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Capital Conundrum

The Big Build will test the industry’s access to Wall Street.

Fortnightly Magazine - September 2008

Risks and Returns

There is plenty of room for funding from newer sources. For example, $302 billion of private equity capital flowed into U.S. funds in 2007. 2 Hedge funds raised $194.5 billion, 3 and in the two years from 2006-07, U.S. infrastructure funds rose by $150 billion. 4 A good proportion of this money could make its way into the utilities industry, which still is highly attractive to investors due to its relatively low risks and stable returns.

The question of which investments will prove most attractive really depends on the individual buyer’s risk-and-return profile. An infrastructure fund, for example, will be drawn to buy rate-regulated utilities, and probably will prefer to invest in states with a track record of consistent, predictable and transparent regulation. 5 But while infrastructure funds likely will be content with the dividend yield that regulated utilities will generate, PE buyers may seek to leverage any such investment to generate greater returns, or exit. Alternatively, PE buyers might avoid regulated utilities altogether in favor of buying generation, which provides the opportunity—particularly in the country’s liquid markets 6—to earn hefty returns. Others (such as ITC Holdings) may be attracted to invest in transmission because of the FERC incentives available. There also could be potential for sovereign wealth funds to invest in infrastructure, although they will face close scrutiny and are likely to be disappointed if the asset they want to buy is considered strategic.

The entry of these alternative buyers has created an opportunity for utilities to sell those businesses that compete for capital with their core, strategic businesses. What also is likely to occur is an increase in divestments to raise the cash for vital new infrastructure spending. 7 Some smaller utilities may be forced to merge or combine to ensure adequate critical mass so they can afford necessary investments.

Return on Investment?

One fundamental question all utility investors want answered favorably is: “Will the regulator allow us to recover the cost of our investments in future years?” Recent disappointing rate cases might give some cause for concern. For example, PNM Resources just received a very unsatisfactory decision slashing its permitted return on equity. This happened before it even started building new infrastructure. When the company begins building in earnest, it will mean further pressure on rates.

Regulatory battles like this can be demoralizing and can prompt company executives to think twice before investing. It’s no wonder that infrastructure funds seek out opportunities in states where they trust they will be allowed to earn steady, regulated returns—as in Macquarie’s recent proposed acquisition of Puget Energy.

However, even if the regulator gives investors serious reasons to pause, realistically at some point further delay is impossible and the money must be spent. Otherwise, the lights go off. Regulators realize this too. Although they may act aggressively on pricing in favor of customers, they know it’s ultimately in the best interest of the consumer to have consistent, fair regulation, because inconsistency adds delay, which in turn impacts both investment and supply reliability. It will be worth watching whether the