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Industry Evolution: Financial Pressures Ahead

Can utilities simultaneously manage rising costs and pressing capital investment needs?

Fortnightly Magazine - October 2006

Does the utility industry have the financial strength sufficient to meet the combined challenges of: (1) sharply increasing and highly volatile fuel and purchased-power costs; (2) significant capital investment requirements; and (3) rising interest rates? 1

The industry has recovered fairly well since the financial meltdown associated with the Western power crisis and the Enron bankruptcy, but recent data also show a downward trend in utility earned returns on equity (ROEs), a decline in operating cash flows, and credit quality that has trended downward over the last five years. These findings suggest that reasonable rate relief and investment-recovery policies will be needed to maintain a financially strong utility industry sufficiently capable of attracting the required capital and meeting its responsibilities in a stable, cost-effective manner. Regulation that does not provide for the full and timely cost recovery of prudent costs will weaken utilities financially, thereby raising investment-related costs and discouraging investments that would yield long-term benefits.

The Last Decade

While primarily focused on assessing the risk of debt holders, credit ratings also reflect overall company and industry fundamentals, as well as factors important to equity holders, such as allowed and earned ROEs. Fig. 1 shows the credit ratings for electric and combination utilities, which are primarily utility operating companies. 2

The figure also shows two notable trends. First, it documents the marked decline of average credit ratings for a sample of 121 operating utilities, which represent the mostly regulated segment of the industry. Until year-end 1999, financially strong companies rated “BBB+” or above accounted for approximately 75 percent of all companies. By the end of 2005, the proportion of utilities rated “BBB+” or above had declined to approximately 45 percent. Second, Fig. 1 documents that the financially weak segment of the industry has been recovering from its weakest period in 2003. Utilities rated “BBB-” or below used to account for only 10 percent to 15 percent of all companies through 2001, but that share increased to almost 30 percent by 2003. However, the proportion of utilities rated “BBB-” or below investment grade improved to approximately 20 percent by the end of 2005.

Fig. 2 shows the same data for a sample of 25 independent power producers (IPPs) and energy traders, i.e., the largely unregulated portion of the industry. Not surprisingly, this figure shows a much stronger response to the recent energy and financial strain created in the aftermath of the Western power crisis and the Enron bankruptcy. The proportion of companies with below-investment-grade ratings ( i.e., below “BBB-”) increased from approximately 15 percent in 2000 to nearly 60 percent in 2002. As with utility operating companies, the last few years show widespread improvement in overall credit ratings, though not to the levels of the mostly regulated segment. By the end

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