Understanding Securitization for Electric Utilities
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As the frequency and impact of natural and manmade disasters in the grid multiplies and aggressive energy transition force retirement of fossil fuel plants, electric utilities are increasingly being saddled with additional operational costs. To make up for shortfall in their balance sheets, they are resorting to securitizations. According to experts, the pace of securitization in the utility industry is expected to increase in the coming years. That is not surprising considering the macro-economic environment.
Low interest rates have diminished borrowing costs for corporates. This development is an especially fortuitous one for electric utilities because they will have to spend heavily to accomplish a zero-carbon future. While figures for 2020 are not available, capital spending in 2019 reached all-time highs according to the Edison Electric Institute, a consortium of investor-owned utilities.
Here is a brief primer on securitization and what it means for the utility business.
What is Securitization?
Securitization is the conversion of company assets into securities that can be sold to investors for a return. The most common form of securitization involves raising debt in bond markets by converting existing assets, such as infrastructure equipment, into securities.
Thanks to innovations in financial markets, the nature of assets used as security has evolved. For example, telecom giant Verizon packaged its customer contracts into a security offering back in 2016. In the current context, securitization refers to the use of a captive customer base by electric utilities to guarantee repayments of bond offerings.
How Does Securitization Work?
There are three components to securitization. They are state legislation to authorize securitization, financing orders to recover costs from rate payers, and special purpose entities to facilitate the transaction.
In the first step, state legislation allows electric utilities to finance recovery of costs through issue of bonds. Florida, Louisiana, Mississippi, and Texas were among the initial batch of states to pass legislation for storm recovery securitization. Other states, notably California, have also joined the list.
Next, the state utility commission issues a finance order to impose non-bypassable charges on utility customers in its service territory. The order issued are generally irrevocable, meaning they cannot be cancelled or annulled.
The final step consists of creating a special purpose entity to handle finances related to the securitization. The utility deposits charges collected from customers into the SPE and bondholders collect them from the account. The configuration of this arrangement is to ensure that ratepayers are not responsible for the costs involved in securitization and do not have to pay income tax on gains or losses accruing from the bonds. The SPE is responsible for these transactions. A separate prefunded reserve account for bondholders acts as a safeguard against utility default.
Is Securitization a New Development in the Electric Utilities Industry?
Securitization originated after the power market reforms of the 1990s. Deregulation left electric utilities with “stranded assets” in the form of power plants that had become uneconomic due to regulatory changes. The earliest iteration of securitization was “rate reduction” bonds or bonds that were financed by line item charges on ratepayer bills. The interest rate on these bonds was low and they were long term bonds, meant to be repaid over durations lasting between ten to twenty years. Over the years, electric utilities have used securitization to mitigate the effect of natural disasters and hasten the energy transition by retiring plants. For example, the Florida Public Services Commission (PSC) allowed utilities to recover costs from the hurricane season in 2004 and 2005. In 2015, utilities in the state marketed bonds for “nuclear asset recovery costs”.
What Are Some Recent Examples of Securitization in the Utility Industry?
Given the prevalence of natural disasters in California in recent times, it is not surprising that electric utilities there have taken the lead in securitization. California Assembly Bill 1054 was signed into law in 2019 by Governor Gavin Newsom and allows utilities to recover wildfire costs. PG&E Corp. last year filed a proposal with CPUC to issue $7.5 billion of fire-cost mitigation recovery bonds. SCE Corp. issued $337.8 million worth of 14- year and 20-year bonds last week and has said that it may issue further bonds to bolster its infrastructure against wildfires. Ratings agency Moody’s rated the bonds AAA. The bond issue was oversubscribed by enthusiastic bond buyers who, according to Bloomberg, are used to single A ratings for corporate bonds. The utility will collect an initial recovery charge of 0.16% from customer bills.
What are the Drawbacks of Securitization?
The incentives in such transactions are skewed in favor of utilities and bondholders and against ratepayers. For utilities, there are very few drawbacks to securitization. They get access to funds at low interest rates. Corporate buyers of utility bonds are on the winning side because they are getting a dependable stream of income for an extended period of time. They are also protected in case of defaults. State governments that have passed securitization legislation have enacted special provisions barring utilities from interfering with a bondholder’s right to repayment. In other words, bondholders can force utilities to make payments by raising money from the ratepayers. In all of this, ratepayers receive the short end of the stick because the funds for repayment of bond principal plus interest come from the special charges tacked into their bills.
Third-party firms that represent customers are increasingly becoming common in financing teams. SCE’s wildfire mitigation bond issuance ran into problems last year after a judge held up the utility's proposal. He pointed out that underwriters, the people who act as middlemen and issue corporate bonds in the markets, had no incentive to lower savings for ratepayers. Part of their fee consists of the underwriting spread - the difference between the price at which a bond issue is bought and the price at which it is sold to investors. This means the higher the difference in interest rates, the more their profits. He asked for the creation of a financing team comprising stakeholders from utilities and CPUC staff and outside financial and legal experts in the pre-issuance review process.
There is also the possibility of a utility default, not due to ratepayer problems but due to natural disasters, as happened in the case of PG&E's 2018 and 2019 wildfire fiasco. Things can get ugly after that.