Like a physician with her stethoscope at the outset of a check-up, astute shareholders and directors should use the level and trend of a utility’s market-to-book ratio (MtB) as one of the first...
Industry Evolution: Financial Pressures Ahead
Can utilities simultaneously manage rising costs and pressing capital investment needs?
higher than in the recent past. Given the challenges ahead, these risks are unlikely to decline.
In sum, fuel- and market-price volatility along with uncertainties over the evolution of industry structure, environmental costs, timely recovery of these costs, and the required costs of financing significant capital expenditures for infrastructure requirements introduce operational and financial risks that can be difficult to quantify or mitigate. This uncertainty itself is raising utilities’ financing costs at a time when the sector’s capital needs are quite large.
1. These questions are explored in more detail in a recent report for the Edison Foundation, upon which this article is based: Basheda, Fox-Penner, Pfeifenberger and Schumacher. “Why Are Electricity Prices Increasing? An Industry Wide Wide Perspective,” The Edison Foundation, June 2006.
2. This sample contains 121 operating utilities. It consists of parent companies and subsidiaries for which financial data are available and reported by Compustat, and includes only companies with Compustat GICS codes for “electric utilities” and “multi utilities.” (This excludes companies in the deregulated segment of the industry, which are classified as “independent power producers” or “energy trading companies.”) To avoid double counting and companies with sizeable unregulated subsidiaries, we excluded utility holding companies whenever financial data for the utility operating subsidiaries were reported separately.
3. This calculation is based on the “capital asset pricing model,” or “CAPM” which says a company’s risk premium equals the product of its beta and the market risk premium. In repeated empirical testing, the cost of capital turns out to be less sensitive to changes in beta than the CAPM predicts. In particular, this research shows that low-beta stocks have higher costs of capital and high-beta stocks lower costs of capital than the CAPM predicts. Using this research, the predicted change would be closer to 175 to 210 basis points than to 200 to 240 basis points.
4. S&P “State Utility Regulation Coming Back in Vogue,” Oct. 7, 2002; “Regulatory Suport for U.S. Electric Utility Credit Continues to Disappoint,” May 29, 2002; “A Fresh Look at U.S. Utility Regulation,” Jan. 29, 2004.
5. The term “funds from operations” (FFO) is typically used by rating agencies. It is defined as operating cash flows without adjusting the change in working capital. We are using FFO and operating cash flow interchangeably here.
6. FitchRatings, U.S. Power and Gas 2006 Outlook, Dec. 15, 2005, p. 1.
7. Lehman Brothers, Capital Lessons, Global Equity Research/North America, March 15, 2006, pp. 1-2.
8. Id., p. 10.
9. Energy Information Administration, 2006 Annual Energy Outlook, Table 19, February 2006 (based on projected yields of AA-rated utility bonds).
10. Long-Range Consensus U.S. Economic Projections, Blue Chip Financial Forecasts, March 10, 2006, p. 15.
11. In May 2005, the 10-year constant maturity Treasury yield was 4.14 percent; during 2005, yields ranged from 4.0 percent to 4.54 percent. ( http://www.federalreserve.gov/releases/h15/data/monthly/H15_TCMNOM_Y10.txt).