Tennessee Valley Authority: Assessment of the 10-Year Business Plan

Published by the Government Accountability Office on 1999-09-22.

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

                          United States General Accounting Office

GAO                       Testimony
                          Before the Subcommittee on Water Resources and
                          Environment, Committee on Transportation and
                          Infrastructure, House of Representatives

For Release on Delivery
Expected at
10 a.m.
                          TENNESSEE VALLEY
September 22, 1999

                          Assessment of the
                          10-Year Business Plan
                          Statement of Linda M. Calbom
                          Director, Resources, Community, and Economic
                          Development Accounting and Financial Management
                          Account and Information Management Division

Mr. Chairman and Members of the Subcommittee:

I am pleased to be here today to summarize the results of our work
analyzing the Tennessee Valley Authority’s (TVA) 10-year business plan. My
testimony is based on our April 1999 report,1 which assesses the plan in

Restructuring of the electricity industry has led to wholesale competition,
which, combined with other factors, has caused wholesale electricity
prices to fall in many parts of the country. This increased competition led
TVA management to develop this plan to position TVA to be more
competitive by, among other things, reducing its high debt servicing and
other fixed costs. Because of concerns about TVA’s ability to achieve the 10-
year plan’s objectives by 2007—when competitive pressures are likely to be
greater and when many of TVA’s long-term contracts could expire—we
were asked to determine whether TVA will be able to reduce debt as
envisioned in the plan and whether its goals and assumptions regarding
capital expenditures and revenues and expenses are achievable or

Specifically, my testimony today will discuss the findings from our April
1999 report concerning

• whether the plan objectives address the key issues confronting TVA,
• major costs that were not included in the plan,
• whether the goals and assumptions in the plan are achievable or
  reasonable, and

TVA’s plans to formally update the plan for significant changes.

In summary, TVA’s 10-year plan is moving TVA in the right direction by
addressing the most important issues facing TVA: its high fixed financing
costs and limited financial flexibility and the large amount of deferred
assets that TVA has not recovered through rates. However, because TVA’s
actual experience and assumptions about certain major costs have varied
in significant ways from those envisioned in the 10-year plan, it is unlikely
that TVA will generate sufficient cash flow to reduce debt and the
corresponding fixed interest costs to the extent stated in the plan through

 Tennessee Valley Authority: Assessment of the 10-Year Business Plan (GAO/AIMD-99-142,
April 30, 1999).

Page 1                                                              GAO/T-AIMD-99-295
             2007. TVA has acknowledged that its debt reduction goal will not be
             achieved until at least 2009. To the extent it does not sufficiently reduce
             debt and related fixed costs and increase financial flexibility during the
             10-year period, TVA’s ultimate strategic objective—to be able to offer
             competitively priced power by the end of 2007—could be jeopardized.

             However, since it is not possible to accurately predict what the market
             price of power will be in 2007, TVA could still achieve its objective of
             offering competitively priced power, even if it does not fully achieve the
             plan’s other goals and objectives. Conversely, depending on the market
             price of power, TVA could fully achieve all of the goals and objectives
             outlined in the plan and still not be positioned to offer competitively priced
             power in 2007 and beyond. Nevertheless, any progress it makes toward its
             goals and objectives will put TVA in a better competitive position.

             I would now like to provide a brief background on (1) TVA’s role in the
             electricity industry, (2) current restructuring efforts and their potential
             impact on TVA, and (3) the general provisions of TVA’s plan. I will then
             provide more details of the findings I just summarized.

Background   As you know, TVA operates as a power generator, producing electricity for
             sale to entities such as municipal and cooperative power distributors who
             market power to end users. The Energy Policy Act of 1992 (EPAct)
             provides TVA with certain protections from competition. Additionally,
             under the TVA Act of 1933 (TVA Act), as amended, TVA is not subject to
             most of the regulatory and oversight requirements that must be satisfied by
             commercial electric utilities; instead, all authority to run and operate TVA
             is vested in its board of directors. In 1959, the Congress amended the TVA
             Act by establishing what is commonly referred to as the TVA “fence,” which
             prohibits TVA—with some exceptions—from entering into contracts to sell
             power outside the service area that TVA and its distributors were serving
             on July 1, 1957. Under EPAct, TVA is exempt from having to allow other
             utilities to use its transmission lines to transmit power to customers within
             TVA’s service area. This legislative framework generally insulates TVA from
             direct wholesale competition and, as a result, TVA remains in a position
             similar to a regulated utility monopoly.

