Arizona Public Service’s short-term rating may be pressured by power plant acquisition

(Standard & Poor's)- June 14 2004

Arizona Public Service Co. (APS; BBB/Negative/A-2) announced on June 1 that it will purchase the Sundance Generating Station, a 450 MW gas-fired peaking unit, from PPL Corp. (BBB/Stable/—) for $190 million. This may pressure the short-term rating on APS. The purchase secures sorely needed peaking generation to meet rapidly expanding demand at an attractive price of about $475 per kW, based on the plant’s summer capacity rating.

Although APS will request that the Arizona Corporation Commission (ACC) authorize the purchase and allow it to defer recovery of the plant’s capital and operating costs, it could take at least a year after the acquisition closes for APS to complete a new rate case seeking to include these costs in the utility’s rate structure. APS is already in the middle of a comprehensive general rate case that is likely to set a critical precedent for how the utility will be expected to procure supplies for its growing load. Settlement negotiations for the existing rate case began in early May. An unsupportive decision could augur poorly for favorable recovery of costs related to the Sundance transaction.

APS expects to finance the purchase with debt and will incur cash expenses for Sundance’s operations, including interest expense, incremental variable operations, and maintenance and fuel purchases, which will not be immediately recoverable in rates. As a result of the additional leverage and the need to carry these cash expenses, the utility’s financial metrics are expected to weaken, at least in the interim. Standard & Poor’s is in the process of analyzing information provided by management to determine the precise effect of these costs on the utility’s financial ratios, particularly in 2005 when APS will be supporting the costs of Sundance without the benefit of rate recovery.

However, the full extent to which such a weakening would affect the utility’s underlying credit quality cannot be known at this time because of APS’ current rate case: a favorable regulatory decision in its pending general rate case that increases its retail rates and allows for a fuel and purchased power pass-through mechanism would in all likelihood compensate for any deterioration that would occur as part of the Sundance purchase. However, as the negative outlook on APS suggests, Standard & Poor’s has also determined that plausible rate case outcomes could cause the utility’s financial performance to deteriorate. Thus, the effect of the Sundance purchase on APS’ financial strength will be heavily conditional on the outcome of the current rate case.

The Sundance purchase is the culmination of a request for proposals (RFP) that APS issued in December 2003 for bids to supply, beginning in 2007, at least 500 MW of power through either a long-term supply contract or asset purchase. PPL’s winning bid was selected from 13 responses. APS will soon request that the ACC approve the purchase by December 2004 and allow the utility to defer all costs, including a return on the deferral, until a future rate case. Specifically, once the current rate case is resolved, management has indicated that it expects to file a new rate case in 2005 to reflect Sundance’s additional costs. Standard & Poor’s estimates that the earliest that the Sundance costs would be placed into rates is one year later. While Standard & Poor’s expects the ACC to continue to provide a stable regulatory environment, Standard & Poor’s cannot eliminate the possibility of a future disallowance of Sundance costs. The ACC could also reject the asset purchase outright, which would likely force APS to issue another RFP for longterm resources, conditional on any additional ACC guidelines. If this occurs, the utility would increase its short-term purchases for the portion of next summer’s requirements that the Sundance purchase would otherwise have met. In the summer of 2005, APS forecasts a need for about 630 MW of peaking resources beyond its owned and contracted supplies.

The Sundance plant’s summer rated capacity is 400 MW, but PPL has a contract to supply 75 MW of capacity to Tucson Electric Power Co. (BB/Watch Neg/—), which will remain in force until December 2006. In addition, about 150 MW of Sundance’s output is also under contract to APS until September 2006 as part of the so-called Track B competitive procurement process ordered by the ACC in 2002. Because of the two contracts, the plant’s additional contribution to APS’ 2005 shortfall, if purchased, will be 175 MW, reducing net peaking requirements to about 455 MW. If the ACC rejects the Sundance acquisition, APS’ modestly increased reliance on short-term purchases would remain a manageable risk. But, by the summer of 2007, the need to purchase additional resources is expected to rise to at least 1,440 MW.

The circumstances that are forcing APS to seek a deferral are in many ways beyond management’s control. APS’ current rate case appears to be moving toward the last six months of what is likely to be an 18-month process. The case is currently in settlement negotiations. Management has concluded that it would be awkward to request parties to consider the Sundance purchase at this advanced stage. However, given the uncertainty associated with the outcome of the rate case, it is a difficult juncture, from a regulatory perspective, to pursue the purchase of a power plant. Yet APS faces a very real need to contract for additional supplies.

While these circumstances are driving the purchase, which otherwise appears to be a strong fit with APS’ existing generation portfolio, the affect on credit quality is uncertain. Constructive resolution of the general rate case late this year could provide some insight and comfort as to whether the ACC is likely to approve the purchase, and, ultimately, allow full cost recovery of the plant’s costs. In the meantime, it is likely that the acquisition-related deferrals will pressure the utility’s short-term rating, as APS’ strong liquidity will be diluted. The negative outlook is expected to remain until the current rate case is resolved.

Anne Selting

San Francisco (1) 415-371-5009

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