Can utilities simultaneously manage rising costs and pressing capital investment needs?
Johannes Pfeifenberger is a principal at the Brattle Group. Contact him at www.brattle.com. The author would like to thank Larry Kolbe, Peter Fox-Penner, Bin Zhou, Adam Schumacher, and Difan Liu for helpful discussion and research.
Does the utility industry have the financial strength sufficient to meet the combined challenges of: (1) sharply increasing and highly volatile fuel and purchased-power costs; (2) significant capital investment requirements; and (3) rising interest rates?1
The industry has recovered fairly well since the financial meltdown associated with the Western power crisis and the Enron bankruptcy, but recent data also show a downward trend in utility earned returns on equity (ROEs), a decline in operating cash flows, and credit quality that has trended downward over the last five years. These findings suggest that reasonable rate relief and investment-recovery policies will be needed to maintain a financially strong utility industry sufficiently capable of attracting the required capital and meeting its responsibilities in a stable, cost-effective manner. Regulation that does not provide for the full and timely cost recovery of prudent costs will weaken utilities financially, thereby raising investment-related costs and discouraging investments that would yield long-term benefits.
The Last Decade
While primarily focused on assessing the risk of debt holders, credit ratings also reflect overall company and industry fundamentals, as well as factors important to equity holders, such as allowed and earned ROEs. Fig. 1 shows the credit ratings for electric and combination utilities, which are primarily utility operating companies.2
The figure also shows two notable trends. First, it documents the marked decline of average credit ratings for a sample of 121 operating utilities, which represent the mostly regulated segment of the industry. Until year-end 1999, financially strong companies rated “BBB+” or above accounted for approximately 75 percent of all companies. By the end of 2005, the proportion of utilities rated “BBB+” or above had declined to approximately 45 percent. Second, Fig. 1 documents that the financially weak segment of the industry has been recovering from its weakest period in 2003. Utilities rated “BBB-” or below used to account for only 10 percent to 15 percent of all companies through 2001, but that share increased to almost 30 percent by 2003. However, the proportion of utilities rated “BBB-” or below investment grade improved to approximately 20 percent by the end of 2005.
Fig. 2 shows the same data for a sample of 25 independent power producers (IPPs) and energy traders, i.e., the largely unregulated portion of the industry. Not surprisingly, this figure shows a much stronger response to the recent energy and financial strain created in the aftermath of the Western power crisis and the Enron bankruptcy. The proportion of companies with below-investment-grade ratings (i.e., below “BBB-”) increased from approximately 15 percent in 2000 to nearly 60 percent in 2002. As with utility operating companies, the last few years show widespread improvement in overall credit ratings, though not to the levels of the mostly regulated segment. By the end of 2005, the below- investment-grade-rated portion of the industry still accounted only for approximately 40 percent of IPPs and energy-trading companies. The portion of IPPs and energy-trading companies rated “BBB+” or higher trended downward from more than 80 percent in 1996 to approximately 70 percent in 2000. The “BBB+” and higher rated portion of this market segment then declined to only 20 percent in 2002, before it recovered to a level of approximately 35 percent by the end of 2005.
Earned and Allowed Returns on Equity
Financial data for the operating utility sample also shows that utilities have been earning a median ROE that exceeded the median of allowed ROEs in recent years. Fig. 3 compares earned returns for the sample of utility operating companies with allowed ROEs and trends in utility bond yields. The figure shows that in the last several years, the median ROE for electric and combination utilities has been somewhat above allowed ROEs. However, the figure also shows that earned returns already have been trending down as the increase in utilities’ fuel and other costs exceeded growth in revenues. For 2003, 2004, and 2005, the median earned ROE was only slightly above median allowed ROE.
This downward trend in utility ROEs demonstrates that utility costs have started to outpace revenue growth, suggesting further financial challenges ahead. But while utilities’ median earned ROEs are declining, they are still (at least on average) within the range of allowed ROEs. So far, the decline in utility ROEs has been mitigated partially by declining interest rates, as shown in Fig. 3 by the trend in “Baa”-rated utility bonds. Allowed ROEs also have declined with bond yields, although utilities’ risks have increased. This decline in allowed ROEs has raised concerns of rating agencies.
Fig. 3 also shows that a sizable portion of the industry is earning returns well below investors’ required returns. One-fourth of utilities earn less than the earned ROE level shown with the line marked as “1st Quartile.” This means utilities’ earned ROEs in this bottom quartile are significantly below the bottom quartile of allowed ROEs and, in fact, sometimes not much higher than the return on utility bonds.
