Regulated Utilities Still Can Raise Capital
by Teresa Hansen, editor in chief
Electrifying one of the world’s largest economies isn’t cheap, and raising money to keep the lights on challenges utilities.
Many financial experts rank the U.S. electric utility industry second only to the federal government in capital spending. The nation’s electric utilities spent $34.5 billion on capital projects in 2002-06 and are on track to spend $54.6 billion for capital projects during 2007-11, said Sean O’Donnell, executive director of energy at JPMorgan Chase & Co. and presenter at the 2010 Electric Light & Power Executive Conference. Banks, shareholders, public utility commissions and equity investors are key in utilities’ efforts to raise money for capital projects.
Gene Rubin is senior vice president of Rivel Research Group, a company that conducts hundreds of interviews annually among institutional investors in U.S. electric utilities. Institutional investors have modest near-term outlooks for the utility industry as an investment, he said.
“In our recent study, which was in-depth interviews with more than 100 U.S. utility investment professionals, the industry was given an average rating of 3.4 out of a possible six,” Rubin said.
Investors’ main concerns are a changing political and regulatory environment and a difficult economy—factors that make it difficult to achieve rate case increases. Investors, however, are interested in the regulated arena—above unregulated operations, merchant operations or both—because of long-term growth potential through infrastructure build outs with emphasis on renewables, Rubin said.
Even during the uncertain economy and regulatory and political environments, most regulated utilities can obtain funds for capital projects. The cost of capital for well-rated utilities is lower than it’s been in a long time. Nevertheless, most utilities operate conservatively and act prudently when spending and borrowing money, said Dee Ann Dorsey, a partner in the business practice group at law firm Hunton & Williams LLP.
“While the capital markets fluctuate from time to time, investment-grade electric utilities are generally not having trouble obtaining capital,” Dorsey said. “Short-term debt rates, and sometimes even long-term debt rates, are actually lower than they were before the financial crisis.”
Fewer deals are being done than before the economic crisis, she said, because utilities have slowed their expected capital investment in new generating capacity to meet the demand that was anticipated a couple of years ago; the Great Recession brought lower electricity demand.
“It’s not because the capital is difficult for them to obtain,” Dorsey said.
Andrew Gerber, another Hunton & Williams partner in the business practice group, said that in some cases when capital is available at more favorable rates, utilities are pre-funding their anticipated capital needs for two or more quarters.
“They are holding the proceeds they raise as cash or short-term investments until they need it rather then waiting until their liquidity needs become more immediate, and then being forced to take what the market can offer at that time,” he said. “This strategy mitigates market risk. Some may use pre-funding to temporarily pay down debt depending on the timing of their anticipated needs.”
Stock Value, Dividends
Favorable financing terms combined with utilities’ capital-intensive nature worries some financial analysts that utilities will or already have become overleveraged and too dependent on banks. The utility industry depends on banks more than most industries, and investors know it, O’Donnell said. Some investors hesitate to buy into the utility industry because they think other industries can offer a better rate of return, he said.
“Many utilities are no longer able to offer a secure and consistent rate of return,” he said.
As utilities deregulated in the late ’90s, they began to shift their shareholder base from local, retail mom-and-pop investors to a more sophisticated base of institutional investors. To attract investment from this audience and to reach higher multiples, utility management teams diversified into other jurisdictions and riskier strategies. It led to uncertainty and volatility previously uncommon for the industry. At times, some of these moves also weighed heavily on balance sheets and even affected some dividends’ security, Rubin said.
“Today, I think that while institutional investors are very much aware of the near-term challenges facing the industry, such as economy, difficult political landscape and potential carbon legislation, they are also attracted to the industry’s potential as they look at long-term global energy needs,” Rubin said.
Raising capital could be a challenge for some electric utilities in the near term, but that should stabilize as the economy strengthens, he said.
“What will be different going forward, however, is that investors will discriminate more than ever before with respect to which electric utilities will get the money,” Rubin said.
Investors might think that many undervalued securities offer a greater opportunity for near-term price appreciation than electric utilities because these companies might be better levered for an economic turnaround, Rubin said. To attract investors, he said, most utilities are reinvesting in the regulated side of the business. This approach makes financial results “more predictable, or “Ëœboring,’ as some investors like to call it, and, therefore more reliable,” he said.
Banks prefer the reliability of future cash flows over the considerable volatility that often accompanies merchant and unregulated businesses, Rubin said.
Views on utility stock values depend on whether investors focus on stock price or dividends, Dorsey said.
“Utilities’ dividends have been fairly consistent year over year,” she said. “Progress Energy has increased its dividends year over year since 1988, and NextEra Energy has increased its dividends year over year since 1994.”
Stock prices might have steered some advisors and investors from utilities, but dividends remain mostly stable, Dorsey said. They have been increasing steadily, even with the financial crisis, but not at the rate they increased in years before the recession.
Investment-grade utilities have generally been able to raise capital through the financial downturn, Gerber said. As Rubin pointed out, however, those utilities that are not investment-grade may have a harder time attracting discriminating investors.
“Sufficient demand for investment-grade utility bonds still exists, particularly secured bonds,” he said. “Offerings of these bonds can often be oversubscribed within a relatively short marketing period. For example, it is not unusual for a utility offering these bonds to find demand from investors significantly exceeding the size of their offering.”
Utilities are not overleveraged, he said, and most are prudent when borrowing from banks or incurring debt. Gerber said that utilities are more conscious about their credit lines now than before the banking crisis. They obtain funding from many avenues. Bank credit lines are just one part of their overall funding strategy. Utilities use banks for both short- and long-term funding, he said.
