A Fresh Look at U.S. Utility Regulation

New York (Standard & Poor's) - 02 Feb 2004

Standard & Poor’s Ratings Services has been tracking the ups and downs of utility regulation for years, and in the past year or so has noted the recent upswing in the amount of attention that regulators and their activities are attracting. With the renewed and increasing influence that regulators are asserting on the creditworthiness of utilities as managements scramble to climb under the protective umbrella of comprehensive regulation, Standard & Poor’s offers this primer on how we analyze its effect on utility credit ratings. The entire range of regulatory actions and inactions are examined in assessing the regulatory support of credit quality, but inevitably it is the analysis of rate case decisions that provides the key indicator of the level of that support.

First, however, it is useful to remember the legal status of utility regulatory bodies when developing the basic analytical approach to their activities and decisions. Most utility commissions are, in a legal sense, “creatures of the legislature”; that is, the role they play is essentially legislative and not judicial in nature. The responsibility for setting utility rates and other functions of the commissions actually belongs to legislators and has been delegated to regulators for practical reasons. Thus, despite the trappings of a court (testimony, rules of evidence, administrative law “judges”) and a long history of accumulated case law governing their activities, the decision-making process of utility commissioners more often resembles that of legislators, with its emphasis on compromise and political considerations, than that of jurists who weigh evidence, construe the law, follow legal precepts, and the like.

The implication for the analyst is that the behavior of regulators can more often be explained by looking to political factors than to analyzing legal precedents or assessing the arguments of opposing parties. That’s why Standard & Poor’s analysts spend considerable time meeting with regulators and staff members and accumulating knowledge about the local and regional political climate and its effect on a utility, in addition to analyzing the impact of a particular rate decision or other commission pronouncements.

Nevertheless, rate cases, once thought to be obsolete as competition arose, appear to be coming to the forefront once again. Here is the fundamental analysis that Standard & Poor’s performs in measuring the effect of a rate case decision on credit quality.

For major rate cases that can directly affect ratings, the analyst will follow the developments in a rate proceeding right from the initial filing. The company’s request for rate relief, the local public reaction to the filing, the rebuttals of important parties and intervenors, and the conduct of the hearings are all monitored, assessed, and commented upon, if necessary, as the case proceeds through its schedule. The ability of the commission to render a fair and balanced decision that appropriately considers the interests of all the participants in the process can sometimes be affected by incidents that occur while the case is developing. Standard & Poor’s tracks whether the case is drawing a lot of attention, influential parties are staking out extreme positions, or outside events such as upcoming elections are affecting the chances of a rate decision that is consistent with the financial projections the ratings are based on.

Once the decision is made, it is analyzed to incorporate the effect on the financial forecast for the company, and also to assess whether the actions and precedents being set by the commission in its decision will have a long-term effect on Standard & Poor’s opinion of the regulatory environment in that jurisdiction. The analysis of the rate case fundamentally explores a two-fold question: are the new rates based on a fair and adequate rate of return, and is the utility being afforded a legitimate opportunity to actually earn that rate of return?

On the former question, the analyst looks to equity returns being authorized to other utilities and the capital structure employed to arrive at the overall rate of return being used to set rates. On the latter, the test year and all of the adjustments made to the company’s filed data are inspected to arrive at the final conclusion. Generally, decisions that feature the most up-to-date information in determining rates, including current test years and all “knownand- measurable” changes, are viewed as providing companies with the best chance to earn a reasonable and cashrich return.

Importantly, credit analysis also incorporates the cashflow effect of a decision, especially if it is the result of a full or partial settlement between the parties. A common method to achieve the compromise often sought by the parties or the regulators is to defer cost recovery into the future, which can preserve earnings but weaken cash flow. Standard & Poor’s places much emphasis on cash flow protection measures when assessing credit quality, and a rate decision that ostensibly looks favorable for investors can sometimes come at the expense of bondholders. Attention to the details is crucial in analyzing a rate decision because some that appear to be favorable on the surface can hide the “bite” that regulators took in the less conspicuous parts of the case, such as a change in the depreciation rate. Finally, one of the most important issues affecting ratings may or may not be a part of the rate-case process, but is constantly tracked by Standard & Poor’s: the recovery of fuel and purchased-power and gas costs. The analysis concentrates on stability of cash flows and the relative certainty of full recovery of these items, the largest expenses for almost all utilities, in arriving at a consensus on the level of a utility’s business risk.

The stability that leads to improved credit quality can be supported by legislators and regulators either through rate design or by carving out fuel and commodity expenses and treating them separate from the normal rate case process. Rate design is established as part of a rate-case decision, and can be used to promote stability by allocating a greater percentage of fixed costs for recovery through the standard monthly charge. The more common method is a separate clause in the tariff that fluctuates automatically or nearautomatically as commodity costs rise and fall. The presence of a fuel and purchased-power or gas clause that helps a utility manage its exposure to commodity price moves is positive for credit ratings. Not all are created equal, however, and each mechanism is studied to determine how closely it allows for matching of customer rates with expenses. Many other factors outside the scope of this commentary can play an important part in the overall assessment of the regulatory environment in which a utility operates.

Incentive ratemaking, special rate riders to recover extraordinary costs (e.g., environmental compliance), deregulation developments, the degree to which regulation insulates a utility from its parent, legislative initiatives, and other nonratemaking considerations can all affect Standard & Poor’s opinion of the quality of regulation. The ability of management to control its regulatory risk and the historical attitude of regulators toward the interests of utility bondholders also enter into the analysis. In the end, the regulation of public utilities is the defining element of the industry and is often the determinative factor in the ratings of a utility.

Previous articles are available in the Standard and Poor's Archive.

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