How Much Should Meralco be Allowed to Profit as a Public Service Utility?

by David Celestra Tan
2 January 2015

Part I

Let us start the New Year by going back to the basics of Meralco’s rates, which is how much should they, as a franchised public service utility, be allowed to profit?

The next relevant question is should they be allowed to profit only in the distribution side or also on the generation side?

The electricity rates of Meralco have been skyrocketing since the passage of the Epira Law in 2001. Remember the PPA jolt of 2002? Then Meralco’s distribution rates which increased 40%. All these years the consumers are only being told carefully crafted justifications why the rates in the Philippines are high, why Meralco has no control over it, and why the consumers should consider it fair and reasonable and accept it as part of life in the Meralco area.

Two years ago someone commissioned a study by an Australian consulting firm which in the end claimed and publicized widely that the reason the other Asian nations have lower rates, like Indonesia, Thailand, Malaysia, Vietnam, etc. is because those countries are subsidizing their power and the Philippines is charging true cost of electricity. They may have a point on the fuel subsidy issue but that’s not the only reason our rates are high. We all seem to have fallen for it, including the think tanks, academia, and government policy makers, and conveniently the DU’s themselves. What a carefully crafted ruse!

While our advocacy group, MSK, had come up with specific reforms that will reduce the cost of the pass on charges of Meralco by P3 per kwh or 25%, these are in the areas of power supply procurement and administration process, in regulatory methodologies, spot market rules, in taxation and other government policies, including legislative rectification. All have nothing to do with government subsidies of fuel.

A fundamental question we have not asked is How much should Meralco be allowed to profit as a public service utility? This is central to the issue on what retail rate setting methodology should be adopted in determining Meralco’s distribution charges. It is even more fundamental than whether it should be PBR (performance base rate setting) or RORB (return on rate base).

Beside the percent per annum of returns, should it be based on their “investment” which is the price at which they bought control of Meralco and paid to the previous owners? Should it be based on the assets of Meralco or on the equity of the stockholders that are reflected in the books of Meralco? Should it be return on equity or return on assets? Should the assets be valued at historical cost or reappraised replacement value? Should that return be income tax free or not?

It is clear from the Meralco website that the new owners, Metro Pacific of the Salim group of Indonesia fully expect to make their target returns on investment in both distribution AND generation when they bought Meralco from the Lopez Group. Metro Pacific, led by Filipino Manuel V. Pangilinan, had declared a target generation capacity of 3,000mw under its newly formed Meralco PowerGen.

A. Distribution Wheeling Business

For now let us first tackle the question on how much should Meralco be allowed to profit from the distribution wheeling business?

(In your Meralco electric bill, Meralco’s charges for the distribution wheeling business are the distribution charge, metering charge, and retail charge.)

For regulatory and rate setting purposes to determine Meralco’s allowable profit as a public service utility and balanced between the interest of the consumers and its stockholders, the fair and reasonable measure is return on assets.

Nonetheless, to address Meralco’s inevitable question on whether it is making enough money for its stockholders, we should also measure their return on equity as shown in Meralco’s official financial statement.

Let us start with the basic facts and considerations.

1. The Business – Meralco as a public service utility

The provision and distribution of electricity is a public service that is delegated by the government to the private sector as franchisee. Among the franchisees obligation as a public service utility is to assure it will invest in the necessary facilities and operate and provide the services to assure sufficient power supply and reasonable rates. It assures that it has the financial and management capability to do so.

Under the deregulated and unbundled structure of the power sector under the Epira Law of 2001, the DU’s business is to provide distribution wheeling services., i.e. the service of delivering the power from the generators and delivered to it by the transmission company to its customers through its own distribution lines.

In return, the government guarantees it with a fair return on investment through rates that are passed on to the consumers but are nonetheless regulated by the Energy Regulatory Commission.

2. Market Protection of a DU like Meralco

Meralco as a public service utility is protected by the government from many business risks specially market competition (in distribution wheeling services) that are faced by other business like shopping malls, real estate, manufacturing, banking, etc.

To assure its viability and provide an environment where the DU franchise holder can keep its rates reasonable and at the same time be economically viable for its investors, the government provides it with a monopoly franchise for its service area. Essentially it has little business risk. Protection from Competition in the distribution wheeling business and full recovery of operating costs, financial consequences of foreign exchange fluctuations, cost of fuel and purchased power, and even its own systems loss and collection efficiency and project delays. If their lines are damaged by typhoons, the repairs are passed on to the consumers. Distribution Market monopoly is granted to it by the government on behalf of the people who are also the electric users.

The government guarantees a fair and reasonable rate of return but the utility must accept the fact that it will be subjected to regulatory oversight to protect the public that they are franchised to serve.

3. Return on and of Investment

This is easier asked than answered. To begin with, there are two parts to this. The percentage and the asset base.

a. How much should be their Return on Investment? Should it be 8% or 10% per year or double the local prime interest rate? Entrepreneurs and their investment bankers, typically like to ask, “how much would be my return from alternative investment opportunities?”. Granted, they should also consider that the risk profile for a DU monopoly is lower and hence justifies lower returns. Profit level is a function of market and operating risks.

b. Next is on which asset valuation are they allowed to profit? Internationally, public service utilities should only be allowed to profit from the investments they put into the utility which is called the “rate base”. To be clear, private stockholders of these utilities are allowed to charge a rate that covers their return of investment (profit and capital recovery plus bonafide operating expenses).