Similar to what can be seen from the bottom range of utility credit ratings, this shows that, compared with the “average,” a fairly sizable number of utilities are in a more vulnerable and relatively weak financial condition. Since the earned ROEs of these utilities have declined more quickly than the ROEs for the utility industry on average, regulatory policies that enable these utilities to recoup in a timely fashion their rising fuel costs and needed capital programs will be very important.
The downward trend of utility credit ratings documents the increase in utilities’ average credit risk, which raises their cost of debt. This means the decline in bond yields for “Baa”-rated utilities as shown in Fig. 3 partly is offset by the fact that utility credit ratings have been declining as well. A similar trend is occurring with respect to utilities’ cost of equity. The risks to which equity holders are exposed have been increasing, due to a variety of economic, operational, and regulatory factors. The increased risks also mean that the risk premium required by utility equity investors has been increasing as well, which leads to higher capital costs that also offset the general decline in interest rates.
The equity risk commonly is expressed through “beta,” which is a quantitative measure of the volatility of a given stock price relative to the market as a whole. Fig. 4 shows that the beta of the electric utility industry has increased from approximately 0.55 in 2000 to approximately 0.85 in 2005. At a market risk premium of 6.5 percent to 8 percent, this increase in risks raises the required return on equity by approximately 2 to 2.4 percentage points (or 200 to 240 basis points).3 This increase in the required ROE approximately offsets the decline in interest rates as reflected in the “Baa”-rated utility bond yields as shown in Fig. 3. Consequently, the recent decline in allowed ROEs, as documented in Fig. 3, may not be consistent with the increase in utilities’ risks as documented in Fig. 4. Thus, credit rating agencies’ concerns over “insufficient regulated authorized returns” also appear to be a valid concern from the perspective of equity holders.4
Operating Cash Flows and Capital Spending
The magnitude of operating cash flows (or “funds from operations”5) relative to interest expense, total debt, and capital spending frequently is used to assess the credit strength of companies. The size of operating cash flows relative to a company’s interest expenses and other fixed obligations also indicates the flexibility that utilities have in order to withstand unexpected financial difficulties resulting from occurrences such as major plant outages or storm damage. If operating costs increase faster than revenues, operating cash flows decline. Importantly, trends in cash flows can be a leading indicator of utilities’ financial conditions because, unlike earnings, cash flow cannot be preserved by accrual accounting and the deferred recovery of costs that often occurs within the regulatory process.
Broadly speaking, the portion of capital expenditures that can be financed from internally generated funds is equal to operating cash flows net of dividend payments. The extent to which funds from operations exceed capital expenditures and dividends is defined as a utility’s “free cash flow” and measures the extent to which utility companies need to rely on external financing.
As internal cash flow declines, a larger portion of a utility’s capital expenditures will need to be financed externally, i.e., through the issuance of debt or equity in the capital markets. Unfortunately, it is not always possible to “make up” declines in internal cash flows through external financing because access to capital markets becomes more limited as a company’s financial flexibility declines. As documented by the industry’s recent liquidity crunch, this can lead to outcomes in which the companies that would need to rely most heavily on external funds also find it most difficult to access such funds.
Fig. 5 compares total operating cash flows (blue line) against the sum of capital expenditures and dividends for the sample of utility operating companies. The figure shows that companies’ total operating cash flows increased from approximately $35 billion in 2000 to approximately $45 billion in 2004. During the same period, free cash flow improved significantly despite increased capital expenditures. These improvements in cash flows again document the overall financial recovery of the industry in recent years.
Fig. 5, however, also documents the more recent financial pressures that have emerged as utilities face much higher operating costs and investment requirements. As the data show, from 2004 to 2005, operating cash flows declined sharply, by approximately $10 billion, while capital expenditures increased. This combination of reduced operating cash flows and increased capital expenditures foreshadows a likely further decline in utility earned returns and significant financial challenges the industry is likely to face in the years ahead.
A slightly different picture, but one that nevertheless suggests a similar outlook for the years ahead, emerges for independent power producers and energy trading companies. Fig. 6 shows that operating cash flows declined from a high of approximately $17 billion in 2000 to approximately $15 billion in 2002 to 2004. From 1999 to 2002, substantial capital expenditures associated with the construction of merchant generating plants greatly exceeded operating cash flows. Similar to the electric and combination utilities represented in Fig. 6, however, operating cash flows have declined sharply in the last year: from $15 billion in 2004 to approximately $10 billion in 2005.
