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FINANCE
Joan Esquivar is manager of financial and tax analysis at the Edison Electric Institute.
Ausma Tomsevics is a financial analyst at the Edison Electric Institute.
Electricity markets focus on debt, risk
In the past several years, companies in the shareholder-owned electric utility industry have made various combinations of their assets, ranging from regulated and merchant generation assets, gas and electric assets, and regulated distribution-only assets. These models have changed business risks fundamentally and prompted increased acquisition activity, asset build-outs, and power trading activities.
At the same time, the wholesale power crisis in California and Enron's bankruptcy have sharpened the sense of business risks. Investors are watchful of potential changes to credit ratings and are pursuing companies that have focused on strengthening their balance sheets through debt reduction. The industry responded strongly to these events and focused efforts on reducing debt and increasing liquidity. By the end of 2001, the investment community had taken notice of the industry's efforts to strengthen electric utility balance sheets.
This year, emphasis is on liquidity margins: Companies are looking for financial flexibility to ensure that they have adequate cash resources to meet their obligations. One way companies are increasing liquidity is through the sale of assets and the issuance of common stock. For example, Cinergy announced last February that it would float equity: The company intends to reduce short-term indebtedness with approximately $200 million in proceeds from the issuance of 6.5 million common stock shares. Companies' cash flow analyses also are emphasizing balance sheet ratios with and without working capital funds. Cash flow predictability is an important variable for investors evaluating a company's future profitability. And analysts are focusing on the effective leverage for both on- and off-balance sheet financing.
The industry's capital structure continues to have a high degree of financial leverage in the deregulated environment, helping to fund new growth and new generation: Higher debt facilitates the increase in leverage. The debt-to-equity ratio increased to 1.32 as of December 31, 2000, for the third time in the last four years, and 28.2 percent higher than the level as of December 31, 1996, a key turning point for the industry in terms of restructuring and regulation. The leverage ratio also grew to 1.38 from September 30, 1999, to September 30, 2000. (See Figure 1.)
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Figure 1
INVESTOR-OWNED ELECTRIC UTILITIES DEBT-TO-EQUITY RATIOS |
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Year |
Debt/equity |
Percent change from previous year |
|
2000 |
1.32 |
4.8 |
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1999 |
1.26 |
11.5 |
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1998 |
1.13 |
-2.6 |
|
1997 |
1.16 |
12.6 |
|
1996 |
1.03 |
-2.6 |
|
1995 |
1.06 |
— |
For the past decade, the level of debt of the shareholder-owned electric utility industry has been cyclical in nature, reflecting both the general business cycle as well as specific industry trends. For example, in 1992 utility debt significantly increased due to cost overruns on nuclear powerplants, and as a result, companies committed themselves to reducing those debts. Thanks to historically low interest rates between 1990 and 1994, refinancing activity increased significantly, reducing the cost of capital.
Concerns about the industry's overall rise in debt levels worsened in 2001 because of declines in forward electricity price curves and in the spark spread spurred by higher wholesale electricity prices. Companies responded by funding debt reduction through selling noncore assets, issuing securitization bonds, and achieving merger synergies. As unregulated investment rose in response to companies seeking new sources of revenues, debt levels followed suit. Companies used both recourse and nonrecourse debt to finance these unregulated activities with arrangements such as project financing debt, hybrid securities, and synthetic leases.
Credit Upgrades and Downgrades
The credit rating ratios of downgrades versus upgrades for electric companies during 2000 and 2001 rose above 2.00, a level last seen in 1994. [See "News & Trends" in this issue, "Financial Retrospect", page 6.] The 2001 changes occurred throughout the first three quarters and were primarily in response to regulatory uncertainty and a decline in wholesale market prices. Driving factors included capital and corporate restructuring, increased investment in nonutility businesses, and merger activity.
Rating agencies are more closely scrutinizing the energy trading business as risks come into focus, including the volatility of power markets, heightened credit risk, and high demands of counter-party risk. These agencies are looking at the implications of including all debt on the balance sheet—including off-balance sheet financing. Increased rating concerns about counter-party confidence and liquidity issues resulted after Enron and caused a downgrade for some power generators. However, risk levels vary, requiring rating agencies to differentiate among generators based on several factors:
- competition in the marketplace,
- production costs,
- competitiveness of fuel sources,
- diversity of generation portfolio,
- robustness of competitive market framework,
- transmission constraints, and
- environmental laws.
Power Markets
A power marketer is subject to the Federal Energy Regulatory Commission's regulations and has specific filing requirements. The first power marketers, primarily gas companies selling natural gas to the electric industry, were experienced in marketing and owned the infrastructure to sell electric power. Enron fit the mold and became one of the largest power marketers, forming alliances to minimize risks.
But Enron's bankruptcy did not have a material destabilizing impact on the power marketing industry. There were no power interruptions, wholesale power prices and spot prices were relatively stable, and power markets functioned well. Some have indicated that this is a testimony to the success of deregulation.
Increased volume of sales and number of players continue to mark the historically rapid growth of power markets: The number of registered power marketers rose from 65 in 1996 to 506 independent power marketers and 170 affiliated power marketers by December 2001. Sales volume grew rapidly from 27.5 million megawatt-hours (MWH) during the first quarter of 1996 to 1,843.7 million MWH in the third quarter of 2001. (See Figure 2.) The most rapid expansion occurred in the North American Electric Reliability Council (NERC) regions Mid-Atlantic Area Council, Mid-America Interconnected Network, and Western Systems Coordinating Council (WSCC). The largest sales volume occurred in NERC regions East Central Area Reliability Coordination Agreement, Northeast Power Coordinating Council, Southeastern Electric Reliability Council, and WSCC regions.
The fall of Enron fostered a closer scrutiny of accounting methods, company balance sheets, and credit quality. Direct repercussions also are evident by the strategic decisions of several power companies announced last February:
- Centrica acquired New Power Holding, a company hit hard by its large exposure to Enron—New Power lost $110 million in collateral to Enron's bankruptcy.
- AES plans to sell generating assets in the United States and abroad to reduce debt and improve credit quality. This also is in response to falling wholesale prices, the economic collapse in Argentina where half of AES's international investments reside, and economic conditions throughout Latin America.
- Mirant agreed to sell its generation assets to Dominion in order to strengthen its balance sheet and improve liquidity following a downgrade of Mirant's debt to junk status late last year.
Federal agencies, legislators, and investors are taking a closer look at the structure of electric utility companies, as well as their power trading and derivative market activities. Congress currently is focused on the issue of federal oversight of energy trading, which at present is unregulated. A bill proposed and debated in March by a group of Western senators would assure transparency, more disclosure, and increased regulatory oversight.
In the near-term, companies will assure investors of appropriate accounting methods while striving for more transparency in trading operations and derivative activities. A key element in evaluating credit quality will be consistency in trading returns. Power marketers may also highlight the duration and counter-party diversity of derivative portfolios for discerning earnings quality. Expectations for the future also include an ongoing focus by companies to improve their balance sheets to alter capital structures. Debt reduction announcements will clearly continue, resulting in increased sales of generation assets and a rise in acquisition activity.
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