oversight

Response to APPA Letter

Published by the Government Accountability Office on 1997-02-10.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

GAO   United States
      General   Accounting
      Washington,
                             Office
                     D.C. 20548

      Accounting   and Information
      Management     Division



      B-275697


      February 10, 1997

      The Honorable John T. Doolittle
      Chairman, Subcommittee on Water
       and Power Resources
      Committee on Resources
      House of Representatives

      The Honorable George Miller
      Ranking Minority Member
      Committee on Resources
      House of Representatives

      As requested, we are providing our evaluation of the comments submitted to the
      Subcommittee by the American Public Power Association (APPA) on our recentlc.
      issued report on three power marketing administrations (PM&): Southeastern
      Power Administration (Southeastern), Southwestern Power Administration
      (Southwestern), and Western Area Power Administration (Western).’ APPA is
      the national service organization representing municipal and other state or local
      government-owned electric utilities throughout the United States. APPA member
      utilities are the primary recipients of the PM&’ low-cost power.

      We reported that unrecovered power-related costs and financing subsidies for
      Southeastern, Southwestern, and Western amounted to about $300 million in
      fiscal year 1995 and several billion dollars over the last 30 years. These
      unrecovered costs, financing subsidies, and inherent cost advantages, compared
      to nonfederal utilities, have allowed PMAs to be low cost marketers of wholesale
      electric power. In addition, our report noted that the PMAs are generally
      following applicable laws and regulations regarding recovery of power-related
      costs and financing of capital projects.




      ‘Power Marketing Administrations: Cost Recoverv. Financing, and Comnarison to
      Nonfederal Utilities (GAO/AIMD-96-145, September 19, 1996).
                                          GAO/AIMD-97-27R Response to APPA Letter
B-275697
APPA declined an invitation to participate in the Subcommittee hearing held on
September 19, 1996, to discuss our report. However, subsequent to the hearing,
APPA submitted written comments on our report to be included in the record of
the hearing. Because APPA’s comments were highly critical of our report and
received wide distribution, your offices asked that we respond to them.

APPA’s comments seek to bolster the message provided by its Deputy Executive
Director at the Subcommittee’s May 18, 1995, oversight hearing at which he told
the Subcommittee that PMAs are self-supporting and are not subsidized. This
view on the cost recovery practices of the PMAs is not supported by the findings
in our report. Following is a summary of the key points in APPA’s letter and our
evaluation of each point. Other, more specific APPA comments are analyzed in
the enclosure.

SUMMARY OF APPA’s COMMENTS AND OUR EVALUATION

Unrecovered Power-Related Costs

APPA stated that our report seriously misrepresents the financial status of the
PMAs by blending currently unrecovered power-related costs with financing
subsidies to produce annual and cumulative estimates of uncollected costs
related to the PMAs’ operations. APPA suggests that the presentation of data in
this fashion blurs the distinction between these two different types of costs and
leaves readers with the inaccurate impression that the unrecovered costs
identified in our report are subsidies. The primary objective of our
congressionally requested review was to determine whether PMAs’ power rates
recovered all power-related costs as of September 30, 1995, and to what extent, if
any, the financing for power-related capital projects is subsidized by the federal
government. We reported that unrecovered power-related costs and financing
subsidies for Southeastern, Southwestern, and Western amounted to about $300
million in fiscal year 1995, and several billion dollars over the last 30 years.
 Combining unrecovered power-related costs and the financing subsidies helps
give the Congress an idea of the magnitude of federal expenditures for the three
PMAs that are not currently being recovered through power charges.

APPA stated that in determinin g power-related costs, we substituted our
judgment for that of the Congress. APPA further stated that we based a large
portion of our estimates on II. . . pure speculation regarding potential future
scenarios-much of which conflicts with available facts and information, and
 contradicts sworn testimony of the federal agencies with responsibility in these
 areas.” APPA stated that our report did not distinguish between unrecovered and
 unrecoverable costs. Finally, APPA implies that because our report identifies

2                                    GAO/AIMD-97-27% Response to APPA Letter
B-275697

unrecovered power-related costs and financing subsidies, we were I’. . . intent on
finding ways for this power [power sold by the PMAs] to be marketed at the
highest possible rates.”

We disagree. The Reclamation Project Act of 1939 and the Flood Control Act of
1944 generally require the recovery through power rates of the costs of
producing and marketing federal hydropower. However, these acts and the DOE
Order implementing the cost recovery requirement of these acts do not specify
which costs are to be recovered. To define the full costs associated with
producing and marketing federal hydropower, we referred to criteria in (1) Office
of Management and Budget (OMB) Circular A-25, “User Fees,” (2) federal
accounting standards recommended by the Federal Accounting Standards
Advisory Board, and (3) accounting and cost recovery practices of investor-
owned and publicly-owned utilities. Applying these criteria, the full cost of
electricity sold by the PMAs would include ah direct and indirect costs incurred
by the operating agencies to produce the power, the PMAs to market and
transmit the power, and any other agencies to support the operating agencies and
PMAs. We see nothing in APPA’s letter that refutes the reasonableness of these
criteria.