             EPAct’s requirement that utilities make their transmission lines accessible
             to other utilities to transmit (wheel) wholesale electricity has enabled
             wholesale customers to obtain electricity from a variety of competing
             suppliers and has resulted in increased wholesale competition in the

             Page 2                                                        GAO/T-AIMD-99-295
electric utility industry across the United States. Because EPAct exempts
TVA from having power wheeled to consumers in its territory, TVA has not
been directly impacted by the ongoing restructuring of the electric utility
industry to the same extent as other utilities. However, if TVA were to lose
its exemption from the wheeling provisions of EPAct, its customers would
have the option of obtaining their power from other sources after the
expiration of their contracts. Under legislation proposed by the
administration to promote retail competition in the electric power industry,
which TVA supports, TVA’s exemption from the wheeling provisions of
EPAct would be eliminated after January 1, 2003. If the legislation is
enacted, TVA may be required to use its transmission lines to transmit the
power of other utilities for consumption within TVA’s service territory. In
addition, the proposed legislation would remove the statutory restrictions
that prevent TVA from selling power outside its service territory. Other bills
on electricity restructuring have also been introduced that could also
impact TVA’s operations, but as of September 17, 1999, none have been

Most of TVA’s power is sold to municipal and cooperative power
distributors who would be directly affected in the future by retail
competition through their customers’ ability to choose alternate power
suppliers. Further, industry restructuring and the possibility of TVA losing
its legislative protections have made many of TVA’s customers more aware
of price differences among utilities, raised expectations of lower prices,
and increased demands for more competitive pricing.

Because of these ongoing industry restructuring efforts, TVA management,
like many industry experts, anticipates that TVA may lose its legislative
protections in the future. Even if TVA does not lose its legislative
protections, TVA’s management has recognized the need to take action to
better position TVA to be competitive in an era of increasing competition
and customer choice and, in July 1997, issued a 10-year business plan with
that goal in mind. TVA established a 10-year horizon for implementing the
key changes outlined in the plan largely because TVA officials expect to be
facing greater competitive pressures within that time frame and many of its
long-term contracts with customers could begin to expire in 2007. The
published plan, which formed the basis of our evaluation, contains three
strategic objectives:

• ⋅reducing TVA’s cost of power in order to be in a position to offer
  competitively priced power in 2007,
• ⋅increasing financial flexibility by reducing fixed costs, and

Page 3                                                       GAO/T-AIMD-99-295
                     • ⋅building customer allegiance.

                     In developing the 10-year plan, TVA set several goals and made certain
                     assumptions about the future. These goals and assumptions, and our
                     analysis of whether they are achievable or reasonable, are discussed in
                     detail in our April 1999 report. I will provide a summary of this analysis
                     today, with particular emphasis on the goals or assumptions that we did not
                     find achievable or reasonable.

Plan Objectives      Implementation of the 10-year plan is moving TVA in the right direction and
                     addresses important issues facing TVA: its high fixed financing costs and
Address Key Issues   limited financial flexibility to respond to competitive pressure and the large
Confronting TVA      amount of deferred assets that have not been recovered through rates.
                     These deferred assets, which totaled about $8.5 billion as of the beginning
                     of the plan period, are primarily the result of investments made since the
                     1970s in nuclear generating plants that were never put into production.
                     This helped contribute to TVA’s large debt, which totaled about $27 billion
                     as of September 30, 1998, and resultant high fixed financing costs.

                     TVA’s ability to meet its strategic objective of being in a position to offer
                     competitively priced power by 2007 and to improve its financial flexibility
                     hinges largely on its being able to meet its goal of reducing debt to about
                     $14 billion by 2007. While not specifically stated in the plan, TVA also plans
                     to recover through rates all but $500 million of its deferred asset costs by
                     the end of the period covered by the plan.2 The year 2007 is key for TVA
                     because it expects to face greater competitive pressures by then and
                     because many long-term contracts with customers could expire at about
                     that time. As a result, the plan emphasizes changes designed to enable TVA
                     to offer competitive rates by the end of 2007. The more progress TVA
                     makes toward addressing the key issues it faces while it maintains its
                     legislative protections and before its customer contracts could begin to
                     expire, the better positioned it will be to successfully operate in a
                     competitive market.

