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Industry Evolution: Financial Pressures Ahead

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

Fortnightly Magazine - October 2006

Fig. 7, industry financing costs as measured by utility bond yields have reached a 40-year low. The decline in interest rates has allowed utilities to mitigate increases in other costs. However, this long period of low and declining interest rates is not expected to continue. During 2005, for example, the Federal Open Market Committee (FOMC) raised the Federal Funds Rate a total of two percentage points. At its first meeting in 2006, the FOMC raised the Federal Funds Rate another quarter percentage point, to 4.5 percent. These recent increases in interest rates are also shown in Fig. 7, though they have not yet affected utility bond yields.

The financing costs of utilities’ investment requirements generally are expected to increase, for at least three reasons: (1) possible increases in long-term interest rates; (2) increases in utilities’ cost of debt due to declining credit quality; and (3) increases in utilities’ cost of equity due to higher risks.

Both Fitch and Standard & Poor’s specifically point to “rising interest rates” as one of several negative credit factors faced by the industry going forward. However, while many industry analysts anticipate that long-term interest rates will be increasing, the extent of such increases is still unclear. For example, Lehman Brothers projects that the yield of 10-year government bonds in 2006 will have increased by 90 basis points from 2005, without further increases through 2010. 8 EIA projects an 80 basis-point increase from 2005 to 2006, with additional increases of 110 basis points through 2010. 9

Based on the long-range consensus forecast compiled by Blue Chip Financial Forecasts, government bond yields are anticipated to increase to 5.5 percent by 2009 and remain at that level for another five to 10 years. 10 In comparison, as of May 5, 2006, the yield on the 10-year government bond was 5.1 percent, which already exceeds May 2005 yields by approximately 100 basis points. 11 These forecasts suggest that long-term interest rates in the years ahead must be expected to be between 100 and 150 basis points above 2005 rates.

In addition to these trends of increasing interest rates, industry- specific risk factors likely will exert additional upward pressures on utilities’ cost of capital. Rising operating costs, the evolution of industry structure, the ultimate costs of environmental and other regulatory mandates, and the extent and timeliness to which these costs can be recovered in rates introduce additional uncertainties that often are difficult to quantify or hedge. These risk factors already have been recognized by rating agencies through reduced credit ratings and negative outlooks. These risks will raise utilities’ cost of debt relative to the general trend in long-term interest rates.

Similar upward pressures exist for utilities’ cost of equity. As the industry’s risks increase through factors such as fuel price volatility, significant capital expenditures, regulatory lags, and the potential for incomplete cost recovery, the re-quired return on the equity-portion of utilities’ rate base also will tend to in-crease faster than the general trend in interest rates. The increase in “beta” shown in Fig. 4 indicates that utilities’ market risks today already are