Carefully applying these criteria, we estimated that the unrecovered power-
related costs and financing subsidy for the three PMAs totaled about $300 million
for fiscal year 1995. While we recognize the distinction between “unrecovered”
and “unrecoverable,” we believe that “unrecoverable” costs are essentially a
subset of “unrecovered” costs. However, most of this estimate pertains to the
financing subsidy and unrecovered pension and postretirement health benefits,
which are not recoverable under existing PMA practices. Unless these practices
change, the financing subsidy and unrecovered benefits will continue to
accumulate.

We disagree with APPA’s statement about the objective of our review. Based on
agreements with the requesters’ staff, we were asked to determine whether all
power-related costs incurred through September 30, 1995, had been recovered
through electricity rates, and whether the financing for power-related capital
projects is subsidized by the federal government. We were not asked to and did
not address whether any changes in PMA cost recovery practices or financing
should be made. Whether any change is needed is a judgment for congressional
decisionmakers.




                                    GAO/AlMD-97-27R Response to APPA Letter
B-275697
Subsidized F’inancing

APPA stated that we selected an arbitrary method for calculating the “alleged
financing subsidies.” It also stated that the only accurate way to establish
whether any “interest rate gap” exists would be to compare PMA interest rates
and the Treasury interest rates project by project. Moreover, APPA stated that
GAO agrees that this is the most accurate method, but dismissed it because
records were not available for all Western projects.

We defined the financing subsidy as the difference between Treasury’s borrowing
cost and the interest rate paid by the three PMAs to Treasury. This interest
differential is the result of explicit subsidies and the economic cost to the federal
government of taking on interest rate risk in the structuring of the PMA
financing. As outlined on pages 52 and 53 of our report, the interest rates the
PMAs paid on outstanding appropriated debt2 for fiscal year 1995 (2.9, 4.4, and
5.5 percent for Southwestern, Southeastern, and Western, respectively) are lower
than the cost to the federal government for fiscal year 1995 (9.1 percent) of
providing this financing. As a result, there is a significant difference between the
interest income earned by Treasury on the appropriated debt and Treasury’s
related interest expense.

As stated on page 57 and again on pages 34 and 86 of our report, there are three
primary components of the financing subsidy to the PMAs. One is the difference
between the P&LA borrowing rate and the closest match of Treasury borrowing in
terms of maturity at the time of the appropriation. The second is the PEAS’
ability to repay the highest interest-bearing appropriated debt first. This source
of financing subsidy occurs because PM&’ debt management flexibility is not
shared by Treasury, which cannot pre-pay most high interest-rate debt during
periods of low interest rates. Finally, the PM&’ appropriated debt has maturities
of up to 50 years, which is beyond the maximum maturity-30 years-of Treasury
bonds. Thus, if PMAs do not pay off appropriated debt within 30 years, Treasury
would have to refinance its corresponding debt.3

2GA0 calls this appropriated debt because Pleas are required to repay, with
interest, appropriations used for capital investments. However, these
reimbursable appropriations are not technically considered lending by the
Treasury.

30ur consideration of the financing subsidy does not include the impact of other
forms of subsidy, such as the difference between Treasury debt being
compounded semiannually versus PMA debt being compounded annually. We
                                                                    (continued...)

4                                     GAO/AI&ID-97-27R Response to APPA Letter
B-276697
As discussed on page 49 of our report, in addition to these three main aspects of
the subsidy, Treasury takes on risk, known as interest rate risk, with regard to
PMAs’ appropriated debt. Appropriated debt carries a fixed interest rate and a
term of 50 years with no ability of Treasury to call4 the debt. Although PMAs are
generally required to pay off the highest interest debt first, they cannot refinance
the debt. Thus, Treasury bears the risk of increases in interest rates and PM&,
to some degree, bear the risk of decreases in interest rates. Western, for
example, has some appropriated debt that is at interest rates above the current
Treasury 30-year bond rate. However, because Western cannot refinance this
debt and does not have sufficient cash flow to pay it off, it must pay the above-
market interest rates. However, as indicated above, the majority of the PMA
appropriated debt is well below Treasury rates. The combination of the explicit
subsidies and the federal government’s interest rate risk has resulted in billions
of dollars of cost to taxpayers, which we defined as the financing subsidy, over
the period the appropriated debt has been outstanding.