                     These issues were highlighted in reports3 we issued in 1995 and 1997, in
                     which we stated that TVA’s annual financing costs and deferred assets were
                     substantially greater than those of the utilities with which TVA would most

                      The remaining $500 million is TVA's estimate of the net realizable value of its deferred
                     assets at the end of 2007.

                     Page 4                                                                   GAO/T-AIMD-99-295
                        likely have to compete. We also reported that these high fixed costs and
                        deferred assets would limit TVA’s flexibility to adjust its rates in a
                        competitive environment. TVA, through its 10-year plan, is taking steps to
                        address these issues. Other utilities are taking similar actions to prepare for
                        competition. For example, utilities we previously identified in 1995 as those
                        most likely to compete with TVA are also taking steps to refinance debt at
                        lower interest rates and accelerate recovery of the costs of their regulatory
                        assets. However, as we reported in 1995 and 1997, these other utilities
                        generally have fewer financing costs and deferred assets than TVA, giving
                        them more flexibility to respond to changing market conditions. To the
                        extent TVA recovers the costs of its deferred assets and increases its
                        financial flexibility, it will increase its ability to adjust rates as necessary to
                        meet changing market conditions. TVA’s focus on these areas before the full
                        advent of competition is key to its chances of being competitive without
                        legislative protections.

Plan Does Not Include   While focusing on the right issues, TVA’s plan does not fully address certain
                        costs. Not addressing these costs could jeopardize full achievement of the
Certain Major Costs     plan’s objectives. Specifically, the plan does not include the following:

                        The capital costs of additional generating capacity that may be acquired to
                        meet growth in demand for power. The plan assumes that TVA would meet
                        the increasing demand for power over the plan period by purchasing power
                        from other utilities. The costs of the power purchases are reflected as
                        operating costs in the 10-year plan. However, since the plan was finalized,
                        TVA officials have told us that they plan to evaluate other power supply
                        options and to invest in new capacity if the resulting long-term increase in
                        costs to produce power (interest and operating expense) would ultimately
                        be less than the cost of purchased power. TVA has already decided to invest
                        in new capacity rather than purchasing power in at least one case—in 1998,
                        TVA announced plans to purchase eight gas-fired combustion turbine units
                        that will be used to replace a like amount of purchased peaking power that
                        was assumed in the original plan. According to TVA officials, while they
                        expect this decision to result in a positive cash flow by 2010, the decision to
                        invest in new generating capacity will require about $65 million more in

                         Tennessee Valley Authority: Financial Problems Raise Questions About Long-term Viability
                        (GAO/AIMD/RCED-95-134, August 17, 1995) and Federal Electricity Activities: The Federal
                        Government's Net Cost and Potential for Future Losses, volumes 1 and 2, GAO/AIMD-97-110
                        and 110A, September 19, 1997).

                        Page 5                                                               GAO/T-AIMD-99-295
                         cash disbursements through 2007 than would have been necessary to
                         purchase a comparable amount of power from other utilities.

                         • ⋅The costs of complying with new environmental regulations. Known
                           environmental costs alone total an estimated $500 million to
                           $600 million. In addition, costs for complying with a proposed
                           environmental regulation that is likely to be implemented before 2007
                           could amount to another $450 million to $500 million, some of which
                           would be incurred before 2007.
                         • ⋅The cost of nonpower programs that, to date, have been funded
                           primarily through appropriations. The plan assumes that TVA will
                           continue to receive appropriations for its nonpower programs, such as
                           flood control and navigation. While this assumption was reasonable
                           when the plan was developed, these appropriations, which amounted to
                           $70 million in fiscal year 1998, have been steadily declining since 1994
                           and are expected to be substantially reduced or discontinued beginning
                           in fiscal year 2000.

                         TVA estimates that these additional costs will total at least $1 billion over
                         the remaining life of the plan and will likely be higher.

