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Industry Evolution: Financial Pressures Ahead

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

Fortnightly Magazine - October 2006

and dividends for the sample of utility operating companies. The figure shows that companies’ total operating cash flows increased from approximately $35 billion in 2000 to approximately $45 billion in 2004. During the same period, free cash flow improved significantly despite increased capital expenditures. These improvements in cash flows again document the overall financial recovery of the industry in recent years.

Fig. 5, however, also documents the more recent financial pressures that have emerged as utilities face much higher operating costs and investment requirements. As the data show, from 2004 to 2005, operating cash flows declined sharply, by approximately $10 billion, while capital expenditures increased. This combination of reduced operating cash flows and increased capital expenditures foreshadows a likely further decline in utility earned returns and significant financial challenges the industry is likely to face in the years ahead.

A slightly different picture, but one that nevertheless suggests a similar outlook for the years ahead, emerges for independent power producers and energy trading companies. Fig. 6 shows that operating cash flows declined from a high of approximately $17 billion in 2000 to approximately $15 billion in 2002 to 2004. From 1999 to 2002, substantial capital expenditures associated with the construction of merchant generating plants greatly exceeded operating cash flows. Similar to the electric and combination utilities represented in Fig. 6, however, operating cash flows have declined sharply in the last year: from $15 billion in 2004 to approximately $10 billion in 2005.

Financial Outlook: The Challenges Ahead

The industry has been recovering reasonably well from the recent financial crisis. The bottom end of credit ratings has improved somewhat for both utilities and unregulated companies. Utilities’ earned ROEs are declining but, at least for the industry average, are still within the range of allowed ROEs. Allowed ROEs have trended down, which has raised concerns of rating agencies, but that decline in allowed ROEs is mitigated, at least in part, by declining interest rates and utility bond yields. And, until recently, utilities had, on average, increasing operating cash flows that were sufficient to fund most of the needed capital expenditure internally.

These recent positive industrywide developments do not imply that forward-looking conditions are expected to remain as favorable, as several trends point to reduced industry financial strength. These trends include:

• Utility earned returns have been declining as rate relief and revenue growth have been outpaced by the combined effect of fuel and purchased-power cost increases. In addition, the bottom quarter of the industry is earning ROEs well below its cost of equity. In 2005, the earned returns of this segment also have been declining at a more rapid rate. This suggests that a sizable portion of the industry may be poorly positioned to address the challenges faced today and in the years ahead.

• In 2005, operating cash flows declined more quickly than industry-earned ROEs, which likely is a leading indicator of further earnings erosion.

• The credit rating of the utility industry overall has trended downward to a point where, as of 2005, less than half of electric and combination utilities were