Introduction

The Free Enterprise Plan ("FEP") is far and away the most absurd plan ever proffered for resolving the problem of high electric rates on Long Island. The plan is a fantasy based upon a wholly unrealistic premise supported by faulty analysis bound in a cover of "free market enterprise". Furthermore, even if implemented, it would result in system chaos, failed reliability and the loss of hundreds, if not thousands, of jobs.

Let's step "through the looking glass" and into the Free Enterprise Wonderland. The FEP identifies "a system of incentives that are intended to induce LILCO to undertake actions to change the Long Island electric system dramatically." The key premise of this plan is for LILCO to voluntarily operate under a rate cap in which its electric rates are reduced by 3.5% each year for eight years, for a cumulative revenue reduction of more than $2.9 billion after eight years. If LILCO is able to reduce its costs by more than these amounts through more efficient operations, it will be able to apply such savings to recover, on an accelerated basis, its remaining $4.5 billion investment in Shoreham and its remaining $690 million investment in Nine Mile Point No. 2 ("NMP2"). However, any portion of such costs not recovered during the eight year period would be written off.

According to this analysis, even with the rate reductions, if LILCO reduces its annual operating costs by $200 million by the end of the third year through "operating efficiencies", it should be able to maintain reliable service, upgrade the transmission and distribution system, retire $1.9 billion of maturing debt and preferred stock, recover all of its Shoreham investment and other strandable costs, and "emerge. . .as a financially healthy company with the ability to provide superior T&D service" to multiple new power supply companies selling power to Long Islanders at half the cost of LILCO today. The FEP claims that even in the worst case scenario, in which LILCO is unable to implement any "innovations" to mitigate the rate reductions, LILCO remains financially viable after the transition period, although it acknowledges that LILCO must write off $3.5 billion of its Shoreham and NMP2 investments ($1 billion more than its current common shareholders' equity). The plan sounds too good to be true because it is.

"Free Enterprise" It's Not

While proponents of the FEP claim that the plan "applies the basic principles of the American free market system to Long Island's electric power crisis", we see little that reflects the free market enterprise of this country. What free market relies on price caps while forcing all the operational risks on a single group of investors? What free market forces one group of investors out of a market after requiring them to invest for the benefit of other investors?

This is not a "Free Enterprise Plan", it is a Soviet-styled "Eight Year Plan". While it may sound good to some, it has no basis in reality and, if attempted, will result in disastrous consequences including a complete breakdown of service to Long Island consumers. LIPA's analyses, discussed in detail below, paint a very different picture. At best, this plan leaves Long Island with a financially weak utility, able to meet its obligations only by selling its generating plants at a loss to third parties, and questionable service reliability. At its worst and most likely outcome, this plan bankrupts the company, causes the lay-off of hundreds, if not thousands of workers and/or jeopardizes the reliability of both the electric and gas systems.

The Basic Premise Is Unrealistic

This plan is based upon one wholly-unrealistic premise, that LILCO would voluntarily submit to price caps which reduce its electric revenues by more than $2.9 billion during the eight year transition period in return for the opportunity to apply any savings it can achieve from "innovations" or "efficiencies" in excess of the 3.5% annual revenue reductions to accelerated recovery of its Shoreham and NMP2 investments. Any portion of such costs not recovered during the eight year period would be written off. However, the PSC will protect Long Islanders by ensuring that LILCO's cost reductions do not affect then current or future system reliability. This is plainly impossible.

This plan constitutes a "taking" without compensation, and therefore, LILCO would never and could never agree to it. A few simple questions expose its absurdity. How can LILCO cut $200 million a year from its operating budget without dramatically affecting system reliability when its annual operating and maintenance costs are only $400 million and its fuel and purchased power costs are $600 million? How can this plan not leave the company weakened financially when the effect of the annual 3.5% rate reductions would exceed the level of current net income from both the gas and electric businesses half-way into the plan? Why would LILCO's shareholders be willing to bear all of the risks of a significant increase in fuel costs or storm costs when their financial margins are being severely reduced and their dividends have been eliminated? Why would LILCO agree to write off any of the remaining Shoreham and NMP2 investments unless required by an order from a court of final jurisdiction?

The FEP's Analysis Is Flawed

In this section we will identify and discuss some of the more glaring problems with the FEP. The bracketed letters in the following paragraphs relate to the corresponding section of the attached FEP.