As our report indicated, new projects, additions, and equipment replacements
made after September 30, 1983, are financed at Treasury market interest rates.6
Thus, the initial below market interest rate aspect of the subsidy was generally
eliminated for post-1983 appropriated debt. However, the PMAs’ ability to repay
the highest interest rate appropriated debt first has resulted in much of the pre-
1983 below market rate debt remaining on the PMAs’ books. This factor will
continue to contribute to the interest rate differential over the next several
decades until all pre-1983 appropriated debt is repaid.

We agree with APPA and the PM& that the most accurate way to assess the first
component of the financing subsidy (the initial below market financing) would be
to compare the PM&s’ and Treasury’s interest rates on a project-by-project basis



also exclude the impact that the risk of hydropower projects might have had on
the PMAs’ interest rates if they had been financed in the private market rather
than through Treasury.
4CaUrefers to the ability of the lender to require the borrower to pay back the
debt before its maturity date.
‘Post-1983 capital projects are maneed at interest rates equal to the average
yield during the preceding year on interest-bearing marketable securities of the
United States, which, at the time the computation is made, have terms of 15
years or more remaining to maturity. Our report shows that these rates
approximate Treasury’s 30-year rates for bonds issued from 1983 to 1996.

5                                    GAO/AIMD-97-27R Response to APPA Letter
B-275697
in the year the project was placed in service. We disagree that the calculation
proposed by APPA and the PM& would accurately capture the full subsidy cost.
As we clearly state on page 57 of our report, such a calculation would only show
a portion of the subsidy-that portion related to the initial below market
financing-and would not recognize the other factors described above. In
addition, data were not available to calculate the first component of the financing
subsidy on a project-by-project basis. Thus, we chose an alternative approach.
Specifically, we calculated the difference between the PM& weighted average
interest rate on appropriated debt outstanding as of the end of fiscal year 1995
and the Treasury’s average interest rate on its entire bond portfolio for the same
period. This approach reasonably captures all facets of the financing subsidy.

Comparison of PM& to Nonfederal Utilities

APPA stated that we engaged in selective and misleading comparisons of the
PMAs and nonfederal utilities.6 APPA also stated that it was inappropriate to
compare the cost of federal power produced with hydropower assets to the cost
of nonfederal power produced from a variety of sources, including coal and
nuclear. Our requesters asked us to compare the three PMAs to nonfederal
utilities and to determine the impact of these differences on power production
costs. Since the PM& compete against all utilities, not just those that are
primarily hydro-based, a comparison of power produced from hydroelectric
facilities would generally be irrelevant to the overall competitive position of the
PMAs. Further, as our report states, we believe power customers are primarily
concerned with production costs and resultant electricity rates, not with whether
the utility is an IOU, POG, or PMA, or whether the utility generates its power
using coal, nuclear, or hydroelectric sources.

As noted in chapter 4 and on page 76 of our report, the PMAs are different from
other utilities in various ways, including cost of production, types of generating
facilities, payment of taxes, accounting and rate-setting, and financing. In
chapter 4 we also discuss the different missions and responsibilities of PM&
IOUs, and POGs. Because increasing competition in the electric utility industry
is expected to drive down future power rates, the current competitive position of
the PMAs, in terms of production costs, is important information for the
Congress to consider as it deliberates the future of the PM&. We noted in our
report that some projects and systems were already facing serious competitive
pressures. PMAs that do not remain low-cost suppliers may not be able to


‘?he nonfederal utilities we refer to are investor-owned utilities (IOUs) and
publicly-owned generating utilities (POGs).

6                                     GAO/AD&D-97-27R Response to APPA Letter
B-275697
market their power at rates sticient to recover costs, and thus, the federal
government may not be able to recover its investment in power-related assets,
including irrigation debt where applicable.

APPA stated that our report fails to balance PMA advantages and disadvantages.
APPA suggests that our report gives greater attention to advantages enjoyed by
the PMAs without giving equal attention to other costs that the PMAs’ customers
must repay that would not normally be charged to nonfederal utility customers.
We disagree. Our report provides an appropriate discussion of the relative
advantages and disadvantages the PMAs have compared to nonfederal utilities.
We did conclude that the advantages outweigh the disadvantages. The PMAs’ use
of hydropower plants built 30 to 60 years ago, and the fact that as federal
agencies they generally do not pay taxes, the unrecovered costs, and the
financing subsidy, in aggregate, provide the PMAs with a substantial cost
advantage compared to nonfederal utilities. This large difference is reflected in
the average revenue per kilowatthour (kWh) comparisons shown in chapter 4
and appendix V of our report. We agree that the PMAs have certain
disadvantages compared to nonfederal utilities, such as the cost of the Hoover
Dam Visitor Center and certain irrigation debt which Western must recover
through power rates and which we acknowledged in our report.

