HomeMy WebLinkAbout20050118Williams Exhibits.pdfCase No. P AC-05-
Exhibit No.
Witness: Bruce N . Williams
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION.
ACIFICORP
Exhibit Accompanying Direct Testimony of Bruce N. Williams
Pro Forma Cost of Long-Term Debt
January 2005
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Case No. PAC-05-
Exhibit No.
Witness: Bruce N. Williams
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
ACIFICORP
Exhibit Accompanying Direct Testimony of Bruce N. Williams
Standard & Poor s Utilities & Perspectives- May 12 2003
January 2005
t. .
Last Week's Rating
Reviews and Activity. . . . . 10
Did You Know?
World Energy Consumption
and Regional Carbon Dioxide
Emissions in 2001, . . . . . . . . . 10
Last Week'
Financing Activity
Duke Energy s $700 Million
Senior Notes Are Rated '
' . . .
Wisconsin Electric Power
$635 Million Debt Issue Is
Rated'
' .................
North Carolina Eastern
Municipal Powers Bonds
AreRated'BBB' ............
Medco Energi's Proposed
$200 Million Notes Are
Rated'
.................
Utility Credit Rankings
Electric/Gas/Water . . . . . . . . . 14
Telecommunications. . . . . . . . 17
International..............
Key Contacts ............
STANDARD
&POOreS
Exhibit No.6 page 1 of 4
CASE NO. P AC-OS-
Witness Bruce N. Williams
Feature Article
Buy Versus Build": Debt Aspects of
Purchased-Power Agreements ..................................
Utility Spotlight
High Commodity Prices Bode Well For Stone
Energy s Cash Flow
.....,................ .........................
Special Report
Survey of State Regulators Reveals Focus
on u.S. Utilities' Financial Strength
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
News Comments
Laclede Group s and Unit's Ratings Are Lowered; Outlook Stable . . . . . . . . . . . . . . . . . . . .7
Sierra Pacific Power s Water Facilities Bond Rating Is Raised to 'B8' ................
Empresa Electrica Guacolda Ratings Are Affirmed; Off Watch . . . . . . . . . . . . . . . . . . . . . .7
Spanish Utilities Gas Natural, Iberdrola Ratings Are Affirmed; Off Watch
. . . . . . . . . . . . .
Enel's and Subs' Ratings Are Affirmed; Off Watch, Outlook Negative
. . . . . . . . . . . . . . . . .
Petrozuata Finance Ratings Is Affirmed; Off Watch. . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . .
~ .
Feature Article
PacifiCorp
Exhibit No.6 page 2 of 4
CASE NO. PAC-O5-
Witness Bruce N. Williams
Buy Versus Build": Debt Aspects of Purchased-Power Agreements
tandard & Poors Ratings Services views electric utility
purchased-power agreements (PPA! as debt-like in
nature, and has historically capitalized these obligations on
a sliding scale known as a "risk spectrum:' Standard &
Poors applies a 0% to 100% "risk factor" to the net present
value (NPV! of the PPA capacity payments, and designates
this amount as the debt equivalent.
While determination of the appropriate risk factor takes
several variables into consideration, including the econom-
ics of the power and regulatory treatment, the overwhelm-
ing factor in selecting a risk factor has been a distinction in
the likelihood of payment by the buyer. Specifically,
Standard & Poor's has divided the PPA universe into two
broad categories: take-or-pay contracts nOp; hell or high
water) and take-and-pay contracts (TAP; performance
based!. To date, TAP contracts have been treated far more
leniently (e., a lower risk factor is applied! than TOP con-
tracts since failure of the seller to deliver energy, or per-
form, results in an attendant reduction in payment by the
buyer. Thus, TAP contracts were deemed substantially less
debt-like. In fact, the risk factor used for many TAP obliga-
tions has been as low as 5% or 10% as opposed to TOPs,
which have been typically at least 50%.
Standard & Poor's originally published its purchased-
power criteria in 1990, and updated it in 1993. Over the past
decade, the industry underwent significant changes related
to deregulation and acquired a history with regard to the
performance and reliability of third-party generators. In gen-
eral, independent generation has performed well; the likeli-
hood of nondelivery-and thus release from the payment
obligation-is low. As a result, Standard & Poor s believes
that the distinction between TOPs and TAPs is minimal, the
result being that the risk factor for TAPs will become more
stringent. This article reiterates Standard & Poors views on
purchased power as a fixed obligation, how to quantify this
risk, and the credit ramifications of purchasing power in
light of updated observations.
Why Capitalize PPAs?
Standard & Poor's evaluates the benefits and risks of pur-
chased power by adjusting a purchasing utilitys reported
financial statements to allow for more meaningful compar-
isons with utilities that build generation. Utilities that build
typically finance construction with a mix of debt and equity.
