr. Rothschild fails to point out that the debt and preferred stock that would need to be purchased or assumed would be in excess of $1.5 billion, not to mention the $260 million of current liabilities which LILCO is assuming results in a purchase price for these assets of $1.9 billion. This is clearly not a nominal amount and such purchase is contrary to LIPA's objective of maximizing private sector involvement.