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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.

Fortnightly Magazine - October 2006

riskier business environment than they were 10 years ago, when competitive forces just were starting to affect the power industry. In this environment, higher credit ratings are more difficult to maintain because utilities face more uncertainties than they did a decade ago. “Investors require a commensurate return,” Kind says. “Even with greater regulatory certainty than we currently have today, you won’t get 100 percent assurance of cost recovery. And to the degree there is more risk, capital costs go up, at least on a relative basis.”

Today, while interest rates still are relatively low and utility valuations are strong, capital costs will remain manageable. But trends in other areas—fuel costs, capacity margins, and rate-regulation practices—are putting pressure on financing discussions. And competition for capital is intensifying as infrastructure development moves forward in many sectors—including utilities, oil and gas, and transportation.

“For most utilities, a major challenge will be that everyone is trying to finance planned investments at the same time,” says Robert Petrosino, a director with Barclays Capital in New York. “Competition for capital will be great over the next couple of years, and utilities will need to tell a strong economic story to get access to low-cost capital.”

In practical terms, this means utilities need to work hard at addressing as many significant risks as possible in contract terms and regulatory pre-approvals when seeking financing for major infrastructure investments. “It’s important to structure a deal that is financially sound on its own,” says Amin Bishara, a vice president at CapGemini in Dallas. “Additionally, the project should address regional or national issues so you can capture tax benefits and regulators can reward you.”

Companies should weigh all their investment and expense needs together, and consider financing priorities in the context of energy policy, ratemaking, and capital-market trends.

“A huge buildout is coming, but we will see capacity shortfalls before the logjam on who pays for this stuff is broken,” Patterson says. “Each sector of the industry—distribution, transmission, and generation—needs to make hard decisions about how to move ahead, and utilities also need to sharpen their understanding of resource allocations across lines of business.”

For some companies, this might translate into new operational strategies, such as business-process outsourcing, to improve efficiencies and investment returns. “Utilities won’t be able to get rate relief as easily, and that means they will be required to do a better job of managing their assets,” says Nana Baffour, managing principal with private-equity firm Knox Lawrence International in New York. “Utilities can’t skimp on capital expenditures or maintenance, so there is nowhere else to go except to change their operating structure, and find ways to do it better and more cost-effectively.”

Regulatory Logjam

Many recent cases of sticker shock involve states that unbundled generation assets from power-delivery businesses and imposed rate caps to demonstrate an immediate benefit to ratepayers. The most dramatic cases, in Maryland and Illinois, were precipitated by the expiration of rate caps installed during deregulation proceedings in the late 1990s. In exchange for the ability to spin off generating assets, utilities agreed to freeze customers’ electricity