EXHIBIT K-1
ANALYSIS OF THE ECONOMIC IMPACT OF A DIVESTITURE OF THE
NORTH CAROLINA NATURAL GAS CORPORATION
OCTOBER 2000
This study was undertaken by the management and staff of Carolina Power &
Light Company ("CP&L"), a North Carolina corporation, and its affiliate, CP&L
Service Company LLC ("Service Company"), a North Carolina limited liability
company. Both CP&L and Service Company are wholly-owned subsidiaries of CP&L
Energy, Inc., a North Carolina corporation ("Applicant" and "CP&L Energy"). The
objective of this study is to quantify the economic impact of divesting CP&L
Energy of its ownership of one hundred percent (100%) of the voting securities
and control of North Carolina Natural Gas Corporation ("NCNG"), a gas utility as
defined under the Public Utility Holding Company Act ("the Act"). NCNG operates
in eastern and south central North Carolina. Its headquarters are in Raleigh,
North Carolina, in the CP&L and CP&L Energy headquarters building.
EXECUTIVE SUMMARY
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The study evaluates the increased costs or "lost economies" associated with
divestiture of NCNG, an historically important business in Eastern North
Carolina and now a vital part of a "converging" energy business CP&L Energy is
building to broaden its service offerings to utility customers in the Carolinas
and in the Southeastern United States. The effect is the direct result of the
increased costs or lost economies resulting from a spin-off or divestiture,
estimated at $17.4 million in one-time costs, and additional costs of $12.5
million annually.
In determining whether the projected lost economies incurred by a
divestiture of a secondary utility system would be "substantial" under clause A
of Section 11(b)(1) of the Public Utility Holding Company Act ("the Act"), the
Commission historically has emphasized the consideration of four ratios that
measure the projected increased costs associated with a divestiture as a
percentage of four operating results: 1) divested business operating revenues;
2) divested business operating expenses or "operating revenue deductions"; 3)
divested business gross income; and 4) divested business net income. See
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Engineers Public Service Co., 12 SEC 41 (1942), rev'd on other grounds and
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remanded, 138 F. 2d 936 (DC Cir. 1943), vacated as moot, 332 US 788 (1947)
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("Engineers").
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In Engineers, the Commission suggested that cost increases that equate to
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6.78% of operating revenues, 9.72% of operating revenue deductions, 25.44% of
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gross income, and 42.46% of net income comprise an "impressive basis for finding
a loss of substantial economies" associated with a divestiture. 12 SEC at 59.
See also Ameren Corporation, Holding Co. Act Release No. 26809 (Dec. 30, 1997);
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New Century Energies, Inc., Holding Co. Act Release No. 26748 (Aug. 1, 1997)
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(citing Engineers). More recently, in Dominion Resources, Inc., Holding Co. Act
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Release No. 27113 (Dec. 15, 1999), the Commission held, citing New England
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Electric System, 41 SEC 888 (1964), that cost increases resulting in a 4.8% loss
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of operating revenues, a 6% increase in operating revenue deductions (excluding
federal income taxes), a 23.3% loss of gross income (before federal income
taxes) and a 29.9% loss of net income (before taxes) would afford an "impressive
basis for finding a loss of substantial economies."
NCNG
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CP&L acquired NCNG in July 1999 and CP&L has integrated certain "shared
service" functions and systems, including the integration of the gas supply and
procurement functions of CP&L and NCNG, over the past year.1 NCNG supplies gas
or gas transportation service to approximately 115,000 residential, commercial,
agricultural, industrial and electric utility customers in 110 cities and towns
in eastern and south central North Carolina and to four municipal gas
distribution systems which serve an additional 46,674 end users. NCNG also
serves gas to CP&L electric generating stations, and both companies are
currently jointly coordinating the construction of a new gas pipeline to serve
CP&L's Rowan County combined cycle generating station, which will be fueled by
natural gas and will be coming on line in the year 2001.
As noted, the gas procurement functions of NCNG and CP&L have been
centralized. CP&L now administers the combined portfolios of supply
transportation and storage contracts for the two companies.
ECONOMIES ACHIEVED THROUGH COMBINED FUNCTIONS
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Since the acquisition in 1999, CP&L has achieved economies by integrating
and coordinating NCNG and CP&L activities within a single company system,
combining functions such as management, procurement, materials management,
customer service, information systems, finance, accounting, legal, engineering
and construction services.