[A] The FEP states that at the end of the eight year transition, the only generating plant costs which will be eligible for inclusion in ratebase (i.e., recoverable from rate payers) will be LILCO's 18% interest in NMP2. Such costs will be limited to "$250 per KW or about $50 million". The FEP provides no support for this judgment. Since the estimated book value of NMP2 in eight years would be at least $450 million, the FEP expects that LILCO will voluntarily write-off a minimum of $400 million. Since LILCO owns only an 18% interest in NMP2, the FEP assumes that LILCO would write-down this asset while the other four owners, with the PSC's approval, continue to include their full investment in ratebase.

[B] The FEP magnanimously offers to credit customers three cents per kWh if they buy power from third parties. The amount of this credit is not supported by any analysis and may very well serve to deny customers the potential of savings due to competition by setting the credit too low. For example, market costs for electricity in Massachusetts (where competition is expected to begin in 1998) are estimated to be about 3.2 cents per kWh. If the market price on Long Island is at a similar level, customers will not switch to third parties without actually incurring added costs.

[C] The FEP calls for the deregulation of generation in a manner which effectively mirrors LIPA's proposal in its December 6, 1995 plan to acquire and then sell, to as many as five buyers, LILCO's generating plants. This plan was soundly criticized by business and labor groups due to its potential adverse impact on system reliability. LIPA heard the criticisms, carefully considered them, and altered its plan. The FEP apparently ignores these concerns.

[D] The FEP states that the eight-year transition period is "long enough to make it profitable for LILCO to undertake the innovations" to achieve the cost reductions required. It ignores the fact that innovations and efficiencies usually have an up-front cost, yet LILCO's ability to fund such investments are limited since its revenues are being systematically reduced. Further, the pay-back period for many investments would extend beyond the transition period, particularly investments required to be made later in the transition period. The FEP apparently does not allow LILCO to recover such costs as it states, "[a]fter the transition period, the benefits of the innovations and efficiencies will accrue to the customers, since the PSC will tie rates for T&D services to these costs."

[E] The FEP suggests that if all fuel price risk was forced onto LILCO by eliminating any adjustments in LILCO's rates due to changes in fuel costs, then LILCO would be incented to achieve "huge" fuel cost reductions, despite the fact that it has no control over market price fluctuations. The FEP cites Union Electric ("Union") as an example of fuel price reductions resulting from elimination of fuel adjustment mechanisms. This example ignores the fact that a large portion of Union's generation fuel is coal. Average coal prices for Missouri electric utilities declined about 36% from 1985 through 1996. Similar reductions were experienced in other Midwestern states. Further, the FEP erroneously surmises that the reduction was due to the fact that the Missouri PSC eliminated Union's fuel adjustment mechanism. If this were the case, then a utility that has a fuel adjustment mechanism in place would not have experienced any reduction in its cost of fuel. However, this is not the case. For example, Northern Indiana Public Service Company's coal costs fell 23% during the period 1989 through 1996, even though it had a fuel cost adjustment in place. The Energy Management Agreement negotiated between LIPA and LILCO would place LILCO at risk for a portion of the generation fuel cost variation not accounted for by market fluctuations. LIPA believes that this will provide a strong incentive for effective fuel procurement practices under the LIPA plan.

[F] The FEP assumes that the PSC will require LILCO to fund the necessary investment to eliminate "load pockets". It estimates that upgrading the T&D system will require approximately $400 million over the eight year transition period, although, once again, there is no support for these numbers in the FEP. The FEP states that LILCO must be "rewarded" for this and says that LILCO should be allowed a return on its investment during this period which would reduce the 3.5% rate reductions by no more than 0.2%, or an average of $5 million a year. However, assuming an after tax return of 8.5% (less than LILCO's current after tax return of 9.3%), the average incremental revenue requirement relating to the pre-tax return on this investment is $17 million a year and the average recoverable depreciation on this investment is $7 million a year for an average annual increase in the revenue requirement of $24 million. This equates to an annual reduction of 1%, five times the FEP's estimate.

[G]The FEP acknowledges that LILCO could implement cost reductions which affect the quality of service. Its answer? Have the PSC set service-quality standards and monitor LILCO's performance. However, the severity of revenue loss would have to result in drastic reorganization in electric service along with hundreds, if not thousands, of lay-offs. PSC "monitoring" just will not work.

[H] Any steam generating plant will be less efficient than "new state-of-the-art" combined cycle units. However, new generating units come with a higher price tag. The combined capital and operating costs for LILCO's steam units is expected to result in lower overall supply costs compared to such new technologies for quite some time. The FEP would have LILCO give up these benefits to its customers. In addition, the FEP ignores the fact that over half of LILCO's energy is supplied from nuclear generation and off-system purchases (51% in 1996). Thus any benefits that new generation technology may produce would be significantly less than the FEP estimates.

