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Storm Clouds Forming

The coming cash flow and dividend stress at America’s electric utilities.

Fortnightly Magazine - May 2012

a drag on future cash flow, investment levels, and potentially dividend payout. Thus, the large relative scale of the industry’s recent deferrals (see Figure 3) foreshadows a threat to future cash flow, investment, and even dividends. Such crises have already begun unfolding in the nation’s banking and insurance industries.

Although the overall patterns do generally forecast future negative trends in the industry’s operating cash flows and net income as these deferred taxes unwind, the impact isn’t uniform across the industry. Individual utilities vary widely in the effect of these recent investments and deferred taxes on their overall financial results (see Figure 5). For example, Great Plains Energy and PPL have continued to exhibit very normal patterns of deferred taxes relative to dividends. They have remained at relatively typical levels, even turning negative in periods of recapture, as one would expect. Alternatively, utilities like AEP and We Energies have gained relatively extraordinary recent cash flow benefits from these tax effects, and ultimately will see this flow of funds reversed in future years.

To summarize, these tax policies and incentives have been bankable, but the cash flows they have enhanced aren’t sustainable and they really aren’t controllable. The future years of recapture might strain some utility cash flows and potentially even dividend levels absent offsetting improvements in revenue and earnings. For example, AEP had a dividend payout ratio of 68 percent in 2010, and its deferred tax and tax credit benefits were 163 percent of dividends. Moreover, it could be complicated further by potential future changes in tax rates that resulted in excess deferred taxes as occurred after the changes in tax rates in the 1980s. 2

Potential Pension Pain

Like virtually all institutions with pensions and other post-retirement obligations, the U.S. utilities industry has experienced an enormous financial shock since the financial crisis of 2008. Plan asset values dropped precipitously and administrators have struggled to define appropriate long-run planning assumptions. The industry’s overall funding status went from generally neutral— i.e., positive and negative intermittently—to sharply negative in the post-2008 era (see Figure 7). The industry’s combined funding deficit is now on the order of total industry net income, an alarming gap especially in the context of overall earnings quality.

This quiet problem might be further obscured by the planning assumptions used in plan administration. For example, the industry’s assumed average return on plan assets has been slowly reduced throughout the most recent decade from slightly over 9 percent to slightly over 8 percent (see Figure 8). This forecast of future plan returns is a hotly debated topic in pension administration circles. After a decade of very low returns and threats of a long-term deleveraging process, it requires continuous analysis.

Perhaps more disconcerting is the recent increase in the industry’s average plan discount rate. The discount rate is the rate used to determine the current value of future benefit costs. Increasing the discount rate has the effect of reducing the present value of the future obligations. The mid-decade improvements in overall pension funding status are much the result of these discount rate increases