Public Utilities Reports

PUR Guide 2012 Fully Updated Version

Available NOW!
PUR Guide

This comprehensive self-study certification course is designed to teach the novice or pro everything they need to understand and succeed in every phase of the public utilities business.

Order Now

Industry Evolution: Financial Pressures Ahead

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

Fortnightly Magazine - October 2006

are exposed have been increasing, due to a variety of economic, operational, and regulatory factors. The increased risks also mean that the risk premium required by utility equity investors has been increasing as well, which leads to higher capital costs that also offset the general decline in interest rates.

The equity risk commonly is expressed through “beta,” which is a quantitative measure of the volatility of a given stock price relative to the market as a whole. Fig. 4 shows that the beta of the electric utility industry has increased from approximately 0.55 in 2000 to approximately 0.85 in 2005. At a market risk premium of 6.5 percent to 8 percent, this increase in risks raises the required return on equity by approximately 2 to 2.4 percentage points (or 200 to 240 basis points). 3 This increase in the required ROE approximately offsets the decline in interest rates as reflected in the “Baa”-rated utility bond yields as shown in Fig. 3. Consequently, the recent decline in allowed ROEs, as documented in Fig. 3, may not be consistent with the increase in utilities’ risks as documented in Fig. 4. Thus, credit rating agencies’ concerns over “insufficient regulated authorized returns” also appear to be a valid concern from the perspective of equity holders. 4

Operating Cash Flows and Capital Spending

The magnitude of operating cash flows (or “funds from operations” 5) relative to interest expense, total debt, and capital spending frequently is used to assess the credit strength of companies. The size of operating cash flows relative to a company’s interest expenses and other fixed obligations also indicates the flexibility that utilities have in order to withstand unexpected financial difficulties resulting from occurrences such as major plant outages or storm damage. If operating costs increase faster than revenues, operating cash flows decline. Importantly, trends in cash flows can be a leading indicator of utilities’ financial conditions because, unlike earnings, cash flow cannot be preserved by accrual accounting and the deferred recovery of costs that often occurs within the regulatory process.

Broadly speaking, the portion of capital expenditures that can be financed from internally generated funds is equal to operating cash flows net of dividend payments. The extent to which funds from operations exceed capital expenditures and dividends is defined as a utility’s “free cash flow” and measures the extent to which utility companies need to rely on external financing.

As internal cash flow declines, a larger portion of a utility’s capital expenditures will need to be financed externally, i.e., through the issuance of debt or equity in the capital markets. Unfortunately, it is not always possible to “make up” declines in internal cash flows through external financing because access to capital markets becomes more limited as a company’s financial flexibility declines. As documented by the industry’s recent liquidity crunch, this can lead to outcomes in which the companies that would need to rely most heavily on external funds also find it most difficult to access such funds.

Fig. 5 compares total operating cash flows (blue line) against the sum of capital expenditures