Bankruptcy may not be better for ratepayers.
Fortnightly Magazine - September 1 2003


Bankruptcy may not be better for ratepayers.

In the Iowa Office of the Consumer Advocate, Gregory Vitale recently raised the question of whether ordinary electric customers stand to gain anything when state regulators try to help the local utility avoid bankruptcy. Vitale was responding to questions posed by the Iowa Utilities Board. The board was wondering if it should go ahead and allow Aquila to pledge its regulated assets as collateral for the working capital requirements of that company's utility operations.

"Assuming hypothetically that a public utility were to file for bankruptcy," the Iowa board wanted to know, "would Iowa customers be better off if the board allowed Iowa assets to be pledged and then the utility filed for bankruptcy, or if the Board disapproves the pledge of Iowa assets and the utility files for bankruptcy?"

There has been little precedent in this area. The only real bankruptcy that has occurred lately in the utility industry is the California crisis-induced bankruptcy of Pacific Gas & Electric. And during the boom years of the late '90s there was not much demand for pledging assets, as interest rates on unsecured debt became competitive with rates on secured debt.

These days, however, Aquila claims that the pledging of utility assets is nothing new. It defends the idea by pointing out that the collateral from the pledged utility assets should help support regulated operations.

Furthermore, some feel the company's current request to pledge assets is unfairly being scrutinized-that there is still bad blood over the collapse of the company's unregulated energy trading unit in which investors lost millions.

Vitale believes Iowa customers would be better off if the board does not approve Aquila's request to pledge its utility assets, whether Aquila files for bankruptcy or manages to avoid bankruptcy. "In the event of bankruptcy, there would be more unsecured assets available to fund interim operations as well as customers' unsecured deposits than there would be if the board approved Aquila's request," he testified. In support of his conclusion, Vitale cited a UBS Warburg report by Ronald Barone that states: "Put simply, Aquila's significant debt burden and obligation under its pre-pay contract will in our opinion be too great for its core domestic utility operations to support once it has disposed of all its other assets. As a result, Aquila's long-term prospects are limited and could include a restructuring at some point."

Back in Iowa, Vitale cited an editorial I wrote in this column (see issue of June 15) as evidence that merchant generators might be better off in bankruptcy. And merchants seemed to prove the wisdom of that view this past summer. But while I may have ventured that bankruptcy could be good for the goose, we have yet to explore in the pages of the Fortnightly whether it would be good as well for the gander. Certainly, the case between Connecticut and NRG shows quite vividly how a utility bankruptcy can create unpredictable consequences, for both regulator and ratepayer-as shown in the "Commission Watch" column in this issue.

The View from an Ex-Regulator

One former state regulator believes the impact on ratepayers from pledged assets will never be clear-cut. "I don't see it as a big deal," the regulator says.

"You are going to make the analysis on what you think the longer-term rate impact will be, and you are going to balance that against the fact when a utility goes into bankruptcy, it is unclear who takes jurisdiction. So, there are going to be some states more concerned about whether they lose jurisdiction to a utility going into bankruptcy than they are going to be concerned over what the final rate impact is," he says.

Would state utility commissions try so hard to retain jurisdiction that they would accept higher rates as a quid pro quo? The ex-regulator offers no easy solution.

"You could be right politically and have the rates go down, or wrong politically and have the rates go up," he says.

In short, the risk of rate shock to customers comes from the chance that a utility under financial duress might lose the regulated assets offered as collateral for the pledge. But can regulators skirt that risk? Let's take a simple case as an illutration. Say, for example, the utility is reducing the ratio of equity in its capital structure.

"In rate making the regulator … can overlook that," the ex-regulator notes.

Say that the commission sets revenue requirement and rates on the assumption of a 50-50 debt-equity ratio in the capital structure. But then suppose that the utility's position deteriorates, with equity shrinking and debt climbing. Will that hurt ratepayers?

"If in the interim it goes to an 80-percent debt ratio, increasing the cost of capital, the regulator is not obligated to pass that through," says the ex-regulator.

"It comes out of the equity owners. That is the protection the regulator has. The regulator can still use the hypothetical capital structure and ignore that."

Ring-Fencing: No Sure Thing

Some ratings agencies have charged that Aquila's corporate structure is a weakness regulators should be aware of due to commingling its regulated and unregulated assets at the holding company level, putting ratepayers and shareholders equally at risk if the company goes bankrupt.

Aquila believes that reliance on an alternate plan, such as the Portland General Electric (PGE) corporate model, with its ring-fencing of Enron from the regulated utility, is misplaced, as it is unclear whether PGE will emerge as a viable concern.

Sharon Bonelli, a managing director at Fitch Ratings, adds in a recent report that ring-fencing techniques rarely provide total insulation of a U.S. utility from problems related to an insolvent parent.

"Even if affiliates are segregated in numerous ways, the presence of a single important unifier, such as a large intercompany loan or an intercompany supply contract critical to continuing operations may nullify all other ring-fencing efforts," she writes.

In an effort to strengthen ring-fencing efforts, FERC in June proposed new rules that would prevent holding companies from raiding their regulated affiliates for cash by making utilities give notice if their capitalization drops below 30 percent.

Moreover, one corporate restructuring specialist says the seizing of regulated assets in a bankruptcy is much more disruptive than pledging the equity or dividend stream from the regulated asset.

"The difference between pledging an asset within rate base as collateral and pledging an equity in a regulated company as collateral is very important," he offers.

"If you pledge an asset within rate base as collateral then you are going to have a change in control in a particular asset. Somebody could foreclose on the asset and want to sell it or do something with it when there is a bankruptcy outside of the regulated entity.

"That seems to me to be much more disruptive than a potential change in control caused by creditors foreclosing on equity in a regulated entity, because you have changes in control on the equity on a regulated entity every day, every hour on the open market with the trading of equities," he says.

And what about Aquila?

In an ironic twist, Aquila now looks more and more like a traditional, stick-to-the-knitting electric utility. There is no longer any unregulated operation to worry about. Aquila claims its will be better off as a low-risk regulated utility.

Perhaps a pledge of assets might now serve as a means to that end.


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