Lending a Hand: How Banks Make Loans—and Assess Credit Risk—for Distribution Utilities

By Jennifer Godin Goss, CoBank

Since mid-2007 it’s been difficult to ignore the cascade of negative headlines about the U.S. sub-prime lending crisis. The resulting global credit crunch has rippled well beyond financial institutions that provide home financing, impacting access to debt capital for borrowers all over the world.

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Fortunately, America’s electric distribution utilities are well positioned to ride out a prolonged period of tightened credit conditions. Though not immune from economic turmoil, they rank among the lowest-risk commercial borrowers, and banks and other financial providers can be expected to continue providing them with reasonably priced loans to meet their day-to-day and long-term business needs.

But, utilities are not all created equal in the eyes of the U.S. banking industry. Differences in strategy, management strength and financial profile will all continue to come into play for lenders as they assess individual utilities and their requests for loans, leases and other financial services.

Industry Environment

While electric distribution utilities face evolving market trends, the industry as a whole has been highly stable in comparison to other sectors of the U.S. economy. Competition within service territories remains limited due to the monopoly status enjoyed by most providers. Demand for energy continues to be robust across the board, as both businesses and residential consumers consume more electricity to power a ballooning array of electronic devices, from high-tech TVs to computer networks. At the same time, increases in supply have been hindered by a nationwide dearth of investment in new generation assets.

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Of paramount concern for utilities has been managing profit margins as the cost of power continues to trend upward. Regulated providers face a political environment in which requests for rate increases are slower to receive approval from utility commissioners. Cooperatives, meanwhile, struggle to balance guaranteed access to affordable power for their members against the long-term financial health of the enterprise.

Any bank with a focus on the utility industry understands these dynamics full well. Industry participants should recognize that quality lenders will undertake a full-scale analysis of their business and the place they occupy in the broader market before agreeing to serve as a source of debt capital for new projects and initiatives.

Assessing Credit Risk

Banks look at an array of indicators when assessing whether or not to extend a loan to a prospective borrower. These indicators fall in both the qualitative and quantitative categories–and can have a major impact on the availability, amount and price of debt as well as overall terms and conditions.

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Qualitative risk includes a variety of factors: History, revenue levels, lines of business, brand equity, and state regulatory regimes all come into play. So does management strength. Lenders like to see proven success in utility management, as well as engineering expertise, financial acumen and solid character and values across the company’s entire leadership team.

For distribution providers in particular, one key risk factor banks look at is a utility’s long-term ability to procure power at reasonable rates. Companies that have access to multi-year agreements with generators will, in general, be viewed more favorably by lenders than those that rely on short-term contracts or the day-ahead market. A region’s overall generation capacity and reserve margin are also key factors in this regard.

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On the quantitative side, lenders generally focus on a number of metrics when evaluating prospective commercial borrowers. Among the most important are:

  • Debt-to-EBITDA, which measures a company’s total debt as a percentage of cash flow. (EBITDA, which stands for “Earnings Before Interest, Taxes, Depreciation and Amortization,” is a widely accepted measure of operating cash flow.) In the power industry, debt-to-EBITDA ratios vary widely depending on the nature of the business in question. Pure distribution companies and G&T cooperatives will generally be allowed higher debt-to-EBITDA ratios than integrated utilities. That’s because of their lower risk profile and their ability to generate cash predictably over the long term.
  • Debt service coverage ratio, which measures cash flow in proportion to annual principal and interest payments. DSC is lower when amortizing long-term debt than for interest-only long-term debt.

What Borrowers Can Do

What can electric utilities do to improve their access to debt capital and lower their overall cost of borrowing? Many measures are basic, like maintaining sound financial controls and investing properly in line upgrades and other infrastructure. But here are three key steps any distribution provider can take to enhance their overall credit profile in the eyes of existing and prospective lenders:

  • Ensure future access to power with long-term procurement contracts and/or access to a diverse portfolio of generation providers.
  • Improve relationships with regulators. Building and nurturing a solid working relationship with local utility commissions is critically important for any distribution company. Those that create an adversarial environment by including unreasonable operating costs in petitions for rate increases not only hurt themselves from a regulatory standpoint, they also harm their long-term standing with banks and other financial service providers.
  • Push for fuel cost adjustments with local regulatory regimes. States like Pennsylvania and Virginia allow some utilities to pass through fluctuations in commodity pricing without a formal rate case hearing. In states that don’t, utilities should be lobbying hard for this type of accommodation.
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Choosing a Lender

As noted above, the utility industry enjoys exceptional access to capital given its uniquely strong characteristics. Most distribution companies looking for debt will have a range of lenders to choose from. But utilities should analyze their prospective banks as carefully as their banks assess them before selecting one as a financial services partner, with a particular eye on the following:

  • Industry expertise. Lenders with a strong focus on utilities will understand the industry’s vagaries and business cycles. That usually translates into a more accurate perception of risk and better loan structures for borrowers.
  • Access to capital markets. The capital-intensive nature of electric distribution means that business loans tend to be large scale. To close deals successfully, banks serving as primary lenders are often required to syndicate loans by bringing in commercial lenders and other investors. Banks with credibility in the financial services industry and extensive syndication experience will have the most success in that regard.
  • Long-term debt instruments. Distribution companies that are making capital investments with a long-term asset life should try to finance a portion of those assets with long-term debt. However, only a select number of banks and insurance companies offer loans with terms of 20 years or more. Adding a long-term lender as a financial service provider will help utilities as they optimize their capital structures.
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Private debt will always be a strategically important source of capital in the utilities industry. Distribution providers that manage their credit profiles effectively–and select their lenders with care–will achieve an important competitive advantage in the market and a future full of promise and opportunity.

Jennifer Godin Goss is senior vice president, electric distribution division, with CoBank. CoBank delivers comprehensive, flexible and effective financial solutions to their customers, including U.S. agribusinesses, agricultural cooperatives, farm credit associations, as well as rural energy, communications and water companies. More information on CoBank can be found online: www.cobank.com.

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