Business & Money

Credit-rating linkage harms certain power companies. Ring-fencing is the best answer for regulators.

In recent years, a persistent battle has developed between state public utility commissions (PUCs) and holding companies over the negative financial and operational impacts on regulated utilities of failed diversification investments. Ratepayers expect to compensate companies for the costs of providing utility service-not those costs associated with the unregulated activities of affiliated companies.

Unfortunately, the realities are often painfully different, and in some instances disastrous for the financial health of the utility. Moreover, ratepayers and politicians are highly sensitive and easily outraged by a utility attempting to recover costs associated with non-regulated companies in the regulated cost of providing utility service.

Credit ratings linkage is an additional worry for state regulators when confronting failed diversification. Fitch and Standard & Poor's, for example, apply linkage in determining the ratings of companies within a holding company structure. This method directly links the credit rating of the utility to the parent and any affiliated companies. Consequently, the regulated utility may be penalized via a lower credit rating, which would not happen if it were a stand-alone company.

In fact, Fitch indicates that ratings linkages caused about half of all rating changes for electric and gas utilities. The consequences of linked credit ratings on utilities, of course, includes higher debt and equity costs that are typically passed along to ratepayers via higher charges for regulated services.

In reaction to the potential contamination of a utility's credit rating by a weaker parent or affiliate, PUCs recently have used various "ring-fencing" policy tools. The goal of a ring-fence is to insulate a utility from the risks of its holding company and affiliates. Depending on the efficacy of the ring-fence, a utility may be rated various notches higher than a weaker parent or affiliate. For example, the Oregon commission successfully ring-fenced Portland General Electric, which was acquired by Enron in 1997 and subsequently survived its parent's bankruptcy. While Enron's debt was downgraded to junk status, Portland General Electric's ratings were many notches higher as a result of the PUC's actions. It is important to note, however, that even with the implementation of strong ring-fencing policies, Portland General Electric did suffer somewhat from linkages when Enron filed for bankruptcy, including lack of access to the commercial paper market and below-investment grade unsecured debt.

However, many PUCs are not as proactive in ring-fencing utilities as the Oregon PUC was, and instead rely on reactive measures. For example, many commissions do not act until the credit rating of the utility has been downgraded below investment grade. Similarly, many attempt to preclude recovery in rate cases of any incremental costs of capital that can be identified as attributable to a riskier parent or unregulated subsidiaries. While measures may provide some relief to ratepayers, credit rating agencies usually require the implementation of or preventative ring-fencing policies before any rating de-linkage is considered. A proper framework would provide for both structural and operational ring-fencing.

Structurally, the utility should be viewed by its creditors and owners as a stand-alone company