In summary, after thoroughly considering APPA’s comments, we continue to
support our report’s primary message: The PMAs’ power rates do not recover all
relevant power-related and Enancing costs.



As agreed, unless you publicly announce its contents earlier, we plan no further
distribution of this letter until 7 days from its date. At that time, we will send
copies to appropriate House and Senate committees, interested Members of the
Congress, the PMAs, the Secretary of Energy, the Secretary of the Interior, the
Secretary of Defense, the Director of the Office of Management and Budget, the
American Public Power Association, and other interested parties.

Please contact me at (202) 612-3341 if you or your staff have any questions
concerningthis letter.



Linda M. Calborn
Director, Civil Audits

7                                    GAOkIMD-97-27RResponseto APPA Letter
ENCLOSURE                                                                     ENCLOSURE
                      GAO’S EVALUATION OF APPA’S COMMENTS

The following are additional GAO comments on APPA’s letter dated October 9, 1996.

UNRECOVERED COSTS

-   APPA noted and our report made clear that, as is the case with ah federal agencies,
    the PMAs do not ;ave authorization to make direct contributions into the Civil Service
    Retirement and Disability Fund (CSRD Fund). APPA, however, incorrectly stated that
    our report seems to recommend that the PMAs find a way of avoiding what appears to
    be a direct prohibition that applies to all federal agencies regarding contributions to
    the CSRD Fund to cover postretirement benefits. APPA’s comments also suggest that
    the PMAs should not pay the full costs associated with postretirement benefits into
    the Treasury’s General Fund (General Fund) since this will not ‘I. . . provide adequate
    assurances that funding will then be allocated [to the CSRD Fund] for stated
    purposes.”

    We did not recommend in our report that PM& recover postretjrement benefits and
    deposit amounts recovered into the CSRD Fund. We identified pension and
    postretirement health benefits as costs related to power that were not being recovered
    through power rates. In their comments on our draft report, the PM& agreed. As we
    stated in our reportz “Our objective was not to address whether PMAs should or
    should not recover these costs; our objective was to determine whether these costs
    were unrecovered.”

    The PMAs raised an augmentation concern in their comments. They stated that they
    could not deposit power revenues into the CSRD Fund to cover unfunded retirement
    benefits because doing so would violate federal appropriations law by augmenting the
    annual appropriation made to the CSRD Fund. In the agency comments section of our
    final report, we agreed with the PMAs, and stated that ‘I. . . should the Congress decide
    that the PMAs should deposit directly into the Fund [CSRD Fund] an amount to cover
    these costs, the Congress should enact legislation permitting a transfer of that amount
    into the Fund [CSRD Fund].” We then noted that “alternatively, the augmentation
    issue could be avoided by depositing amounts recovered, like many other PMA
    ratepayer collections, into the General Fund of the Treasury. . . .I’

    This method of recovering the full cost of Civil Service Retirement System pension
    and postretirement health beneEts would be consistent with the way certain power-
    related costs incurred by the Bureau of Reclamation (Bureau) and Corps of Engineers
    (Corps) are currently recovered and returned to the Treasury. A large portion of the
    power revenues collected by the PMAs and returned to the Treasury are for power-
    related costs incurred by the Bureau and the Corps. At the September 19, 1996,

                                              8
ENCLOSURE                                                                     ENCLOSURE

    hearing of the Subcommittee on Water and Power Resources, the PMAs agreed to
    work with the Congress to identify a way to include the full cost of pension and
    postretirement health benefits in power rates.

    The APPA is correct in noting that upon deposit into the General Fund, there is no
    assurance I’. . . that funding will then be allocated [to the CSRD F’und] for stated
    purposes.” This should not deter PMAs from recovering these costs. It is clear that
    the cost recovery provisions of the Reclamation Project Act of 1939 and the Flood
    Control Act of 1944 are intended to defray the costs incurred by the federal
    government in producing and marketing electric power to the end-user. Depositing
    amounts in the General Fund collected from end-users will accomplish that goal.

-   APPA took exception to GAO questioning the ultimate recoverability of construction
    costs related to the Russell Project at Southeastern and the Trunran Project at
    Southwestern. APPA also took exception to our characterization of deferred payments
    (operations and maintenance and interest) at Western as being unrecovered.

    Our report correctly stated that there are substantial power-related costs associated
    with the Russell and Truman Projects that were not being recovered by the PMAs at
    the time of our review. We pointed out that if the currently nonoperational pumping
    units at these projects are never allowed to operate commercially, it is unclear
    whether the costs associated with their construction will be recovered through rates.
    The circumstances surrounding these projects, as discussed on pages 32 through 36
    and on page 46 of our report, do not offer any assurance that the nonoperational
    components of these two projects will become operational and that the costs will be
    included in future rates. Regarding the Russell Project, our report points out that the
    ultimate operation of the nonoperational pumping units is questionable because these
    units have been in construction-work-in-progress (CWIP) for 20 years and litigation
    preventing operation of the units has been ongoing since 1983. Even if the
    nonoperational components do come on line, no certainty exists that Southeastern will
    be able to recover the related power costs-about $514 million as of the end of fiscal
    year 1996.

