But such market dynamics need not harm investment grade ratings, says Fitch Ratings. The industry must avoid the mistakes of the past, including cost overruns, poor relations with regulators and a propensity to overbuild. Importantly, the capital markets today are liquid and the cost of capital is low, with equity valuations in the sector at historically high levels and bond spreads relatively narrow.

The real storm hit the utility industry hardest in 2002, when the ratings agencies downgraded utility debt at record levels. Utilities hunkered down and met the challenges by reducing their debt levels and watching their expenditures. But, now they are focused on improving reliability in the wake of the 2003 Blackout. And that reality in combination with the need to increase earnings through mergers and acquisitions means that utilities will be spending more money.

"With the bulk of the financial recovery from failed diversification strategies largely behind, Fitch expects many industry participants to embark upon catch-up expenditure programs to enhance reliability and provide future, albeit modest projected growth," says Philip Smyth, an analyst with Fitch. Altogether, he says that the industry collectively increased its capital spending by 15 percent in 2005 and will do so by 30 percent in 2006.

Specifically, he points to Pacific Gas & Electric, Southern California Edison and Southern Company as three companies that are expected to spend a combined $8 billion annually to replace aging infrastructure and build new generation -- in part to meet new environmental standards. Meanwhile, TXU says that it will build 9,000 megawatts of capacity through 2010 at a cost of $10 billion. And, NRG says that it will construct $16 billion in new generation over the next decade, or 10,500 megawatts of capacity.

One of the concerns that Fitch and others have is that the industry will overbuild. That's what happened during the 1990s. When demand dropped and unregulated generators were left with unsold capacity, many suffered, resulting in credit downgrades. But, the credit ratings agency says that times are different today and points to the use of new hedging, or risk mitigation, vehicles. Further, equity valuations are high and inflation and interest rates are still relatively low.

Cyclical Nature

Longer term, the North American Electric Reliability Council says that by 2015 the country will need an additional 141,000 megawatts to accommodate an expected 19 percent increase in electricity usage. Only 57,000 megawatts are on the drawing board.

Fitch, meantime, expects spending on transmission to rise to $31.5 billion by 2009. That's 60 percent more than the last three years. The reliability council reports 335 transmission projects in the works, totaling almost 13,000 miles, all through 2015.

The expected increase in demand along with the pressure on utilities to grow their earnings and dividends means more mergers and acquisitions. Some shareholders say that the traditional earnings of 2-4 percent are too little, which is giving companies the incentive to buy assets. One of the most effective ways is to combine with geographically contiguous companies -- an approach that could add new revenues without distorting expenses, if the synergistic opportunities actually materialize.

Many utilities are now able to buy assets or even whole companies, given that they have reduced their debt levels by selling troubled assets and participating in a low interest rate environment. The payoff: The Dow Jones utilities index grew by 23 percent in 2003 and by 25 percent in 2004. In 2005, the index was up more than 20 percent -- a trend that could be buoyed by higher electricity prices and new investments in transmission reliability and renewable energy technologies.

"We expect more of these deals to occur, including combinations, asset divestitures and inroads from nontraditional utility owners ...," says Standard & Poor's, in its 2007 credit outlook for utilities. "With most of the deals being heavily debt financed, credit quality will likely suffer." Among those non-traditional players on the prowl: Warren Buffett's Berkshire Hathaway, which already owns Mid American Holdings and which has $42 billion in cash on hand. Buffett said recently he is willing and ready.

Both Fitch and Standard & Poor's differentiate between regulated and non-regulated utility assets. The former, whose returns are monitored by public service commissioners, are often able to recover their costs through rate increases. The latter, meanwhile, is subject to market forces and the sky is the limit. In the past, however, that risk has proved too much and left many such enterprises with expensive and non-productive assets.

Down the line, if creditors want to get paid, the unregulated entities must have long-term contracts in hand before constructing facilities. For now, though, the excess capacity -- the amount of power the unregulated facilities could be selling but are not -- will dissipate in some parts of the country within two years. Regions such as New England, New York and California are primed for new generation.

"Lenders now recognize the cyclical nature of power generation and they recognize just how susceptible to fuel prices these facilities can be," says John Reed, CEO of Concentric Energy Advisors, outside Boston. "In the future, they are looking at several scenarios so that they can have a high comfort level that borrowers can meet their debt service even in bad markets."