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Industry Evolution: Financial Pressures Ahead

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

Fortnightly Magazine - October 2006

rated “BBB+” or higher. In fact, during the last five years, the typical utility credit rating declined from “A” to “BBB.” In addition, approximately 20 percent of the industry is rated “BBB-” or below. The ability of these utilities to cope with additional financial challenges may be very limited.

• Further increases in fuel and purchased power costs, other increases in operating costs (including labor, pension, and medical costs), the cost of complying with environmental and other regulatory mandates, the additional capital costs of substantial infrastructure investment requirements, and the likely increase in financing costs will create a significant challenge to the financial health of the industry in the years ahead. And again, while these challenges are significant for the industry on average, variances across regions and companies will mean that a sizable number of individual utilities will be affected much more strongly.

• Finally, the recent sharp increases in costs have forced many utilities to file new rate cases, which often is associated with delayed and sometimes incomplete cost recovery.

The following discussion addresses some of these issues in more detail.

Outlook for Credit Ratings And Earned Returns

Credit rating agencies already have taken note of the potential financial implications of the challenges facing the industry today. According to one credit rating agency, Fitch, “unusually high and volatile natural gas and energy prices raise risk overall.” 6

While it clearly recognizes the improvements in industry financial conditions over the last few years, Standard & Poor’s raises similar concerns over the industry’s emerging challenges. These concerns over the challenges and financial health of the industry in the years ahead are not limited to credit rating agencies and the perspective of debt holders; equity analysts similarly express concerns. For example, Lehman Brothers states in a recent report:

Another Cap-ex Cycle Looms

… In this year’s study of electric utility regulation, we take the results of a bottom-up compilation of fuel and cap-ex spending increases over the next five years and look at the implications for cash flow, returns, equity risk premia, and valuations. We believe this analysis reinforces our negative stance on regulated electric utilities. …

Substantial Rate Increases: Infrastructure investments and high fuel costs spell rate shock, demand destruction, and regulatory risk for traditional utilities. The projected 10 percent-plus annual increases through the next four years could pain consumers, pressure politicians, and harden regulators. …

Decreasing Returns: Historically, electric utility underearning coincides with free cash flow turning negative (which happened in late 2005). … Our free cash estimates imply that earned returns could drop to the 9 percent ROE area in the coming years, a deficit of over 250 [basis points] versus projected allowed levels. 7

Increasing Financing Costs

The capital costs associated with this clear need for infrastructure expansion will form another driver for rate increases in coming years. While the current environment is quite favorable in terms of utilities’ access to capital markets, recent increases in industry specific risk factors and a trend to potentially higher interest rates suggests higher financing costs for investment requirements going forward.

As shown in