Each assumes a vertical breakup, but watch out for securitization.

It can prove difficult to detect any overt difference of opinion among financial credit rating agencies. That appears to be the case in today's electric utility industry, where Moody's, Duff & Phelps, and Standard & Poor's each predicts that a breakup of the vertically integrated utility is now virtually inevitable. The result, they say, will leave us with an industry made up of disaggregated high-risk power generators, and lower-risk companies engaged in transmission, distribution, and other related services.

Surprisingly, each firm also appears to agree that disaggregation by itself should not make any real difference in credit evaluation. Instead, disaggregation simply unbundles all of the risk factors and financial attributes that were already present (though hidden) within the consolidated credit rating of the vertically integrated utility. As a sculptor merely unearths the figure that already lies buried within the stone, disggregation only illuminates the strengths and weaknesses always inherent in each of the traditional utility functions: generation, transmission, and distribution.

Nevertheless, the rating agencies expect to see the industry credit profile become more diverse and unpredictable. In fact, their comments can reveal subtle differences, especially in the area of stranded investment, and the presumed effects of the various cost recovery and "securitization" schemes now under consideration.

Disaggregation:

Revealing What's Already There

Moody's Investors Service (Moody's) anticipates that the vertically integrated electric utility industry will evolve into a partially regulated energy and communications business, allowing a few low-cost, market-oriented companies to thrive. "These companies are likely to see their ratings improve and the gap between their ratings and those of their competitively weaker counterparts widen through the balance of the century," says Moody's Managing Director Susan Abbott.

These participants also will increase their numbers, expand their geographic influence, and increase the diversity of their credit profiles, according to Moody's.

"Until the transition to the new electric utility industry is complete, event risk will continue to be a factor, and ratings will remain volatile as individual companies reinvent themselves," says Abbott.

At Duff and Phelps Credit Rating Co. (D&P), Group Vice President Catherine E. Drake takes a somewhat more pragmatic view, seeing credit quality as hinging on the level of expected cash flows available to pay fixed obligations (em both principle and interest. Competition, says D&P, will contribute to cash-flow volatility, producing real declines in some cases.

Meanwhile, Standard & Poor's (S&P) is busy developing criteria for rating the discrete business functions of utilities, but is finding the process complicated by uncertainties, such as magnitude and time period for stranded investment recovery, potential federal legislation, and state rulings. S&P's Curtis Moulton says the company hopes to have the process completed sometime in February.

(S&P's first attempt to apply a new set of criteria to a disaggregated utility came when it recently assigned ratings to the restructured cooperative, Oglethorpe Power Corp., which had set its disaggregation date for January 1, 1997.)

Generation. In a fully competitive market, a largely unregulated generating company will exhibit the characteristics of a pure-play power marketer, says D&P.

S&P sees generation as a largely regional commodity business, with power pools, bilateral

contracting, high risks, and high rewards. Financial requirements will be substantially lower than for the traditional integrated utility.

Trans. & Distr. By contrast, companies involved only in the transmission and distribution (T&D) segments should present a lower risk profile, says D&P, with more stable cash flows, lower quantitative protection measures, and a higher level of debt capacity. D&P expects average ratings in transmission and distribution (T&D) to run higher than for generating companies.

One important difference from generation, says D&P, is that the T&D affiliate will start the game with a long list of historical customer relationships, broad name recognition, usually a favorable brand image, and as a result, some level of market franchise.

S&P assumes that transmission (high-voltage lines) will remain regulated by the Federal Energy Regulatory Commission, with a rate base and rate of return, thus decreasing risk and requiring higher financial requirements for any given level of rating than the current financial benchmarks for integrated utilities. At the same time, it assumes that distribution will be made up of at least two or three other businesses. A wires business will continue under state regulation with more use of incentive pricing. Other businesses will include marketing and service-related ones. Risk positions will vary substantially among distributors, says S&P.

Electric vs. Gas. D&P predicts credit ratings in the "AA" range for electric distributors. It describes a pure-play electric distribution business as similar in risk profile to today's natural gas local distribution company (LDC).

