The economic climate facing utilities in 2008 is mild. That's the general forecast from the two leading ratings agencies, which say that the troubles facing the housing and banking sectors are less problematic for power companies that are more defensive.

Credit quality in the U.S. electric utility industry has continued to become more stable; however, the sector faces a number of variables that could weigh it down. They involve the need to gain favorable treatment from regulators as it pertains to not only pending rate cases but also as it relates to possible federal carbon legislation. They also include the need to expand their generation and transmission infrastructures to meet expected future demand while also dealing with escalating labor and materials costs.

"Standard & Poor's focus on future principal drivers of credit quality has shifted to the regulatory arena and management quality from an emphasis on noncore asset divestitures and restoration of capital structure balance," says the agency's 2008 utility roundup. "State regulatory commission rulings will be key in determining creditworthiness as companies seek timely recovery of substantial capital expenditures."

Nationwide, state utility commissions are receiving an uncommon number of rate hike requests. According to Tom Serzan, vice president of Regulatory Research Associates, a subsidiary of SNL Financial, nearly $1.4 billion electric and $460 million gas base rate increases were authorized in 70 cases in 2005. And 2006 also proved to be robust. Future cases will also dominate the agenda, he adds, noting spending in transmission and generation is increasing as the demand for power surges.

S&P notes that the state regulatory agencies have been generally supportive of companies' credit quality. While prior commission rulings do not necessarily indicate how future ones will go, S&P says that positive decisions with regard to the construction of new power plants and increasing fuel costs have been handed down.

So far, the commissions in Iowa, Missouri and Colorado have allowed structured cost recovery for utilities doing business there. And, they have done so in such a way that the utilities' financial health would not be compromised during the construction of major generating facilities, the agency adds. States such as Kansas and Indiana, meanwhile, have also been supportive of environmental-tracking mechanisms that allow companies to reflect in their rates capital costs associated with environmental compliance and to do so without having to file formal rate cases.

On the federal front, some large utilities that include American Electric Power, Duke Energy, PNM Resources, Exelon, and Edison International are backing a bill that would reduce greenhouse emissions to 1990 levels by 2030. That, of course, would have huge implications on credit quality -- and something that will depend on whether the cost of compliance can be passed through to ratepayers. Prospective carbon rules should give companies with nuclear and renewable assets a leg up.

Power Demand

The continued increase in power demand also means the industry will have to build new generation and transmission. And the demand for engineering, procurement and construction services also translates into higher capital costs. That's because the global demand for infrastructure-related items is on the rise while domestically, companies must also invest in pollution control equipment.

Regulated utilities will strive to get these higher costs embedded in the rate structure and to do so in pre-approved agreements with state utility commissioners. If those companies have cost recovery mechanisms, they can mitigate the major risks posed by large-scale construction projects. However, they will have to manage the overall risks during the construction process to avoid cost overruns.

"Capital spending for infrastructure projects is expected to remain at relatively high levels over the next two years," says Fitch Ratings, in its 2008 utilities outlook. "Capital investment in the power and gas sector rose meaningfully over the past three years from the cyclical low point in 2003-2004, including a 26 percent rise in 2006 and an estimated 18 percent increase in 2007" for a sample group that Fitch watches. "In the outlook period, the weak U.S. dollar, combined with dependence on foreign suppliers for many components and materials, will add to the cost of infrastructure projects."

Forecasts for 2008 indicate that capital expenditures will continue to rise by 10-20 percent, Fitch adds. Its earlier estimates for next year were higher, although the cancelation of several coal projects -- concerns over future carbon legislation -- caused the agency to trim its expectations. At the same time, it says that the debt reduction trend that dominated the period of 2003-2006 has leveled off. In 2007, the aggregate consolidated debt of utility parent groups increased by a modest 1 percent to 2 percent.

What types of investments are financing those utility expansions and at what level? Altogether, S&P says that the amount of medium to long-term debt, preferred stock, and hybrid securities issued during the first nine months of 2007 was about $35.2 billion. That's compared to about $30 billion during the first nine months of 2006.

Overall, regulated utilities are generally healthy and can handle future outlays. S&P says that 84 percent of those companies carry investment grade ratings while the remainder does not. Nearly three-quarters, meantime, have stable outlooks. About 14 percent have negative outlooks while 11 percent have positive ones. The negative bias is the result of deteriorating financial conditions, unsupportive rate orders and burdensome capital spending programs tied to environmental controls.

In times of volatility, utilities are seen as safe havens. In the last few years, they have trimmed their debt and gotten back to basics. But now they must gear up for future growth by expanding their generation and transmission base -- all while trying to guard against rising fuel, materials and labor costs. If they are to remain fit, utilities must work with customers and regulators alike to win approval for their programs.



 

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