    The Russell Project is part of Southeastern’s Georgia-Alabama-South Carolina system,
    which reported total revenues and total expenses for Escal year 1996 of about $106
    million and $99 million, respectively. If the nonoperational components do eventually
    come on-line, as Southeastern officials believe, interest will have to be paid annually
    on the federal investment rather than being capitalized, as is now done. Paying this
    interest expense, which totaled almost $26 million in fiscal year 1996, would increase
    the system’s total expenses by about 25 percent. Because interest continues to be
    capitalized, each year that the components remain nonoperational, the outstanding
    principal and the associated annual interest payments required if the components

                                             9
ENCLOSURE                                                                      ENCLOSURE
    come on-line continue to grow. Although revenues would also increase if the project
    becomes fully operational, it is unclear whether the Georgia-Alabama-South Carolina
    system would be able to absorb these additional costs. This is especially true given
    that the system’s power rates are approaching the rates of nonfederal utilities at a
    time when increasing competition in the electric utility industry is expected to drive
    down costs further, as we discussed in chapter 4 and appendix V of our report.

    Regarding deferred payments at Western, our report does not suggest that these
    payments will never be recovered. On page 41 of our report, we stated that the
    balance of outstanding deferred payments at Western decreased from $250 million to
    $196 million during fiscal year 1996, and that Southeastern and Southwestern had
    repaid their deferred payments, with interest, prior to September 30, 1996. In addition,
    on page 42, we state that “Western plans to recover the majority of these costs
    [deferred payments] over time.” Our report correctly stated that as of September 30,
    1995, the deferred payments (operations and maintenance and interest) had not been
    fully recovered.

-   APPA stated that our report failed to explore the reasons that the Washoe Project has
    not been able to generate sufficient revenues to cover its expenses. APPA stated that
    if we had done so we would have ‘I. . . discovered that the situation arose as the result
    of anticompetitive activities of an investor-owned utility.”

    The purpose of our review was not to explore all of the reasons Western believes the
    Washoe Project is unlikely to recover the federal investment. However, on pages 35
    and 36 of our report, we did note that, according to Western, the Washoe project has
    not been able to recover the costs of producing power because the project: (1) has
    construction costs that are high in relation to other utilities, (2) has not been able to
    fmd customers to purchase the power at a rate that would recover the full cost of
    producing the power, (3) began producing power in the first year of a 7-year drought,
    and (4) prior to 1992, lacked the transmission service to wheel power to customers
    interested in buying the power. We also noted in our report that the primary re&on
    the Washoe Project has not been able to generate sufficient revenue to cover its costs
    is because its cost of producing power is significantly higher than other utilities. On
    page 36 of our report we noted that, in January 1996, Western projected that the
    Washoe Project would have to sell its power at 11 cents per kWh in order to recover
    its annual operating and maintenance expenses (less depreciation), interest charges,
    and debt repayments on the federal investment; however, in fiscal year 1995, the
    project was selling its power for about 2 cents per kWh. Western’s fiscal year 1995
     annual report also stated that “Based on current conditions, it is unlikely the project
     [Washoe] will be able to generate sufficient revenues to repay the Federal investment.”
    As noted in chapter 4 and appendix V of our report, in 1994, the average revenue per
     kWh for wholesale power sold by IOUs and POGs in the area served by the Washoe

                                              10
ENCLOSURE                                                                    ENCLOSURE
  Project ranged from a low of 3.49 cents per kWh for IOUs to a high of 3.73 cents per
  kWh for POGs. Even if Washoe could sell its power at these rates, Washoe would still
  be losing over 7 cents per kWh on power sold. Clearly, high costs are the most
  significant reason for Washoe’s financial problems.

  APPA incorrectly stated that our report ignores the fact that Congress must approve
  changes to cost allocations of multipurpose water projects. On page 39 of our report,
  we stated that the Congress must approve any change in the cost allocation
  methodology used to distribute costs to the various program purposes at the Pick-
  Sloan Program. Our report did not recommend any changes to the cost allocations.
  Rather, as requested, we identified the unrecovered power-related costs of the three
  PMAs as of September 30, 1996.