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1 CP&L Energy, CP&L's parent company, acquired the stock and control of
NCNG by way of a distribution from CP&L effective July 1, 2000.
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Today, the CP&L Energy holding company system provides many of these same
functions through its subsidiary Service Company, formed August 1, 2000. All of
these economies would be lost if CP&L Energy were required to divest its control
of NCNG and NCNG were to be operated as a stand-alone utility.
LOST ECONOMIES ANALYSIS
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The severance of NCNG assets and business from the CP&L Energy holding
company system would result in increased annual operating costs for the
resulting stand-alone company of approximately $12.5 million. These lost
economies would result primarily from additional capital costs and annual
operating and maintenance (O&M) costs in several categories, including one-time
transition costs associated with establishing NCNG as a separate company.
The projected $12.5 million in annually recurring lost economies would
satisfy the thresholds established in Commission precedent. These lost economies
would represent 5.65% of gas operating revenue, 6.17% of gas operating revenue
deductions, 66.90% of gas gross income, and 308.34% of gas net income. The four
operating results that represent the denominators in these ratios are defined as
follows:
o "Gas operating revenue" refers to the sum of rate revenue and other revenue
for the 12 months ended December 31, 1999 ($221.2 million).
o "Gas operating revenue deductions" refer to all gas operating expenses,
including operating and maintenance expenses, administrative and general
expenses, provisions for depreciation and amortization, appropriations to
retirement and depletion reserves, rents, royalties, uncollectible
customers' accounts, and taxes ($202.6 million).
o "Gas gross income" refers to the difference between gas operating revenue
and gas operating revenue deductions ($18.7 million).
o "Gas net income" refers to electric gross income absent interest on
mortgage bonds and other long-term debt, other interest charges, and
amortization of acquisition adjustment and premium, discount and expense on
debt ($4.1 million).
1. ADDITIONAL CAPITAL COSTS
CP&L and the Service Company estimate that NCNG as a stand-alone entity
would incur significant capital costs of $17.4 million to operate independently.
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These include headquarters costs ($10 million) and new investment in information
technology systems ($3.4 million).
Costs to implement new investments in information technology ("IT") systems
to support the headquarters and customer service center are estimated at $3.4
million, and annually recurring IT costs are estimated at $3.6 million.
2. ADDITIONAL O&M COSTS
CP&L and the Service Company estimate that NCNG, as a stand-alone entity,
would incur additional annual costs of $8.01 million for executive positions,
managers and staff positions that currently are "shared" with NCNG by CP&L and
the Service Company. The expected number of NCNG employees would be about 500,
requiring an incremental increase of 86 employees. Related costs would be
incurred for hiring and recruitment, employee services, leadership development
and training, office space, furnishings and equipment (including computers,
identified as work-point costs). These personnel related costs are estimated at
$2.17 million annually. An additional $203,200 annually is estimated for costs
incurred to support the Board of Directors' meetings and directors' fees and
expenses.
3. OTHER COSTS AND DISECONOMIES
Based on recent experience and estimates obtained from knowledgeable
sources, CP&L estimates that it would incur additional one-time costs to
consummate the spin-off transaction approximating $4.0 million, as detailed
below:
Transactional Costs (one-time)
Investment Banking Fees $3.0 million
Registration Costs $0.1 million
Attorney Fees $0.75 million
Filing Fees $0.15 million
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Total $4.0 million
The spin-off company would also likely incur an increased cost of
short-term borrowing, estimated at $250,000 per year. This assumption is based
on the current practice of inter-company borrowing from CP&L and the economies
of scale and volume of that arrangement, and NCNG's experience of lower interest
rates under the inter-company borrowing arrangement than NCNG could obtain in
the financial markets. Disaggregation would cause NCNG to return to higher rate
short-term borrowings in the financial marketplace.
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NCNG would also incur an estimated $90,000 annually in central remittance
processing costs that are currently shared with the Service Company.
Finally, NCNG would lose an estimated annual savings of $300,000 in gross
margins from off-system gas sales, and annual estimated savings of $629,500 in
system supply economies currently realized because of the joint gas supply and
transportation functions that benefit both NCNG and CP&L today.
