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A Capital Problem: Financing the Next Big Build
As rate disallowances become more commonplace and capital requirements expand, infrastructure development will come with a higher price tag.
Wall Street. If the trend spreads, it could complicate investment plans and perhaps even operational strategies in some cases.
“This could become a very common situation,” says Richard Cortright, managing director with Standard & Poor’s in New York. “We are concerned, from a credit-quality point of view, about the timely recovery of costs. Deferring cost recovery makes it even tougher. The costs keep rising, and it just snowballs” (see sidebar “Ratings & Rate Battles.”)
So far, utilities still are finding an ample supply of financing available in the debt and equity markets. But as the industry’s regulatory risks and capital requirements expand, that financing will come with a higher price tag—and another cost pressure in the ratemaking process.
Paying the Piper
Since the Enron crisis precipitated a sector-wide downgrade in 2002, the credit ratings of U.S. utilities have regained strength as these companies retooled themselves for a back-to-basics strategy. By exiting non-core businesses, writing off bad investments, and restructuring high-cost debt, utilities have improved their balance sheets significantly. This puts them on strong footing to finance new investments in utility infrastructure.
“In general, capital markets are rarely closed to regulated industries, given the bond-like characteristics of their businesses,” says Ian Connor, managing director with Goldman Sachs in New York. “Utilities generally will be able to issue the equity and debt they need to finance those investments, and over time, given the proper regulatory structure, such financing should not be dilutive.”
However, as the dust settles on this industry-wide renovation project, utilities’ credit positions seem to have degraded a bit, compared with pre-Enron levels. In its recent annual report for the industry, the Edison Electric Institute commented on the state of credit quality: “Although some companies are still on the mend, most analysts expect the industry’s benchmark rating going forward to be between BBB and BBB+, about one to two notches below the historical benchmark rating.”
The reasons for this ratings slump vary from issuer to issuer, and as a general matter the reasons for the industry’s overall lower creditworthiness aren’t entirely clear. One reason might be simply that financing costs have remained relatively affordable despite lower credit ratings.
“Utility ratings definitely have taken a step down from where they were 10 years ago,” says Walter Hulse, managing director at UBS Investment Bank in New York. “But 10 years ago, the below-investment grade market wasn’t well defined, and capital markets in general weren’t as liquid as they are today. On a multiple basis, utility valuations are at an all-time high, and companies question whether it’s worth trying to maintain higher credit ratings.”
In other words, if utilities are allowing their ratings to slip, it’s because they can afford it. “There’s a willingness to finance paper that is rated weak ‘triple-B’ and even lower,” notes Peter Kind, head of the power investment banking group at Banc of America Securities in New York. “The costs of being less than ‘A’-rated are more palatable than they previously were. This is the new reality.”
Another aspect of that reality, however, is that utilities are operating in a