A utility that leases a power plant has entered into a debt
transaction for that facility; a capital lease appears on the
utility s balance sheet as debt. A PPA is a similar fixed com-
mitment. When a utility enters into a long-term PPA with a
fixed-cost component, it takes on financial risk. Furthermore,
utilities are typically not financially compensated for the risks
..4 Back to
"II1II Table of Contents
Next Page ~Page May 12, 2003
they assume in purchasing power, as purchased power is usu-
ally recovered dollar-for-dollar as an operating expense.
As electricity deregulation has progressed in some coun-
tries, states, and regions, the line has blurred between tra-
ditional utilities, vertically integrated utilities, and merchant
energy companies, all of which are in the generation busi-
ness. A common contract that has emerged is the tolling
agreement, which gives an energy merchant company the
right to purchase power from a specific power plant. (see
Evaluating Debt Aspects of Power Tolling Agreements,
published Aug. 26, 2002!. The energy merchant, or toller,
typically responsible for procuring and delivering gas to the
plant when it wants the plant to generate power. The power
plant operator must maintain plant availability and produce
electricity at a contractual heat rate. Thus, tolling contracts
exhibit characteristics of both PPAs and leases. However
toilers are typically unregulated entities competing in a
competitive marketplace. Standard & Poor's has determined
that a 70% risk factor should be applied to the NPV of the
fixed tolling payments, reflecting its assessment of the risks
borne by the toller, which are:
Fixed payments that cover debt financing of power plant
(typically highly leveraged at about 70% I.
. Commodity price of inputs,
Energy sales (price and volume), and
Counterparty risk.
Detennining the Risk Factor for PPAs
Alternatively, most entities entering into long-term PPAs, as
an alternative to building and owning power plants. continue
to be regulated utilities. Observations over time indicate the
high likelihood of performance on TAP commitments and,
thus, the high likelihood that utilities must make fixed pay-
ments. However, Standard & Poors believes that vertically
integrated, regulated utilities are afforded greater protection
in the recovery of PPAs, compared with the recovery of fixed
tolling charges by merchant generators. There are two rea-
sons for this. First, tariffs are typically set by regulators to
recover costs. Second, most vertically integrated utilities con-
tinue to have captive customers and an obligation to serve. At
a minimum, purchased power, similar to capital costs and fuel
costs, is included in tariffs as a cost of service.
As a generic guideline for utilities with PPAs included as
an operating expense in base tariffs, Standard & Poor
believes that a 50% risk factor is appropriate for long-term
commitments (e.g. tenors greater than three years!. This risk
factor assumes adequate regulatory treatment, including
recognition of the PPA in tariffs; otherwise a higher risk factor
could be adopted to indicate greater risk of recovery,
Standard & Poor's will apply a 50% risk factor to the capacity
Standard & Poor Utilities & Perspectives
.-', -
Feature Article
. ..
PacifiCorp
Exhibit No.6 page 3 of 4
CASE NO. PAC-O5-
Witness Bruce N. Williams
component of both TAP and TOP PPAs. Where the capacity
component is not broken out separately, we will assume that
50% of the payment is the capacity payment. Furthermore,
Standard & Poors will take counterparty risk into account
when considering the risk factor. If a utility relies on any indi-
vidual seller for a material portion of its energy needs, the
risk of nondelivery will be assessed. To the extent that energy
is not delivered, the utility will be exposed to replacing this
power, potentially at market rates that could be higher than
contracted rates and potentially not recoverable in tariffs.
Standard & Poors continues to view the recovery of
purchased-power costs via a fuel-adjustment clause, as
opposed to base tariffs, as a material risk mitigant. A month-
ly or quarterly adjustment mechanism would ensure dollar-
for-dollar recovery of fixed payments without having to
receive approval from regulators for changes in fuel costs.
This is superior to base tariff treatment, where variations in
volume sales could result in under-recovery if demand is
sluggish or contracting. For utilities in supportive regulatory
jurisdictions with a precedent for timely and full cost recov-
ery of fuel and purchased-power costs, a risk factor of as low
as 30% could be used. In certain cases, Standard & Poor
may consider a lower risk factor of 10% to 20% for distribu-
tion utilities where recovery of certain costs, including
stranded assets, has been legislated. Qualifying facilities
that are blessed by overarching federal legislation may also
fall into this category. This situation would be more typical of
a utility that is transitioning from a vertically integrated to a
disaggregated distribution company. Still, it is unlikely that
Table 1
ABC Utility Co. Adjustment to Capital Structure
no portion of a PPA would be capitalized (zero risk factor!
under any circumstances.