  APPA stated that we substituted our judgment for that of the Congress in regard to
  the irrigation costs at Pick-Sloan and environmental costs at Western. APPA stated
  that the unrecovered power-related cost estimates in our report inaccurately included
  $464 million in unpaid irrigation-related costs, and $13.6 million in estimated interest
  costs related to the Pick-Sloan system. APPA suggested that by referring to the $464
  million as unrecovered power-related costs we were I’. . . second-guessing . . . existing
  laws in an effort to inflate bottom-line estimates of unrecovered costs . . . .I’ In
  addition, APPA stated that our report inaccurately describes the purposes for, and
  funding of, certain environmental enhancement projects at the Shasta and Glen
  Canyon Dams. We disagree. Our report did not state or suggest that PMAs should be
  recovering certain costs that they currently are not required to recover. We were
  asked to report on power-related costs that are not being recovered and are therefore
  not included in rates charged to the PMAs’ customers. Our report factually states that
  power-related costs at Pick-Sloan and certain environmental mitigation costs at the
  Shasta and Glen Canyon Dams are not being recovered. Whether or not these costs
  should be recovered is a matter for congressional decisionmakers.

  APPA incorrectly stated that our report suggested that the entire $454 million in
  %nrecovered power-related costst’at Pick-Sloan would be allocated to power for
  recovery. On page 38 of our report, we used the word ‘rprimarily” to indicate that
  most, but not all, of the $464 million would have been allocated to power if the federal
  investment in hydropower facilities and water storage reservoirs at Pick-Sloan had
  been allocated based on how the facilities are actually being used. As noted by APPA,
  a large portion of the $464 million represents power costs that were originally
  allocated to power, but were then suballocated for irrigation pumping power costs.
  The remaining portion of the $464 million represents joint costs that were also
  allocated to the incomplete and infeasible irrigation projects. A significant portion of
  these joint costs would also have been allocated to power if the allocation had been


                                           11
ENCLOSURE                                                                   ENCLOSURE
    based on how the hydropower facilities and water storage reservoirs are actually being
    used.

    APPA also incorrectly implied that our report referred to the $454 million as a
    financial liability of the PMAs. Our report stated that most of the $464 million
    represents power-related costs that have not been recovered. Changing the terms of
    repayment to recover any of the $464 million investment would require congressional
    action.

-   APPA stated that we fail to credit the PMAs for subsidizing many unanticipated
    nonpower related public uses of the Pick-Sloan system such as recreation, flood
    control, and environmental benefits. Whether the PMAs subsidize nonpower purposes
    such as recreation, flood control, and environmental benefits was beyond the scope of
    this review.

-   With regard to environmental mitigation costs incurred at the Shasta and Glen Canyon
    Dams, APPA stated that the description of the purposes for these environmental
    enhancement projects and the explanation of how the environmental activities have
    been funded included in our report are r5naccurate.fr The information in our report
    about the Shasta and Glen Canyon Dams was either taken from Western’s fiscal year
    1996 annual report, or provided by Western officials. Our report included sufficient
    information to point out that certain environmental mitigation costs associated with
    the Shasta and Glen Canyon Dams have been legislatively excluded from Western’s
    power rates. Moreover, the PM&’ written comments on our report specifically stated
    that they agreed with our discussion of these-unrecovered costs.

    APPA incorrectly stated that our report does not acknowledge that certain of the
    unrecovered costs identified for the Glen Canyon Dam could be included in future
    power rates. On pages 40 and 41 of our report, we state that the Grand Canyon
    Protection Act of 1992 includes a provision that the I’. . . costs [of environmental
    impact studies related to Glen Canyon Dam] could become the responsibility of the
    power customers under certain circumstances.” Our report further states that
    “According to Western, sufficient data does not e&t to determine whether the overall
    provisions of the act would result in a future obligation by the power customersrr

-   APPA stated that our conclusions regarding unrecovered costs are merely speculative
    because we did not examine the specific allocation formulas of the operating agencies
    on a project-by-project basis. APPA further states that an examination of these cost
    allocation formulas could have led to the conclusion that costs are in fact being
    overrecovered. Our report clearly recognizes that we did not assess the
    reasonableness of the methodologies used in developing the operating agency cost
    a3location formulas that are established for each project. We do not know whether an

                                            12
ENCLOSURE                                                                     ENCLOSURE

    examination of the specific cost allocations on a project-by-project basis would have
    revealed that power-related costs are actually being overrecovered or were
    underrecovered. However, the fact that we did not review operating agency cost
    allocations does not eliminate or reduce the signil%ance of the unrecovered costs that
    were identified by our report.

-   APPA stated that our report %peculatesrr about the potential for loss on the $94.1
    million federal investment in Western’s Mead-Phoenix Transmission Line. APPA also
    states that our report did not acknowledge the contributions of the Mead-Phoenix line
    to overall system reliability during the recent electrical outages in the West. Our
    report explained that because of reduced demand for power from the line, the project
    had not generated sufficient revenues to cover all operating and maintenance (O&M)
    and interest expense during its first few months of operation. As a result of this fact,
    our report appropriately questioned the future financial viability of this line. Our
    report did not address system performance and reliability because it was beyond the
    scope of this review. In addition, nothing came to our attention during the review to
    lead us to believe that the contributions of the Mead-Phoenix line during the recent
    power outage in the West would increase the line’s chances of recovering all O&M and
    interest expense or the government’s investment.

