Introduction

It is indeed hard to exercise restraint when responding to a critic who continues to use distorted analyses. While acknowledging that his earlier projections were wrong and that LIPA's savings are $3.6 billion higher than he first projected, Mr. Studness now relies on fantasy scenarios (including one in which LILCO's rates are 55% lower than current rates) in a desperate attempt to discredit the LIPA plan.

Intentional Distortions

In a section of his report entitled "Future Dissavings Confirmed by LIPA's Data", Mr. Studness states that while the data that LIPA provided "covers 40 years (1998-2037), our analysis will be limited to the first 35 years, the maturity of the longest acquisition bonds that LIPA intends to issue." There is no clearer example of an intentional distortion of the truth-if his revised analysis on page 4 were extended by only one more year he would have to acknowledge that LIPA's capital costs would once again be lower, significantly lower, than LILCO's.

Mr. Studness states "LIPA chastises us for a failure to "utilize real dollars", while our entire analysis was based on a steady-state model that explicitly holds the price level constant". As Mr. Studness stated in his May 30 Report, use of a steady-state model allows one to ignore the impact of inflation on variable operations and maintenance costs in order to "isolate the impact that LIPA's refinancing will have on electric rates." But in fact it is inappropriate for comparing capital costs, particularly when most of the costs are fixed at the closing of the transaction. A steady-state analysis ignores the fact that the real cost of any fixed cost obligation will decline over time as a result of inflation. Holding the capital costs price level constant equates a dollar of savings in year one with a dollar of dissavings in year 35. Assuming any level of inflation increases the benefits of the LIPA plan in real terms:

Fantasy Scenarios

Mr. Studness has acknowledged that under his revised analysis, the LIPA plan shows significant savings versus the LILCO status quo: "where our model originally projected net dissavings from LIPA of $0.2 billion. . .the model based on the new LIPA data projects savings of $3.4 billion. . ." In fact, the savings are even greater. Had Mr. Studness extended the analysis period, the savings would have increased by more than $400 million a year. Over a 40 year period, LIPA's capital costs are $5.5 billion lower than LILCO's. Since his own analysis now indicates significant savings attributable to LIPA's lower cost of capital and avoidance of federal income taxes, in desperation, Mr. Studness has had to concoct new assumptions regarding LILCO's future rates.

Mr. Studness now believes that LIPA's rates should be compared against LILCO's assuming significant permanent rate reductions of 5% to 20%. Mr. Studness asserts that LILCO, a company most of whose debt is rated below investment grade, has "the financial resources to absorb rate reductions up to 18% without even having to cut costs." He further states, "LILCO [has] the ability to absorb rate cuts of at least 25% over the next five years without facing financial distress." It should be noted that the PSC Staff's proposed rate reduction of 4.2% last year was not accepted by the Commission. Significant, permanent rate cuts of the magnitude envisioned by Mr. Studness would jeopardize the long-term financial viability of LILCO and would be vigorously contested by LILCO in any PSC rate case, with a high probability of protracted litigation.

Mr. Studness also presents an analysis in which LILCO's rates are assumed to fall through competition by 55% over 20 years. Once again Mr. Studness states "these rate reductions would still offer LILCO an opportunity [to] maintain its financial integrity, given its strong cash flow and its opportunities to improve efficiency." Since competition centers around generation, and power supply costs comprise only 25% of a Long Island rate payer's bill, it is impossible (practically as well as mathematically) that competition alone could result in overall rate reductions of 25% or more on Long Island.

The only way to achieve the substantial LILCO rate cuts envisioned by Mr. Studness (whether through PSC ordered rate cuts or the introduction of competition) is to implicitly or explicitly disallow recovery of a substantial portion of LILCO's stranded costs, principally the Shoreham regulatory asset. Given the history of this regulatory asset, such disallowance would result in protracted litigation with an uncertain outcome. During the pendancy of such litigation, Long Island rate payers would forego the substantial 17% rate reduction that the LIPA plan would have produced.

Struggling to Undermine LIPA's Credibility

In a further attempt to undermine LIPA's very real savings which he has had to acknowledge in his follow-up report, Mr. Studness states "In regard to LIPA's assumption that it can finance the takeover at 6.7%, LIPA is assuming that it will pay a risk premium of 100 basis points over high-grade tax-exempt bonds. While it is unclear what the risk premium will be, it is certainly possible that the premium will be substantially higher than LIPA expects. LIPA could find itself saddled with interest costs of 7.5%-8.0%." Once again, Mr. Studness resorts to speculation, in an area in which he has no apparent expertise.