Financial Outlook: The Challenges Ahead
The industry has been recovering reasonably well from the recent financial crisis. The bottom end of credit ratings has improved somewhat for both utilities and unregulated companies. Utilities’ earned ROEs are declining but, at least for the industry average, are still within the range of allowed ROEs. Allowed ROEs have trended down, which has raised concerns of rating agencies, but that decline in allowed ROEs is mitigated, at least in part, by declining interest rates and utility bond yields. And, until recently, utilities had, on average, increasing operating cash flows that were sufficient to fund most of the needed capital expenditure internally.
These recent positive industrywide developments do not imply that forward-looking conditions are expected to remain as favorable, as several trends point to reduced industry financial strength. These trends include:
• Utility earned returns have been declining as rate relief and revenue growth have been outpaced by the combined effect of fuel and purchased-power cost increases. In addition, the bottom quarter of the industry is earning ROEs well below its cost of equity. In 2005, the earned returns of this segment also have been declining at a more rapid rate. This suggests that a sizable portion of the industry may be poorly positioned to address the challenges faced today and in the years ahead.
• In 2005, operating cash flows declined more quickly than industry-earned ROEs, which likely is a leading indicator of further earnings erosion.
• The credit rating of the utility industry overall has trended downward to a point where, as of 2005, less than half of electric and combination utilities were rated “BBB+” or higher. In fact, during the last five years, the typical utility credit rating declined from “A” to “BBB.” In addition, approximately 20 percent of the industry is rated “BBB-” or below. The ability of these utilities to cope with additional financial challenges may be very limited.
• Further increases in fuel and purchased power costs, other increases in operating costs (including labor, pension, and medical costs), the cost of complying with environmental and other regulatory mandates, the additional capital costs of substantial infrastructure investment requirements, and the likely increase in financing costs will create a significant challenge to the financial health of the industry in the years ahead. And again, while these challenges are significant for the industry on average, variances across regions and companies will mean that a sizable number of individual utilities will be affected much more strongly.
• Finally, the recent sharp increases in costs have forced many utilities to file new rate cases, which often is associated with delayed and sometimes incomplete cost recovery.
The following discussion addresses some of these issues in more detail.
Outlook for Credit Ratings And Earned Returns
Credit rating agencies already have taken note of the potential financial implications of the challenges facing the industry today. According to one credit rating agency, Fitch, “unusually high and volatile natural gas and energy prices raise risk overall.”6
While it clearly recognizes the improvements in industry financial conditions over the last few years, Standard & Poor’s raises similar concerns over the industry’s emerging challenges. These concerns over the challenges and financial health of the industry in the years ahead are not limited to credit rating agencies and the perspective of debt holders; equity analysts similarly express concerns. For example, Lehman Brothers states in a recent report:
Another Cap-ex Cycle Looms
… In this year’s study of electric utility regulation, we take the results of a bottom-up compilation of fuel and cap-ex spending increases over the next five years and look at the implications for cash flow, returns, equity risk premia, and valuations. We believe this analysis reinforces our negative stance on regulated electric utilities. …
Substantial Rate Increases: Infrastructure investments and high fuel costs spell rate shock, demand destruction, and regulatory risk for traditional utilities. The projected 10 percent-plus annual increases through the next four years could pain consumers, pressure politicians, and harden regulators. …
Decreasing Returns: Historically, electric utility underearning coincides with free cash flow turning negative (which happened in late 2005). … Our free cash estimates imply that earned returns could drop to the 9 percent ROE area in the coming years, a deficit of over 250 [basis points] versus projected allowed levels.7
Increasing Financing Costs
The capital costs associated with this clear need for infrastructure expansion will form another driver for rate increases in coming years. While the current environment is quite favorable in terms of utilities’ access to capital markets, recent increases in industry specific risk factors and a trend to potentially higher interest rates suggests higher financing costs for investment requirements going forward.
As shown in Fig. 7, industry financing costs as measured by utility bond yields have reached a 40-year low. The decline in interest rates has allowed utilities to mitigate increases in other costs. However, this long period of low and declining interest rates is not expected to continue. During 2005, for example, the Federal Open Market Committee (FOMC) raised the Federal Funds Rate a total of two percentage points. At its first meeting in 2006, the FOMC raised the Federal Funds Rate another quarter percentage point, to 4.5 percent. These recent increases in interest rates are also shown in Fig. 7, though they have not yet affected utility bond yields.
The financing costs of utilities’ investment requirements generally are expected to increase, for at least three reasons: (1) possible increases in long-term interest rates; (2) increases in utilities’ cost of debt due to declining credit quality; and (3) increases in utilities’ cost of equity due to higher risks.