-   APPA stated that our report fails to point out that the Bureau of Reclamation makes
    annual contributions in lieu of taxes to the states or counties where the federal water
    resource projects are located. This point was raised by the PM.& during our review,
    but when asked to provide specifics or to identify the extent to which the operating
    agencies make payments in lieu of taxes, they were unable to provide any support. It
    is not clear what portion of these contributions, if any, actually pertain to the
    operating agencies, and what portion of any amounts contributed by the operating
    agencies was allocated to power. In the absence of supportable factual information,
    we chose not to include this point in our report.

-   APPA stated that our report does not mention that when some federal power projects
    came on line decades ago, the cost of power produced exceeded the cost of power
    available from other sources. Whether the cost of the PMAs’ power in the early years
    of the water projects exceeded the cost of power available from other sources has no
    bearing on- our calculation of unrecovered costs and financing subsidies or on the
    future competitiveness of the PMAs.

SUBSIDIZED FINANCING

-   APPA states that our conclusion about the amount of the fiscal year 1996 financing
    subsidy for the three PM& identified in our report I’. . . could only have been reached
    through the assumption that the PMAs should have been setting power rates through

                                             13
ENCLOSURE                                                                    ENCLOSURE
  application of current Treasury interest rates to alI of the PM&’ outstanding debt.”
  APPA concludes that if the PMAs had followed this practice, they would have “. . .
  dramatically increased electric rates, and conflicted with the congressional directive to
  sell federal power at the lowest possible rates in accordance with sound business
  principles.” APPA suggests that the problems with such a practice can be
  demonstrated through “. . . the frequently-used analogy of a fixed-rate home mortgage.”

  F’irst, as clearly stated in the report and previously in this letter, we did not address
  whether any changes in financing practices of the PMAs should be made. We were
  asked to and did report on the amount of the financing subsidy. It is up to the
  Congress, given this information, to decide whether any changes in financing practices
  should be made. Second, P&L&’ Enancing is not analogous to a mortgage lending
  situation for the following reasons:

  (1)    In a mortgage-type lending arrangement, the lender, if it wants to remain in
         business, establishes a spread between the rate it charges the borrower and the
         rate it must pay for the capital it lends. However, in the case of the PMAs’
         appropriated debt, the PMAs do not pay higher interest rates than the interest
         rates that Treasury pays on its bonds (or any transaction fees, which private
         sector companies pay). In fact, the highest rate the PM& are subjected to for
         new financing is based on the rates on Treasury securities issued the previous
         year that have terms of 16 years or more to maturity, even though the
         repayment periods for appropriated debt are up to 50 years. No attempt is
         made to charge a differential or take into account the much greater risk of
         having appropriated debt outstanding for 60 years, which is in contrast to a
         mortgage lending situation. In addition, Enancing using Treasury rates gives
         PMAs advantages because Treasury debt is considered “risk-free.” In the
         private sector, PMAs would likely pay higher interest rates to reflect the risks
         associated with hydroelectric power operations.

  (2)     A mortgage lender typically requires that borrowers repay their loans on a
          fixed schedule (principal and interest). The PMAs, in contrast, are not required
          to make fixed payments. Instead, the PM&’ appropriated debt is similar to a
          balloon loan that is due in full at the end of the term, generally 60 years. The
          PM&’ policy is to repay the highest interest debt first in order to m.inin&e
          interest expense. In many cases, low interest rate appropriated debt has been
          outstanding for decades while higher rate debt has been repaid. Unlike a
          typical mortgage situation, PMAs can also defer interest payments if sufficient
          revenue is not available to make these annual payments.

  (3)     The oversight and monitoring of PMA appropriated debt, and principal and
          interest amounts to be recovered annually, is different from any situation that

                                            14
ENCLOSURE                                                                      ENCLOSURE
           we know of in mortgage lending. Mortgage lenders monitor debt balances and
           repayments for appropriateness. In contrast, the PMAs are responsible for
           keeping track of their own balances and ensuring that principal and interest
           payments are appropriate.

    In summary, the PMAs’ appropriated debt is not analogous to a fixed-rate home
    mortgage.

-   APPA suggested that data needed to compute the “interest rate gap” (by comparing the
    PMAs’ interest rates and the Treasury’s interest rates at the time the PMA’s debt is
    incurred) are available for the “vast majority” of Western facilities. This statement is
    contrary to what Western officials told us during our review.