LIPA's financial advisor and other market participants believe that LIPA's bond issues will be rated investment grade and could be sold in today's market at average interest rates of less than 6.00%--more than 70 basis points lower than the conservative 6.70% rate used in LIPA's savings analysis. Obviously, Mr. Studness has not consulted with municipal bond trading firms to substantiate his statement that LIPA's risk premium could be 100 basis points or higher.

Further demonstrating his ignorance of the public power bond market, Mr. Studness states "the most problematic part of the approval process is likely to be the task of selling LIPA's bonds. . .Indeed, the probability of default is very substantial, and LIPA may not be able to market its long-term debt unless it gives bondholders recourse to Long Island sales or property taxes in the event of default." Again, Mr. Studness appears not to have consulted with any nationally recognized public power credit rating agency or research credit analyst regarding this issue. New York State Comptroller McCall told LIPA that "many fund managers have expressed the view that LIPA would have no difficulty placing its bonds, barring significant deterioration in the fixed income markets." According to a recent article in The Bond Buyer, "Fitch Investor Service Executive Managing Director Alan Spen characterized the bondholder security provisions that LIPA is pursuing as standard."

"LIPA is Likely to Have Severe Cost Control Problems"

As LIPA stated in its previous response to Mr. Studness, LIPA has negotiated contracts with incentives and penalties to control O&M costs. Mr. Studness states "LIPA uncritically accepts the 1997 test-year budget that LILCO submitted to the PSC in 1996 as part of its pending rate case as the basis for the first budget." The contracts clearly indicate that LILCO's 1997 test-year budget is one factor to be considered in developing the first budget; other factors to be considered include actual historical costs from 1996 through the date of the adoption of the first budget and known changes in facts and circumstances. The first budget has yet to be negotiated. LIPA disagrees with Mr. Studness when he states that LIPA is "rationalizing the acceptance of high costs and avoiding the tough task of cutting costs." LIPA has accepted the tough task of changing the status quo and trying to cut electric costs for all Long Islanders. LIPA hopes that Mr. Studness would agree that Long Island rate payers will not tolerate excessive operation and maintenance costs regardless of who is operating the electric system.

The "Egregiously Anti-Competitive" LIPA Deal

LIPA has already responded to Mr. Studness regarding competition and self-generation. Long Island rate payers want their electric rates reduced now. Mr. Studness criticizes LIPA's Power Supply Agreement ("PSA") as "egregiously anti-competitive". He states "it is unlikely that LIPA can buy much power at prices that are below LILCO's energy cost, which means that the power supply agreement ties LIPA to BU/LILCO." Mr. Studness should know that LILCO is currently buying 40% of its energy from off-island sources at prices lower than its own costs; this practice is not expected to change under LIPA. In fact, the amount of energy imported could be expanded if a cross-Sound cable is built C a project that LIPA is committed to, provided it is competitive with other sources of power and/or conservation.

"LIPA's Vulnerability to Self-Generation"

The promise of future rate reductions through technology is appealing, but hardly concrete. Although Long Islanders pay the highest electric costs in the continental U.S., self generation is not widespread on Long Island. As LIPA has stated previously, it welcomes self-generation because it will help with load control and protect the environment. However, LIPA's plan will reduce electric rates and thereby reduce the incentive for self-generation.

The extensive use of "micro-turbines" installed at the individual customer level, if it were economically feasible, raises environmental impact concerns. Power plants which use natural gas or fuel oil at commercial size applications (typically 30,000 kilowatts or larger, rather than 5 to 10 kilowatt size which would serve a large home or small business) have sophisticated kilowatt and expensive air emission control equipment to protect the environment.

Conclusion

Mr. Studness' latest report starts out well: he acknowledges that his prior analysis was wrong and that the LIPA plan will save rate payers $3.5 billion over the next 35 years instead of costing an additional $200 million as he had projected. He then draws upon distorted analyses, fantasy projections and speculative statements in an attempt to undermine LIPA's credibility while bolstering his own. The Studness reply is clearly inaccurate, and LIPA stands firmly behind its analyses.