Both Fitch and Standard & Poor’s specifically point to “rising interest rates” as one of several negative credit factors faced by the industry going forward. However, while many industry analysts anticipate that long-term interest rates will be increasing, the extent of such increases is still unclear. For example, Lehman Brothers projects that the yield of 10-year government bonds in 2006 will have increased by 90 basis points from 2005, without further increases through 2010.8 EIA projects an 80 basis-point increase from 2005 to 2006, with additional increases of 110 basis points through 2010.9
Based on the long-range consensus forecast compiled by Blue Chip Financial Forecasts, government bond yields are anticipated to increase to 5.5 percent by 2009 and remain at that level for another five to 10 years.10 In comparison, as of May 5, 2006, the yield on the 10-year government bond was 5.1 percent, which already exceeds May 2005 yields by approximately 100 basis points.11 These forecasts suggest that long-term interest rates in the years ahead must be expected to be between 100 and 150 basis points above 2005 rates.
In addition to these trends of increasing interest rates, industry- specific risk factors likely will exert additional upward pressures on utilities’ cost of capital. Rising operating costs, the evolution of industry structure, the ultimate costs of environmental and other regulatory mandates, and the extent and timeliness to which these costs can be recovered in rates introduce additional uncertainties that often are difficult to quantify or hedge. These risk factors already have been recognized by rating agencies through reduced credit ratings and negative outlooks. These risks will raise utilities’ cost of debt relative to the general trend in long-term interest rates.
Similar upward pressures exist for utilities’ cost of equity. As the industry’s risks increase through factors such as fuel price volatility, significant capital expenditures, regulatory lags, and the potential for incomplete cost recovery, the re-quired return on the equity-portion of utilities’ rate base also will tend to in-crease faster than the general trend in interest rates. The increase in “beta” shown in Fig. 4 indicates that utilities’ market risks today already are higher than in the recent past. Given the challenges ahead, these risks are unlikely to decline.
In sum, fuel- and market-price volatility along with uncertainties over the evolution of industry structure, environmental costs, timely recovery of these costs, and the required costs of financing significant capital expenditures for infrastructure requirements introduce operational and financial risks that can be difficult to quantify or mitigate. This uncertainty itself is raising utilities’ financing costs at a time when the sector’s capital needs are quite large.
1. These questions are explored in more detail in a recent report for the Edison Foundation, upon which this article is based: Basheda, Fox-Penner, Pfeifenberger and Schumacher. “Why Are Electricity Prices Increasing? An Industry Wide Wide Perspective,” The Edison Foundation, June 2006.
2. This sample contains 121 operating utilities. It consists of parent companies and subsidiaries for which financial data are available and reported by Compustat, and includes only companies with Compustat GICS codes for “electric utilities” and “multi utilities.” (This excludes companies in the deregulated segment of the industry, which are classified as “independent power producers” or “energy trading companies.”) To avoid double counting and companies with sizeable unregulated subsidiaries, we excluded utility holding companies whenever financial data for the utility operating subsidiaries were reported separately.
3. This calculation is based on the “capital asset pricing model,” or “CAPM” which says a company’s risk premium equals the product of its beta and the market risk premium. In repeated empirical testing, the cost of capital turns out to be less sensitive to changes in beta than the CAPM predicts. In particular, this research shows that low-beta stocks have higher costs of capital and high-beta stocks lower costs of capital than the CAPM predicts. Using this research, the predicted change would be closer to 175 to 210 basis points than to 200 to 240 basis points.
4. S&P “State Utility Regulation Coming Back in Vogue,” Oct. 7, 2002; “Regulatory Suport for U.S. Electric Utility Credit Continues to Disappoint,” May 29, 2002; “A Fresh Look at U.S. Utility Regulation,” Jan. 29, 2004.
5. The term “funds from operations” (FFO) is typically used by rating agencies. It is defined as operating cash flows without adjusting the change in working capital. We are using FFO and operating cash flow interchangeably here.
6. FitchRatings, U.S. Power and Gas 2006 Outlook, Dec. 15, 2005, p. 1.
7. Lehman Brothers, Capital Lessons, Global Equity Research/North America, March 15, 2006, pp. 1-2.
8. Id., p. 10.
9. Energy Information Administration, 2006 Annual Energy Outlook, Table 19, February 2006 (based on projected yields of AA-rated utility bonds).
10. Long-Range Consensus U.S. Economic Projections, Blue Chip Financial Forecasts, March 10, 2006, p. 15.
11. In May 2005, the 10-year constant maturity Treasury yield was 4.14 percent; during 2005, yields ranged from 4.0 percent to 4.54 percent. (http://www.federalreserve.gov/releases/h15/data/monthly/H15_TCMNOM_Y10.txt).