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...
Banking on the Big Build
The need for many hundreds of billions of dollars in capital expenditures creates huge opportunities and challenges, especially in a more challenging credit environment.
contracts for IGCC projects. For nuclear projects that are not in rate base, it will be even more important for project sponsors to remove market risk for a significant portion of the plant output.
And tax regimes need to be predictable. As of now, the 15 percent tax rate on dividends is scheduled to expire in 2010. Any reversion to standard income tax rates would have a major negative impact on the stock prices of companies that pay high dividends, including utilities. This in turn would raise their cost of equity, and also likely would limit market access during any period of uncertainty. In a similar vein, the extension of production tax credits is clearly of fundamental importance to further investment in renewables.
The track record of utilities in managing large capital expenditure programs has been mixed. The last round of nuclear-plant construction showed the downfall of customizing designs to meet the preferences of individual utilities. If the experience of the next generation of nuclear plants is to be different, utilities need to embrace the benefits of standardization. Constellation Energy has talked of developing a fleet of new EPR reactors that are identical, down to the “carpeting and wallpaper.”
The July 2007 edition of Public Utilities Fortnightly (“Avoiding the Next Debacle ” by Rilck Noel and Terrel LaRoche) also spoke of the need to apply traditional project finance and project-management disciplines. The effective identification of risks and their allocation to parties best able to manage them is critical to funding the industry’s capital needs at reasonable rates.
Consistent with this, utilities need to manage their balance sheets in a way that recognizes the political realities of rising customer bills. In particular, a strategy of pursuing a series of rate increases while increasing financial leverage and rewarding shareholders through above-trend dividend increases and share buybacks is unlikely to find favor with regulators and politicians. Furthermore, aggressive debt-funding of capital expenditure programs may trigger downgrades from credit rating agencies, which will raise the cost of debt and also may hinder market access in volatile credit markets. Conservative funding practices will both preserve balance sheet strength and increase the probability of regulated utilities achieving the rate increases that they need.
To reduce risks for their shareholders and other stakeholders, utilities should explore ways of teaming up with partners. Many of the large projects previously constructed by the utility industry involved two or more companies coming together as co-owners. Partnerships can apply either directly to the projects being financed, or to other non-core areas where much-needed capital is tied up.
One interesting example is the recent announcement by Constellation Energy and Électricité de France (EDF) of a joint venture for developing next-generation nuclear facilities in North America. EDF will contribute up to $625 million in cash to the joint venture, UniStar Nuclear Energy, thereby reducing Constellation’s future funding commitments. In addition, Constellation’s risk profile should be reduced via EDF’s experience as the largest operator of nuclear plants in the world, and its direct experience of new EPR construction from its plant at Flamanville