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Restoring Financial Balance

With looming mandates and aging infrastructure, utilities need regulatory support.

Fortnightly Magazine - November 2011

and Bluefield1 decisions of 1944 and 1923 as they relate to the right to a reasonable return on a utility’s assets. Although mentioned less often in today’s regulatory process, the fundamental rationale for state regulation grew out of the concept of regulating businesses “affected with the public interest.” 2

Historically, the impact of scale economies and changes in technology resulted in both nominal and real price declines in utility service. Beginning in the 1970s, the continued rapid growth in demand for electricity and natural gas coupled with substantial new investment in generation capacity, higher fuel prices, the first generation of environmental controls, and the economic inflation experienced in the U.S., caused electric prices to begin to rise. At the same time, the prices of natural gas also began increasing. Wellhead price controls constrained supplies, and new sources of gas were more expensive and difficult to tap given the then-current technology. By the mid 1970s, both utilities and regulators were concerned about the relative magnitude of rate increases from costly new power plant additions and the higher cost of gas supplies. That concern escalated in the 1980s as new power plants came on line at much higher than the original expected costs.

During the 1970s and 1980s, the impact of inflation, increasing prices for fuel and electricity, and the demand for new investment capital to provide safe and reliable service resulted in a change in the fundamental principles of the regulatory compact. Several outcomes for utilities changed the balance of the compact, including utility bankruptcies, changes in capital structure, consolidation and a watershed change in the financial strength of the utility industry as measured by its bond ratings. In 1970, electric, gas, and electric and gas combination utilities were among the most financially strong domestic industries. Ninety percent of U.S. utilities had credit ratings of A or higher, and none were rated below BBB. In stark contrast, by 2011 only 27 percent of electric, gas, and combination utilities were rated A- or higher and 6 percent were rated BB+ or lower. The remaining 67 percent were rated between BBB+ and BBB-. In addition, electric utilities have been the hardest hit by ratings downgrades and face the largest new capital requirements (see Figures 2 and 3) .

This significant decline in the industry’s financial strength during the 1990s—a period of limited new investments—means that the regulatory balance has indeed shifted between investors and customers. As a result, the current demand for new and significant capital expansion to replace aging infrastructure, meet load growth and a myriad of other new capital requirements will occur at a time when substantial financial strength is required. These weak financial metrics won’t allow utilities to finance major new construction projects at reasonable cost. In order to do so, utilities must improve both their balance sheets and cash flows. This requires restoring the balance of the regulatory compact.

Tracking Costs

Given the decline in the financial strength of utilities, it’s reasonable to conclude that the short-term balancing of customer and utility interests has swung away from utilities and toward