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Fragile Foundation

The capital markets have recovered … or have they?

Fortnightly Magazine - October 2009

regulated utilities will need to build up their renewable energy platforms to comply with a federal RPS. Combine that with the fact a number of renewable energy development companies are small and don’t have access to capital, and it creates an opportunity for utilities to buy vs. build out those portfolios.

Wood: There’s an age-old debate about the best model for renewable energy project ownership. The two camps are utility rate-base ownership vs. independent development of renewable generation with long-term utility off-take contracts.

The U.S. generation market is enormous, and as a consequence there’s ample room for both models. The market is open for the small independent developer, the larger integrated power developer and owner, as well as the utility developer. We believe you will see more utilities enter this market. The tax benefits make it easier for them to meet regulatory requirements and customer demands to make sure things are built out. Every utility will decide where it wants to be in the value chain. It will catch on faster in some regions than in others. California is the most vivid example, but whether it’s a role model for the country is another question.

 

Fortnightly: Where do you see the capital markets headed in the mid-term future, in terms of accessibility and pricing?

Peiffer: I think interest rates will stay lower than what the market expects them to be over the next 12 to 18 months. It will be awhile before inflation kicks in and starts pushing rates up. Also, I expect spreads will continue tightening. We’ve had relatively more positive economic data being announced in recent weeks. Banks and economists are moving up their GDP forecasts, and corporate earnings are more consistently exceeding expectations than not exceeding them. There’s still room for spreads to tighten. However the same improvements in the economy that would cause spreads to tighten also will cause Treasury rates to move up, so you’ll have some offset between Treasury rates and spreads.

However, technical drivers also will keep interest rates low. No one wants to be left sitting on the sidelines with cash when spreads are tightening. This is especially true for utilities, which are known as a strong cash-flow defensive industry. Many investors view 30-year utility paper as quasi-equity. If they can get 5.75 percent pre-tax, that’s a pretty spectacular rate at this point in the economic cycle, where the fundamentals haven’t truly turned around yet.

If we’re entering a weak recovery, conditions still will be very good for utility financing. There always will be demand for utility bonds, because of the strong cash-flow nature of utilities compared to other sectors, such as retail or manufacturing. In late 2008, nobody wanted to buy the bonds of any other sector.

In a slow-growth scenario, we won’t see inflation happening and that’s good for interest rates. Spreads won’t tighten as much, and they might widen, but we’ll still see robust financing for utilities and midstream companies. That’s part of the reason there’s been such a rush to the market to issue bonds right now; issuers that