Business & Money

The utilities industry is in need of more equity.

Regulated utilities, in response to increased risks and bond downratings, have de-leveraged their capital structures. According to preliminary figures from the Edison Electric Institute (EEI), in 2003 utilities cut their short-term debt by more than half compared with 2002. The EEI data also reveal that for 2003, electric utilities issued more than $10 billion of new common equity and repurchased just slightly more than $100 million of common stock. Value Line projects that total capital for electric utilities will increase about 12 percent during the next several years, while common equity will increase nearly 28 percent. Similarly, natural gas distribution company total capital is projected by Value Line to increase about 10 percent, while common equity is projected to increase close to 15 percent. For both industries, the median common equity ratio in the near-term future for companies with investment-grade rated subsidiaries is in the range of 51 to 52 percent. ¹

Common Equity

For utilities, higher equity ratios are desirable for several reasons.

Higher equity ratios enable utilities to offset some of the increase in business risk by lowering financial risk.

Higher equity ratios give utilities flexibility in issuing new debt (or preferred stock) when needed without unbalancing the capital structure. While much attention is paid to the amount of leverage a company employs, utility management must be concerned with the amount of debt not in use. This reserve of unused debt capacity is important because it allows utility management to issue new debt in an orderly manner or to accommodate larger than anticipated issuances of debt. ² Since utilities have an obligation to serve, they cannot sit out adverse market conditions and wait for a more favorable economic environment.

Other things being equal, the higher the equity ratio, the higher will be the debt interest coverage. Higher coverage would tend to lead to higher bond ratings and a lower cost of new debt.

A thicker equity ratio provides a bigger base over which a decline in earnings can be spread. Other things being equal, a higher common equity ratio would reduce the leverage effect on the capital structure and make a company's common stock earnings performance more predictable, and thus less risky.

Other things being equal, the higher the common equity ratio, the lower the risk of ruin (i.e., bankruptcy). While bankruptcy was only a remote possibility for most utilities in the past, it has become a more threatening specter over the past several years. Even in the absence of an immediate threat of bankruptcy, a higher equity ratio can generally help cushion a company if its financial situation deteriorates.

A downward change in the common equity ratio will have a much more significant impact on the required rate of return for equity than an equivalent percentage point upward change in the common equity ratio because of a non-linear relationship between the common equity ratio (, common equity as percent of capital) and the cost of common equity. ³ For example, let us assume a company that has