“Most spread their credit lines and borrow across many banks, not just one or two,” Gerber said. “This safeguards them in case one of the banks goes under. Many of them use double-digit numbers of banks.”
Dorsey has seen utilities use as many as 37 banks in their credit lines, she said.
“When they spread their debt across many banks, it provides more stability should a bank go under,” she said.
In addition to banks and investors, regulators are important to utilities’ financial strengths and successes.
Rating agencies directly impact a utility’s ability to obtain capital. They look at relationships between utilities and their regulators when assigning investment grades, Dorsey said.
“More balance is needed between utilities and regulators,” she said. “They need to communicate better with each other to resolve issues.”
Utilities must be able to recover money for capital investments through the rate base, Gerber said.
“Over the last year or so, rating agencies have taken a hard line on Florida utilities because the agencies believe utilities are in a hostile regulating environment,” Gerber said. “For this reason, Florida utilities are slowing or scaling back on some of their capital investment plans.”
Utility Success in Down Economy
Gerber, Dorsey and Rubin said that investment-grade utilities are successfully navigating the current economic environment. Electric utility management teams have communicated short-, medium- and long-term strategies to investors better than other industries have, Rubin said.
“Guidance and transparency have been strengths as well,” he said. “Electric utilities communicate careful and well-thought out potential returns scenarios, including dividends and earnings growth.”
A clear explanation and understanding of potential returns on a risk-adjusted basis, however, is often understated, Rubin said.
“Too often we see management teams and directors at utilities trying to understand why the market valuations of their respective electric utility companies are undervalued,” he said. “Often it’s because they are comparing their historic returns and future guidance against those of their investment peers. Investors, on the other hand, are most often looking at, and have the most questions about, the risks involved with achieving these goals.”
Utilities are not under financial straights; at least investment-grade utilities aren’t, Dorsey said.
“Utilities are watching their O-and-M expenses and being prudent with their money,” she said.
Renewable Energy Remains Investors’ Favorite
by Andrew Kinross, Navigant Consulting
Renewable energy, primarily wind and solar, continues to attract investors in the United States and worldwide. As in years past, U.S. renewable energy is still a hot, global opportunity for investment, but some uncertainty exists around renewable energy’s continued growth and appeal to investors.
Figures 1 and 2 show Navigant Consulting’s expectations for renewable energy capacity additions during the next five years. These projections assume existing tax credits will not be renewed and no new federal stimulus program will be created.
Expectations include solar growth but contraction of the wind sector because of expirations of the cash grant program on Dec. 31 and the production tax credit on Dec. 31, 2012. The wind tax credits could be extended and significantly improve the picture for the wind sector.
The other renewable energy technologies remain steady but are much smaller in magnitude than solar and wind.
Foreign companies are investing heavily in U.S. renewables, as well as in countries around the world. Figure 3 illustrates that many wind developers and turbine manufacturers doing business in the United States are headquartered elsewhere.
They include: Iberdrola in Spain, E.On in Germany, Horizon Energy owned by EDP of Portugal, enXco owned by EDF of France, Vestas in Denmark, Siemens in Germany, MHI Power Systems in Japan, Suzlon in India, Gamesa in Spain, REPower in Germany, Acciona in Spain and Enercon in Germany.
2009—A Good Year for U.S. Renewable Energy
Wind and solar markets had a record 2009, despite the recession (see Figure 4). The wind market added 10,050 MW, and solar added 475 MW. These additions followed a record 2008: about 8,558 MW and 376 MW, respectively. The size of wind and solar markets in 2009 was about fourfold 2005’s.
Navigant Consulting expects 2010 will be much smaller for wind because of a curtailment of new project development after late 2008’s financial crisis and competition from natural gas-fired plants. Solar, however, is expected to be higher.
Natural Gas Impact on Renewables
Lower natural gas prices have affected the renewable energy market, but maybe not as much as people think. Lower natural gas prices tend to make renewables look less attractive because gas-fired power plants can make electricity cheaper. Renewable energy markets, however, primarily are driven by policies—including renewable portfolio standards, rebates, feed-in tariffs, renewable energy certificates and loans—that generally drive markets higher.
Large wind projects in 2010 have faced competition with gas projects in which public utility commissions have opted for the lower-cost yet high-polluting gas plants in favor of the higher-cost, less-polluting wind plants.
Natural gas prices peaked in 2008 but have dropped dramatically since then. Large U.S. natural gas reserves exist, and new Pennsylvania reserves have been found, making it a domestic fuel. If more supply comes online, prices could remain low.
Environmentally, natural gas is less polluting than coal, yet still much more polluting than renewable energy technologies. In addition, issues concerning transporting gas through pipelines exist. Long term, Navigant Consulting anticipates rising natural gas prices during renewable energy price declines. Generation of natural gas-fired electricity grew in 2009 because often it was the lowest-cost fuel on the margin compared with coal, which declined faster than any fuel. Figure 5, which includes data from the Energy Information Administration (EIA), shows that growth in renewable energy generation was higher on a percentage basis than any other fuel in 2009, including natural gas.
Andrew Kinross is a director in Navigant Consulting’s energy practice and focuses on renewable and distributed energy. He primarily serves private equity clients, utility companies, oil and gas companies and equipment manufacturers on investment decisions and corporate strategy. He also serves government agencies on issues of public policy support. Reach him at firstname.lastname@example.org.