Most Goals and           We assessed 10 goals and assumptions TVA made about the future in
                         developing the 10-year plan. Based on economic forecasts, comparisons
Assumptions of the       with TVA’s results of past operations, and the opinions of industry experts,
Plan Are Achievable or   we concluded that seven of the goals and assumptions were achievable or
                         reasonable, two were unachievable, and one was uncertain. The goals and
Reasonable, but Debt     assumptions we assessed, and our conclusions about each, are summarized
Reduction and Some       in table 1 and are discussed in our April 1999 report. A discussion of the
Others Are Not           two goals we found unachievable and the assumption we found uncertain
                         is included below.

                         Page 6                                                       GAO/T-AIMD-99-295
                      Table 1: GAO Conclusions About 10-Year Plan's Goals and Assumptions

                      Goal or assumption assessed                                         GAO conclusion
                      Future market price of powera                                       Reasonable
                      Increase in demand for power                                        Reasonable
                      Increase in fuel costs                                              Reasonable
                      Supply chain savings                                                Achievable
                      Capital expenditure limitation                                      Unachievable
                      Increased revenues                                                  Uncertain
                      Debt reduction and recovery of deferred assets                      Unachievable
                      Cost improvement initiatives                                        Achievable
                      Labor force reductions                                              Reasonable
                      Customer relations improvements                                     Achievable

                       At the time our report was issued, TVA officials told us that if they were to prepare the 10-year plan
                      today, they would increase the projection for the future market price of wholesale power in 2007, due
                      primarily to new environmental regulations; however, they have not formally updated their projections.
                      Both their original projection and any proposed revisions still fall within a reasonable range compared
                      to other projections of market prices we obtained.

Capital Expenditure   The plan assumes that capital expenditures will be limited to about
Limitation Goal is    $600 million per year and excludes any capital costs for increasing
                      generating capacity and complying with new environmental regulations.
                      However, as discussed previously, known environmental costs alone total
                      an estimated $500 million to $600 million. In addition, costs for complying
                      with a proposed environmental regulation that is likely to be implemented
                      within the plan period could amount to another $450 million to
                      $500 million, some of which would be incurred before 2007. Also, the costs
                      for meeting growth in demand for power with additional generating
                      capacity, which are not fully estimable at this time, could further increase
                      TVA’s required capital expenditures within the period covered by the
                      10-year plan.4 Even though upward revisions in TVA’s projected market
                      price of wholesale power could offset some of these additional costs, TVA
                      is likely to exceed its annual $600 million planned capital expenditures
                      limit, thus making this goal unachievable.

                       TVA believes any capital investments for generating capacity will lower its cost of power
                      relative to the estimate contained in the plan.

                      Page 7                                                                           GAO/T-AIMD-99-295
Assumption About        TVA’s revenues increased significantly in fiscal year 1998 due to a rate
Increased Revenues Is   increase and to increased energy sales. TVA’s fiscal year 1998 revenues
                        totaled about $6.7 billion, compared to $5.9 billion in fiscal year 1997—an
                        increase of about $800 million. According to TVA, about $350 million of the
                        increase is attributed to the rate increase; the balance is attributable to
                        increased sales volume that resulted from extreme weather in the summer
                        months and other factors.

                        The 10-year plan assumes that this rate increase is sustainable and will
                        generate additional revenues of about $325 million annually through 2007.
                        However, based on the decline in TVA’s average revenue per kilowatthour
                        (kWh) over the past 10 years, and expectations of increasing competition in
                        the electricity industry, we agree with some industry experts who question
                        TVA’s ability to meet the plan’s assumption about future revenue.
                        Specifically, an analyst from the Congressional Budget Office (CBO) with
                        expertise in issues related to TVA and consultants from ICF Kaiser
                        Consulting Group (which was hired by the Edison Electric Institute, an
                        industry group for investor-owned utilities, to analyze TVA’s 10-year plan)
                        questioned TVA’s ability to meet its future revenue projections given the
                        decline in its average revenue per kWh over the last several years.

                        As shown in figure 1, from 1988 through 1997, TVA’s average revenues per
                        kWh declined steadily, despite a steady increase in the amount of
                        kilowatthours of energy sold. This decline in average revenues per kWh
                        was attributable to the credits given to large industrial customers. The
                        actual decline in average revenues per kWh over the past 10 years contrasts
                        sharply with the increase projected in the 10-year plan for 1998 through

                        Page 8                                                    GAO/T-AIMD-99-295
Figure 1: Comparison of Average Revenue per kWh to Kilowatthours Sold

                                        Source: GAO analysis based on data from TVA.

