When Électricité de France stepped in to buy Constellation Energy’s nuclear assets and help the company avoid bankruptcy, the Maryland Public Service Commission conditioned the sale on a set of...
Business & Money
for a utility would mean an increase in risk to utility common stockholders without them being able to enjoy the concomitant tax savings from which the common stockholders of unregulated companies benefit.
In examining capital structure issues, per books capital structures of utilities are not taken at face value by the financial community. For example, rating agencies exclude securitized debt balances and the associated interest payments from leverage and coverage calculations. In addition, bond-rating agencies take into account both capitalized leases and long-term purchased power obligations in their analyses by imputing additional debt for the capital structure ratios and additional interest for coverage calculations.
It is important to note that S&P recently indicated that it regarded purchased-power obligations as riskier than under its former assessment and was establishing new, tougher standards relating to its evaluation of such obligations. 6 S&P suggested that to recognize the effects of purchased power upon capital structure, utilities either incorporate more common equity in their capital structure, request higher returns on existing common equity or obtain an incentive return mechanism for economic purchases. 7 The implications of debt-equivalence of purchased power contracts is especially important for transmission and distribution companies. Because such companies no longer have the balanced capital structure and cash flow related to their generation assets, but now merely have a debt imputation related to purchased-power contracts, this could have a significant effect on both the leverage and coverage ratios of such companies. As S&P indicated in the statement cited above, utilities have to be proactive and offset the negative impacts of purchased power contracts in such instances.
The Need For More Equity
Given the increase in utility business risk and the other factors discussed above (, the transformation of most preferred equity into a near-debt-like element of the capital structure, the increase in the amount of purchased power, etc.) the need for more equity and lower leverage is apparent. The forecasts for electric utilities and gas distribution companies indicate they are moving their capital structures in a direction of incorporating a thicker amount of common equity. Such increases in the equity ratio are well warranted under the circumstances.
1. Value Line figures are for the parent companies; in many instances individual operating companies have even higher common equity ratios. The Value Line data exclude short-term debt.
2. Examples of factors leading to unanticipated issuances of debt include increases in deferrals due to spikes in fuel costs, increases in bad debt expense and, at the extreme, emergency expenditures in response to a terrorist attack.
3. In contrast, there is a linear relationship between the debt/equity ratio and the cost of equity.
4. Surveys have indicated that textbooks as well as most financial advisers and corporations employ market-based weights in evaluating capital structure decisions.
5. Five-year default rates for investment-grade bonds are generally 1 percent or less, while the parallel default rates for junk bonds are generally in the 5 to 10 percent range.
6. See Standard & Poor's May 8, 2003 report entitled "'Buy Versus Build': Debt Aspects of Purchased Power Agreements."