The previous scenarios address how purchased power is
quantified for a vertically integrated utility with a bundled
tariff. However, as the industry transitions to disaggregation
and deregulation, various hybrid models have emerged. For
example, a utility can have a deregulated merchant energy
subsidiary, which buys power and off-sells it to the regulat-
ed utility. The utility in turn passes this power through to
customers via a fuel-adjustment mechanism. For the mer-
chant entity, a 10% risk factor would likely be applied to
such a TAP or tolling scheme. But for the utility, a 30% risk
factor would be used. What would be the appropriate treat-
ment here? In part, the decision would be driven by the rat-
ings methodology for the family of companies. Starting from
a consolidated perspective, Standard & Poors would use a
30% risk factor to calculate one debt equivalent on the con-
solidated balance sheet given that for the consolidated
entity the risk of recovery would ultimately be through the
utilitys tariff. However, if the merchant energy company
were deemed noncore and its rating was more a reflection
of its stand-alone creditworthiness, Standard & Poor
would impute a debt equivalent using a 70% risk factor to
its balance sheet, as well as a 30% risk-adjusted debt
equivalent to the utility. Indeed, this is how the purchases
would be reflected for both companies if there were no
ownership relationship. This example is perhaps overly
simplistic because there will be many variations on this
theme. However, Standard & Poor s will apply this logic as
Original capital structure Adjusted capital structure
Debt 1,400 1,400
Adjustment to debt 321
Preferred stock 200 200
Common equity 000 000
Total capitalization 600 100 921 100
Table 2
ABC Utility Co. Adjustment to Pretax Interest Coverage
Net income
Income taxes
120
115
300
300
115Interest expense
Pretax available
~ Back to
Table of Contents
Next Page ~Page May 12, 2003
Original pretax
interest coverage
Adjusted pretax
interest coverage
= 2.
(300+33)
(115+33)= 2.
Standard & Poor's Utilities & Perspectives
Feature Article
a starting point, and modify the analysis case-by-case, com-
mensurate with the risk to the various participants.
Adjusting Financial Ratios
Standard & Poors begins by taking the NPV of the annual
capacity payments over the life of the contract. The ratio-
nale for not capitalizing the energy component. even though
it is also a nondiscretionary fixed payment, is to equate the
comparison between utilities that buy versus build-Le.
Standard & Poor s does not capitalize utility fuel contracts.
In cases where the capacity and energy components of the
fixed payment are not specified, half of the fixed payment is
used as a proxy for the capacity payment. The discount rate
is 10%. To determine the debt equivalent, the NPV is multi-
plied by the risk factor. The resulting amount is added to a
utilitys reported debt to calculate adjusted debt. Similarly,
Standard & Poors imputes an associated interest expense
equivalent of 10%-10% of the debt equivalent is added to
reported interest expense to calculate adjusted interest cov-
erage ratios. Key ratios affected include debt as a percent-
age of total capital, funds from operations (FFO) to debt.
pretax interest coverage, and FFO interest coverage. Clearly,
the higher the risk factor, the greater the effect on adjusted
financial ratios. When analyzing forecasts, the NPV of the
PPA will typically decrease as the maturity of the contract
approaches.
Utility Company Example
To illustrate some of the financial adjustments, consider the
simple example of ABC Utility Co. buying power from XYZ
Independent Power Co. Under the terms of the contract
annual payments made by ABC Utility start at $90 million
2003 and rise 5% per year through the contract's expiration
in 2023. The NPV of these obligations over the life of the
contract discounted at 10% is $1.09 billion. In ABC's case,
Standard & Poor's chose a 30% risk factor, which when mul-
tiplied by the obligation results in $327 million. Table 1 illus-
trates the adjustment to ABC's capital structure, where the
$327 million debt equivalent is added as debt, causing
ABC's total debt to capitalization to rise to 59% from 54%
(48 plus 11). Table 2 shows that ABC's pretax interest cover-
..0IIII Back to
Table of Contents
Next Page ~Page May 12, 2003
PacifiCorp
Exhibit No.6 page 4 of 4
CASE NO. PAC-O5-
Witness Bruce N. Williams
age was 2., without adjusting for off-balance-sheet oblig-
ations, To adjust for the X'(l capacity payments, the $327
million debt adjustment is multiplied by a 10% interest rate
to arrive at about $33 million. When this amount is added to
both the numerator and the denominator, adjusted pretax
interest coverage falls to 2.3x.
Credit Implications
The credit implications of the updated criteria are that
Standard & Poor's now believes that historical risk factors
applied to TAP contracts with favorable recovery mecha-
nisms are insufficient to capture the financial risk of these
fixed obligations. Indeed, in many cases where 5% and 10%
risk factors were applied, the change in adjusted financial
ratios (from unadjusted) was negligible and had no effect on
ratings. Standard & Poor's views the high probability of
energy delivery and attendant payment warrants recognition
of a higher debt equivalent when capitalizing PPAs.