                                        In order to offer competitive rates to its industrial customers, TVA offers
                                        price breaks to its larger industrial customers. In fact, to offset the impact
                                        of the last rate increase, TVA expanded its existing credit program to
                                        include companies with commitments to purchase firm loads of more than
                                        one megawatt. (Previously this credit had been limited to industrial
                                        customers with firm load commitments of more than five megawatts.)
                                        Although restructuring of the electric utility industry is expected to put
                                        downward pressure on rates, the 10-year plan assumes that TVA will not
                                        have to offer any additional price breaks to its large industrial customers
                                        through 2007. This assumption is questionable given that TVA has offered
                                        new credits to reduce the rates of its larger industrial customers for the
                                        past 10 years and competition in the industry is increasing.

                                        Because restructuring of the electric utility industry is expected to
                                        continue to cause future wholesale and retail electricity prices to fall, TVA
                                        will likely feel pressure to continue to reduce rates. In addition, recent

                                        Page 9                                                       GAO/T-AIMD-99-295
                           media coverage about competition has made many utility customers more
                           aware of price differences among utilities and raised expectations of lower
                           prices. All of these factors combined make it uncertain whether TVA can
                           generate an additional $325 million in annual revenues on a sustained basis
                           through 2007.

Debt Reduction and         The 10-year plan calls for reducing debt to about $14 billion by 2007. This
Deferred Assets Recovery   reduction, in turn, would lower TVA’s annual interest costs by half—from
                           about $2 billion in 1997 to about $1 billion in 2007. The additional cash that
Goals Are Unachievable
                           is made available as debt is paid down and interest costs are reduced can
                           be used to further reduce debt. This interrelationship is integral to meeting
                           the debt reduction goal. In addition to reducing interest costs by reducing
                           debt, TVA is pursuing other interest savings by refinancing outstanding
                           debt, as discussed in our April 1999 report.

                           TVA’s ability to meet its strategic objective of being in a position to offer
                           competitively priced power by 2007 depends, to a large extent, on meeting
                           its debt reduction goal. The plan calls for the cash flow needed to achieve
                           this debt reduction to be provided by a combination of planned revenue
                           enhancements, cost savings initiatives, and capital expenditure limitations.
                           However, as discussed previously, the plan excluded additional capital
                           costs related to investing in new generating capacity to meet growth in
                           demand for power, complying with new environmental regulations, and
                           funding nonpower programs that were previously funded through
                           appropriations. TVA exceeded its debt reduction goals for the first 2 years
                           of the plan but does not expect to meet its original estimates for the
                           remaining years due to the additional capital expenditures for new
                           generating capacity and environmental regulations discussed previously.

                           As a result of the changes in certain of its cost estimates, TVA now does not
                           expect to reduce debt by one-half until fiscal year 2009, about 2 years after
                           the plan’s original target date. This revised goal is reflected in TVA’s fiscal
                           year 2000 federal budget request and has been acknowledged publicly by
                           TVA officials. TVA’s original and revised debt reduction timetable is shown
                           in figure 2.

                           Page 10                                                       GAO/T-AIMD-99-295
Figure 2: Original and Revised Debt Reduction Timetables

                                         Source: GAO analysis based on data from TVA.

                                         TVA’s planned revenue enhancements and cost savings were also intended
                                         to provide TVA with the opportunity to recover a portion of the cost of
                                         deferred assets. As noted previously, TVA expects to recover all but about
                                         $500 million—the estimated net realizable value—of its deferred assets.
                                         However, TVA’s ability to include the costs of these assets in its rates
                                         without further rate increases is directly related to its ability to meet the
                                         plan’s revenue and cost savings targets. To the extent TVA does not recover
                                         the cost of its deferred assets while it is legislatively protected from
                                         competition, competitive pressures could prevent it from selling power at
                                         rates sufficient to recover the cost of these assets indefinitely.

                                         Page 11                                                     GAO/T-AIMD-99-295
                        Achieving its debt reduction goals and minimizing its deferred assets is key
                        to TVA meeting its strategic objective of increasing financial flexibility. This
                        in turn is key to its ability to offer competitively priced power in 2007 and
                        beyond—TVA’s ultimate objective.