[I] The FEP proposes a bold capital program by competitors, building 4000 MW of new capacity over the next eight years. The FEP assumes that this new capacity could compete economically against plants with low carrying costs that serve a market with a low load factor. Most of these plants are "peaking" plants which run only when demand is high; many run only a few thousand hours per year. The best analogy LIPA can make for this situation relates to the commuter who uses his old but reliable "gas guzzler" to commute five miles to the train station each day, or 50 miles per week, and only gets 10 miles to the gallon. He could trade that car in for a new, highly efficient car that gets 30 miles to the gallon, but he would only save the cost of 3 gallons of gas per week, yet be "stuck" with a new car loan and higher insurance. It does not take a Ph.D. in economics to know that this is bad economics. So why would the FEP propose this?

[J] The FEP states that if LILCO can obtain purchased power during the transition period equal in amount to the power it currently produces, it will be free to dispose of its generating facilities. This opportunity is hollow; if LILCO has entered into purchased power contracts for all of its needs, how attractive is the opportunity to sell its generators in a market in which there are no on-island customers and limited transmission off-island? Furthermore, the sale and break-up of LILCO's generating units will impair service reliability and storm restoration and result in lay-offs.

[K] The FEP expects that LILCO will sell its surplus land to potential competitors but if LILCO does not agree it will be compelled to sell. This is not a free market; in addition what the FEP proposes is illegal.

Under the FEP LILCO has no incentive to sell the land or generating facilities: "[t]he proceeds. . .will accrue to LILCO up to the amount of the book value of the property sold" (emphasis added). The owners get only their investment back and the rest goes to the ratepayers. In other states on the forefront of electric competition, including California, Massachusetts, New York and Pennsylvania, it is proposed that utilities use asset sale proceeds in excess of book value to compensate for any write-off of stranded assets. The FEP is not progressive, only punitive.

[L] The FEP states that "LILCO generates from 30% to 50% of its power with oil." The fact is that only 24% of LILCO's energy supply was from oil in 1996. Indeed, LILCO has converted many of its generating units so that they are able to burn natural gas, when gas is available at a lower cost than oil. This is expected to further reduce the use of oil for generation. Due to geographic and seasonal constraints on the availability of gas it is not feasible to fully eliminate the use of oil as a generation fuel.

The FEP's comments regarding environmental emissions ignore the fact that LILCO's generating units already achieve low levels of emissions compared to other utilities in the State.

[M] LIPA agrees with the FEP on one point: reducing electric rates will create new jobs on Long Island. Under LIPA's plan the new jobs would be created faster than under the FEP: LIPA's plan will reduce rates immediately by an average of 17%; under the FEP, comparable rate reductions would not be achieved for six years. Furthermore, hundreds, if not thousands, of jobs will be lost at LILCO.

[N] With regard to the Shoreham property tax certiorari judgment, the FEP states "it is certainly appropriate for the judgment be resolved [sic] through electric rates." It also states that it would be possible to satisfy the judgment during the transition period by reducing the size of the 3.5% annual rate reduction for some customers and crediting the proceeds to others. If the $1.2 billion judgment were to be settled by having all Suffolk ratepayers fund $600 million of credits to Nassau rate payers during the eight year transition period, there would be a significant differential in rates between the two Counties; rates in Suffolk would be increased while rates in Nassau would be decreased in each case by more than 6%, resulting in a rate differential of more than 12% between the two Counties. Such a differential would obviously create economic development problems in Suffolk County.

[O] The FEP states that LILCO's current cash flow is so strong that even with the rate reductions during the transition period the company will be able to finance its capital spending needs and its debt and preferred stock retirement requirements with internally generated funds. The FEP acknowledges that in this scenario LILCO would be unable to pay any dividends or invest on behalf of its shareholders. It also recognizes that in this scenario LILCO would have to write-off approximately $3.5 billion of Shoreham and NMP2, which it says equals $2.3 billion after tax.

However, the analysis is seriously flawed. Using the FEP's starting discretionary cash flow in 1996 of $632 million, the change in cash flows should be greater than the slight decline in cash flows the FEP shows after 2000. Since revenues should decline by approximately 2% per year (3.5% reduction offset by the FEP's assumed 1.5% increase resulting from sales growth and price elasticity), cash flows, after adjusting for taxes and incremental fuel costs, should be declining by approximately $36 million per year. If we assume LILCO does not sell its generating facilities and cannot generate O&M expense reductions, then LILCO's projected ending cash position should be $636 million lower than the FEP estimates or $287 million "in the hole" at the end of the eighth year as illustrated in the graph on the following page. Also, writing off all of the Shoreham related accounts, when considered together, would result in an after tax cost of $3.3 billion not $2.3 billion as the FEP states. In this scenario, 100% of LILCO's projected shareholder's equity is "wiped-out". Industry professionals, including institutional investors, research analysts and credit rating agencies would not consider this to be the profile of a "financially viable" company.

