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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.
percent or higher, growth in electricity consumption for most companies recently has been in the range of 1.1 to 1.6 percent per annum. Capital spending of approximately $40 billion in each of 2003 and 2004 averaged roughly 7.5 percent of net book investment in PP&E.
Fitch projects that utility capital investment will exceed 8 percent of electric utilities’ net book value of PP&E for the next 4 to 5 years on average. Companies making major environmental upgrades to coal plants and those building new baseload generation will have higher investment rates. Unless the new investments result in major reductions in other operating costs, the effect of rolling in the capital recovery for new rate-base assets will be to add 3 to 5 percent per annum to electric utilities’ revenue requirements, assuming no further decline in the rate of demand growth. This trend will spur the need for continuing base-rate increases over the next 4 to 5 years.
The cost of marginal investments in capital equipment has exceeded the embedded cost of existing PP&E for some years, and ongoing capital spending by utilities in recent years has consistently exceeded the rate of growth of sales demand. However, this cost trend was offset by declines in other expense categories, notably by refinancing debt at lower interest rates as well as by a long trend of generally declining costs from their peak in 1981-1984 until 2000. Looking forward, neither interest expenses nor fuel costs are expected to moderate the effect of rising capital investment or pension and employee benefit costs, so base-rate increases will be required.
Leverage May Rise
Utilities typically fund a portion of their capital expenditures with short-term debt prior to permanent funding with a mixture of debt and equity. A rise in the prices of fuels or purchased power typically results in increased working capital needs. Furthermore, regulatory/political resistance to rate hikes may result in deferred recovery of commodity costs and thus, more borrowing needs. Worse still is the possibility of regulatory disallowance of deferred costs, which would result in lower cash flow and more debt. In addition, utility cash flows could be adversely affected by slower customer payments and reduced demand, as residential, industrial, and commercial consumers experience difficulty in coping with higher energy bills.
Moreover, access to capital also will be a major issue in the future in respect to rising unit costs. In 2003-2004, many utility holding companies were overleveraged and suffered significant reverses in their non-utility and competitive businesses.
A major benefit for the sector in recovering its credit profile was ample access to capital markets and the bank market at low interest rates, both in the investment-grade and speculative-grade categories. Utilities took advantage of favorable capital market conditions to term out their short-term debt balances and pare back scheduled maturities to manageable levels, thereby improving liquidity and lessening refinancing risk and exposure in the event of a rise in interest rates. In 2004-2005, utilities and utility holding groups were favored by easy conditions in the debt and bank market, high equity valuations, and lower cost of capital.