This has long been the practice and called RORB (return of rate base). Majority of US public service utilities make 9.5 t0 10%. Prime interest rates in the US is 2.5% and in the Philippines it is 4.5%. So what should be the fair return on investment for Meralco given Philippine financial and economic conditions?

If Meralco is allowed a 10% return on assets plus an average depreciation charge of 10 years or 10% of asset cost, that means a total of 20% annual cash recovery from the consumers. Every 5 years the consumers is full paying for the asset base of Meralco.

c. Due to heavy lobbying, the Epira Law of 2001 opened the doors for alternative rate making which was used by the new Energy Regulatory Commission to adopt a new rate setting methodology called “Performance Based Rate Making” or PBR.
In simple terms, PBR entitled Meralco to not only charge the old RORB but allowed it to charge to the consumers their forecasted investments for the next 4 years. And under the rules set by the ERC, it is not mandatory that Meralco actually makes the investment. The pa-consuelo to consumers is they re-evaluate in the next “regulatory re-set” and “reduce” the allowable rate recovery for the next 4 years. (yes they don’t recover the excess in the last four years which could run into billions in excess charges!)

In Pilipino, PBR is LSM. Luto sa Sariling Mantika! (more on this in another article)

4. Rate Base Valuation
If the rates to the consumers would be based on the value of the rate base, the issue for utilities is should it be at historical cost or at their current replacement value?

Do you know that for rate making determination, the old assets of Meralco is re-appraised every so many years?

ERC’s current PBR is based on current replacement value minus depreciation. (Please refer to the ERC PBR Presentation in the reference archives section).

The dissertation is purely from the point of view of fairness to the investor. They don’t discuss what is fair to the consumers who actually has an “equity” in the public utility since they are the ones paying for all its charges and risks including the guarantee of profit. Essentially as the ultimate payors, they are actually the guarantors of the investment recovery and profits of the private investor in Meralco.

Therefore, the consumers are entitled to similar equity and fairness in determining what is the cost of service. This boils down to what is the fair return of investment of the utility investor? Should they be allowed to profit from the periodic revaluations without really investing?

In the case of Meralco, a big part of its capital came from customer deposits which were used to bankroll the capital acquisitions of Meralco. Yet when those assets arose in value like the Meralco property in Ortigas Center, the increase in value goes to the stockholders. Nothing is given to benefit the electricity consumers who practically paid for those assets.

Moreover, the utility has already recovered from them the original cost of the asset base including their profits. Yet, every rate “re-basing” those assets are revalued (of course upwards) and used as a basis to further increase the rates to the consumers. Kawawa naman. They get it coming and going, front, behind, and center!

They only consider the “cost of service” but not really the “affordability of service” to the consumers who do not have the benefit of inflation revaluations.

This is one reason the private distribution utility business is so profitable. They have no risks and they have perpetual recovery from assets that are continually being revalued upwards. With PBR, they even recover in advance their projected capital investments. Things are getting worse for the consumers.

Under PBR the electric consumers are effectively paying for in advance the capital investments of Meralco. What is not clear is whether these assets thus acquired will then become part of Meralco’s asset base on which it will again profit perpetually even if it was the consumers who paid for it?

5. Corporate income taxes

This has long been a contentious issue. Actually this is another issue that has two parts to it.

The question of whether corporate income taxes should be passed on to the consumers is really a matter of how much is the consumers being made to guarantee a fair return on investment of the private utility investor. It can be either net of income tax or gross before tax. Private investors try to compare the profits they will make from other investments and forget that in comparing they are referring to returns that are gross and expecting net after tax returns from the DU business.

Politically though it is not palatable to consumers to be told they are paying for the corporate income tax of Meralco. So the guaranteed return on rate base must be gross before corporate income tax.

The bigger question is the anomalous disparity between what corporate income tax is Meralco passing on and recovering from the consumers compared to what they could be actually paying to the national government AFTER corporate tax avoidance strategies.

In the US, they call this “turning a consumer burden into corporate profits”. From consumer pockets to corporate coffers.

B. Power Generation
On top of this, Metro Pacific would like to profit from the self-negotiated and monopolized power generation supply contracts in Meralco.

The new Meralco (lets call this Meralco III) is evidently expecting to go back to the old Meralco (lets call it Meralco I) under the Lopez Patriarch, the venerable Eugenio Lopez Sr. under whose regime Meralco was both generator and distributor like in the old utility models in the USA. The Epira Laws that was passed in June of 2001 aspired to limit cross-ownership between generation and distribution and market domination and monopoly. Meralco II is the era post-people power when it was returned to the descendants of the old Patriarch until it was sold to Metro Pacific in 2010.

Matuwid na Singil sa Kuryente Consumer Alliance Inc.

Next: The business models of Meralco II and Meralco III. And Meralco’s ROI.