The feasibility of municipalization
Your discussion, “Public power gains popularity as sector sustains its financial strength,” in the March 2004 EL&P prompts these comments:
You note that public entities have higher bond ratings than do investor-owned entities. I have observed that electric industry restructuring has made investors more aware of the risks of regulation, which I suspect is responsible for much of the rating difference.
I have observed municipalization to raise some interesting valuation issues. Such a transaction often involves acquiring a portion of the selling entity’s business, which suggests use of the income approach for determining the appropriate price. However, I have found that it is not unusual for appraisers representing the acquiring entity to propose a transaction price based on the cost approach, sometimes even going so far as to propose net book value when the selling entity is price regulated. I have never heard of net book value being accepted as the basis for such a transaction, and never expect to.
The cost approach requires addition of “going concern value,” and I have yet to encounter an approach for estimating going concern value that I thought was accurate. The most accurate approach is to prepare appraisals using both the income and the cost approaches—their difference being the going concern value. However, preparing two appraisals is not cost-effective, so relying on only the income approach makes sense.
The income approach would likely determine the appropriate price from the present value of the income lost by the seller. For a transaction involving only a portion of the selling entity’s business, the income lost consists of a revenue decrease that reflects average costs and an expense saving that reflects incremental costs. My experience is that this average/incremental situation produces a transaction price well in excess of the depreciated current cost of the facilities involved.
Sellers are unlikely to be interested in losing part of their business, so municipalization often involves condemnation. The appropriate price for a condemnation is that which would make the seller’s stockholders and remaining customers indifferent to the transaction. The lost income approach does this, but a tax-paying entity would also need to be reimbursed for any income taxes due on the transaction, and any selling entity would need to be reimbursed for severance damages.
It behooves potential acquirers to conduct realistic feasibility studies for their contemplated transactions. My experience suggests that a reasonable assumption for preliminary feasibility studies is that the transaction price for an electric distribution system will be in the neighborhood of three to four times the net book value of the facilities involved. I deem the low end of this range to be for a seller that does not pay income taxes, and the high end to be for a seller that pays income taxes. While economics may not be the driving force behind the transaction, a realistic feasibility study will prevent an unpleasant surprise.