(UtiliPoint - Mar. 24)

By Ken Silverstein Director, Energy Industry Analysis

The balancing act that state and local governments must perform is having an immediate effect on public power companies. Because these governments are strapped for cash, they are forced to look for revenues where they can get them. While municipal utilities typically provide “payments in lieu of taxes” to city coffers, some are now under pressure to give more. This issue is most pronounced in California.

California's situation is uncommon. The difficulty of raising revenues there often puts the state and local governments in a bind. Some California cities that run their own electric systems are able to underwrite city services and it may be appropriate to increase transfers. But, it might also be sticky if such demands become excessive. That could harm the credit quality of public power or prevent adequate investment in much-needed infrastructure improvements—all a time when there is a focus on reliability.

“It takes forbearance on behalf of city leaders,” says Alan Richardson, CEO of the American Public Power Association in Washington, D.C. “They are the leaders and they have the fiduciary responsibility for the financial health of the public power enterprise.”

The challenge, of course, is to find the “sweet spot,” says Richardson. To do so, city leaders have to look at the current electric rates and compare those to surrounding communities. If it is determined that higher assessments are a possibility, the next question is the effect that any increase would have on a utility's competitiveness. And, it comes down to personal philosophy and whether the proceeds from any rate hike would be used wisely and in such areas that serve the greater good. Ultimately, cities have to take responsibility for their decisions and understand how bond ratings and future investment decisions would be affected, says Richardson.

While all communities are different, Richardson says transfers that get into the “double-digit range”—operating revenues that are switched into a city's general fund—are “problematic.” In the past, he says that some cities relied too heavily on their public power companies to underwrite their budgets. Levies have been as high as 20-25 percent, he says.

Balancing Act

The national average for transfers is 5.7 percent of operating revenues. In California, it is more. According to Fitch Ratings, the median transfer or payment in the last year from California municipal electric utilities to their respective cities' general funds has increased from 5.5 percent to 7.5 percent. While the increase is relatively minor and is only one aspect of a utility's financial performance, it is a credit risk that Fitch has cited over the past year in several public power reports on California issuers. Fitch says that it believes that pressure to raise the transfer will escalate in certain cities because of significant spending reductions announced in Gov. Schwarzenegger's proposed 2005 budget. Pasadena, for example, just passed an increase of 0.85 percent for the next four years.

“Their electricity rates are their major source of support,” says Lina Santoro, credit analyst in the public power sector for Fitch Ratings in New York City. “If there is continued pressure to increase the city transfer, at some point it could start to affect the rate and financial flexibility of a utility.” She adds that many California municipals hold higher cash reserves than before restructuring, which serves to improve their ability to make the higher payments. Moreover, many city charters cap the amount of transfer that can be made, although those with caps in the 7-8 percent of gross operating revenue range still pose a credit risk, she says.

While Fitch expects no near-term change in the credit ratings for California public power utilities, the trend of rising electric utility transfers becomes of greater concern, particularly in the coming months as city councils review their budgets. Increases have thus far been modest, it says. But, if such hikes should escalate, public power companies may lose their financial flexibility and rely increasingly on debt financing for capital expenditures. Or, they will have to increase their rates and the effects of that are difficult to gauge, although commercial and industrial businesses would be hardest hit.

“When you are dealing with local control, there is no ultimate solution,” says public power's Richardson. “It is what works for the utility and the city—and what is in the best interest of all concerned.”

City transfers are always touchy. And while Fitch does raise a red flag it also says that it expects municipal power providers nationally will maintain their 'A' and 'A+' ratings because of successful risk management techniques that also include reducing debt levels. That has allowed the sector generally to handle rising natural gas prices and to guard against other unexpected developments. Meanwhile, the liquidity of those companies has increased, which has permitted them to easily meet their operating needs.

Despite their aversion to risks, municipal utilities—and all others too—do face risk management challenges such as wholesale electricity and gas price volatility. They will furthermore have to deal with increased investments in transmission, all to improve reliability. And, they must continue to be vigilant when it comes to counter party risks. Take gas prices: If power contracts are not properly managed, companies could be subjected to wide price swings in the wholesale market. That could force cities to drain their reserves and borrow more money, if they wanted to minimize rate increases to consumers.

Needless-to-say, balancing state and local budgets requires foresight. Many concerns compete for limited dollars and the tendency could be overwhelming to dun public power companies. But, if those companies are stretched too thin, the ripple effect across communities might be more palpable than figuring out other ways to raise new revenues.

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