GENERAL STUDY ASSUMPTIONS
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The assumptions, information and data utilized in the analyses undertaken
in this Study are based on the energy industry expertise and experience
possessed by the management and staff of CP&L and Service Company. Employees
with experience in the operations of NCNG were consulted and provided input. The
Study's aggregate conclusions are the result of independent inputs and analyses
from qualified individuals familiar with the company operations.
CP&L and the Service Company analyzed major cost components that may be
associated with a divestiture. The major cost components associated with a
divestiture were identified, quantified, and included in the Study results. No
estimates for the cost of capital were assumed or estimated. A more exhaustive
analysis would probably produce additional costs and diseconomies, including the
cost of capital, resulting from a divestiture of NCNG.
The remainder of this section discusses the major assumptions that were
employed in developing the Study.
A. For the purposes of developing the impacts of a spin-off, it is
assumed that the organization to be spun-off would operate as an
independent, stand-alone company. Therefore, it will have all of the
necessary management and personnel, along with the computer systems,
facilities, equipment, materials and supplies required to operate as a
stand-alone company.
B. For the purpose of determining the staffing requirements of the
stand-alone company, the guiding principle was that a sufficient
number of employees be included in order to assure that all present
functions applicable to the stand-alone organization are performed,
and that the present level and quality of service remain unchanged.
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C. Labor costs are based on an assessment of straight-time, overtime, and
pension and benefit costs for each employee of the stand-alone
organizations. Benefit levels would remain unchanged.
D. Unless otherwise discussed, the non-labor costs would remain
essentially unchanged from those costs allocated to the organization
to be spun-off.
E. Annual facility costs relating to the additional employees required to
maintain the current levels of service have been incorporated into the
analyses.
F. It is assumed that each organization will be subject to the regulation
of the same state and federal agencies that presently regulate each
organization.
G. If there currently exists a contract for services from independent
third-parties, the contract will continue for the spun-off
organizations.
H. Only the categories of costs that are expected to change significantly
were analyzed. Clearly many other costs beyond those presented in this
study will be impacted by a divestiture.
THE "ABC CLAUSE" TEST
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Under the "ABC" clauses of Section 11(b)(1) of the Act, a registered
holding company can own "one or more additional integrated systems if certain
conditions are met. Specifically, the Securities and Exchange Commission must
find that (A) the additional system "cannot be operated as an independent system
without the loss of substantial economies which can be secured by the retention
of control by such holding company of such system," (B) "the additional system
is located in one state or adjoining states," and (C) "the combination of
systems under the control of a single holding company is not so large . . . as
to impair the advantages of localized management, efficient operation, or the
effectiveness of regulation."
Many regulated utilities are in the midst of, or have completed,
restructurings or major transactions designed to permit them to become complete
energy services companies which can offer customers an array of fuels to meet
their complete energy needs through a "one-stop" energy company, an industry
shift that the Commission has expressly recognized. Recently, the Commission has
approved a number of transactions involving the combination of gas companies and
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electric companies serving overlapping areas.2 All of those transactions
demonstrate that market forces are pushing for the convergence of electric and
gas operations in one corporate entity; namely, a full service energy utility
company.
Permitting CP&L Energy to retain NCNG will assure NCNG access to greater
financial and other resources, and, at the same time, enable CP&L to evolve into
a total energy services provider and achieve the other strategic goals it
envisioned in acquiring NCNG. In this regard, a combination electric and gas
utility system can offer a wide range of benefits to customers, including the
convenience and efficiency of dealing with a single energy supplier. From the
customer's standpoint, this can reduce transaction costs incurred in gathering
and analyzing information, contacting energy suppliers, negotiating terms of
multiple service contracts and paying bills. Combining gas and electric
operations can also simplify community planning on energy-related matters. For
utility shareholders and employees, a total energy service provider is better
positioned to respond to a competitive environment and to remain an attractive
investment opportunity for shareholders and an appealing employer for utility
employees.
