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A Utility Executives' Guide to 2007: A Cloudy Forecast

Experts predict the top issues that utilities will have to weather this year, and beyond.

Fortnightly Magazine - January 2007

business risks CERA respondents identified were input commodity price volatility, output commodity price volatility, and a restrictive carbon mandate. How might these issues affect the industry?

In this 2007 Utility Executives’ Guide, Public Utilities Fortnightly provides an overview of how these forecasts and others could shape the industry’s future.

Mergers, Spinoffs and Interest Rates

Speaking at Accenture’s International Utilities and Energy Conference (IUEC) late last year in Boca Raton, Fla., Kenneth Marks, managing director at Morgan Stanley, made his predictions for 2007.

“The industry is entering a challenging period. There will be substantial rate increases needed to fund capital expenditures. Commodity prices are likely to remain relatively high, although [they] may come down somewhat, and [be] volatile, putting additional pressure on the need for increased rates. And interest rates are more likely to rise than to fall,” Marks predicted.

These pressures might not drive M&A activity only, but also create the potential for separation transactions or spinoffs—creating “pure plays”—in transmission and generation. Such spinoffs will be driven by the need to enhance shareholder value for the parent company, as well as improve prospects for the spun-off venture.

“While an integrated company may not be willing to leverage up its balance sheet and risk a downgrade in its credit ratings, a stand-alone genco can do this,” Marks said. Additionally, generation companies are valued in the market place on a cash-flow basis at a relatively high metric.

“Merchant gencos are trading about 9 to 10 times 2007 EBITDA, reflecting the benefit of being a pure play and having additional leverage,” Marks said. “By contrast, the nifty 50 utilities trade at about 8 times 2007 EBITDA.” Finally, being a pure-play genco avoids negative synergistic situations where “the temptation of regulators may be to have the generation business subsidize the distribution business.” Moreover, many of the issues associated with managing counterparty credit associated with pure-play gencos have been resolved with the emergence of improved credit offerings and products.

Turning to transmission, Marks advocated the divesture of transmission as a potentially attractive proposition, reflecting increased returns available, better leverage and higher valuation. Additionally, FERC provides an return-on-equity adder as long as the owner of transmission is not deemed to be a market participant, and he said there’s potential to receive a rate-base adder in certain circumstances.

Of course, Marks conceded that several factors impede such a transaction. It’s difficult to separate the transmission business if: 1) It isn’t already in a separate subsidiary; 2) there’s a need from the utility standpoint to replace the earnings of the transmission business; and 3) transmission ownership is perceived as a strategic asset.

Meanwhile, on the mergers and acquisitions (M&A) front, this Morgan Stanley investment banker expects additional M&A transactions, although there will be continuing concerns about state regulatory approvals.

As a result, Marks believes more M&A activity will involve medium and small-cap companies because issues on the regulatory side probably will be easier to manage. “Certainly there will be a focus on combinations that don’t have the obvious issues with regard to federal and state regulatory approvals that the Exelon-PSEG