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Energy Risks: Sex, Murder, Public Utility Capital Ratios

What do you mean Public Utilities and MURDER?

By Adam James

What do all three have in common? They all carry a certain level of risk.

Let’s start with the most exciting one; capital ratios for public utilities. A capital ratio is the proportion of debt to equity that the company holds. This ratio will affect the rate of return that a utility can collect each year, and therefore, what kinds of rates are paid by consumers.

Say you are starting a public utility. First things first: you need some money. There are two kinds of money you can get. The first is debt, where investors provide you with capital and you make regular payments plus interest. The second is equity, where investors buy and hold stock in the company and recompense their investment later through dividends or capital gains.

Renting your money

The cost of capital— or what it costs to rent the money—is different in these two situations because the investor providing the capital is assuming different levels of risk by giving it to you. With debt, the investor can expect a steady stream of repayments- and if the company goes under, they get first claim to assets that can be used to recoup their investments. This means that debt is cheaper, since the lender has lower risk. Equity is more expensive, or has a “higher cost of capital,” because the lender may not get their money back and so they are banking on the success of the company.  However, an equity stake in the company enables them a level of control that is not afforded to debt investors.

So the proportion between these two kinds of financing is known as a capital ratio, and any given utility will have a capital structure that has a certain combination of debt to equity (or, more accurately, long-term debt, short-term debt, common and preferred equity). This ratio is prescribed by the state regulatory body (the public utility commission).

Why does all this matter?

Let’s take a step back for a second. Why does this matter? It has to do with how a utility makes money, and how much consumers pay on their utility bills.

A utility makes money by earning a rate of return on their rate base (which is the total of all the long-lived investments made by the company). This rate of return is determined by the public utility commission, and it determines a portion of consumer’s energy bills.

Capital ratios and Goldilocks: Not too much or too little, but just right

A company shouldn’t have 100 percent debt or 100 percent equity, the key is to have a healthy mix.

The Regulatory Assistance Project explains the importance of the mix in capital ratio’s this way:

“…the mix greatly affects the overall (weighted) rate of return… because the utility is subject to income tax on its return on equity, and gets an income tax deduction for its interest payments on debt, a higher share of equity quickly calculates to higher rates for consumers.”

In other words, when a utility’s capital ratio is tipped towards equity—consumers can see higher bills.

On the other side of the coin though, a company that takes on too much debt may see slow growth and face an increased risk of default. Capital ratios are regularly assessed by credit agencies and having the flexibility to bring on new debt or equity can increase a company’s leverage. In this sense, taking on a lot of debt compared to other companies in the industry can indicate weak financial strength, since the company may not be able to generate enough cash to satisfy debts. Therefore, investors may be concerned about putting in more money if they are concerned about getting their money back if the business fails. This is also bad for consumers.

Some lingering thoughts on utility capital ratios

There are a few interesting things about the role of capital ratios in the utility business model that I’ll throw out there.

First, since most long-term investments by utilities are big, capital intensive projects (like transmission lines or power plants) sometimes taking on a lot of debt can actually mean that the business is expanding. Using debt financing for these projects isn’t unusual. If a company has large amounts of debt, but consistently high revenues, then the high levels of debt may not matter as much. For example, if you look at any single company’s debt ratio, you can see it peak and trough.

Second, this issue makes clear the very important distinction between shareholders and ratepayers. Ratepayers to an investor-owned utility are their customers, but shareholders are who the company ultimately answers to. Low debt-to-equity ratio’s may be good for shareholders, who see higher dividends (because they are subject to fewer claims to profits from debt investors) but because of the tax issues explained above this often translates to higher rates for consumers. Also, and this is very important, a utility only profits off the portion of its ratebase financed with equity. However, taking on more debt through undertaking big capital-intensive projects can both increase the rate base and make the company a riskier financial proposition. This, too, can harm consumers who depend on the stability of the company to get access to affordable and reliable electricity. This dynamic isn’t really unusual: when consumers are charged more, the shareholders see higher profits.

Third, all this points to the question “what is the best capital ratio for a utility?” As far as I know, there isn’t one. But, it is still interesting to take a look at this list of 94 utility companies (worldwide) and see their debt to equity ratios. Most American companies land right in the middle of the pack, both compared to other countries and in terms of the actual ratio (which ranges between 0.8 and 1.2, or averaging around 50 percent debt to equity). The Regulatory Assistance Project points out Canadian utilities have higher debt ratios (65-70 percent), indicating “higher investor confidence in the certainty of utility earnings.” This enables the utility to “more easily attract bond investors and use lower-cost debt to provide a higher percentage of its total capital.” This generally translates to lower bills for consumers.

Since the rate of return is set by the public utility commission, capital ratios are an important part of how consumers’ energy bills are made. The rate of return for the utility is supposed to be sufficient to attract new investment, and usually fall around 10 percent. Remarkably, some utilities believe this is too low (hard to imagine why). In fact, it may be time to revisit some of these capital ratios and see if they are primarily benefiting shareholders or consumers.

 

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Adam James is a Research Assistant for Energy Policy at the Center for American Progress, Executive Director of the Clean Energy Leadership Institute, and a Freelance writer for Greentechmedia. You can email him at adamjames@cleanenergyleaders.org and sure oughta follow him on Twitter @adam_s_james.


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