[P] The FEP states that, "[e]lectric O&M expense was $1,027 million in 1996, up from an average of $978 million the four preceding years". The FEP claims that the $50 million increase in 1996 was "entirely attributable to an increase in fuel expense" and suggests that the increase was caused by LILCO's discretionary shift to higher cost residual oil. LILCO in 1996, and LIPA in the future, will be subjected to weather-related price rises in the energy markets and will need to address fuel-shifting strategies that reflect both fuel price and fuel availability. The FEP ignores both of these concepts.

The FEP misinterprets the fact that natural gas prices are lower than oil prices. This is certainly true in general, but seasonal and weather-related factors need to be acknowledged. Also, in the Long Island market, natural gas is not always available for boiler fuel, or becomes priced at prohibitive levels. In these situations it is more prudent, if not necessary, to turn to oil.

Fuel prices during calendar 1996 at the Northport power plant averaged $2.63 per MMBtu for natural gas and $3.60 per MMBtu for oil. This oversimplification is perhaps why the FEP considers oil as simply the "higher-cost fuel." Natural gas is cheaper than oil when it is readily available, such as during the summer and during mild winters. With mild winter weather conditions, the seasonal price swings for natural gas are also minimized. In 1995, which was a mild winter, the monthly average price for natural gas at the wellhead in January and February was lower than the cost of gas for April, May, June and August as illustrated in the graph on the following page. By the end of 1995, however, more typical weather conditions prevailed. The price of gas in December was $1.00 per MMBtu more than the price in July. Since low prices and high availability go together in the natural gas market, it was easy to burn cheap gas at the power plants.

The situation in 1996 was remarkably different. Gas prices in February, March and December were $3.00 per MMBtu or more, and the price in January was close to that level. At these levels, natural gas is neither cheap nor available, especially when you add in the cost of transportation from the Gulf to the Northeast. Interstate transportation adds around $0.50 per MMBtu to the delivered cost of gas.

The bottom line is that the economics of fuel choice are neither controllable by LILCO nor an area of guaranteed savings through better management. They are subject to the same competitive marketplace that the FEP claims is good for the electric consumer.

[Q] The "major cost savings" cash flow projections for LILCO under the FEP are based on absurd assumptions and are mathematically flawed. The FEP assumes that LILCO will sell its fossil fueled generating facilities for $300 million to raise cash. As a result, LILCO's discretionary cash flow in subsequent years will decline because it will be required to pay third parties for the purchase of power it no longer produces. Any purchaser of LILCO's generating facilities will have to sell almost all of the output from such plants to LILCO because (i) during peak load periods, Long Island is transmission constrained and (ii) during off-peak periods, these older plants generally are not competitive on a variable cost basis. As a result, LILCO's annual cash outlay for power would be higher after the $300 million sale of generating assets because the purchaser(s) of LILCO's fossil fueled generating units will bargain for power sales prices which allow them to recover depreciation and a return on investment based upon the price they paid for LILCO's plants.

The assumption that LILCO can cut its operating costs by $200 million annually by the third year of the transition is absurd. As justification, the FEP cites the testimony of the Staff of the PSC in the 1996 rate case. The FEP states "[t]he Staff calculated that the difference between LILCO's unit costs and the peer-average accounted for $55.7 million of LILCO's expense and recommended that LILCO's rates be reduced by that amount. The $55.7 million is equal to 15% of LILCO's total T&D and customer service O&M expense." How can the FEP assume a $200 million cut in operating costs is realistic based on a PSC Staff recommendation of a $55.7 million rate reduction? The FEP assumes operating cost reductions almost four times larger than the PSC Staff contemplated. Finally, this analysis repeats the mistakes identified in the "worst case" analysis, and consequently overstates the ending cash balance by $1.4 billion as shown in the graph below.

[R] The FEP does not try to suggest where the efficiencies can be found, it simply indicates that they are out there to be found if only the company is properly motivated. This avoids the embarrassment of explaining whether the cuts are coming from service reliability cuts, the jobs or wages of the workers, the tax payments to the local schools or the state, or from the shareholders.

