Ken Silverstein EnergyBiz Insider Editor-in-Chief

Public utilities' missions are to provide reliable electric and gas service at competitive rates. But the external factors that have thrown their investor-owned utility counterparts for a loop could potentially do the same for the municipal sector: volatile wholesale power prices, counterparty credit risks and a reliance on certain fuel mixes. Such companies do have the flexibility to respond to changing conditions without going first to state regulatory commissions, which differentiates those public power companies from their for-profit cousins -- a key reason why Fitch continues to view them favorably.

"Fitch believes that some (municipal) utilities will be vulnerable to deteriorating financial margins in a higher energy cost environment," the ratings agency says in its U.S. Public Power 2006 Outlook. "The vulnerability can be exacerbated by an increased likelihood that some utilities will decide to postpone or reduce planned rate increases. Over time, these decisions could result in a structural diminution of a utility's financial profile and cause a negative rating action."

Clearly, runaway wholesale prices have not helped publicly-owned utilities. And neither has third party credit risks, which leave them financially exposed. But, such entities have shown that they are able to adapt to changing times by reducing their fixed costs and setting aside their surplus revenues for "rainy days" -- funds that have permitted them to avoid borrowing funds and dramatically escalating rates. Some of them have also built their own generation so as to avoid buying power on expensive spot markets.

Public power utilities are financed by debt and therefore, it is the bondholders who bear the risks. Yet, those note holders are normally willing to issue debt to cities under favorable rates because they are self-regulating. That means a city can readily modify its rate structure to maintain its costs, minimizing the risk of a municipal utility falling into financial disarray. That reality, coupled with their existing and effective risk management techniques, mean that the average public power entity received 'A' ratings from Fitch.

Fitch points to the California Department of Water Resources as a company with solid operating and debt-service reserves. Its management has furthermore met its revenue requirements and resolved outstanding legal issues. The utility also has enough power in reserve that it can avoid having to buy expensive power from the wholesale markets. Likewise, the Grand River Dam Authority in Oklahoma has a positive outlook, reflecting a proactive management and a willingness to raise rates to strengthen its financial position. It has also expanded its coal and hydro resources.

The Horizon

But Fitch is concerned about a number of factors on the horizon. For starters, it says that an increasing number of base-load coal fired plants -- plants that run most of the time -- are going up. The risks to such a strategy are not just the huge capital costs but also the price of procuring the fuel source and then transporting it. Furthermore, coal plants will likely be targeted by tougher regulations and increase their cost even more. And while companies can avoid spot markets by building new generation, most will still have to participate in the wholesale markets.

Those are tough conditions. And it's the reason why Fitch says that the two-year credit outlook for investor-owned utilities has shifted from stable in 2005 to negative in 2006.

Fitch and other rating agencies say that it is therefore essential to employ risk management techniques to minimize potential losses. Companies may have to drain their reserves, for example, if they don't properly manage power contracts.

Building sufficient reserves to guard against market uncertainties and wide price spikes is an effective risk management tool. A number of municipals are realizing that they must build that cash reserve to more than the typical 30-60 days of historical operating expenses, says Standard and Poor's. At the same time, it says that all companies must monitor counterparties, diversify their fuel sources and manage their debt so that long-term assets are financed with long-term debt.

The uncertainty caused many of the utilities Fitch reviewed to experience "less-than-expected" financial results. At least half of them showed declining operating cash flow margins, or operating revenues less operating expenses plus depreciation. It's a notable trend, adds Fitch, because most public power systems actually strengthened their financial profiles during the toughest of times in 2000-2001.

"In many cases, utilities have passed on rate increases that will soon come into effect and alleviate the additional cost pressure," says Fitch. "Alternatively, some utilities have not yet made any rate adjustments and continue to experience reduced financial margins." Altogether, Fitch reviewed 144 public power systems, giving 87 percent of them "stable" outlooks. Eight percent got positive outlooks while 5 percent had negative trends.

The revisions to negative were generally indicative of a utility's inability to pass through increased power costs to customers. Lakeland, Fla., for example, had invested in a state-of-the-art combined cycle plant. But when that project was delayed, the city was forced to buy replacement power from the wholesale market at much higher prices than it had expected. The result: a $5 million unplanned expense. Tallahassee, Florida Energy, meanwhile, is considered too gas-dependent and reluctant to pass on the higher associated cost, causing it to go from a stable outlook to a negative one.

Public power systems have weathered the worst part of the storm. But an uncertain forecast means that if such systems are to maintain their generally stable outlooks, they will have to be strident, beef up their reserves and increase rates if necessary.

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