-   APPA stated that the 9.1 percent interest rate we used in our report to calculate the
     PMAs’ financing subsidy in fiscal year 1995 represents the very recent interest rate
    paid on Treasury’s outstanding bonds in fiscal year 1995. The 9.1 percent we used in
     calculating the PMAs’ fiscal year 1996 financing subsidy represents the Treasury’s
     average interest rate on its entire bond oortfolio outstanding for fiscal year 1996, not
    just those bonds issued in fiscal year 1996. We used the 9.1 percent interest rate on
    Treasury’s outstanding bond portfolio, which has maturities up to 30 years, because it
    most closely matches the PMAs’ outstanding debt, which has maturities up to 60 years.

COMPARISON OF PMAS TO NONFEDERAL UTILITIES

-   APPA stated that our use of average revenue per kWh to compare the power
    production costs of the PMAs to nonfederal utilities was “simplistic” and an “apples to
    oranges” comparison. We disagree. While we agree that average revenue per kWh
    should not be used as a substitute for price, it is a strong indicator of power
    production costs. For PpJlAsand POGs, average revenue per kWh should equal cost
    over time because each operates as a nonprofit organization that recovers costs
    through revenues. For IOUs, average revenue per kWh should represent cost plus the
    regulated rate of return. Given that about 80 percent of IOU.+ rate of return (net
    income) is used to pay common stock dividends, which is a financing cost, average
    revenue per kWh also approximates power production costs for IOUs.

-   APPA stated that our calculation of the average annual revenue per kWh for
    Southwestern’s Willis system was incorrect because we did not consider that this
    project was financed by a nonfederal entity. Our report does not mention that the
    Willis system was financed by a nonfederal entity, because all three PMAs have
    ratesetting systems/projects with unique characteristics that we factored into our
    analysis but did not discuss since they were not the main focus of our analysis. APPA
    stated that the average revenue per kWh for the Willis project was 60 cents, not 66

                                             16
ENCLOSURE                                                                        ENCLOSURE

    cents, as cited in our report. Southwestern officials who read and commented on a
    draft of our report did not take exception to our calculation of the average revenue
    per kWh for the Willis project.

    APPA stated that the PM&’ power rates ‘. . . overtly subsidize irrigation
    assistance . . .” but did not provide any specifics. As noted in our report, Western is
    required to use its power revenues to recover capital costs of irrigation facilities that
    are beyond the ability of irrigation customers to repay (irrigation assistance). Our
    review did not find that irrigation assistance is a large subsidy currently being paid by
    Western’s customers. Our report stated that as of September 30, 1996, according to
    Western, about $32 million of the $1.6 billion of total irrigation debt (construction
    costs incurred and assigned to power) had been recovered through electricity rates.
    To the extent that Western’s ratepayers actually repay this irrigation debt, the power
    users are subsidizing irrigators. In addition to the existing irrigation debt, billions of
    dollars of additional irrigation construction costs are planned. These future irrigation
    investments have not been incurred, and it is questionable whether they ever will be.
    Until these future irrigation costs are incurred and repaid to Treasury, or funds are set
    aside for their future repayment, they do not represent a disadvantage to Western.

-   APPA states that “close political oversight” is a common characteristic of public power
    but is %&ingff with respect to investor-owned utilities (IOUs). Our report did not
    focus on the tfpolitical oversight” of the IOUs; however, we do not agree that oversight
    of the IOUs is ftlacking.tf IOUs, to varying degrees, are subject to oversight and/or
    monitoring by public utility commissions; the Securities and Exchange Commission;
    the Federal Energy Regulatory Commission (FERC); boards of directors; local, state,
    and federal governments; independent external auditors; customers; stockholders;
    bond rating agencies; bondholders; and various public interest groups. Based on our
    review, FERC’s oversight of the PMAs is more limited than its oversight of IOUs.

OTHER

-   APPA incorrectly states that our report did not mention that PMAs are required to
    transmit and dispose of their power and energy in such a manner as to encourage the
    most widespread use thereof at the lowest possible rate to consumers consistent with
    sound business principles. On page 16, our report states that ‘I. . . PMAs sell electricity
    primarily on a wholesale basis with the legislated goal of encouraging widespread use
    of power at the lowest possible cost to consumers consistent with sound business
    principles.”

-   APPA suggests that our description of the rate review process in appendix VI of our
    report is incomplete because it does not address the public’s involvement in the rate-
    setting process. APPA states that by excluding this information, our report will lead

                                               16
ENCLOSURE                                                                    ENCLOSURE
   readers to conclude that F’ERC’s oversight of the PMAs’ rate-setting process is “unduly
   limited.” As agreed to with the requesters’ staff, our report was to provide a brief
   description of FERC’s oversight of the PMAs. We included a brief, page and a half
   description of this process in appendix VI.




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                                            17
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