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Corporate Unbundling: Are We Ready Yet? A Bondholder's Primer

Fortnightly Magazine - June 1 1996

include CPUC, SEC, NRC, FERC, plus state and local agencies.

Bond Outlook: Up or Down?

An Interview with Dan Scotto

"There are two types of utilities right now: Those having no upside and those having only downside." That sobering advice comes from utility analyst Dan Scotto, now senior managing director at Bear Stearns, writing in his latest financial update, 1996 Electric Utilities Outlook: Is There Life After Deregulation? (Bear Stearns, February 1996).

And Scotto sees precious little relief for utility bondholders.

"Bondholders' prayers have been answered-and the answer is 'No.' The gap between utility dividend yields and the yield on the Treasury long bond is narrowing," he notes. "In fact, the two actually touched for a brief moment two years ago-on April 20, 1994-the date the CPUC issued its originally "Blue Book" proposal."

Does that mean we've seen the end of it?

"We aren't nearly fully discounted in the bond market yet," says Scotto. "Yes, utility bonds have underperformed, but at some point we're going to hit an air pocket. Then we'll see utility bonds really head South."

In the long-term, Scotto sees a 10-year transition on the way to two distinct industries: Commodity (generation) and wire services (T&D). The first five years (1996-2000) promise "event risk, asset revaluation, equity dislocations, and margin pressure." The second five will see an "equilibrium."

I asked Scotto whether consumers will wind up better off in 10 years, paying lower rates.

"I think the answer is clearly 'No,'" Scotto warns. "We still have excess capacity, but the cost is already installed. And based on our forecasts, reserve margins get thin (14 to 12 percent) in the 2003-2005 period. Extending this time frame to 2010, capacity shortages clearly surface, with reserves getting as low as 10 percent."

"If you're an IPP," adds Scotto. "You're not going to be satisfied with an 11.5-percent return on equity. You're going to want 18 to 20 percent. So the next building cycle will be more expensive."

Dan Scotto is senior managing director at Bear Stearns and head of electric utility research. His article, "Credit Parameters in Flux: When Assets are Liabilities," appeared in Public Utilities Fortnightly, May 15, 1995.

1. Proposed Policies Governing Restructuring California's Elec. Servs. Industry and Reforming Regulation, Decision 95-12-063, Dec. 20, 1995, modified by Decision 96-01-009, Jan. 10, 1996, 166 PUR4th 1, 42, 85 (Cal.P.U.C.). As an incentive to do so, the CPUC said it would offer a reward to each company of up to 10 basis points in return on equity for each divested 10-percent share of fossil plant. Id., 166 PUR4th at 42.

2. Id., at 166 PUR4th 40, 84.

3. Alex Henney, "The Mega-NOPR," Public Utilities Fortnightly, July 1, 1995, p. 29.

4. See generally, Joint Petition of American Public Power Asso. and National Rural Elec. Co-op, Asso., FERC Docket No. RM96-8-000, filed Jan. 17, 1996. In its Mega-NOPR comments, the FTC staff described operational unbundling as likely "more effective" but "less costly than industry-wide divestiture."

5. See, e.g., "FERC's Evolving Merger Policy," Address by William L. Massey, Commissioner, FERC, Edison Electric Institute Fall