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Rising Unit Costs & Credit Quality: Warning Signals

With increasing unit costs, the financial prospects and credit outlook for many utilities will depend on their success in passing along such costs to consumers.

Fortnightly Magazine - February 2006

The most immediate effect of rising costs will be felt by those local gas distribution companies (LDCs) that did not hedge the vast majority of their customers’ winter gas consumption. Conversely, non-utility power generators with predominantly coal and nuclear resources typically benefit from the effect of higher gas prices to raise wholesale electricity prices, and if their sales previously were not contracted at lower fixed prices, they stand to reap windfall cash flows.

In the case of integrated electric utilities with predominantly coal and nuclear resources, the primary beneficiaries of their favorable resource mix are consumers (ratepayers), but the utilities themselves benefit by maintaining more stable profitability and credit ratings. While costs of power produced from coal have risen more gradually than gas-fueled power generation, future environmental compliance and potential new investments in base-load capacity additions will drive cost increases for coal-based power generators during the next five years.

Long-Term Trends and Historical Precedents

The electric utility sector previously experienced several sustained periods of rising or falling unit costs. A significant and prolonged increase in real unit production costs from 1974 through 1982 was associated with reduced growth (or even declines) in utilities’ sales volumes, contraction of profit margins, adverse regulatory decisions, and declining credit measures. On the other hand, prolonged declines in real unit costs (such as 1950-1970 or 1983-1999) are associated with growing demand and improving profitability. All other things being equal, the latter environment is more conducive to stable or improving profitability and financial conditions.

Figure 1 illustrates the long-term trend in electric power prices over the past 40 years, both in nominal dollars and in constant 2004 dollars. Fitch views utilities’ prices as a reasonable proxy for their costs over the long term, although tariff regulation normally creates a lag in the linkage between costs and prices both on the upside and downside.

In a period of sustained rising prices per unit of sales in the decade following the 1974 oil shock, electric utilities experienced difficulty in passing through all expense increases to consumers, resulting in shrinking cash flow from operations and increased dependence on external financing. The era from 1983 through 2001 was a period of relatively flat prices in nominal terms and declining real prices.

Today’s circumstances are not a perfect analogue to the 1974-1985 era, and at present, Fitch has no reason to expect that the coming five years will replicate the financial distress utilities experienced in that period. A number of factors in the current environment may mitigate the negative effects of rising unit costs over the next five years. These include:

  • Capital expenditures going forward are estimated at 8 to 9 percent per annum of the sector’s net property, plant, and equipment (PP&E), versus 10 to 15 percent in the 1970s and early 1980s.
  • Utilities are unlikely to make substantial investments in utility fixed assets today without a reasonably firm commitment from their state regulators on investment recovery.
  • State regulatory commissions are more aware today that utilities cannot afford to subsidize fuel costs and that utility insolvency potentially would transfer supply responsibility to