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Interest Rates and Fiscal Armageddon

How to prepare for killer capital costs on future power-plant builds.

Fortnightly Magazine - December 2005

companies at risk if the project doesn’t get done.

“You have to have some surety that the plant is going to be built. If you don’t have that kind of surety, you wouldn’t really buy the insurance. Certain hedges really get expensive if they are not used. And you have big time accounting issues if you never issue the underlying financing in the first place.”

Baliff says some derivatives options the bank offers are cheaper on a risk-adjusted basis than just buying a forward contract.

“‘Swaptions’ are a way that you can buy protection with less surety, but you have to pay for it today,” he says.

Utility executives can buy protection. If the project doesn’t happen, they don’t have to exercise the option or buy the underlying Treasury.

Baliff says swaptions still don’t protect against underlying credit-spread risk. “The best way to lock in an all-in coupon (Treasury plus credit spread) is to issue long-term bonds today. This would be the dream situation, but some experts say utilities, which know they will have to build power plants to meet demand in the coming years, have not received the proper support from regulators.

Meanwhile, as regulators and utilities debate the need for a particular plant, the cost of capital continues to rise. How do utilities avoid getting caught in the interest-rate vice? Baliff has one phrase for utilities: “Talk to your regulator.”

“The regulator needs to understand this risk. There are some regulators and some jurisdictions out there that do understand that and are allowing plants into ratebase or other interest-rate protection measures. Some regulators have started thinking about signing contracts today that have the ability to pass through interest rate costs.”

A Not So Palatable Strategy

It might be a mistake for utilities to continue to keep buying back their stock at what many agree could be the highest point in their valuations, says the anonymous investment banker. Instead of buying their own stock at steep valuations, they should sell at the top (or at least not buy back) to raise capital for “cap-ex,” or capital expenditures.

“Would you be aggressively buying back equity now—for earnings management—if you were a CFO? I think you would answer ‘no’ just because of where valuations are,” the investment banker says. He admits such a strategy may not fit well with the current culture at utilities, where stock buybacks are used as an earnings-management tool.

The best strategy, in addition to locking in low long-term interest rates, might be to sell equity and use the proceeds to pay down short-term debt, he says. “Say you are 50 percent debt and 50 percent equity in an ideal world. Why not go down to 45 percent debt and 55 percent equity for the next couple of years? When equity gets cheap again, then start buying it back.”

With analysts convinced utility valuations will come down in the next couple of years, many believe it will be cheaper to buy back stock in the future and more expensive to raise debt. But Credit Suisse First Boston’s Baliff doesn’t