That comparison might prove unfruitful, however, as gas utilities, which have enjoyed a price advantage over electricity during the past decade, slowly respond to changes in electric markets. At Moody's, for example, senior analyst Alexandra S. Parker notes that some gas utilities might prove vulnerable to losses brought about by electric competition, depending on such factors as customer mix, location, size, and cost position, plus the pace of change in the local regulation of both electricity and natural gas.

In fact, Moody's suggests that increasing competition between natural gas and electric utilities will place local gas distributors at risk of revenue loss as customers leave the system, or of margin deterioration as rates are discounted to retain at-risk customers. Perhaps of even more significance to the bondholder is that the convergence of the end-use energy markets likely will spawn greater merger and acquisition activity between the electric and gas industries. %n1%n

Moody's concludes that over the next decade, competition, not only from pipelines and independent gas marketers, but also from electric and combination utilities, will join with mergers and acquisitions between the electric and natural gas industries and with more traditional risk factors, such as changing regulation and diversifications into nonenergy-related marketing businesses, to erode average credit quality. Although the average senior debt rating for pure natural gas distribution

companies has been relatively high and quite stable, remaining between "A2" and "A3" since 1979, the rating outlook for the industry taken as a whole is negative, says Moody's.

Stranded Assets:

A Close Look at "Securitization"

How will stranded investment and related regulatory policies affect credit ratings.

Importantly, D&P notes that the obligation of the electric distributor to collect a surcharge or other levy for stranded costs should have no impact on its credit quality. But for a stand-alone generating company, a transition cost charge would dampen cash flow volatility during the collection period. Ironically, that means that generating companies with large stranded asset positions and high transition charge levels should demonstrate a lower level of cash flow volatility than their less-burdened peers, making them appear financially stronger in the early years of cost recovery.

Regulators and legislators in a number of states are now or have considered various proposals for "securitizing" stranded costs (em i.e., creating an enforceable obligation to pay transition costs that is supported by tariffs and that can be pledged as collateral to provide financing to utilities. Two examples stand out: 1) California, where Assembly Bill 1890 (signed into law) will provide for rate reduction bonds issued by the state's Infrastructure and Economic Development Bank, and 2) New York state, where Governor Pataki has proposed the Electric Ratepayers Relief Act %n2%n to securitize stranded costs.

Lisa B. Metros, a vice president

at Duff and Phelps, notes that securitization can "accelerate the recovery of stranded costs, or provide a more certain recovery, allowing utilities to pay down transition-related debt, or make other balance sheet improvements." %n3%n One benefit, she notes, comes from the lower cost of capital made possible by using a trust structure to finance transition costs.

In the California example, utilities would receive the proceeds from a proposed $5 billion revenue bond issued by a state trust, and the legislation would designate as an irrevocable property right the future competitive transition charge revenues received from smaller retail customers. The revenues, received from monthly transition-related surcharges on monthly customer bills, would become the collateral and funding for the trust debt service.

As Metros explains, the primary assets of the trust are the statutory rights to receive nonbypassable future transition revenues. While utilities act as servicing agents to make collections of the transition charges, they would sell the rights to the future revenues to the trust, and therefore, any associated collection risks.

George Leung, Moody's Managing Director for State Ratings, notes, however, that the California bonds should not qualify as direct, general obligations of the state of California. Thus, Moody's views these bonds as "pure conduit financings," not necessarily reflecting the credit of the state as a

public institution. The nonbypassable charge pledged to the bonds in California is not a tax, says Leung, but a responsibility of ratepayers. Leung also points out the potential for political pressure or risk of change to the legislation should it not achieve its intended purpose of reducing electric rates by 10 percent by 1998. The possibility of legislative impairment, especially as it relates to the

nonbypassable charge, represents a potential credit risk, says Leung.

Leung's comments point out the importance of scrutinizing any securitization scheme. So what does a rating agency look for when rating a securitization backed by revenues dedicated to the recovery of specified stranded costs or assets?