In contrast, CP&L Energy's competitive position in the market would suffer
as a result of any divestiture of NCNG because, as the electric and gas
industries continue to converge, energy suppliers must be able to offer their
customers a range of energy options. One other gas company in North Carolina
(Public Service Company of North Carolina) has already completed a business
combination with an out-of-state utility that is primarily an electric company
(SCANA Corporation).3 The same sort of merger and acquisition activity
involving combinations of electric companies and gas companies is also taking
place in Pennsylvania, Connecticut, Massachusetts, Ohio, Maryland, and West
Virginia.
The Division of Investment Management's (the "Division") June 1995 report
to the Commission entitled "The Regulation of Public-Utility Holding Companies"
(the "1995 Report"), noted that "it does not appear that the SEC's precedent
concerning additional systems precludes the SEC from relaxing its interpretation
of Section 11(b)(1)(A)" and "that the utility industry is evolving toward the
creation of one-source energy companies that will provide their customers with
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2 See e.g., TUC Holdings Company, et al., Holding Co. Act Release No. 26749
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(Aug. 1, 1997); BL Holding Corp., Holding Co. Act Release No. 26875 (May 15,
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1998); and Sempra Energy, Holding Co. Act Release No. 26890 (June 26, 1998); and
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Northeast Utilities, Holding Co. Act Release No. 27127 (Jan. 31, 2000).
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3 See SCANA Corporation, Holding Co. Act Release No. 27133 (Feb. 9, 2000).
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whatever type of energy supply they want, whether electricity or gas." The
Division recommended that the Commission interpret Section 11(b)(1) of the Act
to allow registered holding companies to hold both gas and electric operations
as long as each affected state utility regulatory commission approves of the
existence of such a company.
In this connection, it is appropriate for the Commission to consider that,
in approving the affiliation of CP&L and NCNG, the North Carolina Utilities
Commission ("NCUC") found that North Carolina utility customers would benefit in
several important respects. Specifically, the NCUC found that the combination of
CP&L and NCNG would help ensure CP&L an adequate, reliable and cost-effective
supply of natural gas for its gas-fired electric generating assets; promote the
expansion of intrastate natural gas transmission lines in North Carolina, in
that the overall economies of expansion plans would improve when CP&L's need for
gas as a fuel is combined with NCNG's need for gas transportation; and make it
more likely that natural gas service would be extended into unserved parts of
North Carolina as and when CP&L gas-fired generating units become the "anchor
tenant" providing the economic justification for expansion of gas service into
the nearby local communities. While not all of these benefits are quantifiable,
they are undoubtedly important. In this regard, although CP&L has owned NCNG for
only a short time, the two companies are already working together to develop new
pipeline expansions into eastern North Carolina and are jointly managing their
portfolios of gas supply, transportation and storage assets.
Further, in approving CP&L's acquisition of NCNG, the NCUC also adopted a
comprehensive code of conduct and related set of regulatory conditions designed
to, among other things, prevent CP&L and NCNG from unreasonably favoring their
affiliates, assure the continuation of competition between gas and electric
service, and prevent discrimination against other gas-fired electric generators.
Accordingly, to the extent that the preservation of inter-modal competition
between gas and electric service was a significant reason for forcing the
separation of secondary gas systems in the past, it is clear that these concerns
have been addressed by the NCUC.
Under Clause A, this study demonstrates that substantial economies would be
lost by divestiture. Clause B is easily satisfied; NCNG and the principal
service areas of CP&L overlap in a single state, North Carolina. Finally, as the
brief history of their combination has proved, the Clause C test is also
satisfied, as CP&L and NCNG have been combined and operated with no impairment
of localized management, efficient operation, or the effectiveness of
regulation. Indeed, this study demonstrates that divestiture of NCNG would
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likely result in less efficient operations than are currently enjoyed with the
current combined condition.
CONCLUSION
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This study demonstrates substantial increased costs or "lost economies"
would be the price of divestiture of NCNG, an increasingly important and
integral segment of CP&L's energy business. The effect is the direct result of
the increased costs or lost economies resulting from a spin-off or divestiture,
estimated at $17.4 million in one-time costs, and annual costs of $12.5 million.
Therefore, divestiture would not serve the public interest, or the
interests of CP&L shareholders or customers. The Commission should find that
retention of control of NCNG by CP&L Energy satisfies the "ABC Clause" tests of
Section 11(b)(1) of the Act, and that retention is in the public interest.
NCNG: Gas Retention Study rev 9/29/00
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