Standard & Poor s will attempt to identify utilities that are
more vulnerable to modifications in purchased-power
adjustments. Utilities can offset these financial adjustments
by recognizing purchased power as a debt equivalent, and
incorporating more common equity in their capital struc-
tures. However, Standard & Poor s is aware that utilities
have been reluctant to take this action because many regu-
lators will not recognize the necessity for, and authorize a
return on, this additional wedge of common equity.
Alternatively. regulators could authorize higher returns on
existing common equity or provide an incentive return mech-
anism for economic purchases. Notwithstanding unsupport-
ive regulators, the burden will still fall on utilities to offset
the financial risk associated with purchases by either quali-
tative or quantitative means. 8
Jeffrey Wolinsky, CFA
New York (1) 212 438-2117
Dimitri Nikas
New York (1) 212-438-7807
Anthony Flintoff
London (44) 20-7826-3874
Laurence Conheady
Melbourne (61) 3-9631-2036
Standard & Poor Utilities & Perspectives
Case No. PAC-05-
Exhibit No.
Witness: Bruce N. Williams
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
ACIFICORP
Exhibit Accompanying Direct Testimony of Bruce N. Williams
Indicative Forward PCRB Variable Rates
January 2005
Idaho Rate Case
Indicative Forward PCRB Variable Rates
For September 30, 2005
Oct-
Nov-
Dec-
J an-
F eb-
Mar-
Apr-
May-
Jun-
Jul-
Aug-
Sep-
Oct-
Nov-
Dec-
J an-
Feb-
Mar-
Apr-
May-
Jun-
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Aug-
Sep-
Oct-
Nov-
Dec-
Jan-
Feb-
Mar-
Apr-O 1
May-O 1
Jun-
Jul-
Aug-O 1
Sep-O 1
Oct-O 1
Nov-
Dec-O 1
J an-
Feb-
Mar-
Apr-
30 Day LIBOR
(a)
5.31%
24%
55%
98%
94%
94%
92%
91%
04%
5.18%
29%
5.38%
5.41%
56%
6.41%
81%
89%
05%
16%
540/0
65%
63%
62%
62%
62%
64%
69%
87%
52%
5.13%
80%
4.16%
91%
82%
64%
15%
2.48%
13%
1.95%
1.80%
85%
1.89%
86%
Floating Rate PCRBs
(b)
34%
14%
26%
80%
69%
93%
05%
24%
3.40%
98%
11%
3.49%
39%
38%
77%
27%
64%
70%
95%
90%
39%
77%
12%
53%
23%
36%
18%
03%
70%
29%
85%
3.49%
13%
74%
2.46%
50%
27%
89%
79%
69%
57%
69%
83%
PacifiCorp
Exhibit No.7 page 1 of 2
CASE NO. PAC-O5-
Witness Bruce N. Williams
PCRB / LIBOR
(b)/(a)
63%
60%
59%
56%
54%
59%
62%
66%
67%
58%
59%
65%
63%
61%
59%
56%
62%
61%
64%
75%
66%
57%
62%
68%
64%
66%
62%
52%
67%
64%
80%
84%
80%
72%
67%
79%
91%
89%
92%
94%
85%
90%
98%
PacifiCorp
Exhibit No.7 page 2 of 2
CASE NO. P AC-O5-
Witnes "3ruce N. Williams
May-84%86%101%
Jun-1.84%77%96%
Jul-1.83%1.70%93%
Aug-80%1. 7 95%
Sep-82%1.87%102%
Oct-80%02%112%
Nov-1.44%86%129%
Dec-1.42%75%123%
Jan-1.36%59%117%
Feb-34%1.61%120%
Mar-30%1.53%118%
Apr-1.31 %68%128%
May-32%72%130%
Jun-1.16%1.38%119%
Jul-1.11%12%101%
Aug-1.11%1.16%105%
Sep-1.12%1.21 %108%
Oct-1.12%1.24%111%
Nov-1.13%28%114%
Dec-1.15%32%114%
Jan-1.11%1. 1 106%
Feb-1.10%1.1 7%107%
Mar-09%20%110%
Apr-1.10%27%115%
May-1.10%22%111%
Jun-25%28%102%
Jul-1.41 %26%89%
Aug-60%37%86%
Sep-78%1.49%83%
Average 85%
Historical Floating Forecast
Forward 30 Day Rate PCRB / 30 Floating
LIBOR*Day LlBOR Rate PCRB
9/30/2005 34%85%84%
* Source: Bloomberg LP.
Case No. PAC-05-
Exhibit No.
Witness: Bruce N. Williams
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
ACIFICORP
Exhibit Accompanying Direct Testimony of Bruce N. Williams
Pro Forma Cost of Preferred Stock - September 30, 2005
January 2005
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63
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