EXHIBIT K-2
CP&L ANALYSIS OF THE ECONOMIC IMPACT OF A DIVESTITURE OF
THE CP&L WESTERN REGION AND WESTERN CONTROL AREA
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 of
its electric assets and business in CP&L's Western Region, situated in western
North Carolina. The Western Region's base of operations is located in Asheville,
North Carolina.
EXECUTIVE SUMMARY
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The study evaluates the increased costs or "lost economies" associated with
divestiture of the Western Region, an historically important and integral
segment of CP&L's electric business. The effect is the direct result of the
increased costs or lost economies resulting from a spin-off or divestiture,
estimated at $126.5 million in one-time costs, and additional costs of $51.7
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
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."
THE WESTERN REGION
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CP&L's Western Region has been an integrated and interconnected part of
CP&L's system since the acquisition of Asheville Power & Light Company in 1926.
The Western Region serves approximately 131,000 customers in seven counties, in
and around the Asheville area. Western Region electric loads are served in the
Western control area by 869 megawatts (winter rating) of generation, from three
Western Region generating plants and by interconnections with the CP&L Eastern
Control Area and other electric utilities in the Southeast, including Duke
Power, Appalachian Power, the Tennessee Valley Authority, and Georgia Power. In
1999, the Western Region customers purchased 3.4 billion kiloWatt-hours of
electricity, generating revenues of $221.9 million.
The Western Region's load requirements are centrally dispatched by the CP&L
Skaale Energy Control Center located in Raleigh, North Carolina.
ECONOMIES ACHIEVED THROUGH COMBINED FUNCTIONS
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Historically, CP&L has achieved substantial economies by integrating and
coordinating Western Region 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, system planning and operations, including day-to-day and
hour-to-hour energy control and dispatch.
Today, the CP&L Energy holding company system provides many of these same
functions through its subsidiary Service Company, and CP&L continues to operate
both its Eastern and Western control areas through a centralized system planning
and operations department, including a centralized energy control center, and
centralized transmission, distribution and engineering functions. All of these
economies would be lost if the Western Region were required to be operated as a
stand-alone utility.
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LOST ECONOMIES ANALYSIS
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The severance of CP&L's electric assets and business in the Western Region
would result in increased annual operating costs for the resulting stand-alone
company of approximately $51.7 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 a separate company, (hereinafter "Westco") .
The projected $51.7 million in annually recurring lost economies would
satisfy the thresholds established in Commission precedent. These lost economies
would represent 18.32% of electric operating revenue, 25.36% of electric
operating revenue deductions, 66.02% of electric gross income, and 142.78% of
electric net income. The four operating results that represent the denominators
in these ratios are defined as follows:
o "Electric operating revenue" refers to the sum of rate revenue and other
revenue for the 12 months ended December 31, 1999 ($282.5 million).
o "Electric operating revenue deductions" refer to all electric 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 ($204.1 million).
o "Electric gross income" refers to the difference between electric operating
revenue and electric operating revenue deductions ($78.4 million).
o "Electric 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 ($36.3 million).
1. ADDITIONAL CAPITAL COSTS
CP&L and the Service Company estimate that the stand-alone entity, Westco,
would incur one-time capital costs of $126.5 million to operate independently.
These include headquarters costs ($10 million), procurement of additional
generating capacity ($65 million), construction of an energy control center ($10
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million), a new customer service center [$10 million] and new investment in
information technology systems ($27.5 million).
Divestiture of the Western Region would necessitate a number of significant
operating costs for generation and energy control system resources. The Western
Region generation resources and load are currently controlled by the CP&L energy
control center in Raleigh. A new energy control center would have to be built
and staffed in the western area, duplicating the existing system planning and
operations functions. North American Electric Reliability Council (NERC)
requirements dictate that each control area maintain operating reserves
sufficient to cover the loss of its largest unit. The Western Region is a NERC
control area. The Western Region would not have sufficient resources on its own
to accomplish this and would have to install or purchase additional generating
capacity. Further, significant benefits associated with economic energy exchange
between the east and west would be lost. The impact of these factors is
summarized below:
New Energy Control Center
Capital Additions $ 10 million
Annual operating costs $ 3 million
Additional Generating Capacity
Capital Additions $ 65 million
Annual costs Not quantified 1
Energy Transfers - annual costs
West to East $ 0.6 million
East to West $ 16.0 million
It would also be necessary to establish a state-of-the-art customer service
center (comparable to the CSC that currently serves both CP&L's Eastern and
Western Regions] in order to assure comparable high quality customer service and
effective dispatch of transmission and distribution employees to connect new
service lines, to perform regular maintenance, to respond to trouble calls and
to make storm repairs. The estimated capital cost for a new customer service
center is $10 million.
Costs to implement new investments in information technology systems to
support the headquarters, energy control center and customer service center are
estimated at $27.5 million, and annually recurring costs are estimated at $4.9
million.
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1 If the new entity were to build rather than buy the additional generating
capacity estimated in this study, then there would be additional substantial
operating and maintenance costs incurred to maintain the physical assets.
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2. ADDITIONAL O&M COSTS
CP&L and the Service Company estimate that Westco, as a stand-alone entity,
would incur additional annual costs of $18.3 million for executive positions,
managers and staff positions that currently are "shared" with the Western Region
by CP&L and the Service Company. The expected number of Westco employees would
be about 500, requiring an incremental increase of 191 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 workpoint costs). These personnel related costs are
estimated at $3.04 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
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 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
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 the Western Region and Western Control Area
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
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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 divestiture of Westco.
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.
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
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were analyzed. Clearly many other costs beyond those presented in this
study will be impacted by a divestiture.
I. At the time of divestiture of Western Region and Western Control Area,
a release of Western Region properties from the existing bond
indentures from Bank of New York would be required. New bond
indentures would be written for the new company.
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."
If the Commission were to find that the CP&L Western Region is a discrete
"integrated system" (which conclusion Applicant contends is not the correct
conclusion, given the historical interconnection and coordination of CP&L
Eastern and Western Region operations since the early days of the 20th century),
the Commission must also find that Applicant satisfies all three tests of the
ABC Clause with retention of control of the CP&L Western Region by the CP&L
Energy holding company system.
Under Clause A, this study demonstrates that substantial economies would be
lost by divestiture. Clause B is easily satisfied; the Western Region and the
Eastern Region are both located in a single state, North Carolina. Finally, as
history has proved, the Clause C test is also satisfied, as the CP&L Eastern
Region and Western Region 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 the Western Region would
likely result in less efficient operations than are currently enjoyed with the
current combined condition, and the creation of a new stand-alone company would
increase the burden of the State regulatory commission.
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CONCLUSION
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This study demonstrates substantial increased costs or "lost economies"
would be the price of divestiture of the Western Region, an historically
important and integral segment of CP&L's electric business. The effect is the
direct result of the increased costs or lost economies resulting from a spin-off
or divestiture, estimated at $126.5 million one-time costs, and annual costs of
$ 51.7 million.
Moreover, divestiture and creation of a new stand-alone company would
impose additional administrative and financial burdens on local, State and
Federal regulatory and taxing authorities and agencies, thus imposing additional
societal costs and burdens that are not imposed by operation of the Western
Region as part of the combined operations of CP&L.
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 the Western Region 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.
#88697 - Retention DRAFT
