The Changing Economic Environment

An Industry PerspectiveSociety of Utility and Regulatory

Financial Analysts42nd Financial Forum

April 29, 2010

2

Characteristics of US Capital Markets

• Large• Liquid• Sophisticated• Backed by largest and most flexible economy• Top-quality legal infrastructure

– Corporate law– Bankruptcy law

• Ownership is widely held

3

Characteristics of US Electric Utilities

• Seasoned companies and regulatory environments• Transparent business organizations• Large number of comparators• Many utilities have:

– Scale businesses– Ample research coverage– Liquid securities

4

Did Something Happen in the Last Two Years to Change These Conclusions?

• Volatility in the US and global economies• Volatility in the US and global financial markets• But utilities did fairly well on the whole

– No bankruptcy filings– Capital mostly preserved– New capital available most of the time

5

0

1

2

3

4

5

6

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

10-Y

ear

Spr

ead

ove

r T

reas

ury

(%)

A Utility BBB Utility A Corporate BBB Corporate

Lehman Bankruptcy

Utility Bond Performance

Source: Bloomberg

6

Utility Stock Performance

40

50

60

70

80

90

100

110

120

130

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

Janu

ary

2007

= 1

00

S&P 500 S&P 500 Utilities

Lehman Bankruptcy

Source: Bloomberg

7

So what is the problem?

8

The crisis itself is not the problem

9

The Problem is

• Investors have begun to realize that long-term returns for utilities are poor– Equity: returns to equity are not “fair and equitable” – Debt: credit quality has deteriorated and will continue

deteriorating

10

Utility Equity Returns Are Not Fair and Equitable

Supreme Court standards

• Bluefield Water Works v. PSC, 262 U.S. 679 (1923)

a return “equal to that generally made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties….”

• FPC v Hope Nat. Gas, 320 U.S. 591 (1944)

“It is not the theory, but the impact of the rate order, which counts.”

“By that standard, the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risk”

11

Utility Equity Returns Are Not Fair and Equitable

• How has US regulation performed relative to that standard?

– Returns are set on tangible book value, so therefore “fairness and equity” must be measured using earned returns on tangible book equity

– Five-year (2005-2009) average earned ROEs• S&P500 Utilities = 12.28% • S&P500 Industrials = 19.59% and • S&P500 average = 16.03%

12

But Lower Returns Are Fair Because Risk Is Lower

• The risk is the regulatory outcome (i.e, the taking without just compensation)

13

-1

-0.5

0

0.5

1

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Pe

rce

nt

Utility 'A' less Corporate 'A' 10-Yr Yield

But Even if Results Are Bad, Investors Haven’t Gone Away

They won’t, they simply re-price

0

1

2

3

4

5

6

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Ma

rke

t/Bo

ok

Ra

tio

Utilities S&P 500

Source: Bloomberg

14

15

No Basis for Applying Market Returns to Book Values

• Formulas are market-based – CAPM– Dividend discount model– Conclusions of other utility regulators

• As applied, current regulatory model drives the market value of utility equity to equal book value– No other common equity in the economy works this way– No basis in statute or precedent for this result– No known theoretical justification for this treatment

Fair and equitable

Market Rate X Market Value = Market Return

Book Rate X Book Value = Book Return

Current U.S.

practiceMarket Rate X Book Value = Taking

Book Rate X Market Value = Excessive Profit

16

Forcing Market to Equal Book Is Not Just Unfair and Unreasonable

• The brinksmanship of this regulatory model– Raises costs of capital in the long-term – Instills inflexibility – Encourages conservatism– Is difficult to reverse

17

Possible solutions

1. Market rate x Market valuea. UK model for utility returnsb. (Marginal return) x (rate base increased by inflator)

2. Book rate x Book valuea. (ROE from competitive businesses) x (book value of

rate base)b. (Use book values in dividend discount model) x

(book value of rate base)

18

Other Sources of Investor Discomfort with Returns

• Regulatory lag– Many jurisdictions don’t fully reflect cost of operations in

the year for which rates are set– Fixes: forward test year, trackers or true-ups

• Penalty-orientation– Many jurisdictions prefer the optics of punishment to

those of rewards– Fix: balance in incentives and penalties

• Mixed messages– Reduced equity returns for higher credit ratings– Merger economics taken as customer benefit– Reduce cash flow, then describe business as low risk

19

Debt: Average Credit Quality Has Deteriorated

Source: Utility operating company ratings as determined by S&P

5.00

5.50

6.00

6.50

7.00

7.50

8.00

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

A

A-

BBB+

BBB

20

Why should we care?

21

What Is the Problem That Returns Need to Address?

1. Utility financing needs continue2. Investors have other investment choices3. Smaller utilities are already under pressure4. Utilities face risk from increases in interest rates

and inflation5. Cost of litigation?

22

1. Utility Financing Needs Continue

• Utilities have always been capital intensive– Spend twice as much on capital as they recover in

depreciation, twice what industrials spend

• Potential for significant new needs– Customer demand – New technologies (e.g., smart grid)– Government mandates (e.g., climate objectives)

• Revenue requirement for replacement plant far exceeds the revenue requirement of what it replaces

23

Utility Free Cash Flow Forecast to be Negative

Source: Barclays Capital, June 2009Note: Free cash flow defined as operating cash flow less cap ex.

($20)

($15)

($10)

($5)

$0

$5

$10

$15

$20

$25

1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013E

Fre

e ca

sh f

low

(bi

llio

ns)

Actual Projected

24

2. Investors Have Other Investment Choices

Investors don’t have to own utilities on current terms: they can hold out for more

• Utilities are a small factor in capital markets– 8% of corporate debt issuance– 3% of equity

• Investors have demonstrated a willingness to stop funding other industries: e.g., autos, banks

25

3. Smaller Utilities Already Under Pressure

• Implication: underspend• Implication: risk averse, community averse• Implication: sell out, see 1995-2010 consolidation

1

1.2

1.4

1.6

1.8

2

2.2

2.4

2.6

2001 2002 2003 2004 2005 2006 2007 2008 2009

Ma

rke

t/B

oo

k M

ultip

les

Large Utilities Small Utilities

26

4. Utilities Face Risk from Inflation and Rising Interest Rates

• Change in direction of interest rates and inflation driven by government deficits

• Utility earned vs. allowed return has suffered in inflationary times

• Utility valuations generally lower in high inflation environments due to regulatory lag, structural underestimation of capital costs, and an aversion to sizable increases.

27

-6

-4

-2

0

2

4

6

8

10

12

1973 1977 1981 1985 1989 1993 1997 2001 2005

Ra

tes,

in P

erce

nt

Earned Return less Allowed Return Inflation (GDP Deflator)

Inflation Leads to Utility Earnings Shortfalls

Source: Barclays research, June 2009

28

In Turn, Utility Market-to-Book Faces an Inflation Threat

Source: Barclays research, June 2009

0

1

2

3

4

5

1972 1976 1980 1984 1988 1992 1996 2000 2004 2008

Ma

rke

t/B

oo

k M

ultip

le

S&P 500 Utilities