Plan Has Not Yet Been   As previously mentioned, since the 10-year plan was issued in July 1997,
                        actual experience related to certain key goals and assumptions has differed
Updated to Reflect      from that projected in the plan, and certain expectations about the future
Significant Changes     have changed. For example, at the time our report was issued, TVA officials
                        indicated that if they were to update the 10-year plan, they would increase
                        their projection for the future market price of power and would include
                        costs for new environmental regulations. However, TVA has not formally
                        updated the plan to reflect these and other changes.

                        Changes in individual goals or assumptions or actual experience that
                        differs from that projected when the plan was developed can affect the
                        entire plan. For example, the unplanned purchase of additional generating
                        capacity results in a decrease in projected cash flow through 2007. This
                        affects the availability of cash to pay down debt, which further impacts
                        interest costs. The result of these and other unplanned expenditures, such
                        as for new environmental regulations, is that TVA’s time frame to meet its
                        debt reduction goal has been extended from 2007 to 2009. In contrast, the
                        change in TVA’s assumption for the future market price of power increases
                        TVA’s target price for power in 2007. This means that even if TVA does not
                        achieve all of its other cost reductions and/or revenue enhancements
                        planned through 2007, it could still be in a position to offer competitively
                        priced power at that time.

                        TVA officials told us that they have internally analyzed the combined
                        impact of the upward revision in the projected market price of wholesale
                        power in 2007 and lower-than-planned debt reduction on TVA’s ultimate
                        objective, which is to be in a position to offer competitively priced power in
                        2007. While TVA officials acknowledge that they will not meet the debt
                        reduction goal by 2007, they believe, based on their internal analyses, that
                        TVA will still be in a position to offer competitively priced power in 2007.
                        However, these analyses have not been formalized, nor have the results
                        been communicated to users of the plan.

                        Although TVA views the plan as a living document and recognizes that
                        projections in the plan will change over time, there is no formal mechanism
                        for communicating changes to those who use the plan. In addition, there is

                        Page 12                                                       GAO/T-AIMD-99-295
no mechanism available to plan users to gauge TVA’s progress toward
achieving the plan’s goals and objectives. Therefore, while variances in
results, changes in goals and assumptions, and progress toward plan
objectives may be known to TVA, they are generally not known by the
plan’s users. These users include public policymakers considering
legislation that might impact TVA’s future, analysts and investors who use
information in the plan when assessing the desirability of TVA’s debt
offerings, and customers who are considering alternative sources of
electricity in the future. As a result, those who rely on the plan to make
investment and policy decisions cannot fully assess the impact of the
variances and changes in assumptions on TVA’s ability to meet its strategic
objectives as set forth in the plan.

The legislation proposed by the administration to promote retail
competition in the electric power industry, which was mentioned
previously, would require that TVA annually report several types of
information to the Congress. If enacted, the legislation would require that
TVA annually report, among other things, its progress toward its goal of
competitively priced power, its prospects for meeting the objectives of the
10-year plan, any changes in assumptions that may have a material effect
on TVA’s long-range financial plans, the amount by which its debt has been
reduced, and the projected amount by which its debt will be reduced. This
type of reporting to the Congress would help provide the information
needed to monitor TVA’s readiness for a competitive environment.

Since we published our report, TVA officials have indicated that they do
plan to revise and reissue an updated 10-year plan. However, they also
stated that they anticipate the appointment of two new board members
soon, and expect that they will want to be involved in such an action.
Notwithstanding this, until the plan is formally updated, the Congress and
other external users of the plan will not have the current information
needed to make policy, oversight, and investment decisions related to TVA.
Therefore, we reaffirm the recommendation we made in our report in April
to move quickly to improve reporting by reissuing the plan to reflect
evolving conditions.

Mr. Chairman, that concludes my statement. I would be happy to answer
any questions you or other Members of the Subcommittee may have.

Page 13                                                    GAO/T-AIMD-99-295
Contact and        For further information regarding this testimony, please contact Linda
                   Calbom at (202) 512-9508. Individuals making key contributions to this
Acknowledgment     testimony include Rob Martin, Don Neff, Pat Petersen, Jack Warner, and
                   Meg Mills.

(913873)   Leter   Page 14                                                  GAO/T-AIMD-99-295
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