[S] The FEP misrepresents the benefits of LIPA's plan: by refinancing LILCO's assets at a lower cost of capital through the issuance of tax-exempt debt and avoiding the requirement to pay federal income taxes, LIPA can offer Long Island ratepayers significant, sustainable savings. LIPA's savings are real and are supported by hard analysis; the FEP's savings are illusory and based upon wishful thinking.

[T] The FEP states that the "extent of the rate advantage of the Free Enterprise Plan over LIPA unfortunately cannot be determined with great precision; LIPA's rates are difficult to project, and LIPA has not published projections of the rates it expects to charge aside from claims of savings relative to hypothetical LILCO rates." LIPA has published rate projections based upon real data and hard analysis. LIPA's projected rate reduction of 17% are from current LILCO rates. What is missing in the FEP's analysis is any support for its own rate projections. The FEP's rate savings are achieved by assuming that LILCO will agree to reduce its revenues by $2.9 billion over eight years while assuming greater operational and financial risks.

Contrary to the FEP's assertions, the LIPA Plan controls operating costs. The initial operating budget will be based upon historical costs and then tied to regional indices, with financial incentives and penalties for BU/LILCO to lower costs and improve efficiency and reliability. Further, the FEP fails to acknowledge that after the sixth year of the takeover, the management contract will be bid out. Competitive pressure will be brought to bear on BU/LILCO to hold down costs in order to retain the contract. The LIPA plan, which the FEP characterizes as "socialist", relies on the free market to achieve the lowest costs while the "Free Enterprise Plan" relies on government regulation by the same PSC which brought us to the current situation.

[U] The FEP distorts the data in the chart on page 16 by comparing rates only through the last year that LIPA's acquisition debt is outstanding; if the analysis was extended one more year it would have to show that LIPA's rates are less than the "Free Enterprise Rates".

[V] Other absurd assumptions of the FEP are that the plan can be implemented on January 1, 1998, just one and a half months from now but that the LIPA plan can not be implemented until late 1998. Although the need for legislation and changes in regulation are acknowledged in the FEP, it does not provide the State or County legislatures with sufficient time to review or to hold hearings. Beyond that, the FEP ignores the amount of time that would be taken up in litigation (probably five to ten years) required in order to obtain LILCO's "voluntary" cooperation.

[W] The FEP states that "LIPA's high rates" make it vulnerable to "lethal competition from self generation." If this is so, then LILCO's significantly higher rates would have provided even more fertile grounds for self generation. This has not been the case. Therefore, the FEP's predicted "death spiral" rests on the unsupported assertion that the technology costs will decline substantially in the future, along with the implication that customers will disconnect from the power lines in droves. These assumptions, at a minimum, ignore the likely problems with decreased power supply reliability and potential environmental problems associated with numerous new generating sources.

[X] The FEP asserts that LIPA will become insolvent and the NYS legislature will respond with a tax levy on Long Island. Both of these assertions are wrong. LIPA will achieve investment grade credit ratings, which will reflect the opinions of experienced and knowledgeable independent credit rating agencies that LIPA is credit worthy and unlikely to become insolvent. Furthermore, since LIPA's debt will only be secured by LIPA revenues, the taxing power of the State or any of its political subdivisions will not be pledged to repay LIPA bonds.

[Y] The LIPA/LILCO transaction does more than "allude" to the eventual introduction of competition. LIPA has committed to bringing more competition to Long Island and will establish by July 1998 a clear timetable for open access for all customers within ten years or less. As a first step, LIPA has proposed to offer 100 MW of retail access in its first year of ownership.

[Z] The FEP claims that its key element, price caps, "are already widely used". Yet the examples cited differ significantly from the FEP's price cap mechanism. This mechanism in the examples actually caps price increases. In the U.K., for example, prices are allowed to increase over time at growth rates related to inflation. The price cap of the FEP force rates to decrease each year regardless of inflation. The U.K. model attempts to cap prices relating to controllable costs. The FEP's mechanism is just punitive.

Conclusion

The FEP claims that the "LILCO/LIPA takeover proposal is now unproductively absorbing a huge amount of time of the Long Island community. . .The Free Enterprise Plan offers closure and will allow the community to turn to productive matters." Nothing could be less productive than introducing the FEP into the ongoing debate. The FEP is simply unrealistic, illegal and impossible to implement. Furthermore, even if the FEP could be implemented, it would result in chaos, destroy service reliability and jeopardize the jobs of hundreds, if not thousands, of LILCO's employees. It is a recipe for disaster.