D&P examines the legislation that allows the tariff, and the true-up mechanisms that adjust the tariff. It looks for two conditions: 1) certainty that the tariff is legally enforceable (and will recover the requisite costs regardless of shifting demographics or usage patterns), and 2) assurance that the obligation to pay stranded costs, if sold to a trust, will be judged a "true sale." %n4%n

Although the rating of the issuing utility does not directly affect the rating of the securitization, D&P will consider the rating to assess commingling of risk, because the payment of the tariff is generally included with the payment of the monthly electric bill.

Metros believes the New York securitization proposal also could "enhance overall credit quality." On December 30, however, Moody's released a report stating that California's plan for recovery of about $21 billion in potential stranded assets was not exportable to most other states. %n5%n The reasoning was that in California the three major investor-owned utilities have similar risk profiles, and their stranded cost exposures originate largely in high-cost, state-mandated purchased power contracts.

Moody's explained that as those contracts start to expire in 1997 and 1998, the California companies will be able to apply the difference between new, lower power costs and rates that have been frozen just below present levels to pay down a substantial portion of above-market fixed obligations. But in other parts of the country, says Moody's, generating costs are not likely to decline, so there would be no excess cash flows available to pay down stranded investments. t

Lori A. Burkhart is an associate legal editor of PUBLIC UTILITIES FORTNIGHTLY.

Cities and Counties

An Unwelcome Tax Cut

George Leung, Moody's Managing Director for State Ratings, sees electric utility deregulation as placing additional fiscal stress on local city and county governments, especially in California, where tax assessments on utility property will fall after 1999, with the allowance of accelerated depreciation on uneconomic power plants.

Nuclear Power

More Bad News

The investor-owned electric utilities most vulnerable to ratings pressure are those "for which nuclear investments represent a significant portion of the asset base and that are suffering form poor operating performance, with attendant repair and replacement power costs, earnings penalties, and the threat of early retirement," according to Moody's Vice President Mo Ying W. Seto, and Senior Analyst Kevin G. Rose.*

"The cash costs tied to nuclear power production remain high and may not be recoverable in the rates dictated by an open market."

Seto and Rose conclude that while the average rating for the U.S. electric utility industry is likely to decline to "Baa1," the average rating for utilities with significant nuclear investments will decline further, to "Baa2."

Making things worse, notes Curtis Moulton of Standard & Poor's, is the recent emphasis at the Nuclear Regulatory Commission (NRC) on compliance with detailed procedures, which Moulton says has negative implications for nuclear electric utilities. The tougher stance by the NRC is attributed to the poor performance at the Millstone nuclear plant in Connecticut, as well as accusations that the NRC has been lax in regulation enforcement. Moulton says this tougher stance will likely cause lower plant capacity factors and longer refueling outages, raising the cost of nuclear power production, or leading to a premature plant closures.

*See, "Moody's Assesses Nuclear Power Risks in a More Competitive

Market," by Mo Ying W. Seto, Kevin G. Rose, and Susan D. Abbott

(Moody's, November 1996).

1See, "Electric Deregulation May Pressure Ratings of Natural Gas Distribution Companies," by Kevin G. Rose, Ted A. Izatt, and Alexandra S. Parker (Moody's, September 1996).

2See, "Stranded Costs: Qualified Financing for Intangible Assets," by Anastasia M. Song and Hugh M. Dougan, PUBLIC UTILITIES FORTNIGHTLY, Oct. 1, 1996, p. 44.

3"Legislative & Public Policy Developments in the Electric Utility Industry," by Lisa B. Metros (D&P, October 1996).

4D&P found those tests satisfied when it issued its 1995 credit rating of Puget Sound Power & Light Co., after Puget Power had begun financing its potentially stranded investment in demand-side management through a conservation grantor trust (em then the only domestic securitization of recovery revenues to date. In the Puget Power situation, said D&P, the right of the utility to collect the tariff could not be rescinded or adversely changed, and the sale of the right to receive the revenues would be judged a true sale. See also, "Mortgaging Your Conservation: A Way Out for Stranded Investment? by Andrea L. Kelly and Donald E. Gaines, PUBLIC UTILITIES FORTNIGHTLY, Oct. 15, 1995, p. 21.

5"Moody's Calculates Little Change in Potential Stranded Investments," by A. Tucker Hackett, Jonathan Cohen, and Susan D. Abbott (Moody's, December 1996).

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