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Crisis Capital

Volatile markets call for alternative financial models.

Fortnightly Magazine - September 2009

what they were in July 2008. The bottom line, though, is that non-investment-grade utilities and merchant players still need to pay appreciably more for money now versus a year ago.

Even investment-grade utilities have not been spared the pinch of higher interest rates and spreads, and consumers may be affected as a result. Utility bond yields ( the red line in the upper part of Figure 2 ) increased from 6 percent in July 2008 to 6.75 percent today, after reaching a high of 8.5 percent, while utility spreads ( the lower part of Figure 2 ) have increased by up to 75 bps. Over the last three months, the current yields and spreads have reduced considerably from their November 2008 peaks but remain materially higher than historical averages.

It’s important to understand the increasing utility yields in the context of the regulator’s allowed rates of return on equity. At the onset of the credit crisis, credit-rating agencies and utility executives expressed concern that the increasing debt costs were approaching the authorized equity rate of returns (ROE), and that the current levels of ROE in many jurisdictions were inadequate compensation to investors who perceived a significantly higher level of risks. Their concern was that the need for higher equity compensation could lead to utility requests for higher authorized equity returns, regulatory uncertainty, and correspondingly higher consumer rates. Recently, however, due to declining debt costs, these concerns have been allayed, but this issue could return if capital markets become volatile once again.

Determining Cost of Capital

Empirical frameworks show how the quantitative cost of capital to the power sector has been impacted due to the current credit crisis. Two well-known and often-cited approaches to determining that cost are the capital asset pricing model (CAPM) and the discounted cash flow methodology (DCF). These models can be used to further demonstrate the clear differences between regulated and merchant entities.

The CAPM relies on historically traded stock prices for capturing equity risk, and given that, typically uses a five-year estimation period, to mitigate the impacts of recent stock price volatility. DCF also provides an alternative view of the cost of equity. Both approaches have drawbacks, so using a combination of these two methods is a reasonable solution.

The five independent power providers (IPPs) mentioned previously provide a reasonable set of comparable companies for the merchant class. For utilities, the Edison Electric Institute’s (EEI) regulated class of utilities 2 provides a readily comparable set of companies. Those in the EEI class have 80 percent or more of their assets in markets with a regulated rate-of-return market structure, allowing analysts to assess market risks at the low end of the spectrum.

By comparison, merchants are on a higher future trajectory for the cost of capital, compared to utilities. However, this must be verified by determining the two groups’ weighted average cost of capital (WACC), including the two principal components of WACC—the expected return on debt (cost of debt) and the expected return on equity (cost of equity).

CAPM Methodology : The CAPM approach determines the cost of