by Richard McMahon, Edison Electric Institute
Everyone–consumers, small businesses and large corporations–feels the effects of the credit crisis. For the U.S. electric power industry, one of the nation’s most capital-intensive industries, the economic issues sharply magnify its need for ready access to capital on reasonable terms.
Edison Electric Institute (EEI) estimates that during the next two years the cost to make needed improvements including transmission and distribution system upgrades, environmental and energy-efficiency advances and generating-capacity additions will reach $150 billion.
This figure reflects recent decisions by many electric companies to lower capital expenditures as a result of the economic downturn. Looking at the cost to complete the transformation to generate, transmit, distribute and use electricity more efficiently and with less environmental impact, EEI anticipates it likely will require up to $2 trillion by 2030.
Financing these capital expenditures at reasonable rates will be crucial for the industry’s viability. The industry most recently experienced major building during the late 1970s and early 1980s. Back then, long-term bonds were largely rated “A” and “AA.” Today, given the more diverse and competitive industry, senior debt is typically rated “BBB.”
Although many factors including the current economic crisis influence overall borrowing costs, this drop in credit ratings has caused relative borrowing costs to rise. For example, in mid-2008, the average “BBB+”-rated company was paying a yield about 0.5 percentage points higher than what the average “A”-rated bond was paying. And by January, this difference had grown to around 1 percent. Our bonds are paying higher interest rates today, as well.
Issuing stock has become a more expensive way to raise cash, too. With stock prices hovering near 52-week lows, fewer companies have been eager to try to price a stock offering in this market. In addition, issuing stock at prices below book value–where some electric utilities are now trading–weakens shareholder value.
But with a large-scale construction cycle already underway, electric companies are taking measures to improve their access to the capital they need at rates they can afford. When the credit markets froze in September 2008, many companies proactively extended and expanded their existing bank credit lines. Every company also is maintaining a sharp focus on internal costs, including its operations and maintenance budget.
But the key to keep capital costs under control is regulatory policy that reflects the new risks inherent in the current business environment. Companies are urging state regulators to provide them with a return on equity (ROE) that will attract equity investors at reasonable rates. With industry bondholders earning an average of 8.2 percent, the industry’s average allowed ROE will need to be high enough to attract potential stock buyers who face greater investment risks.
Besides obtaining an ROE that reflects today’s higher cost and riskier investment climate, companies are seeking to strengthen their liquidity and cash flow–two measures that potential investors focus on closely. Regulatory certainty is critical for achieving these.
EEI is working with regulators to obtain timely decision-making–both in general rate cases as well as issue-specific proceedings such as corporate reorganizations and financing approvals. Lengthy rate cases translate into greater uncertainty and thus higher required returns for investors. And with the frequency and size of rate cases expected to increase as a result of the industry’s large capital expenditure needs, the need for timely regulatory actions will only gain in importance.
Other steps EEI is taking to reduce uncertainty include advocating for preapproval of construction projects, putting construction work in progress funding in the rate base, use of future rate-case test years or other forward-looking measures and the automatic recovery of prudently incurred fuel and nonfuel expenses.
Regulatory approval of financing costs is especially critical. Although some state commissions already use some of these mechanisms in their ratemaking, adoption by more jurisdictions would be a constructive step forward.
Other steps include actions by EEI’s Wall Street Advisory Group, composed of utility chief financial officers and Wall Street executives, to maintain dialogue between the industry and the financial community on which it depends. This group also is facilitating communication with state commissioners to discuss financial issues confronting the industry.
EEI is pursuing a frank and open discussion with the Federal Energy Regulatory Commission to help federal regulators understand the industry’s challenges on Wall Street, along with the importance of utilities’ being able to access capital for needed infrastructure projects.
The industry and nation face difficult economic times. EEI is confident that by maintaining rigorous cost controls and working to foster a constructive and transparent dialogue with regulators, the industry will come through this recession stronger and better able to meet the needs of the 21st century.
Richard McMahon is executive director of energy supply and finance at Edison Electric Institute. In this capacity, he advances the public policy and commercial interests of its member companies on issues including fossil, renewable and hydropower; risk management; and tax and financial.